The international tax rules are being reformed to cope with the increasing digitalisation of business. Work is ongoing to reach an international consensus. Meanwhile some countries, including the UK and France, are taking unilateral action.

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 is considering a digital levy as an interim solution and individual countries, including the UK, France and Spain 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 European 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 ruled that a number of digital taxes unfairly target 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 digitisation of all types of business. 

OECD

The OECD is considering how the international tax system could be reformed. It had hoped to  come up with an agreed approach to taxing the digital economy by the end of 2020, but it was not possible to achieve international agreement in that timescale. It hopes to reach agreement in mid 2021.

In October 2020, the OECD published 'blueprints' of its proposals for reform of the international tax system.

The proposals are divided into two 'pillars'. Pillar one addresses the allocation of taxing rights between jurisdictions and considers proposals for new profit allocation and nexus rules. Under this proposal, market jurisdictions would be given the right to tax some of the "deemed residual profit" of certain multinationals from carrying on consumer-facing businesses. The portion of the deemed residual profit that is taxable in each market jurisdiction would be shared between them on the basis of a formulary apportionment.

Pillar two 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 by ensuring that multinationals pay a minimum level of tax, regardless of where they are headquartered or the jurisdictions in which they operate.

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.

The OECD estimates that the pillar one and pillar two reforms could increase global corporate income tax revenues by around $50-80 billion a year.

Although the OECD estimates that pillar one would lead to a modest increase in global tax revenues with low, middle and high income economies benefiting but investment hubs losing out, pillar one's main impact would be to reallocate taxing rights between countries. 'Market jurisdictions' where customers are based, such as many European countries, would benefit at the expense of countries, such as the US, where some of the biggest digital companies are headquartered. The OECD estimates that pillar one could reallocate taxing rights on about $100bn of profit to market jurisdictions.

In contrast, the OECD estimates that pillar two would lead to a significant increase in tax revenue across low, middle and high income economies. Part of the reason it would increase revenues is that it would act as a significant deterrent to shifting profits to low tax jurisdictions.

The US government has expressed opposition to aspects of pillar one, which will have the effect of shifting some of the tax revenues of some of the biggest technology companies which are headquartered in the US, to market jurisdictions, particularly in Europe.

European Commission proposals

In January 2021 the European Commission asked for views on an EU-wide digital levy, which would cover digital services, including social media, online market places, and other online platforms that operate in the EU.

Back 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.

In 2018 it proposed that until comprehensive changes could 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. However, in the face of opposition from some EU countries, including Ireland, Luxembourg and the Nordic countries, EU finance ministers agreed in March 2019 to concentrate on the OECD's project and not to proceed with their DST. The slow progress in the OECD has led to the Commission considering again a digital levy.

UK

The UK has introduced a digital services tax (DST). It began to apply from April 2020. DST is a 2% tax on the revenues of search engines, social media platforms and online marketplaces to the extent that their revenues are linked to 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 is not a tax on online sales of goods and only applies to revenues earned from intermediating such sales, not from making the online sale. It also only catches 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 need to generate revenues from in-scope business models of at least £500m globally. The first £25m of relevant UK revenues are 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 on revenues attributable to that activity.

A financial and payment services exemption means that a regulated activity which primarily involves facilitation of the trading or creation of financial assets is not considered an online marketplace for DST purposes.

As a number of other countries are also introducing digital services taxes, to alleviate double taxation only 50% of the revenues will be taxed if they arise 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 jurisdictions

Other countries have proposed or have introduced unilateral measures in relation to the taxation of the digital economy. Some examples are: 

  • 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 3% tax on revenues from digital advertising, digital platforms enabling users to interact and the transmission of data collected from users and generated by the use of a digital interface. It began to apply from 1 January 2020;
  • France has introduced 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 introduced a digital services tax from January 2021. It imposes a 3% tax on revenues from Spanish users in respect of online advertising services, online intermediation services and online data transmission;
  • Austria imposes a 5% tax on gross revenues from digital advertising services provided in Austria;
  • Brazil, the Czech Republic, Indonesia and Turkey are also considering or have imposed a digital services tax.