A wave of legislation has come into force requiring that VAT (or similar taxes) be charged on digital services supplied to local customers from abroad. Non-compliance with these rules is becoming increasingly risky as tax authorities get creative about enforcement and statutory auditors become more aware of the new legislation.
Technological progress in the past two decades has created new opportunities for businesses to supply digital services to customers around the world. The lack of any need for a local presence has allowed digital service providers to scale globally at incredible speeds. On-demand streaming services and online learning platforms, for example, have been able to expand around the world in only a few years.
This shift has posed significant challenges to tax authorities. The existing tax rules historically did not require foreign digital service providers to charge VAT (or similar taxes) when making sales to local customers. This was not a material issue, as the digital economy was still small.
But as the digital economy has grown exponentially in recent years, tax authorities have been unable to access a huge source of potential tax revenue. It also put local providers of digital services, who were required to charge VAT to local customers, at a competitive disadvantage.
What have countries done to respond to this challenge?
Countries have been racing to establish rules and regulations to subject imported digital services to VAT. Roughly 90 countries now require that foreign digital service providers register locally and charge VAT (generally for B2C sales only, although there are exceptions). 12 additional countries currently have legislation pending that would do the same thing.
The initial focus of the new rules has been on the largest digital service suppliers. It is no accident that VAT on imported digital services is commonly called a “Netflix tax”. Tax authorities have had a good amount of success in having these large players register for and charge VAT to local customers as required. This has generated a significant amount of additional tax revenue.
But the digital economy is much larger than Netflix, Google, and iTunes. The size and name recognition of these companies make them the “low hanging fruit” for tax authorities - however this low hanging fruit has now mostly been picked and the laws taxing imported digital services also capture within their scope countless other lesser known businesses. Many of these laws are extremely broad and would capture even companies that can show some manual intervention in their digital supplies.
With COVID-19 depleting government coffers and the potential upcoming economic downturn looking likely to do the same, tax authorities are now more actively than ever looking beyond these large players. Smaller, but still significant digital service companies that make up the bulk of the digital economy are an attractive target. What we have seen so far then is just the tip of the iceberg.
Consequences of non-compliance
Can a tax authority really enforce their tax laws and regulations against a business with no presence in the country? Besides penalties, are there other reasons foreign digital service businesses would charge VAT on their sales? The short answer is a resounding yes.
1. Using payment processors as an enforcement mechanism
One strategy used in several LATAM countries is to mandate that local payment processors or banks withhold a portion of the payment made by a local customer to a foreign digital service provider. Countries in other regions are looking at this enforcement option as well.
The mechanism is rather simple. First, the tax authority identifies a particular foreign digital service provider. Next, any payment made with a local credit card or through a local payment provider to the foreign digital service provider is reduced by the VAT amount.
Several countries have already attempted using this mechanism as a generalized way to collect the required VAT from foreign companies. There have been some practical difficulties however, in part because credit card companies and payment processors don’t always have enough information to know when to withhold VAT or not. What we see now is a move toward using this as an enforcement mechanism against businesses who don’t comply voluntarily. Indeed, this approach to enforcement was recently recognized by the OECD.
If you’re doing business in LATAM, it’s worth imagining all the payments coming from local customers will suddenly be reduced by around 20%, and potentially significantly more to compensate for penalties and interest.
2. Criminal penalties
Most countries provide for criminal penalties for tax evasion, which could in theory extend to wilful non-compliance with VAT obligations on foreign digital service providers.
Some countries, like Thailand, go further. In Thailand there are specific criminal provisions for foreign digital service providers who don’t register and charge VAT locally. This is explicitly noted in Section 90/2 of the Thai Revenue Code.
Any failure to respect the requirements is punishable by up to a month in prison, regardless of whether there is an intention to avoid taxes. Where there is intentional avoidance, the penalties are significantly higher. This means thinking twice before having company personnel travel to Thailand or to countries with similar rules.
3. Naming and shaming
Another approach, used notably in South Korea and Slovenia as well as being considered by other countries, is to publish a list of companies and individuals that do not respect their local tax obligations.
This can pose a significant risk to your company’s reputation in a local market. A potential customer that googles your business could see your name on this list and decide to take their business elsewhere. We’ve even seen tax non-compliance by foreign digital service providers used as a marketing strategy by local competitors, whereby the local competitors encourage customers to choose local companies who pay their taxes.
4. Shutting down your website
Mexico and Turkey have a particularly aggressive approach to enforcement. The tax authorities have recently been authorized by law to temporarily block a non-resident company’s website from the internet (known as the “kill switch”).
This power was specifically created to target non-compliant foreign digital service providers, and can be used against any such business that fails to charge VAT to local customers or fails to report and remit this VAT to the tax authorities. The tax authorities can do this on their own accord, without even a court order. To unblock the website, the business would need to fully regularize and pay substantial penalties and interest.
5. Future presence
You may not currently have a local presence that a tax authority can go after, but what about in the future? Most of the largest markets have passed laws requiring foreign digital service providers to charge VAT to local customers.
Perhaps your company wants to open a branch or rep office in the EU or Japan as part of its business strategy? No tax director would relish having to tell the operational side of the business that the strategy should not be pursued because of past tax non-compliance. Better to comply now than to cause future roadblocks to your company’s growth.
6. Statutory auditors
As taxation of foreign digital service providers becomes more widespread, statutory auditors are becoming increasingly aware of these issues. Any tax risks need to be provisioned for, but at what cost?
The potential risk is huge - uncharged VAT, plus penalties and interest, on any digital services provided to customers in applicable jurisdictions. That’s over 90 countries. This provision will be a direct hit to P&L, significantly reducing the profitability of any company that is in scope.
How can Fonoa help?
Managing VAT on digital services around the world is hard if you don’t have the right tools:
- How do you keep track of rates in all jurisdictions?
- How do you verify if a customer is a private consumer or taxable business in 90+ jurisdictions, many of which do not have an easily accessible tax id verification portal?
- Can you react quickly enough when there is a change in the law requiring that you charge tax (or allowing you to stop charging tax)?
- In countries where VAT must be charged, do you have the capacity to produce locally compliant invoices?
That’s where Fonoa comes in. Our suite of products, usable via an easy to implement API that is far simpler than a traditional system integration, takes care of all these issues and then some. Get in touch to discover how we can help you meet the challenges posed by the shifting tax landscape and take the complexity out of tax.