The challenges of taxing the digital economy
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The challenges of taxing the digital economy

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Bruno Fajersztajn and Ramon Tomazela Santos of Mariz de Oliveira e Siqueira Campos Advogados look at how Brazil has embraced the growing digitalisation of its economy and assess the unique challenges that lay ahead.

It is a truism to say that the digital economy has imposed new challenges on tax policymakers. This is the case in relation to the application of tax rules designed for brick-and-mortar activities to new disruptive business models, but also with regard to the effective enforcement of such tax rules against companies that do not have a physical presence within the country. These threats to national tax systems derive from the absence of physical presence, the strong dependence on intangible assets, the complex nature of the transactions carried out in the digital economy, and the difficulty of qualifying assets, activities and types of income.

This article will examine the challenges created by the digital economy from the perspective of the Brazilian tax system. To this end, this article will initially cover the economic justifications and constraints on the taxation of the digital economy. Then, it will briefly examine the path followed by Brazil, whose tax system is characterised by the high degree of rigidity derived from the wide range of tax rules set forth at the constitutional level.

Changing the taxation of the digital economy

In general, countries that have adopted new tax measures to tax the digital economy seek a larger allocation of taxing rights to the source state, in which the consumer market is located. They argue that the allocation of taxing rights should reflect the present stage of economic development, in which multinational companies develop their business without a physical presence.

In addition, the adoption of measures to tax the digital economy would serve to reduce the competitive advantages of companies operating in the digital economy. These large technology companies allegedly face a lower tax burden than their competitors in the traditional economy, which has led to a scenario that distorts competition and increases the economic power of digital giants.

The taxation of the digital economy would also prevent an increase in the tax burden levied on less volatile elements, such as labour income.

Finally, countries claim that the exponential increase of the digital economy and the digitalisation of the traditional economy require the adoption of new tax rules, given the growing gap between the economic reality and tax systems, which did not follow the development of new business models.

Constraints and tax policy guidelines on unilateral tax measures

From a legal standpoint, the only actual constraint on the introduction of unilateral tax measures lies in the obligation to comply with international commitments, such as tax treaties and trade agreements. However, in practice, several unilateral tax measures have been adopted at the margins of international commitments because of the lengthy and bureaucratic procedure required for the renegotiation of international agreements.

One important aspect to be considered upon the introduction of new tax measures is to avoid segregation between digital and non-digital activities. In the 2015 BEPS Action 1 Report, the OECD highlighted that the digital economy is not at the margins of some real or physical economy, because the whole economy is becoming digital to a certain extent. Several companies are increasingly engaged both in the digital and physical world, so that ring-fencing the digital economy would lead to debates related to unequal treatment and enormous practical difficulties.

The temporary nature of new unilateral tax measures is another aspect frequently highlighted from an international standpoint because such rules should only be effective until countries reach a comprehensive and multilateral solution. For this reason, such new tax measures should not give rise to high compliance or administrative costs, since it would make no sense to oblige companies to invest significant amounts in systems and controls to fulfill ancillary obligations related to the new tax if it will be levied on a temporary basis.

Finally, an important element to be considered by tax policymakers is that such tax measures should only balance the tax burden, without overtaxing digital companies. The goal is to preserve neutrality and competition between companies operating in the digital economy and the traditional economy, without hampering the economic development and the growth of start-up companies.

Brazil's approach to tax the digital economy

Traditionally, Brazil does not adopt the concept of permanent establishment to tax the income obtained by non-residents that sell goods or provide services to customers in Brazil, except in very specific situations. Consequently, it would not be a useful tax policy alternative for Brazil to adopt the idea of a virtual permanent establishment to tax the income of digital companies.

Moreover, the concept of a virtual permanent establishment may create several difficulties for developing countries. The need to amend the entire tax treaty network, the small amount of profit that could be allocated to a digital presence in the absence of assets, risks and functions, and the high compliance costs for monitoring and quantifying the digital presence could all indirectly lead to problems.

It is probably for these reasons that Brazil still maintains its tax policy of taxing cross-border income at source, which has been an efficient way of taxing business-to-business (B2B) transactions. Indeed, Brazil imposes withholding income tax (WHT) on almost all cross-border payments made to non-residents, regardless of their legal nature. The most relevant exception is that Brazilian tax legislation does not provide for the levy of WHT on amounts remitted abroad as the price for the acquisition of goods. This approach of imposing WHT on almost all cross-border payments intends to reduce the erosion of tax bases in Brazil, since payments made by the Brazilian company under B2B transactions are usually deductible from the corporate taxes in Brazil.

The levy of WHT on the gross payment made to non-residents may give rise to over taxation of certain types of income, when the tax burden in the source state is greater than that in the residence state. However, in practice, the risk of actual double taxation can be mitigated by calibrating the rates charged in the source state on the gross payment. A common problem in taxing the digital economy is that the profit margin in each individual transaction is relatively small. The bulk of the profit comes from the high volume of transactions. On-demand rides are a good example, since the price per ride is small, but the total volume of the business developed in a single country is relevant. Thus, the calibration of tax rates is an important aspect to be considered by Brazil in a future tax reform.

A complex aspect of the solution adopted by Brazil involves business-to-consumer (B2C) transactions. From a theoretical perspective, it is possible to oblige individuals in Brazil to withhold the income tax on payments made to non-residents, such as online video and music streaming services. However, in practice, it would be very difficult and cost-inefficient to supervise millions of users in relation to the compliance of their tax obligations. In order to deal with such issues, Brazil decides to impose a tax on foreign exchange transactions (IOF/FX) at 0.38%. As a consequence, if a Brazilian individual uses a credit card or any other official payment method to pay for a product or service in a foreign currency, the IOF/FX will be levied and the credit card company, or whatever institution processes the relevant transaction, will be responsible for collecting the relevant tax.

On this subject, one would argue that virtual currencies may undermine the solution adopted by Brazil with the IOF/FX. Although this criticism is well founded, the acquisition of goods or services with virtual currencies still represents a small fraction of the total of income derived from cross-border transactions. Moreover, even if transactions with virtual currencies increase in the future, it is undeniable that great progress may also be expected in the area of tax enforcement on such transactions, due to the use of blockchain technology and the strengthening of regulatory control by central monetary authorities.

Finally, with regard to consumption taxes, the Brazilian Federal Constitution distributes the power to tax goods and services between sub-national political units: states can impose a tax on the circulation of goods (ICMS), while municipalities can tax the provision of services of any nature (ISS).

This division of taxing rights has created a conflict between states and municipalities in relation to the taxation of intangible assets. A classic example lies in the commercialisation of software. In 2010, the Supreme Court, during the judgment of the Direct Action of Unconstitutionality No. 1945/MT (ADI/MC 1945), held that the ICMS should be levied on the commercialisation of standardised software by way of downloads, even in the absence of physical support for the software. The criterion that prevailed in determining the existence of merchandise was the standardisation of the software and, therefore, the presence of 'off-the-shelf software'. Conversely, one would imply that, in the case of 'customised software', the transaction is subject to the levy of ISS.

Nevertheless, there is no case law from the higher courts in Brazil on the tax consequences of various types of activities developed by digital companies, such as cloud computing, streaming, 3D printing, marketplaces, among others.

It remains to be seen how judicial courts will qualify these new activities under the concepts used by the Brazilian federal constitution. Historically, since the judgment of the Extraordinary Appeal No. 116.121-3, on October 11 2000, the Supreme Court held that the constitutional concept of service only reached an "obligation to perform" in accordance with private law definition. Consequently, the Supreme Court declared unconstitutional the inclusion of "rental of movable property" in the list of services attached to the repealed Decree-Law No. 406/1968.

However, more recently, when judging the Extraordinary Appeal No. 651.703, the Supreme Court considered the levy of ISS on the activities carried out by health plan operators was constitutional. In that judgment, the STF apparently departed from its traditional case law because the vote handed down by Justice Luiz Fux held that the concept of service provision is not based on the civil law meaning, but related to the provision of an economic utility to another party, based on a set of immaterial activities developed regularly and with profit intent.

Despite that, it is not possible to state categorically that this judgment entails an absolute turnaround in the Supreme Court's case law on the matter, because some justices have followed up the vote of Justice Luiz Fux based on his conclusions. Moreover, Binding Precedent No. 31, which excludes the "assignment of the right of use" from the scope of the ISS based on the private law meaning, has not been revoked by the Supreme Court.

Given this, it is possible to conclude that the case law related to the taxation of the digital economy is uncertain in Brazil. A possible trend of the decisions rendered by the Supreme Court would be to soften the constitutional concepts of "merchandise" and "services", in order to consider that dematerialised products (digital products) are subject to the ICMS, while other activities, which involve provision of a utility to its users, are taxed by the ISS. Nonetheless, the complex nature of the transactions carried out in the digital economy makes it difficult to predict the path that will be followed by judicial courts.

In the meantime, there are different tax reform proposals being discussed in the Brazilian Congress, especially the Proposals for Constitutional Amendment No. 45/2019 and 110/2019, which aim to replace several existing taxes with a single federal tax on goods and services. A broad tax on goods and services may reduce existing debates on the taxation of the digital economy in Brazil, although there are no specific rules dealing with this issue in such projects.

Final conclusions

The growing digitalisation of the economy has brought new challenges to the tax systems of several countries. In this context, Brazil has opted for maintaining its tax policy of taxing cross-border income at source, which has been considered as an efficient way of taxing B2B transactions, because all deductible payments also give rise to the levy of the WHT.

In relation to B2C transactions, Brazil imposes the IOF/FX at 0.38% when Brazilian individuals use a credit card or any other official payment method to buy a product or service in a foreign currency. This is an interesting strategy for taxing the digital economy, because tax measures designed to capture B2C usually create persistent tax compliance and enforcement problems.

The use of blockchain may also bring significant benefits to tax inspection procedures, which will allow the encrypted registration of transactions. These new technologies will be extremely important for tax enforcement because of the dynamics and volume of transactions in the digital economy.

Finally, with respect to indirect taxes, it remains to be seen whether the Supreme Court will soften the constitutional concepts of "merchandise" and "services" to allow the levy of ICMS and ISS on digital activities.

Bruno Fajersztajn



Mariz de Oliveira e Siqueira Campos Advogados

Tel: +55 11 3704 1312

Bruno Fajersztajn is a partner at Mariz de Oliveira e Siqueira Campos Advogados.

He is active in areas involving consulting and administrative litigation related to direct taxes – in particular IRPJ / IRPF and CSLL. He is also active on contributions to PIS, COFINS, CIDE and other social security contributions.

He is also a director of the Brazilian Institute of Tax Law (IBDT). He holds a LLM in tax law from the University of São Paulo, and is a visiting professor and lecturer in tax law courses and events across Brazil.

Ramon Tomazela Santos



Mariz de Oliveira e Siqueira Campos Advogados

Tel: +55 11 3704 1305

Ramon Tomazela Santos is a partner at Mariz de Oliveira e Siqueira Campos Advogados.

He is active in areas involving consulting and administrative litigation related to direct taxes – in particular IRPJ / IRPF and CSLL. He is also active on contributions to PIS, COFINS, CIDE and other social security contributions.

He is a PhD candidate and holds a LLM in tax law from the University of São Paulo and the Vienna University of Economics and Business. He is also a visiting professor and lecturer in tax law courses and events in Brazil.

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