OF THE DIGITALISED BUSINESS MODELS AND RECOMMENDATIONS FOR THE FUTURE
i. INTRODUCTION
The previous two chapters elucidated the nature of the digitalised economy, the digitalised business models proliferated therein, the resultant challenges to direct taxation and, finally, the existing South African framework for source-based taxation. Necessarily, this chapter seeks to reconcile the existing framework for source-based taxation and the challenges to direct taxation posed by the new digitalised business models.
The adequacy of the existing domestic framework must be considered in its application to digitalised business models. The evaluation will be conducted through the lens of the benefit theory, which provides a normative framework and theoretical justification for the imposition of tax liability on the basis of source. Accordingly, both the judicial and statutory approach to the determination of source will be evaluated in order to determine the adequacy of the entire South African framework for source-based taxation. Firstly, the scope of the tests for the determination of source, provided by the judiciary, is evaluated to determine their applicability to the digitalised business models. Additionally, the issue of multiple sources and apportionment will be further considered in light of the digital business models. This chapter concludes with a discussion of the existing statutory rules for the determination of source and the proposal of a new statutory rule for the determination of source that is applicable to the digitalised economy.
ii. THE JUDICIAL APPROACH TO THE DETERMINATION OF SOURCE The ability of digitalised business models to conduct substantial economic activities that are integral to the derivation of income, without creating a traditionally acknowledged physical presence in a source state, has been well established in the previous chapters. The growing irrelevance of physical presence appears to be at odds with the current South African
framework for source-based taxation. It was submitted in the previous chapter that source- based taxation can be broadly justified in terms of the ‘benefit theory’, whereby source-based taxation is justified by the benefit derived by non-residents through the affordances to compete with residents for the use and enjoyment of income-earning opportunities, resources and infrastructure in the source state. Therefore, it is necessary to reconcile the ability of digitalised business models to draw substantial economic benefit from the non-resident state with little- to-no physical presence.
The judicial approach to the determination of source is flexible and nuanced. Moreover, the courts have endeavoured to provide tests, factors and considerations which should be considered in the determination of source. Therefore, the question is whether the tests, factors and considerations emerging from the case law can be extended to encompass digitalised business models, specifically to situations where entities are able to derive significant economic benefit from South Africa without the traditional physical presence.
Gutuza valiantly argues in favour of an extension of the judicial tests to ameliorate the challenges of digitalised business models in order to establish that a server or internet service provider (ISP) located in South Africa could be regarded as the source of the income.267 While it is noted that the reliance on the location of the server or the ISP may be regarded as outdated, given the prevalence of cloud computing and other technological avenues which vitiate the need for servers and ISPs within the source state, it is interesting to consider whether the judicial conception of source may be extended to scenarios where there is no physical activity or involvement by the taxpayer within the source state. Accordingly, Gutuza identifies the ‘use of the taxpayer’s capital’ and the ‘lease of the taxpayer’s property’ as two situations where physical activity or involvement by the taxpayer is not necessary for the determination of source.268
The ‘use of capital test’ was discussed in Black, where Schreiner ACJ considered the role of a firm in London to be agents that were entitled to buy and sell shares on the taxpayer’s behalf without obtaining confirmation and authorisation from the South African resident taxpayer.269 Schreiner went on to conclude that a reasonable conclusion which could not be said to be untrue
267 Tracy Gutuza ‘Tax and e-commerce: where is the source’ (2010) 127(2) SALJ 332 at 331.
268 Ibid at 332.
269 Black supra note 195 at 393.
was that the ‘main, the real, the dominant, the substantial source’ of the income was the use of the taxpayer’s capital in London.270
By analogous and logical extension, it can be argued that the source of the income may be located where the taxpayer’s capital is used, regardless of whether the capital is money (as in Black) or other forms of capital.271 Unfortunately as noted before, the issue with the
‘employment of capital’ test is that the court has failed to give content to the term ‘capital’.
However, this pitfall may provide the judiciary with an opportunity to adopt and formulate a conception of capital which could encapsulate digitalised forms of capital and bring the income earned by digitalised business models within the realm of taxability. There exists guidance from other areas of tax law which may help give content to the concept of capital, such as CIR v Visser,272 where the court counterposes income and capital by stating that income is what capital produces and the relationship is that of a fruit and a tree.273
This approach is limited by Black to an extent as Schreiner requires the linking of the taxpayer’s activities or the activities of the taxpayer’s agent and the capital in question.274 The pertinent question remains whether the use of capital in one country can give rise to a determination of source where authorisation is located elsewhere. Schreiner’s minority judgement in Lever Brothers and Epstein provides persuasive authority for the possibility that some activity by the taxpayer is not always required for the determination of source. In Lever Brothers, the learned judge stated that the originating cause may take the form of the employment of capital either by using it to earn income or by letting it to someone else.275 Moreover, in Epstein, Schreiner acknowledges that where the taxpayer carries on the business through which the income is derived may be crucial to the determination of source and furthermore that where the income originates is not where the taxpayer personally exerts himself, but where the business profits are realised.276
270 Ibid.
271 Gutuza op cit note 267 at 332.
272 CIR v Visser 1937 TPD 77 (TPD).
273 Ibid at 81.
274 Gutuza op cit note 267 at 332.
275 Lever Brothers supra note 11 at 9.
276 Epstein supra note 208 at 14.
The leasing of the taxpayer’s movable property which results in the derivation of the taxpayer’s income may also support the proposition that physical presence is not required.277 Given that the use of the lessor’s property by the lessee is the originating cause of the derivation of the income, the originating cause may accordingly be located at the place where the property is used or the place where the business of leasing is undertaken.278 However, it is noted that there exists no express judicial principle regarding what exactly constitutes the originating cause of the income derived from the leasing of property.
Interestingly, the non-binding judgement in COT v British United Shoe Machinery,279 intimated that there were two guides as to the location of the source. Firstly, the contract through which the property is leased and, secondly, the place where the income producing asset produces the income. If the contract indicates where the property is to be used and the emphasis is placed on the property being used at the specific place, then the source is located where the asset is used.280 Thereby, it appears as though the source can be determined without reference to the activities of the taxpayer nor the physical presence of the taxpayer.
While there appears to exist scope for the determination of source in the absence of physical presence, there still seems to be some requirement of activity undertaken by the taxpayer. The above-mentioned tests illustrate that what is of importance is the use or leasing of the capital in question. It may therefore be contended that if the use of the capital is to be regarded as the activity which generates the income, neither the physical presence nor an activity undertaken by the taxpayer is required.281
It must be noted that where the use of the server or the ISP is regarded as the originating cause, the taxpayer’s other activities in the generation of income in question must be fairly limited.282 Indeed, it is noted that where the taxpayer undertakes vital income-making decisions elsewhere it may be fatal to the above submission.283 Accordingly, there is limited scope for the above argument where the taxpayer is exercising their wits and labour at the time at which profits are
277 Gutuza op cit note 267 at 335.
278 Ibid at 335.
279 COT v British United Shoe Machinery (SA) (Pty) Ltd 1964 (3) SA 193 (FC).
280 Gutuza op cit note 267 at 335.
281 Ibid.
282 Ibid.
283 Ibid.
being made.284 This limitation is not necessarily fatal in its application to digitalised business models that are increasingly automated and conduct their business with little or even no human intervention. As far as the provision of digital goods and services are in question there is no need for human intervention to effect delivery in most cases.285
Therefore, it is submitted that while there exists scope to extend some of the judicial tests to determine source in the absence of activity and physical presence on the part of the taxpayer, this scope is extremely limited. The other judicial tests depend on the activities of the taxpayers to a large extent and therefore, to depart from this would require a jurisprudential reset for the determination of source. The judicial approach to the determination of source is not geared to deal with the complexities of the ever-changing digitalised economy, as the fundamental tenets were established with reference to traditional business models. Hence, it is submitted that the judicial approach on its own is inadequate in regard to its application to the digitalised economy and the business models proliferated therein.
iii. APPORTIONMENT AND MULTIPLE SOURCES
It is necessary to discuss apportionment when considering the adequacy of the domestic source rules of taxation as it will significantly impact the determination of whether there is a domestic right to tax on the basis of source. This is best illustrated by the Katz Commission’s concern that an all-or-nothing approach may be subject to abuse.286 By enabling apportionment at the domestic level, a country will ensure that where one of the originating causes of the receipt or accrual of income is located in South Africa, the income received can be taxed on the basis of source.
The discussion of apportionment in Chapter III elucidated that, while courts have been open to the idea of apportionment – Schreiner, in Epstein, even acknowledging situations where it would be appropriate – the courts are hesitant to implement apportionment in the absence of
284 Ibid.
285 Ibid at 336.
286 Katz Commission Fifth Interim Report of the Commission of Enquiry into certain aspects of the Tax Structure of South Africa ‘Basing the South African Income Tax System on the source or residence principle – options and recommendations’ (1997) Department of Finance at §5.5.
any authority or statutory guidelines.287 Academics have also recognised the practical difficulty of implementing apportionment in the absence of statutory intervention.288
The second obstacle in the way of apportionment is the formulation of the ‘dominant or main or substantial or real and basic cause of the receipt’, as it appears to disregard the possibility of apportionment. This obstacle is not without contention. It is submitted that parties have continuously failed to raise apportionment between multiple sources and as such the courts have not considered its possibility.289 The formulation of the dominant or main cause was adopted in Black and if the court sought to reject the possibility of apportionment (which was not raised in that case) they would have done so expressly.290 As noted in Chapter III, the judgment by Maisels J in Transvaal Associated Hides, entertained the idea of apportionment but did not go further as it was not raised. However, what is important is that the learned judge applied the dominant or main cause test, but nevertheless entertained apportionment, indicating that the test does not necessarily preclude the application of apportionment.291
It is contended that it has become clear that the absence of legislative intervention which provides clear guidelines for apportionment has hampered the development of a coherent mechanism for apportionment. Therefore, it is submitted that the current state of the approach to the apportionment is inadequate and needs revision, failing which the concerns about the erosion of the tax base and the abuse of the ‘all-or-nothing’ approach to the determination of source will persist indefinitely. The uncertainty of apportionment within the judicial approach – exacerbated by the evidently hesitant and inconsistent judicial approach to apportionment – could be remedied by enshrining a coherent principle of apportionment within our law through legislative enactment which would provide adequate guidance and an obligation on the courts to apportion in the case of a multiplicity of originating causes.292
Additionally, there must be congruence regarding the principles of taxation at the international and domestic levels. The Katz Commission recommends that in developing domestic apportionment legislation, the legislature should follow the well-established examples of
287 Epstein supra note 208 at 14.
288 Ketchemin op cit note 131 at 224.
289 Ibid at 225.
290 Trevor Emslie & Richard Jooste ‘Causation concomitant issue of apportionment with reference to gross income in South African income-tax’ (1989) 106 SALJ 292 at 306.
291 Ibid.
292 Katz Commission op cit note 286 at §5.5.2.
international DTAs.293 It should be noted that the underlying principle of this recommendation of the Katz Commission’s remains defensible and domestic apportionment would do well to be aligned with international apportionment rules. However, the OECD’s nexus requirement and profit allocation rules are highly contentious as they currently stand. Therefore, South Africa would do well to exercise caution and resist applying outdated international apportionment rules. Nevertheless, the legislature should attempt to attain congruence with international apportionment as far as possible.
iv. THE STATUTORY APPROACH TO THE DETERMINATION OF SOURCE The inadequacy of the domestic approach to the determination of source in light of the digitalisation of the economy has long been acknowledged. Such concerns were raised by the Katz Commission in 1997.294 The commission recommended that South Africa should avoid uprooting the entire tax framework, but rather that SA should ‘internationalise’ its tax laws pertaining to international trade.295 The Davis Tax Committee (DTC) notes that in the context of South Africa, as a developing country, it is essential that all subsequent legislative enactments are necessarily required to strike a balance between the taxation of the digitalised economy and the need to ensure legislation does not stifle the much-needed economic development in South Africa.296
Section 9 of the ITA – which provides the statutory rules for the determination of source – makes no reference to e-commerce or income derived specifically within the digitalised economy. The relationship between section 9 and the judicial approach – as stated in Chapter III – is that where s9 is silent the common law principles must apply. Therefore, in respect of digitalised business models and e-commerce, resort must be had to the judicial approach to determine the source of the income in question. In addition to the discussion regarding the inadequacy of the judicial approach as applied to digitalised busines models, the DTC also notes that the judicial approach is not well equipped to deal with the complexities of the digitalised economy.297 The DTC concludes that there is no adequate legal basis to justify the
293 Katz Commission op cit note 286 at §5.5.3.
294 Davis Tax Commission op cit note 18 at 59.
295 Ibid.
296 Ibid at 61.
297 Ibid at 62.
expansion of South African fiscal jurisdiction to allow for the taxation of the non-resident taxpayer’s income derived from e-commerce transaction with South African residents.298
Particular focus in the previous chapter regarding the source rules contained in s9 of the ITA illustrated the importance and the applicability of the provisions relating to royalties. The heavy reliance on intangible assets and intellectual property has become a cornerstone of digitalised business models. Therefore, a statutory rule for the determination of the source of royalties that is adequately applicable to digitalised business models is very important.
The source of royalties and income received from the use or right to use of certain identified knowledge will be located in South Africa, where the person paying the royalty or fee is a resident for tax purposes in South Africa or where the use or right of use of the intellectual property or specific identified knowledge is in South Africa.299 The prerequisite of a payment in order to determine the source of the income received is incongruent with the reality of the digitalised economy.
ATAF provides a broad criticism of the ‘payer principle’, which determines source on the basis of the residency and location of the person making the payment, in the digitalised economy.
Often value creation by entities occurs without the payment of a fee when conducting advertising and similar activities in the digitalised economy. In the example of advertising, it is possible that there are no payments being made. However, a jurisdiction may have a significant number of users or viewers that are targeted by the advertising.300 Thus, this approach to the allocation of taxing rights would be at odds with the benefit theory as previously discussed.
Moreover, one of the primary concerns of the fiscal response to the digitalised economy is to develop new profit allocation rules that would allocate taxing rights where the value is created by the new digitalised business models.301 This is broadly analogous to the benefit theory.
Additionally, user participation and network effects derived from users are incredibly
298 Ibid.
299 Income Tax Act at ss9(c)-(f).
300 African Tax Administration Forum ‘Technical review of the draft article 12B United Nations model tax convention’ (2020) at 2.
301 Ibid.
important drivers of revenue in the digitalised era.302 The realisation and observation of
‘prosumption’ cannot be ignored as part of the value creation process.
The adoption and application of the payer principle does not capture this stream of value – whereby the prerequisite of a payment in the determination of source narrows the scope of the provisions in question.303 Accordingly, integral and profitable value creation processes relying on the use of, and the right to use, certain intellectual property and knowledge will remain untaxed in these jurisdictions due to the absence of a payment. Therefore, the narrowed scope of applicability to the digitalised economy makes such provisions inadequate in that they do not encompass value creation processes that are integral to business models in the digitalised economy.
The definition of intellectual property and ‘property of a similar nature’ in s9(1) and s23I of the ITA, as discussed in the previous chapter, is of importance given the reliance on user contributions and network effects in the digitalised economy. Digitalised business models are able to derive revenue and value from user contributions which constitute the original work of users through their creative or intellectual efforts. There is seldom payment in these arrangements and therefore determining the source of the revenue created through these user contributions cannot be determined solely by the prerequisite of a payment.304 This approach is misaligned with the benefit theory and the process of aligning taxing rights with the value creation process in the digitalised economy.
The DTC recognises that the challenges posed to the South African direct tax law system are of an international nature and the Commission submits that South Africa adopts the recommendations made by the OECD.305 Firstly, in drafting the necessary legislation, the legislature must remain cognisant of the ever-changing nature of the digitalisation of the economy and the affordances of rapid technological advancements.306 Thus, it is necessary that the drafted legislation must avoid conceptual attachment to a certain type of technology as it is likely that the technology may become obsolete or redundant over time.307
302 Ibid.
303 Ibid.
304 Ibid.
305 DTC op cit note 18 at 63.
306 Ibid.
307 Ibid.