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Digitalization of the Economy &the International Taxation System
By Satoshi Watanabe

The international taxation system, which has been regarded as aquite robust system for a century, is faced with a serious challenge
caused by the digitalization of the economy. This article discusses
underlying problems and policy options from an economic point ofview.

BackgroundThe digitalization of the economy has become a focal point of
discussions on international taxation. In 2015, one of the final
reports of the OECD/G20 Base Erosion and Profit Shifting (BEPS)
Project addressed the tax challenges of digitalization, but the final
report just surveyed the recent development of the digitalization of
the economy and did not mention concrete proposals to resolve theissues. The analysis of the final report was also complicated because
it discussed both BEPS issues and issues beyond the BEPS project
together.
Since 2018, international discussions on the digitalization issues
have been activated. On the one hand, several countries including
European countries started to take unilateral measures to introduce a“digital services tax” (DST) on revenues of huge highly digitalizedcompanies like Google, Amazon, Facebook and Apple. On the other
hand, the tax reform in the United States at the end of 2017
introduced anti-tax avoidance measures against multinational
companies shifting intangible assets and profits to low-tax countries.
Thus, many countries recognized the need for coordinated reform of
the international tax system.
Following the interim report on tax challenges arising fromdigitalization issued in 2018, the OECD has issued many reports in
2019, including a policy note in January, a public consultation paperin February, and a work program in May. In June 2019, the G20
Summit took place in Osaka. G20 leaders endorsed the ambitious
work program proposed by the OECD and the G20 leaders’declaration announced “we will redouble our efforts for a consensusbased solution with a final report by 2020.” Since then, energetic
international consultations have been conducted and it is expectedthat an outline of the consensus-based solution will be reached byearly 2021. It is not possible to predict the actual outcome of theinternational discussions. This article just tries to consider basic
underlying problems and policy issues.

https://www.jef.or.jp/journal/

Author Satoshi Watanabe

The Concept of Value Creation
In the context of the BEPS project, the notion of “taxationaccording to the value creation” has often been emphasized. For
example, a BEPS final report on transfer pricing is titled as “Aligning
Transfer Pricing Outcome with Value Creation”. On digitalization, themain concern has been that highly digitalized companies might not
pay an appropriate amount of corporate income tax to the country
where they have many users. In particular, it was argued that usersof some highly digitalized companies provide useful information,
which makes it possible for these companies to get huge profits, andthat these companies should pay some tax in the country wherethese users reside because the source of value creation is provided
by these users.
The concept of value creation is a new concept in international
taxation, and what it means is not clear enough. Companies can get
profits either because they produce good products using useful
inputs including intangibles, or because the customers evaluate theproducts supplied by the companies. It is quite difficult to articulate
how much value is created by various factors. Value creation is sucha vague concept that some commentators have said it is just a
mantra.
In spite of its vagueness, value creation is situated at the center ofthe BEPS project as a kind of ideology, and it is no longer possible tototally disregard the argument based on the value creation concept,
which is based on some notion of the fairness of tax revenue
distribution between countries. To think about the basic problem ofhighly digitalized companies in the context of international corporate
taxation, it might be useful to take a closer look at the businessmodel of highly digitalized companies. These companies often work
as digital platforms and the business model of digital platforms is ofparticular characteristics as discussed below.

Business Model of a Digital Platform
Chart 1 illustrates an example of the business model of a digitalplatform. A highly digitized company called G Co. is a digital platform
which provides its users (Type B Users, who are usually consumers)
with sophisticated search services. G Co. can collect huge amounts
of information on Type B Users through the searching activities ofthese users, and G Co. can use the information to makeadvertisements more effective. Also, effective advertisements can be
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CHART 1

Example of a digital platform
G Co.

AdvertisingServices[Home Country]

Indirect Network Effect[Production
Country]

FeesType A Users(Producers)

PrivateInformation
Goods and Services

Search Services[MarketCountry]Type B Users(Final Consumers)

Source: Compiled by the author

CHART 2

Increase in excess profits of G Co. caused byprovision of information from Type B Users
P(Advertising fee)

Demand Curve of Type A Users when q>0.

F

Increased demand of Type A Users for AdvertisingServices owing to Indirect Network Effect: q=0
where q indicates the price charge on Type B Users.

Pm

O

K

L

N

M

D (Demand of Type A Users
for Advertising Services
provided by G Co.)

Source: Compiled by the author

automatically conveyed to Type B Users when they use the searchservices. Type A Users, who are usually producers of goods andservices for consumers, purchase advertisement services from G
Co., which can generate huge profits from the advertising fees paid
by Type A Users.
In this article, we happen to use the example of G Co., which
provides search services. However, we can make essentially thesame argument for other types of digital platforms. We can use theexample of F Co., which provides SNS, or the example of Am Co.,
which provides market making services, or the example of Ali Co.,
which provides settlement services. We might be able to discuss
digital platform issues in a simpler framework if we take the exampleof Ub Co., which facilitates the provision of taxi services, or theexample of Abb Co., which facilitates the provision of lodging
services.
Two points should be mentioned about the business model of G
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Co. First, G Co. has two kinds of customers:
Type A Users and Type B Users. Type B Users
are potential customers of Type A Users, but
we are not interested in the actual transactions
conducted between them. We focus on thebusiness conducted by G Co. becauseinternational taxation problems arise for thebusiness profits of G Co. As a digital platform
G Co. facilitates transactions between two
types of customers, and it is sometimes calleda multi-sided platform.
Second, although G Co. can generate huge
profits, no money is paid to G Co. by Type B
Users. By not charging Type B Users, G Co.
can get more information from them because
they engage in search activities more intensely
when they can use search services for free.
More information from Type B Users makes
the advertisement services for Type A Users
more effective and increases the demand foradvertising, resulting in huge profits for G Co.
Thus, G Co. can generate more profits bysetting the price of search services (q=0) for
Type B Users, rather than charging service feesfrom both types of customers. Demand forservices provided by G Co. for Type A Users isinterrelated to demand for services provided
by G Co. for Type B Users. Thus, G Co. is facedwith two-sided markets and its price strategy
becomes complicated when there are indirect
network effects between two-sided markets (amarket for advertising services and a market
for search services)

Indirect Network Effects
Chart 2 shows the demand curve of Type A Users (producers) for
advertising services provided by G Co. Assume that G Co. firstcharged Type B Users (consumers) some fee for the search services(q>0), and the demand curve of Type A Users for the advertising
services was like the steep blue line (FK). Then, G Co. sets the fee forthe search as free (q=0), causing indirect network effects to increase
the demand by Type A Users for the advertising services. When q=0,
Type B Users use more search services and provide more
information to G Co., which improves the quality of the advertising
services. Thus, the demand curve for the advertising services isshifted to the red-dotted flatter line (FL), that is, Type A Users
purchase larger amounts of adverting services from G Co.
In Chart 2, it is supposed, for convenience, that the marginal costSpecial

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for providing the advertising services is zero. G Co. has invested alarge amount in developing the system (and so it has incurred a
substantial fixed cost), but the running cost for providing theadvertising services is supposed to be zero. When the fee for the
search services was positive (q>0), the size of the excess profit of G
Co. is indicated as the area of the rectangle PmKNO plus some profit
earned from the fee for the search services. (Strictly speaking, theamount of the fixed cost has to be subtracted when the excess profit
of G Co. is calculated, but it is not the point in the current context.) If
G Co. sets q=0, it loses some profit from the search services, but theexcess profit from the advertising services increases by the size ofrectangle KLMN.
We should add another point implied by Chart 2. The demand
curve of Type A Users indicates the marginal revenue that they canenjoy by purchasing advertising services from G Co. Note that TypeA Users purchase advertising services as long as the revenue arisingfrom the additional one unit of advertising services (marginal
revenue) exceeds the cost of purchasing one unit of advertising
services (marginal cost), which is the price of the service Pm. Thus,
the area of the triangle FKL indicates the increase of excess profits ofType A Users. Because the value of the advertising services wasincreased by the indirect network effect, not only the profit of G Co.,but also the profits of Type A Users increases.

Implications for International Taxation
See Chart 1 again. G Co., Type A Users, and Type B Users arelocated in Home Country, Production Country, and Market Country,
respectively. Although Type A Users are customers of G Co., they
produce goods and services for Type B Users; therefore, Type A
Users’ country is called Production Country. Production Country canbe the same country as Market County, but they can be different.
Type A Users and Type B Users can be located in many Production
Countries and in many Market Countries, but we are going to discusson the assumption indicated in the chart for simplicity.
Corporate income tax is basically imposed in a source country
where the corporation or the permanent establishment of thecorporation is engaged in business activities. From an economic
point of view, the concept of a source country might be as vague as
the place of value creation, but there is an accumulation of detailed
analysis on the source country concept from a legal point of view.
Following the traditional source country concept, the excess profit of
G Co. should be taxed by Home Country because G Co. does nothave a permanent establishment either in Production Country or inMarket Country.
See Chart 2 again. For the excess profit of G Co. (corresponding to
the area of the rectangle PmLMO), traditional source-based
corporate income tax should be collected by Home Country.
However, we might wonder if Home Country should be able to tax allof the increased excess profit due to the indirect network effect(corresponding to the area of the rectangle KLMN). The increased
excess profit of G Co. is due to the indirect network effect caused by
the input of information from Type B Users in Market Country. If
Market Country is to be able to impose corporate income tax on the
profit of G Co., the rationale cannot be the existence of thepermanent establishment in the traditional sense. Market Country
has to refer to some other rationale such as “user participation”.
Note that Market Country in Chart 2 might not be the same as thedestination country in the context of taxing the profits of G Co. TypeA Users in Production Country might be able to provide more goods
and services thanks to the effective advertising services provided by
G Co., and if we focus on the transactions between Type A Users andType B Users, Market Country is clearly the destination country.
However, G Co. provides search services to Type B Users withoutcharging a service fee. If the information provided by Type B Users
to G Co. is not regarded as a consideration for the search services of
G Co., Market Country cannot claim the tax right as a destination
country. Even if the information is regarded as a consideration, thevalue of the provided search services might be evaluated to be quite
low, compared with the huge excess profit of G Co. Therefore, theadoption of destination-based corporate income tax might not be ofhelp for Market Country.
By contrast, Production Country gets a large benefit if thedestination country-based system is introduced. Because the huge
profit of G Co. arises from the payment by Type A Users foradvertising services, Production Country can probably claim aconsiderable amount of corporate income tax on the profit of G Co. if
the destination-based corporate income tax system is introduced.
Practically, it is often the case that Market Country and Production
Country are the same country; therefore, the adoption of adestination-based system might be considered as beneficial forMarket Country, too. However, it is still important to recognize theconceptual difference between Market Country and Production
Country.
Note also that under the current corporate tax system, Production
Country can collect corporate income tax from Type A Users because
they get excess profit (corresponding to the triangle FLPm) by
getting the advertising services of G Co., while Market Country
cannot get any corporate income tax revenue under the current
system. Under the current VAT system, Production Country cancollect VAT using a reverse charge system applied to the transactions
between G Co. and Type A Users, while Market Country cannot get
any VAT revenue because Type B Users use the search services of G
Co. for free.

Destination-Based Corporate Income Tax & VAT
Some commentators propose changing the current source-based
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corporate income tax to the destination-based corporate income tax.
One variation of this proposal is to introduce a Destination-BasedCash Flow Tax (DBCFT). This proposal implies quite a drastic shift intax revenue allocation when it is applied to digital platforms. See
Chart 1 again. If all the corporate income tax revenue belongs to thedestination country, the profit of G Co. is only taxable in Production
Country. Even if Production Country is very happy about thesituation, that outcome is probably unfair from the viewpoint ofHome Country, where business activities of G Co. take place.
It is more likely that some factor of the destination country would
be taken into account in allocating the tax revenue, rather thanreplacing the current corporate income tax system with thedestination-based corporate income tax. In that case, some kind of aformula apportion system for the international allocation of tax
revenue might be considered. In that case, however, some attention
should be paid to the point that Market Country in the businessmodel of digital platforms is not necessarily the destination country,
as long as we have to make a distinction between Production
Country where Type A Users are located and Market Country where
Type B Users are located.
Instead of a radical shift of the corporate income tax system to thedestination-based system, it might be more practical to graduallyreplace the current corporate income tax with VAT. Actually, in many
countries, the weight of VAT is increasing and the weight ofcorporate income tax is decreasing, partly due to intensified tax
competition. VAT is also relatively robust against tax planning.
However, VAT might not be a direct answer to cope with thedigitalization of the economy. In the digitalization context, the focal
point is the excess profit of some multilateral companies. VAT is a
general tax on final consumption and final consumption covers not
only the excess profits of the companies but also wages and salaries
paid to employees of these companies.
Thus, shifting the weight of tax revenue from corporate income tax
to VAT implies not only strengthened tax powers of the destination
country, but also a shift of the tax base from business income toconsumption, which might have adverse distributional
consequences. Also, as discussed above, because VAT is usually
imposed on the basis of transactions with considerations, to apply
VAT to the transactions between G Co. and Type B Users might bedifficult. In that case, replacing corporate income tax with VAT might
not be satisfactory from the viewpoint of Market Country.

and policy makers because they are accustomed to the concept ofmarketing intangibles. The approach also has the merit of wide
applicability including but not restricted to highly digitalizedbusinesses.
However, it is not certain whether the concept applied to thebusiness model of digital platforms works well. For example, howdoes the concept of the marketing intangibles of G Co. make adifference when applied to Production Country and to Market
Country? More generally, how is the value of marketing intangibles
evaluated and how is it reflected in the tax revenue allocation? Thereis some concern that the new concept would be generally applied to
traditional international businesses as well, and increase compliancecosts of a wide range of taxpayers.
Digital Services Tax (DST) might be considered as a practicalresponse to the need to shift some tax revenue to Production
Country, or to Market Country when the tax base can be related tothe intensity of searching activities by final consumers. It should be
noted, however, that DST can produce distortions because theexcess profit of digital platforms is not pure rent but quasi rent
arising from R&D activities, and if DST is introduced as a unilateralmeasure taken by specific countries, it could make international
cooperation for reforming the international taxation system moredifficult.

Conclusion
Digital platforms pose serious problems for the current
international taxation system and active discussions about reforming
the system are ongoing. The international taxation system isinevitably related to the allocation of tax revenue among countries,
and therefore it is inevitably of some political nature. The actual
policies taken to reform the current system is likely to be a result ofpolitical compromise among countries with different interests.
However, it is also of some use to investigate the underlying
theoretical issues. As discussed in this article, the business model ofdigital platforms might cause special taxation issues, which aresomewhat different from general problems concerning thedigitalization of the economy. It is expected that the actual policies
chosen for reform will not produce too many distortions ininternational economic activities or too many compliance costs forinternational businesses.

Marketing Intangibles & DST
By recognizing marketing intangibles in the country where
customers are located, some reallocation of corporate tax revenue
between countries can be achieved, and this approach has been
attracting support from many commentators. This approachprobably has the merit of relatively high acceptability by practitioners
30 Japan SPOTLIGHT • November / December 2019

Satoshi Watanabe is a professor at the School of International and Public
Policy, Hitotsubashi University. He is a former Ministry of Finance official, andspecializes in taxation and public finance.