When the world is transforming gradually into a digital economy, disregarding the brick-and-Mortar presence, with the physical assets rapidly moving to digital ones, it is the time when a developing country like Pakistan should start reevaluating the existing taxation laws by taxing the digital economy in the form of imposing Digital Service Tax [DST]. The current tax laws have failed to accommodate this huge change. As a consequence, the profit-shifting from Pakistan to low or no tax jurisdiction is taking place at a large scale. So to have a fair share of tax, Pakistan needs to take some firefighting measures. The scope of DST would be to charge tax on digital business activities, including the virtual commodities in the form of digital goods like software, website developments, application creation and digital assets, including the digital services like online advertisements or digital consumer analysis. The companies that would be tapped under the DST would mainly be the social media companies, online platforms or marketplaces and the content providers.
The concept of DST is different from the Value Added Tax [VAT] as the former is charged directly to the companies and the latter is charged to the consumers. Although there is a chance that these companies might try to pass on the burden to the consumers when DST is levied, still their income generation can be monitored if brought to the tax net by making some required amendments in tax laws. This tax is also known as French Digital Tax as France was the first country to impose this DST, while France term it as GAFA tax, an acronym which targets Google, Amazon, Facebook and Apple. The French authorities clarified that they intend to tax such big players not limited to these groups only, the under the tax which is applicable from January 1, 2019. The legislators in Pakistan should consider that where digital era is providing more opportunities for businesses, simultaneously, it has identified loopholes in our prevailing tax system which needs to be immediately fixed.
The scope of DST would be to charge tax on digital business activities
To understand the DST better, we should ponder upon the current taxation system. There are two ways under which the countries establish their rights of taxation– source-based taxation and residence-based taxation. Source-based taxation means that a country shall tax a person when the income has been generated in that country. Whereas residence-based taxation means that if a person is a resident of a country, based on the principles laid down in domestic law, that person shall be liable to pay tax on his worldwide income in that country. Meaning thereby, that if a person is not resident than only he shall be liable to discharge tax to the extent of income sourced in that country. The Organisation of Economic Co-operation and Development [OECD] has explicitly mentioned whether and when an income would be taxed on source-based or residence-based in its Model Tax Conventions. Now, for companies which are conducting business in a country but do not pass the residence criterion than it is difficult to identify its presence and to tax it right away. This led to the giving the concept of Permanent Establishment (PE), which means if a PE is identified in a country than its world-wide income would not be subject to tax in that jurisdiction rather the profits will be taxed to the extent of that generated in the country where PE is established.
However, the problem with existing PE criteria is that it generally states the rules based on the physical presence, which are not effective when we talk about companies running their business digitally with little or no physical presence. No rules are there to tax them due to which their income remains untaxed in the country in which they generate income. The existing corporate tax rate in Pakistan for companies or PE is of 29 per cent of the taxable income, which means Pakistan is losing its significant tax revenue by not imposing a tax on this sector. For digital economy, there is a need that PE criteria should consider where the sales are being generated or in other words where the consumers or users are located.
Undoubtedly, the need of the time is to tax those who are earning billions from Pakistan at the name of bringing foreign direct investment. The money that is being repatriated outside Pakistan in the form of passive income is far more than the quantum of investment inflicting damage on the national kitty. These global tech companies who are not interested in setting up their businesses in Pakistan are severely affecting our domestic tech industries by eating up the local advertisements, promoting the international brands and taking all their money back without a penny being taxed domestically. The clear difference should be there in those who are setting up their business in Pakistan and those who are not by former being incentivized.
Pakistan, in an attempt to tax these offshore digital services being provided by non-residents, introduced a provision vide Finance Act, 2018, whereby digital services such as online advertising, online marketplace, online data collection and processing, online content and data provision etc. were brought to tax at the rate of five per cent of the gross amount being a final tax on the income of the non-resident recipient. The amounts being paid to the non-residents are subject to withholding on the same rate, to be done by every banking company or a financial institution remitting outside Pakistan on behalf of any resident or a PE of a non-resident in Pakistan and such person falls under the list of the prescribed person as mentioned under sub-section 8 of section 152 of the Income Tax Ordinance, 2001 [the Ordinance].
This introduction by legislators would not have anticipated the limitations that would come along with it. Firstly, the non-residents are still getting what they used to get, which means, the tax is being paid by the local persons obtaining their services by way of reverse charge mechanism, thus, the tax being received by national exchequer is the inflated cost for the taxpayers in Pakistan without these non-residents being charged for it. Secondly, the tax introduced is collected when a withholding tax agent makes a payment, what if the persons other than the prescribed persons make a payment then that Pakistan source income of these non-residents would remain untaxed in Pakistan. Thirdly, a PE is supposed to file its return of income in Pakistan being a foreign company, however, we are not aware of the actual incomes being generated by these non-residents giants from Pakistan as presently there is no direct provision mandating these non-resident digital companies to file their return of income in Pakistan although non-residents generating Pakistan source income are indirectly liable to file their return of income even if they are not PE. Fourthly, it has also been observed that the taxpayers who are making payments are obtaining exemption on payment to these companies under subsection 5 of section 152 of the Ordinance, giving an argument that the payments being made fall under Article 7 of the Double Tax Treaty [DTT] which means the income being generated is the Income from Business and since no PE is there in Pakistan under Article 5 of DTT so no tax would be charged in Pakistan. Whereas, it is being ignored that it shall fall into domestic law taxation of fee for offshore digital services through the article dealing with other income of DTT. Lastly, this introduction disregarded a thing that a corporate tax rate of 29 per cent can never be a replacement for this nominal rate.
Owing to the above, there is a need that Pakistan should follow the footprints of the countries by imposing DST unilaterally as an interim measure till the OECD comes up with a unified approach solution which although is expected to come by the end of 2020 but seems difficult as it requires consensus of many countries. Presently, France, United Kingdom, Turkey, Italy, Austria and Hungary have imposed DST. Whereas, many others have either officially announced or have shown their intention to implement this tax. The tax rates range between two per cent in the UK to 7.5 per cent in Turkey and Hungary. However, the major difference between the tax as introduced by Pakistan and these countries is that these countries take into account global turnover and domestic turnover of the digital giants, due to which no income would escape from being taxed locally. For instance, France, being a leader in imposing the DST, would charge this tax to any international group having a global turnover of €750 million ($835 million) and €25million ($27.8 million) in a year.
In the light of the above discussion, the legislation must be done on a priority basis to insert provisions in the law for DST subject to turnover thresholds. The tax liability required to be discharged shall be at par with the standard rate which European Countries are levying and the domestic tax laws of Pakistan i-e; higher of a minimum tax rate of three per cent of gross income or 29 per cent of the taxable income, to the extent of income generated in Pakistan. These digital companies must also be compulsorily required to file their annual return of income in Pakistan so that the compliance can be monitored. This change will help Pakistan in creating additional tax revenues to national treasury by bringing social media networks, search engines and other similar portals on board. The potential retaliation from these giant companies must also be ignored considering it is in our national interests to bring them to tax net and without a doubt, no country can forgo its legitimate tax which is being generated from income derived in its jurisdiction.
The writer is a tax expert, researcher and corporate trainer. He has studied International Taxation from the Chartered Institute of Taxation in the UK and is also a member of the Institute of Chartered Accountant of Pakistan (ICAP). He can be reached at [email protected].