Budget 2017: digital taxation paper "probably the most radical" of Budget proposals, says expert

The paper proposes short, medium and long-term solutions to the increasingly difficult political problem of how to make sure that digital businesses pay their "fair share" of tax. It introduces the new concept of "user-generated value".

The extremely rapid growth of tech companies, and particularly the enormous market capitalisation of some relatively young businesses, has led to governments around the world questioning whether the tax system is still fit for purpose.

The OECD's Base Erosion and Profit-Sharing Project (BEPS) is giving rise to significant changes, particularly in relation to anti-avoidance rules such as the Treaty anti-abuse rules now included in the Multilateral Instrument, but this is still seen by many as a sticking plaster rather than a long-term solution to the challenge of how to tax digital businesses.

An important issue is that much of the value of a digital business lies in its intellectual property. It is relatively easy, particularly for US multinationals, for significant value to be allocated to the holding of intellectual property rights in a tax haven. Under a traditional transfer pricing model, profits are allocated between the various members of the multinational group, but crucially the mere sales of goods or services to a country does not give rise to a local tax charge, unless the group has a physical presence in that country – and digital companies do not need a physical presence to generate sales.

The BEPS proposals will deal with some elements of the problem, such as the use of hybrid entities or payments made through a conduit in a Treaty country. The EU's state aid investigations into companies such as Apple and Amazon are attacking the issue from another angle, claiming that the low tax rates achieved in some European countries are as a result of illegal subsidies.

And, of course, the UK introduced the Diverted Profits Tax (DPT) in 2015, which will impose a tax charge where arrangements which lack economic substance result in profits being 'diverted' from the UK. Meanwhile, the saga of possible US tax reform is still at an early stage.

The political clamour to do something continues. The response is this Position Paper. It is an unusual format, setting out the government's current position and likely direction of travel and inviting comments, by 31 January 2018. But it is not, formally, a consultation document.

The key concept put forward in the paper is that of value attributable to users, or "user-generated value". This is suggested as a concept which is unlikely to be relevant to 'traditional' businesses selling digitally, but is particularly important to businesses which generate value through their user base, typically by receiving advertising revenue or by taking a commission on user-to-user transactions. The larger the user base, and the greater the use of data about that base, the higher the ultimate revenue.

Interestingly, this definition answers one of the major criticisms usually levelled at a 'digital' tax, by narrowing the category of businesses likely to be within its scope.

The paper says that in the long term, the solution should be a multinational one, probably being achieved via the continuation of the OECD's work. The OECD has recently concluded a consultation on the taxation of the digital economy and is meeting in spring to discuss the next steps.

The UK is, effectively, advocating that the arm's length principle should be amended to allocate profits to user-generated value, possibly by an approach which comes close to formulary apportionment. This would be a major step for the OECD to take, and the UK recognises that it is likely to take some time.

In the paper, the UK suggests that, as an interim measure, a revenue-based digital tax, effectively a sales tax, could be introduced. It recognises that this would probably not accurately capture value, and would also be difficult to apply to companies with very different profit margins. Indeed, in the early years of a digital business, a sales tax would risk being an additional burden on a loss-making business.

Difficult issues are also likely to arise in resolving double taxation disputes: if the country where the sales take place levies tax, will the country where the company is resident be willing to give relief?

The idea of a sales tax has been mooted by the EU as a possible short-term option, although the UK paper strongly recommends that action should be taken at the wider OECD level, rather than only by the EU.

Finally, there is a proposal for a withholding tax on royalties paid "in connection with sales to UK customers", where the ultimate recipient is in a low tax jurisdiction and has limited economic substance.

Levying such a tax is likely to present a number of major challenges. Firstly, it will be levied wherever the payer is based, so it is likely that the legislation will first have to expand the definition of a UK-source royalty, and second impose an obligation to notify chargeability on an overseas payer of such royalties, even where the payer has no UK presence.

The typical structure, illustrated in the document, is of sales to UK residents by an offshore company in an EU location. The EU company pays little tax, because it pays a royalty, based on total sales, to a company in a tax haven which owns the intellectual property. It is the EU company which would be required to account for UK income tax in these circumstances.

Most UK double tax agreements provide that the UK cannot levy a withholding tax on UK-source royalties paid to a resident of the other state. It is not clear how the legislation will override the double tax treaty. Finally, there is the small matter of collecting tax from a non-resident payer.

The complexities of the short-term solution perhaps indicate why the projected yield is a mere £200 million. Levying tax on the significant sales revenues generated by digital companies sounds popular, but will be more easily said than done.

Eloise Walker is a tax expert at Pinsent Masons, the law firm behind Out-Law.com