As of 2017, Turkey’s major efforts to tax the digital economy started with the Virtual Permanent Establishment (PE) audits conducted on nonresident digital companies and continued with the introduction of the new VAT regime on electronically supplied services (ESS) and the new withholding tax on online advertising services. Turkey’s latest measure was the introduction of digital services tax (DST) that gave rise to numerous criticisms due to its broad scope. Esin Attorney Partnership, member firm of Baker McKenzie International, a Swiss Verein, represented two important litigation cases in Turkey, leading to the first court victories regarding the “digital medium” concept in the Turkish DST legislation.
In the GCC, the digital economy is taxed by virtue of the VAT regime that four out of the six countries (the United Arab Emirates, the Kingdom of Saudi Arabia, Bahrain and Oman) have introduced since 2018. Although there are similarities between these countries, the scope of ESS and the interpretation of use and enjoyment is not harmonized. Furthermore, each country has its own rules and practical challenges when it comes to the VAT registration and VAT return process, payment, invoicing and penalties for noncompliance. It is important for businesses to consider this when operating in the GCC.
A. International developments in digital economy taxation
Over the last few decades, digital transformation has reached a substantial economic magnitude that challenges the efficacy of conventional domestic and international tax regimes developed in “brick-and-mortar” economic environments. Therefore, the taxation of the digitalized economy, specifically cross-border activities, has been the primary focus of the Organisation for Economic Co-operation and Development (OECD) for several years.
The OECD’s first action plan, as part of the Base Erosion Profit Sharing (BEPS) project, was to find a comprehensive, consensus-based solution on the taxation of the digital economy. As a result of years-long studies conducted within the scope of the BEPS project, over 135 countries and jurisdictions have joined the Two-Pillar Solution to reform international taxation rules and ensure that multinational enterprises pay a fair share of tax wherever they operate. Expected to come into effect in 2023, Pillar 1 introduces a new profit allocation method to address the challenges arising from the existing physical presence-driven nexus rules, and Pillar 2 deals with a wider issue, introducing a global minimum corporate tax rate that countries can use to protect their tax bases.
While the OECD’s long-awaited mutual solution has taken shape, in the face of the global digital economy’s accelerating growth, many countries, including Turkey and the GCC countries, have taken initiative in the form of certain unilateral measures in an attempt to tax the digital economy within the scope of cross-border activities.
On 21 October 2021, the United States, Austria, France, Italy, Spain, and the United Kingdom issued a joint statement regarding a compromise on a transitional approach to existing unilateral measures during the interim period (i.e., the period beginning on 1 January 2022, and ending on the earlier of the date the Pillar 1 multilateral convention comes into force or 31 December 2023). On 22 November 2021, the United States and Turkey agreed that the same terms would be applicable between the United States and Turkey with respect to Turkey’s digital services tax (DST). Accordingly, these countries will continue to implement DSTs until Pillar 1 is in effect, and will allow companies that paid DSTs during that interim period to enjoy a credit mechanism that is still in development.
B. Turkey’s major unilateral measures on the taxation of the digital economy
1) Virtual PE audits
Turkey’s first major reaction was to conduct tax audits on several nonresident digital companies operating in Turkey. Since 2017, the Turkish Tax Authority (TTA) has argued during such tax audits that companies’ websites or other digital platforms per se can constitute a PE in Turkey, without requiring a physical presence (such as a server) in Turkey. Based on these ‘virtual PE’ assertions, the TTA made significant tax assessments on nonresident digital companies subjected to tax audits in terms of corporate income tax, advance tax (a type of advance corporate income tax), dividend withholding tax, VAT, tax loss penalties and special irregularity penalties.
At Esin Attorney Partnership, member firm of Baker McKenzie International, a Swiss Verein, we represented the majority of nonresident digital companies before the Turkish tax courts the lawsuits filed for the cancellation of their virtual PE assessments. Considering that the virtual PE claim is contrary to both the PE rules under the Turkish domestic legislation and the applicable double tax treaties, we managed to obtain victories in both first-degree tax courts and the Istanbul Regional Administrative Court (still subject to the final approval of the Council of State). Although those court decisions are not public, they constitute an important and persuasive court precedent regarding the virtual PE issue for all nonresident digital companies operating in Turkey.
2) VAT on ESS
Historically, the Turkish VAT Law includes a general reverse charge mechanism making Turkish residents responsible for declaring and paying the VAT related to the purchases of goods or services from persons having no residence, workplace, headquarters or business center in Turkey. Although in theory the reverse charge mechanism applies regardless of whether the Turkish customer is an individual or entity, in practice, non-VAT registered individuals could not self-declare the VAT received from nonresident suppliers.
Therefore, Turkey needed a new mechanism to ensure the collection of VAT arising from cross-border business-to-consumer transactions, particularly those supplied electronically to individuals in Turkey.
As a result, Turkey’s next major move was the introduction of a new VAT regime making nonresident suppliers responsible for collecting, declaring and remitting the VAT arising from their ESS to non-VAT registered individuals in Turkey, which came into effect as of January 2018.
The VAT legislation also clarified that services supplied electronically through a PE in Turkey do not fall within the scope of the new ESS rules, and therefore the VAT arising from these services must be declared and paid in line with general VAT rules (a PE in Turkey should already be registered in Turkey for all taxes, including VAT).
3) Withholding tax on online advertising services
Turkey’s endeavors to tax the digital economy continued with the introduction of a new withholding tax for payments made for online advertising services to the providers of these services or to those who act as an intermediary for the provision of these services, effective as of January 2019. The withholding tax rate was determined as 15% for payments made from Turkey to nonresident service providers.
This withholding tax liability caused many controversies due to its inconsistency with the double tax treaties concluded between Turkey and the country where the nonresident entity providing online advertising services is a resident. In fact, many Turkish taxpayers receiving online advertising services, being responsible for this withholding tax, challenged this issue in litigation based on treaty override arguments.
The vast majority of the first-degree tax courts ruled in favor of taxpayers, and those decisions are being approved by the Istanbul Regional Administrative Court (still subject to the final approval of the Council of State).
General overview of Turkey’s DST
Turkey’s last measure was the introduction of the DST Law, effective as of March 2020. Turkey’s 7.5% DST covers digital service providers exceeding a global revenue threshold of EUR 750 million and local revenue of TRY 20 million. The tax is mainly applicable to revenue generated from online advertising services, digital content sales/services and digital platform services.
However, since its introduction, Turkey’s DST has given rise to numerous debates and criticisms, mainly due to its broad and vague scope. In fact, the “digital medium” concept defined in the DST Law has already been subjected to two important litigation cases in Turkey, leading to the first court victories against the TTA obtained regarding the Turkish DST. Esin Attorney Partnership, member firm of Baker McKenzie International, a Swiss Verein, represented the winning parties in these litigation cases.
Precedential Turkish court victories on DST
The DST disputes revolved around the interpretation of Article 1/1-b of the DST Law regarding the digital content sales in the context of “which sales should be deemed conducted in digital medium.”
The first litigation case was filed by the Turkish subsidiary of one of the world’s leading software companies operating as the distributor for the group’s software licensing and cloud services sales in Turkey. We argued that the disputed sales (directly to end users) should not fall within the scope of Article 1/1-b of the DST Law, since these sales are not realized in a “digital medium” as required by the DST Law. Indeed, we argued that the DST Law only targets sales made in virtual stores without any human intervention (i.e., click and buy arrangements). The classic example of an “online sale” is a virtual store, where a Turkish consumer purchases a song, game or film on an online store. These sales are performed without any human interaction or involvement and in an entirely virtual environment.
In our client’s case, however, the disputed sales involved complex software products used by large businesses and public entities that are not realized on a click-and-buy basis. The sales instead required person-to-person human interactions between the seller’s employees working in the sales, marketing and technical support departments and the customer, in order to understand and/or determine the needs of the customer.
In August 2021, the first-degree tax court unanimously ruled in favor of our client, stating that the taxpayer’s activities cannot be deemed as realized in the digital medium, as the major and essential part of the taxpayer’s activities rely on activities conducted physically (such as long meetings with customers to determine their needs, in-person trainings, and sales contracts negotiations), even if the software/service is delivered online.
Our second DST dispute victory was filed by a nonresident software company concerning whether the granting of the right to resell software or cloud services would fall within the scope of the DST in Turkey.
With respect to the disputed sales, our nonresident client only grants the right to resell its products (software and cloud services) to a third-party ‘distributor’ in Turkey under a distributorship agreement, whereby the distributor’s right is limited to sales made to ‘resellers’ in Turkey, who ultimately sell the products to the end users in Turkey. We argued that the granting of the right to resell products to the distributor under a distributorship agreement should not fall within the scope of the DST Law, as disputed sales are not carried out in a digital medium as required by the DST Law.
In December 2021, the first-degree court unanimously concluded that the disputed sales were not made in a digital medium, considering that the distributor does not have the right to sell the products directly to the end customers in Turkey and the distributor is not authorized to use the products or use or keep the product keys, codes, license files, account information or passwords without our client’s consent.
As the very first court decisions issued regarding the scope of the DST Law (subject to the approval of the Istanbul Regional Administrative Court and Council of State), the decisions clarified the sale of a digital content in a ‘digital medium’ under the DST Law. Although the court decisions are not public, other taxpayers can still utilize them as a persuasive court precedent in case of a possible DST audit/litigation in Turkey.
C. Digital economy taxation in the GCC
At the beginning of 2017, the GCC (comprising the Kingdom of Saudi Arabia (KSA), United Arab Emirates (UAE), Bahrain, Oman, Qatar and Kuwait) signed the Unified VAT Agreement. The Unified VAT Agreement sets out the basic principles of the VAT regime in the GCC but does not have a similar status as the European Union’s Principal VAT Directive.
VAT was introduced at a standard rate of 5% in the UAE and the KSA on 1 January 2018, in Bahrain on 1 January 2019, and in Oman on 16 April 2021. Qatar and Kuwait are expected to introduce VAT in due course, with Qatar most likely being the next jurisdiction. The KSA and Bahrain have increased the standard VAT rate to 15% (1 July 2020) and 10% respectively (1 January 2022).
The Unified VAT Agreement states that the place of supply for wired and wireless telecommunication services and ESS is the place of actual use of or benefit from the services.
What constitutes ESS and how actual use and/or benefit should be determined is not defined in the Unified VAT Agreement and is thus up to the GCC country’s discretion. As a result, the scope of ESS and use and enjoyment is not harmonized across the GCC. However, in all GCC countries, nonresident service providers are only required to register when they provide ESS to customers that are not registered or required to register for VAT. There is no VAT registration threshold for nonresident taxpayers in any of the GCC countries, and the nonresident is required to apply for registration from the first supply made to a non-registered customer.
The registration threshold for resident companies is USD 100,000 of annual turnover in all jurisdictions, which could mean that although the customer is in business it is not registered or required to register for VAT. If this is the case, the nonresident service provider should register and account for VAT. The VAT registration numbers can and should be verified on the websites of the various tax authorities.
Scope of ESS
The UAE defines ESS as “services which are automatically delivered over the internet, or an electronic network, or an electronic marketplace” and then provides a non-exhaustive list of services that fall within the scope of ESS. In the guidance, the tax authorities clarify that a service only qualifies as an ESS when it is on the (non-exhaustive) list of services and is delivered over the internet, an electronic network or an electronic marketplace with minimal or no human intervention. The tax authorities thus appear to apply a narrow (as opposed to the EU) interpretation. Unfortunately, the guidance of the authorities is not binding and may be amended at any time.
The KSA does not define ESS in the legislation but merely provide a non-exhaustive list of services that are regarded as wired and wireless telecommunications services and ESS. In its guidance, the KSA tax authority states that ESS and telecommunication services are services that are closely related and that involve the transmission of information to a recipient or to recipients. It is further clarified that new types of ESS provided over the internet or other electronic means will also be included in this definition. The guidance also provides examples of services that may be regarded as ESS, such as the use of a mobile application to book a taxi.
In the Bahrain, ESS are defined as “services provided over the internet or any electronic platform, and which operate in an automated manner with limited human intervention and which are impossible to complete without the use of information technology.” It also provides a non-exhaustive list of services that fall under this definition in its legislation.
Oman defines ESS as “services supplied directly through the internet or an electronic network, where the supply of the services is principally automatic and requires minimum human interference and can be supplied only with the use of information technology.” No further guidance is available.
The scope of ESS is not harmonized in the GCC whereby the KSA appears to apply a broad definition as compared to the other GCC countries and other jurisdictions.
Actual use or benefit
ESS are within the scope of VAT if the actual use or benefit is in the country.
The UAE VAT legislation does not stipulate how to determine the place of actual use or benefit. The guidance states that factors such as IP address, country code of the SIM card, place of residence of the customer, billing details and bank account should be considered. The supplier should give priority to the factors that give the most precise information.
The KSA Implementing Regulations set out the difference between location-based ESS and ESS that are not used at a specific location. Location-based ESS include, for example, ESS provided at a telephone box, an internet café, a restaurant or hotel lobby. It is characterized by the fact that the physical presence of the customer at a particular location is required for the services to be provided. The customer consumes and enjoys a location-based ESS at that location. The customer is deemed to consume and enjoy all other ESS in the place of its usual residence, which may be identified by reference to invoice address, bank account details, IP address or the country code of the SIM card.
In Bahrain, the method to determine the actual use or benefit depends on the VAT registration status of the customer. The place of supply of services provided to a non-registered customer is the place where the services are actually used and enjoyed. For a VAT-registered customer, the place of supply is the place of residence of the customer identified by reference to the tax invoice, customer bank account number, the IP address, country code of the SIM card, or other information of a commercial nature. The legislation does not state how the place of use and enjoyment should be determined for services provided to non-registered customers. However, the guidance states that the place of contract and the place of payment are irrelevant.
Oman has stipulated in the legislation which factors should be taken into account to determine the actual use and enjoyment of ESS. These include IP address, bank account details, address stated on the invoice, and the international symbol of the chip used to receive the services. It is unclear whether a hierarchy applies.
When ESS are provided by a company not established in the country to a customer that is not registered for VAT, the nonresident service provider is required to register for VAT, account for VAT, issue invoices and submit VAT returns. As highlighted before, there is no registration threshold for nonresident service providers.
The VAT invoicing rules, registration procedures and other administrative requirements that need to be complied with (such as record keeping) vary in each jurisdiction. For example, taxpayers in the KSA are required to issue invoices in Arabic (bilingual invoices are also allowed), whilst those in the other three countries can issue invoices in English. The KSA is also the only jurisdiction that has a deemed reseller provision for platforms that are acting as intermediaries for nonresident suppliers. Contrary to the other jurisdictions, the UAE requires taxpayers to submit the VAT return and settle the tax due within 28 days of the end of the VAT period (as opposed to the last day of the month following the tax period in the other GCC countries). Furthermore, a nonresident in the KSA may be required to provide a bank guarantee in order to register without a tax representative. None of the GCC countries requires nonresidents to appoint a tax representative in principle.
In practice, nonresident taxpayers have faced numerous challenges such as the ability to gain and retain access to the VAT registration portal (especially in the KSA, which may require the nonresident to appoint a tax representative although strictly not required under the law), submit VAT returns and make payments in time.
Noncompliance may result in significant penalties.