CLOUDY WITH A CHANCE OF TAXATION.

• Author: Azam, Rifat

INTRODUCTION 502 I. TAXING CLOUD COMPUTING 507 A. Cloud Computing: A New IT Paradigm 508 B. The Broad-Based Multistage Taxation of the VAT 510 C. The Challenges of Applying the VAT to 514 Cloud Computing 1. Characterizing the Transactions 514 2. Locating the Place of Supply 517 3. Collecting VAT: Registration and Compliance 520 4. Tackling Fraud and Avoidance Schemes 521 II. CURRENT APPROACHES 522 A. Characterizing the Transactions 523 1. OECD Approach 523 2. EU Approach 524 B. Locating the Place of Supply 526 1. OECD Approach 527 2. EU Approach 530 C. Collecting VAT: Registration and Compliance 534 1. OECD Approach 534 2. EU Approach 536 D. Tackling VAT Fraud and Avoidance 539 1. OECD Approach 540 2. EU Approach 542 III. RECOMMENDATIONS FOR REFORM 545 A. Improving the Registration-Based VAT System 546 1. Identity Authentication Technologies to 546 Address Characterization Challenges 2. Payment Intermediaries to Facilitate 548 Locating the Place of Supply 3. VAT Administration Unions and Technology 550 to Improve Compliance 4. Technologies and Real-Time Automatic 557 Information Exchange to Tackle VAT Fraud and Evasion B. Implementing a Real-Time Blockchain VAT System 559 C. Collecting VAT Through Payment Intermediaries 563 CONCLUSION 570 INTRODUCTION

The digital economy is changing the world. (1) It has digitalized our economy, society, and lives, which, in turn, has revolutionized everything from the way we consume and interact to the way we do business. (2) Given this new environment, almost every sector of the economy has had to evolve to take into account these changes. (3) The tax system is no exception.

This new global digital era has significant implications for our current tax systems. These systems are unable to adequately tax digital transactions, giving rise to uncertainty for taxpayers and concern for tax administrations. Given the rapid and widespread shift in consumption from the physical world to the digital world, one particular area of concern is the continued viability of consumption tax systems, such as the value added tax (VAT).

Several methods can be used to tax the value of goods and services consumed by taxpayers, the most popular of which is the VAT. Coinciding with this digital revolution, the VAT has become the "go to" tax for many countries across the world. (4) Limited to use in less than 10 countries in the late 1960s, today the VAT system (including the Goods and Services Tax (GST)) (5) is an important source of revenue in more than 166 countries worldwide. (6) This number is expected to grow through the 21st century as the digital economy continues to pose threats to the viability of current tax systems and introduces new ways to capture additional tax revenue. (7)

Although the United States is one of the few modern economies without a VAT system, the VAT can have a significant impact on any business engaged in international trade, including many U.S. businesses. (8) As the world becomes more digital, the number of businesses engaged in cross-border economic activities continues to increase exponentially, thereby exposing more companies to VAT liability in numerous jurisdictions. Moreover, because the VAT system is not equipped to tax this new world, businesses confront uncertainty, heavy compliance burdens, and potential double taxation when trying to comply with their VAT obligations. At the same time, applying current VAT principles to the digital world gives rise to VAT collection and enforcement challenges, which threaten government tax revenues, distort competition, and burden international trade. (9) Given the Supreme Court's recent holding in South Dakota v. Wayfair, enabling states to impose retail sales tax collection duties on out-of-state retailers, the implications of the VAT debate have become even more significant for the U.S. sales tax system. (10) Thus, even from a U.S. perspective, the ability of current VAT systems to effectively tax digital transactions has considerable implications that should be taken seriously.

With the digital economy continuing to rapidly grow and transform, addressing these challenges has increasingly been the subject of ongoing discussions. (11) Although countries are beginning to adapt their VAT systems, more significant reforms are needed. Now is the time to seriously consider how to adapt our VAT rules to the 21st century, and we seek to further these efforts. Specifically, this Article makes three key contributions to the evolving debate over taxing the digital economy.

First, this Article provides a detailed examination of the main difficulties that the digital economy poses for the application of existing VAT rules. Cloud computing, a significant component of the digital economy, magnifies many of the challenges that the digital economy creates for our current VAT system. (12) In particular, the cloud environment involves the use of borderless, anonymous, instantaneous transactions and has facilitated the electronic delivery of services on a much larger scale than previously experienced. Consequently, there has been a significant increase in both the number of transactions subject to VAT and the number of suppliers who must comply with VAT requirements. These features of the cloud environment contradict fundamental premises of the VAT system, giving rise to substantial challenges when attempting to capture the appropriate amount of VAT on cloud computing transactions.

For instance, the use of the cloud generally eliminates the transfer of any physical components. (13) Therefore, border controls cannot apply to virtual transactions as they do to physical goods, contributing to VAT compliance and enforcement complexities. Because many cloud transactions are relatively small and are often consummated between parties in different places that do not necessarily know each other's location, it is often difficult for both suppliers and tax authorities to acquire and verify the customer information. This difficulty is compounded by the fact that cloud transactions are unrestrained by time and place, which means that cloud services are often provided from remote locations that may vary throughout the term of the cloud service agreement and may not necessarily correspond to, or may even obscure, the place of consumption. (14) Thus, the place of consumption and the jurisdiction with taxing authority can be difficult for a service provider and tax authorities to identify. This determination also depends on correctly characterizing the transaction. However, the virtual nature of cloud computing transactions blurs the distinction between goods and services and gives rise to other characterization issues. (15) Given these features, cloud computing has proven to be a disruptive technology, not only in the business world, but also in the tax world.

Second, building on this background, this Article contributes to the existing literature by critically evaluating the progress made at the international level (by reviewing the work of the OECD) and the progress made at the national level (by considering the approaches taken by the European Union (EU)) in addressing these challenges. Despite important progress made by both the OECD and EU, we argue that the current approaches are not enough and more substantial reform is needed.

Third, we build upon and address the shortcomings of these current approaches to develop a range of policy options. Recognizing that there is no easy solution to the challenges that the digital revolution has created for VAT systems, this Article provides an arsenal of tools that VAT jurisdictions and international institutions can consider in their attempts to better cope with the challenges of VAT and cloud computing and to protect their tax bases.

The remainder of this Article proceeds as follows: Part I provides a brief overview of the key principles that underlie most VAT systems and identifies the key features of cloud computing transactions that present the main challenges to current VAT systems. Part II explores the numerous challenges that cloud computing transactions pose for VAT systems and how these challenges, collectively, threaten to undermine the VAT tax base. Part III discusses the initiatives taken by the OECD and EU to address these challenges and analyzes their progress in this regard. Part IV argues that additional and more substantial VAT reform is essential and sets forth several recommendations for VAT reform. In making these recommendations, we seek to ensure that our consumption tax systems evolve to reflect the economic realities of this global, digital era.

1. TAXING CLOUD COMPUTING

   The rise of the VAT is one of the most interesting stories and significant trends in the evolution of global tax systems in recent times and has become one of the world's most dominant revenue instruments. (16) With the exception of the United States, (17) the VAT system now applies in most major economies throughout the world, and its use continues to grow as more countries adopt VAT systems and revise their current ones. (18)

   The increasing popularity of the VAT interacts with another fascinating trend: the growing and prevalent use of cloud computing. Given the scalable, relatively inexpensive, on-demand access to information technology (IT) capabilities that the cloud provides, more and more companies have moved their business to the cloud. As a result, cloud computing has contributed to the rapid and widespread shift in consumption from the physical world to the virtual world in a manner that has created significant challenges for VAT systems worldwide. This trend is only expected to continue to increase as experts predict the public cloud market will grow to $236 billion in 2020. (19)

   1. Cloud Computing: A New IT Paradigm

      Broadly speaking, cloud computing refers to the on-demand delivery of computing resources remotely through the internet (the "cloud"). (20) These transactions differ from the...