Taxing the digital economy

DIEGO ALEJANDRO LÓPEZ RAMÍREZ¹

SUMMARY: I. Introduction. II. Taxation Subjection Criteria. III. Base Erosion and Profit Shifting in a Digital Economy. IV. México’s 2020 Federal Tax Reform on Digital Taxation. V. Final Considerations.

Abstract. Pursuant to the OECD BEPS Action Plan Action 1 Tax Challenges Arising from Digitalization, some member states have analyzed and prepared preliminary measures to address double non-taxation or minimum taxation regarding digital service providers. With its 2020 Federal Tax Reform, México has taken its first steps to subject such transactions to taxation within its jurisdiction, but nonetheless has been careful of not undermining the principle of consensus and cooperation which is considered as the foundation of International Tax Law and bilateral tax treaties.

Keywords: International Taxation, BEPS, Digital Services, OECD.

Resumen. De conformidad con la Acción 1 del Plan de Acción BEPS de la OCDE, Desafíos fiscales derivados de la digitalización, algunos estados miembros han analizado y preparado medidas preliminares para abordar la doble no imposición o la imposición mínima con respecto a los proveedores de servicios digitales. Con su Reforma Tributaria Federal 2020, México ha dado sus primeros pasos para someter tales transacciones a tributación dentro de su jurisdicción, sin embargo, se ha cuidado de no socavar el principio de consenso y cooperación que se considera como la base del Derecho Tributario Internacional y los tratados bilaterales sobre impuestos.

Palabras clave: Fiscalidad Internacional, BEPS, Servicios Digitales, OCDE.

The rapid development of Information and Communications Technology (ICT) during the last decades, has significantly impacted many sectors of society, and has been key in many innovative advances, economic growth and development, market integration and the emergence of new business models. Nonetheless, the broad scope in which ICT’s innovate today and the speed in which they are adopted rises new challenges in policy makers, in matters of anti-money laundering, personal data protection, banking and financial regulation, local and international taxation, among others. Our use and reliance upon ICT’s has severely increased as of late in light of the COVID-19 global health pandemic. As global economies come to a standstill, companies and enterprises of all industries and sizes have made substantial efforts to continue operating as normally as possible by working from home and establishing digital means of communication. Furthermore, companies pertaining to traditional economic sectors that had not priorly adopted characteristics of a digital business model in any degree, have turned to digital or electronic platforms to promote, buy or sale goods and/or services to maintain levels of income in order to avoid bankruptcy or a generalized dismissal of current personnel.

ICT’s transcendental impact on global economies, has become a major issue for international taxation, as this digital economy phenomena applied strains to the existing legal framework, which was designed during the 1920’s and after World War II². Tax planning strategies developed and implemented by Multinational Enterprises (MNE) with the purpose of eluding a subjection criterion in high taxation jurisdictions or which shifted profits to low or no taxation jurisdictions, entailed a grave problematic to governments worldwide as they constantly have to deal with the erosion of their taxable base and an increasingly strained public budget.

It is worth mention, international tax planning developed by Multinational Enterprises (MNE) to reduce or elude taxation in some countries were, in most cases, not designed on the basis of fraud or illegal activity. On the contrary, such strategies were implemented taking in consideration contradictions or divergencies of local legislation between different jurisdictions and the absence of adequate rules of international taxation that address the activities and business models developed from ICTs. If convenient, we recommend the reader of the present paper to review material pertaining to Google’s questioning before the Public Accounts Committee of the House of Commons in the UK, which we provide a link hereunder³. Essentially, Mr. Matt Britton, Vice President for Sales and Operations at Google in Europe was questioned regarding the low amount of corporate tax paid in the UK, notwithstanding significant digital presence in the whole of the UK that resulted in a substantial economic benefit to its Irish entity. As can be noted, Google’s questioning was not based in the legality of their operation, organization or business model, but was obliged to appear before the committee for matters of morality, as so plainly stated by Ms. Margaret Hodge, who acted as the chair of the panel [view min 11:24 of video].

Regulating a digital economy for tax purposes may prove challenging, as cooperation and consensus must be had between the different stakeholders to ensure⁴: i. neutrality, in order to avoid unjustifiably benefiting or impairing digital economy businesses regarding double or non-double taxation; ii. efficiency, to ensure costs are minimized for both businesses and tax administrations; iii. certainty and simplicity in the development of tax policy; iv. effectiveness and fairness, to ensure a fair share of taxes are paid in jurisdictions were economic benefit is obtained through digital presence and value creation, as well as, minimize risk relating to tax avoidance and evasion; and v. the legal framework that regulates international taxation matters must be reasonably flexible and dynamic to keep pace with innovative business models of the digital economy.

Collection of taxes derives from the sovereign power of the State, by determining applicable characteristics, criteria and rules that identify, oblige or exempt any given person to contribute part of their wealth to the common well-being of their country. The context of such characteristics, criteria and rules have been translated to international tax law to avoid double taxation in inbound and outbound operations.

The citizenship criteria is not very common at a global scale, but becomes relevant when developing countries economically interact with developed countries that abide by such subjection standard, such is the case of Mexico and the US. Citizenship in the US derives from the XIV Amendment Section 1 to the Constitution that provides [a]ll persons born or naturalized in the United States and subject to the jurisdiction thereof, are citizens of the United States and of the State wherein they reside […].⁵ In this sense, the criteria of citizenship is in nature a criterion of belonging, not just from an economical sense but from a social and political stand point. In taxation matters, the US is among the few countries around the world that taxes it citizens’ worldwide income, regardless of their residency. In Cook Vs. Tait, 265 U.S. 47 (1924), the US Supreme Court determined that taxing a US citizen that resided in Mexico did not violate the US Constitution or international law, as such theory was justified taking in consideration that the benefits of citizenship extend far beyond its territory as the US tends to provide protection to all its citizens abroad and who also have the right to return to US territory at any time to benefit and participate in its economic system⁶.

In order to standardize tax-payers global income, both the Committee of Experts on International Cooperation in Tax Matters of the United Nations and the OECD Centre for Tax Policy and Administration elaborated Model Tax Conventions (MTC) that serve as guidelines or soft law for international bilateral tax treaties. Article 1 of the MTC provides de general criteria of subjection of persons who are resident of one or both Contracting States. The concept of persons under the MTC includes an individual, a company or any other body of persons.⁷ Article 4 of the MTC provides that the resident of a [c]ontracting State means any person who under the laws of the State, is liable to tax therein by reason of domicile, residence, place of management or any other criteria of similar nature […]. In a similar manner, article 4 of the Bilateral Tax Treaty between Mexico and the US (USMX Treaty) provides an identical definition of residency that of the MTC.⁸

Globalization allows for cross-border operations and activities to take place in a jurisdiction by natural or legal entities that are not considered as resident taxpayers by local legislation or the bilateral tax treaty, but nonetheless income derived from such activity or operations may be subject to tax under a permanent establishment (PE) criteria. Under article 5 (1) and (2) of the MTC, PE is defined as a fixed place of business through which an enterprise is wholly or partially carried on. This model provision further states that the term PE includes: i. a place of management; ii. a branch; iii. an office; iv. a factory; v. a workshop; vi. a mine, an oil or gas well, a quarry or any other place for the extraction of natural resources; and vii. a building site or construction or installation project constitutes a PE only if it lasts more than twelfth months.⁹

The source of wealth criteria, applies when a business activity and value creation that generates income is carried out by a foreign taxpayer in a jurisdiction, whereas such taxpayer does not meet the criteria of resident for tax purposes or such activity (sale of goods or the rendering of services) does not constitute a PE under local legislation or in such case, under the applicable bilateral tax treaty in force between the source and residence jurisdiction. In general terms, the withholding tax applied to transactions pertaining to a source of wealth criteria are subject to a gross rate with regards to its value without the benefit of any deduction. Nonetheless, taxes paid under such criteria may be granted relief under a bilateral tax treaty or local legislation in order to avoid double taxation in respect to the same taxpayer, income and period of time in the form of a tax credit or an exception of income in the State of residency.

Notwithstanding, sourcing rules may vary from country to country, a general consensus has been achieved regarding the concepts that may be subject to withholding tax under the source of wealth criteria, such as: i. income on immovable property; ii. income from employment; iii. dividends; iv. interests; v. royalties; vi. capital gains; vii. director’s fees, among others. Bilateral tax treaties may provide for different rates of withholding tax regarding taxable income at the source jurisdiction in order to achieve an adequate apportionment of taxable base between contracting States. Each bilateral tax treaty may also provide a unilateral benefit, awarding the taxation authority to either the source or residency jurisdiction with regards to particular items of income, such as business profits or dividends.

On the other hand, taxing Value Added Tax (VAT) in a digital economy may also prove challenging. VAT is an indirect local tax that is applied to the value of operations or economic acts carried out within the source jurisdiction. This indirect tax is usually endured by the final consumer (unless the seller’s or provider’s products or services are classified as exempt). VAT is charged as part of the transactional cost throughout the value chain and is transferred to the final consumer by a system of credit or exemption methods with regards to VAT paid and VAT collected by each link in the value chain.

Nonetheless, BEPS issues are exacerbated by the characteristics of a digital economy, as the law may subject digital services to indirect tax under a broad interpretation, but the actual problematic resides in more practical concerns, such as: i. self-assessment of taxpayers in low or minimum value transactions; ii. the current incentive structure of compliance; iii. the ability of a tax administration of identifying individual taxable transactions in high volume operations; and iv. the administrative cost of collecting such taxes in comparison to the possible value or amount of tax to be collected by the respective tax authorities. The digital economy has important repercussions regarding indirect taxation, especially in those jurisdictions that heavily rely in such taxes to address public expenditure.

The digital economy may constitute particular challenges to both direct and indirect taxation. As ICTs rapidly develop and provide for new business models that allow for increasing mobility of intangibles within the value and operational chain, more pressure is applied to current local and international rules regarding taxation subjection. In addition, appropriate characterization of specific transactions, identifying and determining value creation, the absence of a physical presence in the source jurisdiction, market segregation, taxpayer residency and allocation of assets, are some of the concerns that where specifically identified to address the taxing challenges of a digital economy in a holistic and comprehensive manner.

The absence of physical presence in the source jurisdiction and in respect to transactions carried out directly as B2C by a foreign provider, would render the measures address by other Base Erosion and Profit Shifting (BEPS) Actions ineffective as: i. transfer pricing regulations would not apply as transactions are not carried out between related parties; ii. there is no holding, subsidiary, affiliate, or PE in the jurisdiction of source, and therefore the bilateral tax treaty in force would not apply regarding residency or PE; iii. the lack of physical presence of the foreign provider would entail a high level of difficulty by the tax administration to oversee, audit and/or collect taxes from low value transactions; and iv. if the existing subjection rules do not provide a concept or term by which to legally constitute a nexus between digital enterprises and the activities carried out in the jurisdiction of source in regards to income generated, then legally that income would be taxed at the jurisdiction of residency, pursuant to article 7(1) of the MTC.

For the above purpose, and to provide a better understanding of the legal and practical implications and challenges both taxpayers and tax administrations have to address in taxing the digital economy¹⁰. Companies in the digital service streaming industry, provide members or users access to their platforms, where online content may be viewed, such as, tv or net series, news, movies, videos, lectures, podcasts, among others. As consideration for such access the user may pay a onetime fee or a periodic fee to the owner of the platform.

Ex. Company A located in the Netherlands is a subsidiary owned by a Holding Company in the Bahamas. Most of the MNE’s worldwide operations are done through Company A to the exception of financial, administrative and compliance functions carried out through the Holding Company, which is the proprietor of the MNE’s intellectual property, including trademarks and platform content. The MNE’s determined that establishing servers in the jurisdiction of Liechtenstein was appropriate in light of connectivity, weather¹¹ and a strategical central point to provide market clients in Asia, Europe and America access to platform content.

Users in Mexico may enjoy the access to the content provided by Company A by creating their own account via laptop or smartphone applications. The digital platform that operates such applications, their access and content is supported by the servers located in Liechtenstein. At this point in the example, we can deduce that there is no physical presence or location in Mexico, notwithstanding there may be a large customer base in the source jurisdiction. Mexican customers then apply payment(s) of the respective fee via debit or credit card directly to Company A. Taking in consideration the different online streaming digital platforms that currently operate in Mexico the fees charged to users or members may vary, but for the purposes of this paper will refer to a standard monthly fee of $100.00 MXN.¹²

This fee may not be subjected under a withholding tax income or valued added tax for the following considerations: i. There is no physical nexus of Company A within Mexico’s jurisdiction, and therefore income derived from fees paid by Mexican users may not be legally attributable to the jurisdiction of source under a residence or PE status criteria; ii. In addition, the income referred in subsection (a) above, may be classified as business profits rather than any other item of income subject to a withholding tax under a source of wealth criteria pursuant to local tax legislation or the bilateral tax treaty in force, specially taking in consideration that the nature of such transactions are B2C; iii. Regarding VAT, the transactions carried out under the present scenario would not be exempted from taxation under legal considerations, as under article 1 Value Added Tax Law (VATL) the rendering of services are to be taxed at a 16% rate (to the exception of certain class of services) and article 14 (I) & (VI) VATL provides that services are to be understood as any obligation to give, do or not due in favor of a person, notwithstanding the act of origin or the name or classification given by other bodies of law, as long as, it is not considered a transmission of property.

Despite a clear interpretation by which digital services are to be subjected to VAT in Mexico, such transactions were rarely imposed upon, for practical considerations. If we consider that the monthly service fee is equivalent to USD $4.46, collecting VAT for such transactions could be considered inviable as: i. Company A is not located in Mexico and has no physical presence, enforcing the entity’s formal and substantive obligations under Mexican tax legislation would be a difficult and costly procedure for high volume low value transactions; ii. if the obligation was transferred to the consumer, the incentive structure for compliance would not be adequate as self-assessment of such tax obligation would outweigh the substantive value of the tax (USD ¢ 0.71 a month or an annual USD $8.56); iii. following this scenario, the cost the tax administration would incur to individually collect USD $8.56 from a significant number of local consumers would be considerably greater than tax collected (audit, administrative and/or jurisdictional procedures); and iv. the payment structure provided by such service providers do not allow for the consumer to withhold any tax, leaving the burden to the latter. The examples provided above, elaborate on a limited number of risks and challenges that tax administrations may encounter when addressing tax policy in respect to a digital economy. In summary, the Final Report of Action 1 of the OECD BEPS Action Plan analyzed the substantive and administrative challenges to be address as follows:

1.- Substantive Challenges

Nexus. The reduced need for an extensive physical presence of digital business models in the market of source and the increasing network effects¹³ generated by clients, may suggest that the current legal framework is not appropriate.¹⁴

Data. The manner in which to attribute value created regarding the use and collection of information that is analyzed to generate valuable data that may be applied in products and services, as well as the characterization of such transactions.¹⁵

Characterization. Characterization of payments made in the context of new business models deriving from de development of new digital products, (payment per services, royalties, goods, cloud storage, interests, etc.).¹⁶

2.- Administrative Challenges¹⁷

Identification. The identification of remote sellers or service providers may prove challenging, which also raises issued regarding transaction identification, volume and value determination and therefore compliance with domestic tax legislation.

Determination of Extent Activities. The lack of accounting records and other supporting documentation may present a challenge in determining the extent of transactions carried out within the market jurisdiction.

Information Collection and Verification. Tax authorities that intend on verifying information provided by a foreign entity with no physical presence in the market jurisdiction will have to rely on the reciprocity of the tax administration in the residency jurisdiction, which may or not exist.

Identification of Customers. Even if the identification of customers may be possible through various means, such as Ip tracking, it may also prove burdensome for both businesses and tax administrations in high volume operations, and which may render fruitless as customers are able to disguise their location through the use of certain software (VPN may be an example).

3.- OECD’s Approach to Digital Economy Taxation

In order to address the challenges identified by the Final Report on Action 1, the OECD’s Task Force on the Digital Economy (TFDE), received and discussed various proposals, such as the modification of PE status regulation, establishing a withholding tax on digital transactions and/or the introduction of a bandwidth levy for the use of local telecommunications infrastructure. In general terms, the main problematic resides in establishing a physical nexus that may subject income or profits in the market jurisdiction, which also entails the assessment of value creation, apportionment of taxable revenue between jurisdictions and the lack or limited access of information regarding operations deriving from such business models. In order to address such issues in a holistic manner, the Final Report on Action 1 proposed the creation of a significant digital presence concept as a new and additional criteria of taxation subjection. A nexus criteria base on the concept of significant digital presence will have to foresee factors that determine a taxable presence in a jurisdiction where a none resident taxpayer perceives income from a remote location, as well as, standards by which to determine the apportionment of adequate taxes between the source and residency jurisdiction.

1. Significant Digital Presence Determination Factors

Revenue-based factor. Revenue generated in the source or market jurisdiction may be considered as a potential factor to establish significant digital presence, as long as, such revenue is sustained during a determinable period of time, which would exclude segregated or sporadic transactions. This factor may constitute a base determinant but may have to be complemented with other factors to adequately identify and subject revenue of foreign digital goods or service providers to taxation in the source jurisdiction. Revenue generated by market customers via digital platforms would be a suitable indicator to significant digital presence, as transactions are executed by the use of automated contracting mechanisms with no physical presence in the source jurisdiction. Nonetheless tax administrations would have to establish a high enough level of threshold regarding gross revenues in absolute terms and in local currency in order to avoid manipulation risks and excessive compliance burdens on both the enterprise and the tax administration.

Digital Factor. Several circumstances such as customer service, connectivity, local marketing strategies via online website (language, customs and general manner of contracting) may be adopted in order to penetrate and expand customer base in the source or market jurisdiction. The use of local domain name, local digital platforms and local payment options are also factors that may allow tax administrations to determine that a foreign enterprise has a significant digital presence within its jurisdiction.

User-Based Factor. Digital business models may rely on a recurring customer base who are local residents of the source jurisdiction. To determine such factor the OECD’s Final Report on Action 1 proposed the concept of monthly active users to determine in a thirty-day period the size and level of customer engagement. This metric or factor would have to be carefully applied as figures may be manipulated or unreliable (users with more than one account; dormant user accounts; false, inaccurate or outdated information provided by users, bot data, among others). Online contracting and data collected may also be elements that provide evidence of this factor, as digital goods and service providers generally conclude contracts by means of their digital platforms and on the other hand, the levels of data collected may be significant enough to entail a high value asset for foreign digital enterprises, under certain considerations, such as data collected for statistical purposes regarding environmental protection or health, which do not have a purpose of speculating, but rather to determine international public policy.

These factors may be applied jointly or separately, taking in consideration tax policy and the special circumstances of the source jurisdiction. Many digital business models that interact in the market jurisdiction economy have regular interaction with local customers, which combined with the revenue and digital factors may provide evidence of a sustained and purposeful participation in the source jurisdiction. A combined approach of the factors described above may provide a comprehensive significant digital presence concept that lowers the possibility or risk of manipulation, elusion and/or divergence with other similar or traditional business models, that may unfairly benefit or burden certain taxpayers.

2. Taxation Alternatives of Digital Business Models

Once a significant digital presence criterion has been established to determine which foreign enterprises and digital economic activities are to be subjected to taxation in the source jurisdiction, the manner and level of taxation has to be determined. Fractional apportionment and deemed profit methods have been proposed to determine the amount of taxable income that is to be attributed between the source jurisdiction and the residency jurisdiction. The application of this methods would be collected via a withholding tax or the introduction of an equalization levy.

As the significant digital presence criteria and these taxation alternatives significantly diverge from current subjection and apportionment rules, tax administrations and legislators would have to consider which transactions are applicable, an appropriate manner to calculate the taxable base, and the rate or level of such taxation. The introduction of a deemed profit system or the introduction of a levy on digital business models would have to evaluate an adequate margin or tax rate as to avoid excessively burdening such transactions, as they do not take in consideration in a case to case basis, investments on labor and capital or operational expenses undertaken by the foreign digital enterprise to provide goods and services. Pillar One of the Program of Work developed by the OECD aims to provide alternatives to allocate among countries taxing rights on income generated from cross boarder digital activities such as, user participation proposal, marketing intangibles proposal and the significant digital presence proposal.¹⁸

Other issues that would have to be addressed in order to effectively apply the proposals aforementioned, would be but not limited to: i. the modification of current tax credit rules, as equalization levies may not be applied against income or corporate tax in the jurisdiction of the foreign digital enterprise; ii. identification of responsible entity, intermediary or taxpayer regarding application of withholding tax in B2C transactions; iii. the establishment of objective criteria and methods by which to determine the economic status of the digital service enterprise, hence its capacity to pay taxes not just in the source jurisdiction but in the residency jurisdiction, in order to safeguard the proportionality of taxes paid in respect to the same income within a determinate period of time.

According to the OECD Interim Report on Tax Challenges Arising from the Digital Economy, Mexico had not implemented the recommendations provided by the Final Report on Action 1 as of 2018.¹⁹ As an active member of the G20, Mexico adopted diverse BEPS measures within its internal legal framework to comply with the commitments undertaken since 2014, in respect to transfer pricing, hybrid mismatches and transparency. Recently under the Federal Tax Reform in force as of January 1^st, 2020 (the Reform), Mexico has complemented its BEPS regulation relating to transparent tax vehicles and entities, anti-elusion clause, limitation on financial interest payment deductions between related parties and taxation of digital services.

It is worth mention that the Reform does not directly subject foreign digital service providers to income tax but rather subjects local taxpayers to income derived from specific digital services, as described hereunder. This approach is most likely to have been taken as a partial measure to avoid tax competition, negative market disruption and/or avoiding disputes in relation to international bilateral tax treaties in force. Moreover, the Reform does not provide for a special or individualized tax on digital services, as they are subject to taxation under the ITL and VATL, which may avoid ring fencing enterprises of the digital economy and unjustifiably benefiting or burdening the participants of such transactions.

1.- Income Tax

Article 113-A of the ITL provides that any natural person that pursues a business activity by transferring goods or rendering services by means of the internet, software applications, technological platforms and other of similar nature (as referred by article 18-B section II of VATL) will be subject to tax, regarding income generated by such means and for the activities aforementioned, including any additional payments perceived in such regard²⁰. Income tax that becomes due in light of the aforementioned activities will be paid by applying a withholding tax, which will be collected and paid by the legal entity or any individual person that are tax residents in Mexico or by a foreign resident taxpayer, with or without a PE, that directly or indirectly provide the use of their digital platform.

Pursuant to article 18-B section II VATL, digital services will be considered as those intermediated between third parties that offer goods or services and those that demand such. Moreover, article 16 third paragraph VATL provides that digital services are deemed to be rendered in Mexico by a foreign resident, when the receptor of such service is located in Mexican territory. It is worth mention that the criteria provided by article 16 VATL does not provide a basis for a significant digital presence criterion, as VAT is a local tax that is applicable to the value of transactions carried out in the source jurisdiction, notwithstanding the nature or residence of the payer and/or the receptor pursuant to article 18-E VATL.

As can be deduced from article 113-A ITL, only natural persons will be subject to tax under a digital business model regime and not for example a foreign corporation. In this manner, a digital service rendered to a local or foreign corporation will not be subject to an income withholding tax. Furthermore, these provisions only subject the income generated by the offeror of goods and services and not the proprietor of the digital platform, as the latter may not hold a PE or a physical nexus in Mexican territory. The modifications of PE regulation in Mexico was limited to considering that an MNE has a PE in the country, if it pursues commercial activities by a dependent party (natural person or legal entity) and/or in such case, avoid the fragmentation of its activities to take advantage of exceptions provided to preparatory or auxiliary activities, without including a relevant digital presence criterion.

The foregoing entails that foreign companies that provide services through digital platforms, which lack a PE or a related party subsidiary in Mexico, may still be legally able to elude income tax, making the examples of sections III above plausible. Although the first paragraph of article 133-A ITL may seem to subject a wide variety of digital services, the third paragraph of the referred legal provision limits the scope of transactions subject to a withholding tax, which are described as follows:

Under this structure local residents that provide goods and services by means of third-party digital platforms will have to bear the income tax, but formal obligations such as declaring such income, withholding and paying the respective tax in a monthly basis (provisional income tax payments) are transferred to the proprietors of digital platforms. Furthermore, local residents that perceive income from the activities described above may consider income tax paid as definitive, as long as, the annual amount of income perceived does not exceed $300,000.00 MXN, instead of applying a progressive tax rate up to 35% in accordance to article 106 ITL.

The incentive provided to local residents is optional and conditioned to not exceeding the established threshold and the compliance of certain formal obligations, such as being inscribed in the federal taxpayer registry, keeping invoice records and issue invoices to users for goods or services provided and provide notice to the federal tax administration of adhering to the incentive. Local taxpayers will have to analyze if the option to consider withheld tax as a definitive payment, without deducting related expenses, will be financially beneficial, as opposed to deducting their operational expenses and calculating their taxable base at the annual ordinary tax rate.

The Reform applies a policy structure that may prove effective with regards to raising tax revenue from the intermediation of digital services, as a lower income tax rate may encourage local residents to comply with their substantive and formal obligations. Moreover, the obligations provided to digital service providers, allows the inclusion of goods and service providers into the formal economy without excessive burdens to local taxpayers. This approach also prevents significantly diverging from current international tax rules that could potentially create disputes between the source and residency jurisdiction in respect to the attribution of income tax in cross boarder operations.

2.- Value Added Tax

As previously mentioned, under a broad interpretation of articles 1 section II and 14 VATL, digital service transactions could have been subjected to indirect taxation, but in light of challenges described in the immediately preceding section (IV), the Mexican Federal Government established a special tax regime for particular digital activities. Pursuant to articles 16 and 18-B of VATL, foreign residents without a PE in Mexico, that provide services through digital platforms or through the internet or any other network, which are fundamentally automated and may or may not require minimal human intervention and consideration is paid for such services.

The following activities will be subject to VAT as described hereunder: Downloading and accessing images, movies, texts, information, videos, audio, music, games, including games of chance, as well as other multimedia content, multiplayer environments, mobile ringtones, online news, traffic information, weather forecasts and statistics, to the exception of the downloading or access of books, newspapers and online magazines. Those of intermediation between third parties that are bidders of goods or services and those who demand such goods and services, to the exception of the transfer or sale of used goods. Persons who priorly purchase goods and then sell them after use are exempted from paying VAT under article 9 VALT, unless such sell is done by an enterprise. Online clubs and dating apps and distance learning or testing or exercises.

Pursuant to articles 16 and 18-C VATL, digital services will be considered to be rendered in Mexico, when the receptor provides a local address or telephone number, provides payment through an intermediary located within Mexican jurisdiction or the Ip of the electronic device corresponds to the range of addresses assigned to Mexico. The Federal Tax Administration will have to carefully filter such information, as it may be intentionally or unintentionally altered or unreliable, for example in the case a foreign taxpayer buys a laptop in Mexico but uses it in his or her country of residence. In order to address the indirect taxation of bundled digital services, article 18-H VATL, provides that the VAT at a 16% will only be applicable to the services described in the above paragraph, as long as, the other services are expressly and separately identified in the respective invoice and where charged at the value in which they could be acquired if purchased individually. Otherwise, if such separation is not made, it will be considered that the services rendered pursuant to article 18-B VATL represents 70% of consideration and will be subject to VAT accordingly.

In a similar manner to the ITL, the special VAT regime for digital services provides a tax incentive to natural persons that perceive income up to MXN$300,000.00 from digital platforms belonging to third parties abroad, and as long as they do not perceive additional income from other sources to the exception of salaries or the transfer of immovable property. The incentive of VAT for digital services consist of a reduced tax rate of 8%, may it be charged directly by the local taxpayer or the foreign digital platform, as long as the formal obligations described in the following section are complied with. If local taxpayers choose to adhere to the tax incentive aforementioned, they will be precluded from crediting VAT paid from investments or expenses incurred in their economic activities, for which they will have to analyze if such option is financially beneficial.

Although the Reform on VAT regulation aims to subject foreign digital service providers to indirect taxation in Mexico, article 1-A VATL, provides that resident taxpayers that provide digital services as referred by article 18-B to local clients, who act as intermediaries to third party activities subject to VAT, in addition to their ordinary obligations will be obliged to perform the obligations set forth by article 18-J (formal obligations as described in the following subsection). The second paragraph of article 1-A VATL further states that legal entities and natural persons that carry out activities subject to VAT by means of a resident intermediary as described above, must abide by articles 18-K (offer services identifying the amount corresponding to VAT), 18-L (tax incentive) and 18-M (tax incentive), respectively. Holding local and foreign residents to the same obligational standard under VATL, may allow; (a) avoid unjustified differentiated treatment between taxpayers that carry out identical or similar activities, (b) allow local taxpayers that use digital platforms to carry out an economic activity to access tax incentives provided by the new digital service tax regime, and (c) include a wider range of local taxpayers into the formal economy.

3.- Administrative Measures

In order to enforce this new and special digital service tax regime, the Mexican authorities provided formal obligations upon foreign residents that participate in Mexico’s digital economy, as well as local taxpayers that make use of digital platforms. Article 113-C ITL provides that foreign legal entities (transparent or not) and natural persons with or without PE status, will have the following obligations: i.- comply with the obligations set forth in articles 18-D sections I, VI and VII and 18-J section II subsection (d) of VATL, which will be referred to further on; ii. Provide invoices to taxpayers that were subject to a withholding tax, which specifies the amount paid and tax withheld, in addition to any other information requested by the federal tax authority, within the first 5 days of the following month in which withholding took place; iii. Provide the federal tax authority the information referred to by article 18-J section III VATL; iv. withhold and pay to the federal tax administration the income tax referred in article 113-A ITL, by a tax statement that must be filed on the 17^th of the following month. If local taxpayers fail to provide the foreign taxpayer their federal tax ID, the withholding tax will be of 20% over the value of the transaction; and v. Preserver accounting records that attest to income taxes withheld and paid in the terms provided.

Regarding foreign residents that participate in Mexico’s digital economy by allowing local residents the use of their digital platform they will be subject to comply with the following obligations under article 18-D VATL: i. register before the Federal Taxpayer Registry within the following 30 days in which they began rendering digital services; ii. jointly offer and collect, the purchase price and VAT in an express and separate manner; iii. provide the federal tax authority information pertaining to the number of monthly services or transactions executed with local residents, classifying the nature of the service or transaction, their price, the number of clients, as well as, keeping the respective records; iv. calculate the respective VAT each month at a 16% tax rate, considering the value of consideration effectively perceived for each operation and provide payment of the resulting tax on the 17^th of the following month; v. issue and deliver electronically, invoices to clients for the corresponding payment of consideration, expressly and separately identifying, such concept and the respective tax, when requested by the recipients of the goods or services. Such invoices are required to identify both the service provider and the recipient; vi. Designate before the federal tax administration a legal representative and a local address to receive notices and comply with the tax obligations set forth under tax legislation for such activities, at the moment of inscription before the Federal Taxpayer Registry; and vii. Process their advanced electronic signature, in accordance to article 19-A of the Federal Tax Code.

In addition to the formal obligations provided by article 18-D VATL foreign service providers will also have to comply with the following obligations under article 18-J: i. publish on their website, application, platform or any other similar means, expressly and separately, the VAT corresponding to the price at which the goods or services are offered by the sellers, service providers or grantors of use or temporary enjoyment of assets (the platform users), in which they operate as intermediaries; ii. when payment is perceived for the activities aforementioned in subsection i. above, they must withhold from platform users 8% of VAT; iii. register before the Federal Taxpayer Registry as withholding taxpayer; iv. collect from platform users, the following information, even if they do not directly collect the corresponding fee or purchase price and did not withhold taxes; name or corporate denomination, taxpayer ID, unique population ID, tax address, financial institution and interbank wire transfer code, value of operations carried out within monthly periods; and v. pertaining to accommodation services, the address of the property, among others.

Regarding platform users, they have the obligation to provide their information to the foreign digital service provider, for which failure to do so will preclude them from participating in the tax incentives provided by articles 18-L and 18-M VATL and will be subject to a 20% income withholding tax. Platform users will also have the obligation of being registered before the Federal Taxpayer Registry, keep records of invoices issued to them, issue invoices to the foreign digital service provider or the client in such case, file notice of tax incentive option and abstain from crediting VAT paid for expenses or investments pertaining to their activity in such case they adhere to the tax incentive previously described.

It will also be important to review such policy structure when dealing with high volume low value transactions in which platform users interact, as the economic sanctions may heavily out way the value of taxes not filed and criminal sanctions that may be imposed to platform users in the form of prison, may be considered disproportionate under the same assumption. During the initial drafting of the Reform, it was proposed that non-complying foreign digital service providers be sanctioned by blocking their webpage, platform or digital application to preclude its use in Mexican territory, but was not included in the final version. However, within a short period of time the Mexican Government has experienced fruits from the application of this new digital taxation regime, as some important MNEs such as Uber, Microsoft and Netflix have already began complying with such obligations. On July 9^th, 2020, the federal tax administration published in the Federal Official Gazette a list of foreign service providers that registered before the Federal Tax Payer Registry in accordance to article 18-D VALT.²²

According to the OECD the fiscal impact and cost regarding MNE’s tax avoidance ranged from USD$ 100 to $240 billion (equivalent to 4% - 10% of corporate tax) worldwide.²³ Since the BEPS Action Plan was set in motion 135 countries around the globe have adopted recommended measures²⁴ and have seen certain success in doing so. Regarding digital taxation, countries that have in some form implemented the recommendations of Action 1 have raised significant revenue from cross boarder B2C supply of digital services and intangibles, such as Australia (AUD 269 million, first year), European Unión (EUR 10.2 billion, first three years ), New Zealand (NZD 131 million, from April 2017 – March 2018), Norway (NOK 5.8 billion, from July 2011 – 2018) and South Africa (ZAR 3 billion, from June 2014 – February 2019).²⁵

One of the most important challenges in a digital economy is the allocation, distribution or apportionment of wealth created from digital services in developing countries that do not participate from revenue generated in their jurisdiction. Establishing a new subjection criteria or nexus that allows developing and developed countries to share the taxable base of a digital economy is subject to the consensus and understanding that can be achieved. The biggest tech and digital enterprises are born in developed countries, such as the US, China, Japan and South Korea, so these countries will have to renounce part of the taxable resources deriving from digital services in favor of developing countries. This matter is of such importance that the United Nations, is also working alongside countries and the OECD to find more equitable rules that benefit both developed and developing countries, so they may share the revenue a digital economy represents and will meet on October 21^st, 2020 to address international cooperation matters.²⁶

Nonetheless, negative economic effects deriving from the COVID-19 pandemic have impacted the world’s economies to a significant degree, and therefore developed countries may not be currently inclined to agree on new apportionment rules with developing countries, in order to off-set revenue losses due to the current financial situation of most industries pertaining to their national economy.

AMENDMENTS TO THE CONSTITUTION OF THE UNITED STATES OF AMERICA, Authenticated U.S. Government Information, GPO, https://www.govinfo.gov/content/pkg/GPO-CONAN-1992/pdf/GPO-CONAN-1992-7.pdf.

DOERNBERG, Richard L., International Taxation, In a Nutshell, 10th Edition, Wes Academic Publishing, 2016.

ERNST & YOUNG (EY), World Wide Corporate Tax Guide, 2019 p.656, downloadable at https://www.ey.com/en_gl/tax-guides/worldwide-corporate-tax-guide-2019.

FEDERAL OFFICIAL GAZZETTE (DOF). Official Communication 700-04-02-00-00-2020-78 through which the list of Digital Service Providers Registered in the Federal Taxpayer Registry is disclosed, in terms of article 18-D, section I of the Value Added Tax Law, June 19^th, 2020, https://www.dof.gob.mx/nota_detalle.php?codigo=5596447&fecha=09/07/2020

FEDERAL OFFICIAL GAZETTE (Mexico), Treaty between the Government of the United Mexican States and the Government of the United States of America to avoid double taxation and prevent tax evasion regarding Income Tax, http://dof.gob.mx/nota_detalle.php?codigo=4666376&fecha=03/02/1994.

ISENBERG, Joseph, International Taxation, Third Edition, Foundation Press, 2010

OECD (2015), Addressing the Tax Challenges of the Digital Economy, Action 1 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project OECD Publishing, Paris.

OECD, Action 11 BEPS Data Analysis, https://www.oecd.org/tax/beps/beps-actions/action11/, 2019.

OECD, International collaboration to end tax avoidance, https://www.oecd.org/tax/beps/, 2019.

OECD, OECD/G20 Inclusive Framework on BEPS, Progress Report July 2018 – May 2019.

OECD (2017), Model Tax Convention on Income and on Capital: Condensed Version 2017, OECD Publishing http://dx.doi.org/10.1787/mtc_cond-2017-en

OECD (2019), Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalization of the Economy, OECD/G20 Inclusive Framework on BEPS, OECD, Paris, ww.oecd.org/tax/beps/programme-of-work-to-develop-aconsensus-solution-to-the-tax-challenges-arising-from-the-digitalisation-of-the-economy.htm.

OECD, Taxation and Electronic Commerce, Implementing the Ottawa Taxation Framework Conditions, OECD Publication Service, 2001.

OECD (2018), Tax Challenges Arising from Digitalization – Interim Report 2018: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264293083-en.