Background

The players in the digital economy took the world by storm at the turn of this century. This was aided by the advent of global system for mobile telecommunication (GSM) that made telecommunication facilities and services accessible to most people, breaking the barrier created by income inequality. The digital players latched on the massive opportunity and designed unique and unconventional business models. For instance, it was previously not conceivable that someone else will pay for the service enjoyed by others at such a massive scale. There is a complete paradigm shift from the norm.

The unique business model of the digital players also created some fiscal issues. Generally, in most jurisdictions all over the world, companies are liable to tax on the profits attributable to their respective jurisdiction. Profits in this instance is the excess of income attributable to a service provider in such jurisdiction less expenditure that are deemed to have been wholly, reasonably exclusively and necessarily (WREN) incurred to generate such income. These are generally accepted principles for taxation of companies in most jurisdictions.

The borderless nature of business model of digital economy players has challenged this norm. A digital service provider can earn income from a single service beneficiary across several international boundaries. It is therefore difficult, if not impossible, to allocate with any degree of certainty income earned from a single service beneficiary across multiple jurisdictions without some level of subjectivity.

Most jurisdictions have also challenged the allocation keys used on several principles. For instance, there are arguments whether the host country where the digital player's facility was developed and maintained should take precedence over the markets where the benefits are exploited. There is no superiority of any argument in this instance since each claim the uniqueness of its economy in exploiting value from the facility. For instance, whilst host countries claim that they provided the proper enabling environment for the development of the item, the markets' response is that without the opportunity available within their respective jurisdictions, such invention may not yield the intended economic benefits, thereby discouraging the developers.

Similarly, the ability to allocate expenses that will meet the standard WREN test for most jurisdictions is also limited. Digital players not only incur significant costs in developing the item, they also continue to spend on research and development not only to protect their intellectual property, but ensure that services offered to their numerous customers meet the required minimum standard. In some instances, the various units that combine to provide the services are spread across multiple jurisdictions. The need to aggregate these costs and allocate them across international boundaries where the income is derived is no mean task. The level of documentation is also significant. The volatility in exchange rate among countries also has its inherent problem. For instance, a significant loss of a country's foreign exchange rate, holding all other country's similar rate constant, may imply that part of the cost allocated to the first country may have to be transferred to others, if revenue is used as allocation key. How do other countries now suffer for the problem that happen in another one.

Some jurisdictions also have some restrictive rules on tax deductibility of certain expenses especially those relating to intellectual property and research and development. For instance, the amount deductible in respect of payment for exploitation of intellectual property by a company incorporated in Nigeria to a related party is limited to 5% of the Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) and the consideration for that exploitation. Thus, where a company's operations result in a negative EBITDA for a particular year, no amount will be deductible for tax purpose for the year. This is in spite of the fact that the company's entire business model may be centered on the use of the intellectual property. The appropriate yardstick may therefore be turnover rather EBITDA.

Nevertheless, the foregoing illustrates the myriad of issues surrounding the determination of profit attributable to a digital company's operations in any jurisdiction. It should be noted that we have assumed that such companies are even liable to tax in the first instance using the concept of fixed base developed several years ago by the comity of nations. In most instances, especially when combined with the protections that are available under the double tax treaty agreements, some digital players do not fall within the tax net of most countries. This is in spite of their obvious usage of their facility in these countries and significant income being realized therefrom.

Turnover basis of taxation

Most countries have addressed the problem in one singular way - adoption of non-conventional base for determination of tax payable. Rather than the usual profit-based system where appropriate revenue attributable to a jurisdiction is determined first and the tax deductible expenses are also computed in order to determine the profit on which the applicable tax rate will be applied, countries have simply adopted a methodology where a relatively low rate is applied to the attributable turnover. The available rates range from 0.75% to 5% across most countries covered by a survey report issued in December 2020 by KPMG India ( https://tax.kpmg.us/content/dam/tax/en/pdfs/2020/digitalized-economy-taxation-developments-summary.pdf?tue). It was only in two instances that the rate was in double digit. The first relates to Paraguay where the rate is 15% of income net of VAT from provision of digital services by foreign suppliers; whilst the second is Turkey with a non-conventional formula where the general rate is 7.5%, but could be reduced to as low as 1% or doubled to 15% by the President.

From the foregoing, it is clear that most countries attempting to tax the digitalized economy have simply adopted a simple method of applying a tax rate to the turnover of digital companies covered by the relevant laws. Most of these countries have also jettisoned the need to prepare financial statements based on the usual accounting and auditing standards for this purpose. This is not unexpected since taxes would now be based on revenue generated, irrespective of the level of expenses incurred to generate such revenue. To make it easier as well, most countries define revenue not according to the accounting rule, but rather as amount payable by service beneficiaries within their jurisdiction for such services. Thus, where a service beneficiary makes payment for a service that will be consumed across multiple jurisdictions, the digital tax system in most countries ignore where the economic benefits will be derived and simply deem the payment originating from their economy as part of turnover that will be subjected to digital taxation.

Nigeria: Significant Economic Presence

In 2020, Nigeria amended the Companies Income Tax Act through the Finance Act 2020 to address the basis of taxation for digital economy players. Consequently, Section 13(2) of CITA was amended and the Minister of Finance, Alhaja Zainab Ahmed, issued an Order {Companies Income Tax (Significant Economic Presence) Order, 2020} in this regard. The amended CITA and Order brought digital economy players with revenue in excess of N25.0m (about US$65,000 at official foreign exchange rate in January 2021) in any financial year within the Nigeria's tax net.

However, in reality, the changes created more problems for the affected companies. Both the amended CITA and Order seem oblivious of all the issues that we have explained earlier with regards to income recognition and expense deductibility. To make matters worse, in the Finance Act 2021, these companies would now be required to prepare and submit two sets of financial statements for the purpose of filing tax returns in Nigeria. The first will cover the legal entity's worldwide operations audited by possibly one auditor in a different jurisdiction; whilst the same legal entity is also required to prepare another financial statements covering its Nigeria's operations (possibly audited by another external auditor since only Nigeria's certified auditor is permitted for the one covering Nigeria) and then submit the two to the tax authority. The myriad of problems that will arise is a subject of part three of this series!

Nevertheless, it is noteworthy to conclude that Nigeria has moved in the opposite direction relative to most other countries. The major challenge of this approach is the uncertainty that it will create for the digital economy players. We have no doubt in our mind that where the final income statement of the affected companies show a net operating/tax loss and therefore no income tax payable, the Federal Inland Revenue Service will put such company to task. We therefore strongly advise that FIRS should revisit the approach and learn from most other countries that have put similar but better compliant-friendly legislation in place for the purpose of taxation of digital economy players.

Conclusion

Necessity, as the saying goes, is the mother of invention. The unique business model peculiar to digital economy players has necessitated a non-conventional system of taxation in most countries. The main objective is to ensure that everyone that relies on properly working socio-economic system also contributes to its sustenance through payment of appropriate tax. The system is simple, though not perfect in itself. It however meets the minimum criteria required for certainty in taxation. We also encourage Nigeria to borrow a leaf from these countries and follow suit.

Tayo Ogungbenro and Elizabeth Olaghere are Partner and Senior Manager in the Tax, Regulatory & People Services Division of KPMG Advisory Services in Nigeria. Their area of specialization includes taxation of players in the digital economy. The opinion expressed in this article however remains that of the author(s).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.