Some countries want an increased share of tax on the profits of multinational businesses generated from users based in their countries. The Organisation for Economic Cooperation and Development (OECD) is considering global solutions to the problem. The European Commission has put forward proposals which include a digital services tax as an interim solution and individual countries, including the UK, are taking or threatening unilateral action.
Current international tax rules allow countries to tax profits of non-resident companies which are attributable to a permanent establishment in that country. Transfer pricing rules seek to ensure that a multinational group's profits are divided between the group companies in accordance with each company's contribution to the profits generated.
The concept of permanent establishment currently requires some form of fixed base in a country. The rules, which date from the 1920s, were not designed to cater for the digital economy where businesses may be global have little or no physical presence in the countries where their customers are based.
For example, technology companies with digital platforms such as search engines and social media platforms can make substantial profits through the sale of advertising. Adverts may be targeted at users of the platform in a particular country, yet the technology company may have no substantial physical presence there.
In recent years considerable media attention has focused on the fact that US owned technology companies have made large profits from interactions with individuals resident in the UK and other EU countries but have paid low levels of tax in those countries, or indeed anywhere. The European Commission has tried to use the EU State aid rules to attack some of these structures. The US opposes action which significantly impacts on US companies and has launched an investigation into whether France's digital tax unfairly targets US companies.
However, the issue is wider than just technology companies. Some think that the international tax system needs to be radically reformed to deal with the increasing digitalisation of all types of business.
The Organisation for Economic Cooperation and Development (OECD) is considering how the international tax system could be reformed and has said it will try to come up with an agreed approach to taxing the digital economy by 2020.
The OECD says that for a solution to be presented by the end of 2020, the outlines of the architecture will need to be agreed by January 2020. Revisiting fundamental aspects of the international tax system will require political engagement and compromises as it will involve a reallocation of the tax revenues between countries, so there will be winners and losers.
The OECD published an interim report on the tax challenges arising from digitalisation in March 2018, and published a policy paper in January 2019 and a public consultation document in February 2019. A programme of work was endorsed by G20 Finance Ministers in June 2019.
The proposals are divided into two 'pillars'. Pillar one looks at how taxing rights on income generated from cross-border activities in the digital age should be allocated among countries. Here three different proposals - user participation, marketing intangibles and significant economic presence – have been put forward, but need to be narrowed down.
User participation involves changing profit allocation rules to reflect the value created by digitalised businesses such as social media platforms, through developing an active and engaged user base and soliciting data and content contributions from them.
The marketing intangibles proposal would apply to a wider range of businesses and addresses a situation where a company can 'reach' into a jurisdiction either remotely or with a limited local presence to develop a user or customer base. It aims to allocate profits to jurisdictions where income can be attributed to 'marketing intangibles' such as brands, trade names and customer data.
The remaining pillar one proposal is that a taxable presence in a jurisdiction should arise when a non-resident company has a 'significant economic presence', established through factors including revenue generation, the existence of a user base or sustained marketing activities.
The second pillar is the 'global anti-base erosion' (GloBE) proposal, which seeks to address the continued risk of profit shifting to entities subject to low or zero taxation, as some countries think that the base erosion and profit shifting (BEPS) measures to date do not go far enough. This type of profit shifting is a particular problem in the digital economy in relation to profits relating to intangibles, but it also causes problems more broadly, such as where group entities are financed with equity capital and generate profits from intra-group financing or similar activities.
Under GloBE countries would remain free to decide whether to have a corporate income tax and their own tax rates, but other jurisdictions would be able to apply new rules where income is taxed at an effective rate below a minimum rate.
GloBE involves two inter-related rules: an income inclusion rule that would tax the income of a foreign branch or controlled entity if that income was subject to tax at an effective rate below a minimum rate; and a tax on base eroding payments that would deny a deduction or impose a withholding tax.
It would not be limited to highly digitalised businesses. It is designed to stop the 'race to the bottom' in relation to tax rates and to ensure that all internationally operating businesses pay a minimum level of tax.
European Commission proposals
In 2018 the European Commission proposed reforming international tax rules so that profits are taxed where businesses have significant interaction with users through digital channels. It proposed that a digital platform should be deemed to have a taxable 'digital presence' or a virtual permanent establishment in a member state if it has more than a specified amount of revenues and users in the state.
The Commission has proposed that until comprehensive changes can be made, a 3% interim digital services tax (DST) should be applied to revenues created from activities where users play a major role in value creation, such as social media platforms.
Tax revenues would be collected by the member states where the users are located – in a similar way to the VAT mini one stop shop (MOSS).
The Commission proposed that DST would only apply to companies with total annual worldwide revenues of more than €750 million and EU revenues of more than €50 million. The Commission's proposals would catch those selling online advertising space, digital intermediary activities, and those selling user-generated data and content.
Some EU countries, including Ireland, Luxembourg and the Nordic countries voiced their opposition to the Commission's proposals, even when watered down to only apply to advertising revenues. EU finance ministers agreed in March 2019 to concentrate on the OECD's project and not to proceed, for now, with an EU proposal for a tax on the revenues of digital companies.
In July 2019, the UK government confirmed that it would be going ahead with a new Digital Services Tax (DST) from April 2020. It published draft legislation and draft guidance, which are subject to a consultation process.
DST will apply a 2% tax on the revenues of search engines, social media platforms and online marketplaces where their revenues are linked the participation of UK users, regardless of where the corporate owner of those revenues is located and irrespective of the physical presence that the corporate has in the UK. It will not be a tax on online sales of goods and will only apply to revenues earnt from intermediating such sales, not from making the online sale. It will also only catch the revenues from online advertising or the collection of data where the business is providing a search engine, social media platform or online marketplace.
To be caught by DST businesses will need to generate revenues from in-scope business models of at least £500m globally. The first £25m of relevant UK revenues will also not taxable. This is designed to exclude small businesses from the scope of the tax, but rapidly growing businesses will fall within the DST as soon as they pass the £500m threshold.
If a 'safe harbour' election is made, the DST tax rate will be calculated by reference to the UK operating margin of an activity which is within the scope of DST. This is designed to ensure that where the UK activity is loss making, no DST needs to be paid onrevenues attributable to that activity.
A financial and payment services exemption will mean that a regulated activity which primarily involves facilitation of the trading or creation of financial assets will not be considered an online marketplace for DST purposes.
As a number of other countries are also introducing digital services taxes, the UK government proposes to alleviate double taxation by only taxing 50% of the revenues arising directly as a result of transactions where one of the users is located in a country which also has a DST that applies to marketplace transactions.
The UK government has said that it is committed to disapplying DST once an "appropriate international solution" is in place.
The UK has already introduced diverted profits tax (DPT) aimed at multinationals operating in the UK which have structures which avoid UK tax, although in practice it has much wider application.
Other countries have proposed or have introduced unilateral measures in relation to the taxation of the digital economy. Some examples are:
- Australia has introduced a tax similar to the UK's diverted profits tax.
- India has introduced an equalisation levy whereby a percentage of any payment made to a non-resident in respect of online advertising is withheld by the Indian taxpayer.
- Italy has introduced a tax on digital transactions which catches electronic services supplied to businesses and will require a 3% withholding by the Italian customer. It is not yet in force.
- France is introducing a digital services tax backdated to 1 January 2019. It imposes a 3% tax on revenues deemed to have been generated in France from platforms enabling users to interact with each other and on digital advertising revenue.
- Spain and Austria have also proposed unilateral measures.
- New Zealand is considering a digital services tax if insufficient progress is made by the OECD in 2019.