Digital VAT, DST, retaliatory taxes and US laws

The United States has historically objected to Digital Services Taxes, revenue-based levies that target large multinational tech firms and bypass traditional tax treaties

This article explores the legal and policy mechanisms the United States employs to counter foreign trade practices, with a particular emphasis on Digital Services Taxes (DSTs) and how they differ from Value Added Taxes (VAT). It also analyses the Trump administration’s strategic use of these tools—especially trade threats and Section 301 of the Trade Act of 1974 investigations to challenge DSTs, which are often seen as discriminatory toward US tech companies.

Retaliatory tariffs to be added on to 30% 

President Trump, upon unveiling the new tariff rates recently (30% for Sri Lanka), warned that any nation striking back with retaliatory tariffs, would find those surcharges effectively piled onto their existing US tariff obligations. – “If for any reason you decide to raise your tariffs, then, whatever the number you choose to raise them by, will be added onto the 30% that we charge” (July 9, 2025 letter from White House)

Digital VAT Vs. Digital Services Tax

A central issue in the debate over the potential for USA to top up 30% with additional 18% on account of digital VAT to be introduced from October, is the widespread confusion between two fundamentally different forms of digital taxation: the Digital Value Added Tax (VAT) and the Digital Services Tax (DST).

Digital VAT: A standard consumption tax

Digital VAT is a consumption-based tax imposed on the end-user of digital services. For example, Sri Lanka’s 18% VAT on nonresident digital service providers who provides services via electronic platform, requires these companies to register locally and collect VAT from Sri Lankan consumers who purchase services such as streaming, online gaming, or cloud-based software, etc. 

This system mirrors the treatment of other goods and services consumed domestically, ensuring tax neutrality and fairness. It also aligns with the OECD’s VAT/GST guidelines, which recommend taxing consumption at the point of use known as the “destination principle.” has been widely adopted by countries around the world, including, Australia, New Zealand, and EU member states.

Several countries in the region that apply VAT or GST to digital services have recently benefited from reduced US tariff rates under Trump’s reciprocal trade policy. For example, India, which imposes an 18% GST on most digital services, has been assigned a lower US tariff rate of 26%. Similarly, Vietnam, with a 5% VAT on digital services, now faces a reduced US tariff rate of 20%. Despite India’s earlier use of equalisation levies (India’s version of DST) its continued application of GST on digital services provided by foreign entities highlights that VAT remains a widely accepted and standard taxation method.

Digital Services Tax (DST): A revenue-based levy

Digital Services Taxes (DSTs) emerged as a way for countries to assert their right to tax the digital economy, especially in response to perceived tax avoidance by large tech firms like Google, Amazon, and Meta. These companies often shifted profits to low-tax jurisdictions, exploiting outdated tax rules based on physical presence. In the absence of a modern global tax framework, countries introduced DSTs to capture revenue from digital activities within their borders. However, these unilateral taxes sparked opposition from the US, which viewed them as discriminatory and retaliated with trade measures.

To resolve these tensions, the OECD proposed a two-pillar solution: Pillar One, which reallocates taxing rights based on user location, and Pillar Two, which sets a global minimum corporate tax rate of 15%. While DSTs are not part of the OECD’s framework and were meant as temporary measures, many countries adopted them due to delays in global implementation. In contrast, the OECD supports VAT systems for digital services, emphasizing principles like “neutrality” between domestic and foreign suppliers, taxation based on consumption location (destination principle), mandatory registration for non-resident providers, and efficient administration through digital filing and transparent audits. 

DST targets the gross revenues of large multinational digital firms derived from specific services within a jurisdiction such as online advertising, social networking, or monetisation of user data etc. These taxes are designed to address concerns about profit shifting and the under-taxation of digital giants that operate extensively in a country without a physical presence. Unlike VAT, DSTs are not levied on consumers but directly on corporate revenues, making them more controversial in international trade discussions.

Sri Lanka’s policy: A clear case of VAT, not DST

It is important to emphasise that Sri Lanka’s 18% levy is a digital VAT, not a DST. This distinction is critical, as US trade investigations and retaliatory actions have been directed exclusively at DST regimes, which are perceived as discriminatory toward US-based tech companies. In contrast, countries that apply digital VATs in accordance with international norms have not faced similar scrutiny or sanctions from the United States. It is significant to note that currently over 100 countries are levying VAT on cross border Digital Services.

Laws of USA

Section 301 of the Trade Act of 1974: A strategic US trade enforcement tool

Section 301 of the Trade Act of 1974 remains one of the most powerful instruments in the US trade enforcement arsenal. It authorises the US Trade Representative (USTR) to investigate and respond to foreign trade practices that are deemed unfair, discriminatory, or harmful to American commercial interests.

The law allows the USTR to act against foreign policies that violate trade agreements or otherwise disadvantage US businesses even if those practices don’t explicitly breach international law. This includes barriers to market access, discriminatory tax regimes, or inadequate protection of intellectual property.

Investigations can be initiated by the USTR or triggered by petitions from US industries. Once launched, the process typically begins with consultations between the US and the foreign government. If no resolution is reached, the USTR may escalate the matter to formal dispute settlement mechanisms, such as those under the World Trade Organization (WTO).

If the foreign practice is found to be actionable, the US can impose retaliatory measures ranging from tariffs and import restrictions to the suspension of trade benefits. Notably, Section 301 also permits unilateral action, allowing the US to respond swiftly without waiting for international rulings.

This flexibility has made Section 301 a favoured tool for administrations seeking to protect US economic interests, particularly in sectors like technology, digital services, and manufacturing. As global trade dynamics evolve, Section 301 continues to serve as a key mechanism for enforcing fair trade and levelling the playing field for American companies.

Section 891 of Internal Revenue Code (IRC): A dormant but potent US tax retaliation tool

As global tax tensions rise, particularly around digital services taxes (DSTs), the United States has begun revisiting a rarely used but powerful statutory provision: Section 891 of the Internal Revenue Code. Originally enacted in 1934, this law allows the US President to double the tax rates on US-source income earned by citizens and corporations of countries that impose discriminatory or extraterritorial taxes on Americans.

Under Section 891, if the US Treasury working with the Commerce Department and the US Trade Representative determines that a foreign country is unfairly targeting US businesses or individuals through its tax policies, the President can authorise significantly higher tax rates on income such as dividends, interest, royalties, and even compensation for services performed in the US.

This provision has never been invoked, and its application remains largely theoretical. However, recent executive memoranda under the Trump administration have signalled a willingness to use Section 891 as a retaliatory measure, particularly against countries that have implemented DSTs perceived to disproportionately affect US tech firms.

While the statute lacks detailed procedural guidance and does not define what constitutes a “discriminatory” tax, its mere threat can serve as a strategic lever in trade negotiations. That said, its effectiveness may be limited by existing tax treaties, which could override Section 891 under the “later-in-time” rule unless the President chooses to suspend or terminate those treaties.

In today’s increasingly complex international tax environment, Section 891 represents a symbolic and strategic tool—one that underscores the US government’s readiness to defend its economic interests through both diplomatic and fiscal channels.

Proposed Section 899 Internal Revenue Code: A bold US tax response to foreign digital levies 

In a significant move to counter what it views as discriminatory foreign tax regimes, the US Congress has proposed a new provision Section 899 of the Internal Revenue Code as part of the 2025 “One Big Beautiful Bill Act.” This proposed legislation aims to protect American businesses from foreign tax measures such as Digital Services Taxes (DSTs), Under Taxed Profits Rules (UTPRs), and Diverted Profits Taxes (DPTs) by imposing retaliatory tax increases on entities from countries that adopt such policies.

Section 899 would authorise the US Treasury to designate countries with “unfair foreign taxes” and impose graduated surcharges on US-source income earned by individuals, corporations, and governments from those jurisdictions. The surcharge would begin at 5% and increase annually—up to 20% above the standard tax rate on items such as dividends, interest, royalties, and real estate gains.

The proposal also expands the Base Erosion and Anti-Abuse Tax (BEAT) for foreign-owned US companies from targeted countries. Notably, it removes the $ 500 million gross receipts threshold, applying the tax even in cases of minimal base erosion. This “Super BEAT” is designed to close loopholes and ensure that foreign multinationals cannot avoid US tax obligations through aggressive structuring.

Perhaps most controversially, Section 899 would allow the US to override existing tax treaty benefits. For example, a treaty-reduced 5% withholding rate on dividends could rise to 25% after four years of surcharge escalation effectively nullifying long-standing bilateral agreements.

The law would apply to a broad range of “applicable persons,” including foreign governments, residents, corporations, and trusts from designated countries. However, US-controlled foreign entities (with at least 50% US ownership) and standard income or VAT regimes would be exempt.

To ensure responsiveness, the Treasury would publish quarterly lists of offending jurisdictions. Once a country repeals its unfair tax, the US surcharges would be lifted on a prospective basis. While still in the proposal stage, Section 899 signals a more aggressive US stance on international tax disputes. If enacted, it could reshape the global tax landscape—raising the stakes for countries considering unilateral digital tax measures and reinforcing the US commitment to defending its tax base and multinational competitiveness.

Trump administration intensifies opposition to foreign digital taxes

Trump’s administration took a firm stance against Digital Services Taxes, arguing they unfairly targeted American tech giants such as Google, Amazon, Meta, and Apple. These taxes, introduced by several countries, were viewed by Washington as de facto import tariffs on digital services, posing a threat to US economic and national interests. In response, the US launched Section 301 investigations into DST regimes in countries like France, the UK, and Canada, concluding that the taxes were discriminatory and violated global tax norms by targeting revenue instead of profits.

This aggressive trade posture prompted several nations to rethink their digital tax services tax strategy. India, for instance, repealed its equalisation levy on charged at 6% on digital advertising and its 2% levy on foreign e-commerce platforms on 1 April 2025 and 1 August 2024 respectively. These levies, which functioned as DSTs, were seen as bypassing traditional tax treaties and were withdrawn as part of India’s commitment to the OECD’s Pillar One framework for a coordinated global tax system and due to vulnerable global trade environment. But however it continue to charge 18% GST (Digital VAT similar to Sri Lanka) on cross border digital services.

Canada followed a similar path. Although it passed a 3% DST in June 2024 with retroactive effect from 2022, its implementation remains on hold. The Canada Revenue Agency recently announced that businesses are no longer required to file DST returns, and legislation to repeal the tax is expected.

These developments reflect a broader US strategy of using trade tools to discourage unilateral digital taxes and promote multilateral solutions. Crucially, the US opposition has focused on revenue-based DSTs, not standard consumption taxes like VAT. This distinction suggests that Sri Lanka’s Digital VAT—being a consumption tax aligned with OECD principles—is unlikely to attract similar pushback.

Clarifying misconceptions: Sri Lanka’s Digital VAT is not a trigger for US tariffs

Recent speculation that Sri Lanka’s newly introduced 18% VAT on non-resident digital service providers could trigger additional US tariffs on top of the existing 30% duty on exports has raised unnecessary alarm. These concerns are based on a misunderstanding of international tax norms and US trade enforcement history.

The United States has historically objected to Digital Services Taxes, revenue-based levies that target large multinational tech firms and bypass traditional tax treaties. However, Sri Lanka’s VAT is a consumption tax, applied uniformly to all digital services consumed within the country, regardless of the provider’s nationality. It follows OECD guidelines and is similar to VAT systems used in countries like India, Vietnam, etc.

Unlike DSTs, which have prompted US investigations and retaliatory tariffs under Section 301 of the Trade Act, digital VATs have not been subject to such measures. The US objections have focused on taxes that are discriminatory and profit-diverting not on standard VAT regimes. Therefore, fears of trade retaliation against Sri Lanka’s VAT are unfounded as it may not fall under purview of Section 301 USTR investigations.

While the timing of the VAT’s introduction may coincide with global trade tensions, the policy itself reflects a legitimate effort to modernise Sri Lanka’s tax system and capture revenue from the expanding digital economy. Rolling back the VAT now would risk signalling policy inconsistency and undermine fiscal reform.

To improve implementation, Sri Lanka could consider applying a reverse charge mechanism for business-to-business (B2B) transactions, shifting VAT liability to local recipients and easing compliance for foreign providers. For business-to-consumer (B2C) services, requiring foreign suppliers to register and collect VAT would ensure fairness and efficiency.

In conclusion, Sri Lanka’s digital VAT is a globally aligned, non-discriminatory tax measure. It is unlikely to attract US trade retaliation and should be viewed as a forward-looking step in strengthening the country’s tax framework 

(The author is the Principal, Head of Tax and Regulatory at KPMG in Sri Lanka)