Digitalization of our economic activities and pervasive new technologies have been and are a key driver of change and bring significant benefits and opportunities. They are also disrupting the world as we know it, and have a profound reach into everyday life. They affect how we live, work, communicate and interact, connect, consume and produce, how we create knowledge, how we function and act as a society, and so much more. According to CISCO, the global internet community consisted of 3 billion users in 2015, with 16.3 billion devices connected to the internet globally, which CISCO expects to increase to 4.1 billion users and 26.3 billion devices by 2020. New businesses are created that range from being entirely digital, relying on intangible assets and user participation, no longer requiring physical assets such as offices or sales outlets or large numbers of employees, to businesses that have digitalized some of their aspects and functions. For example, Airbnb, the world’s largest accommodation provider, owns no real estate and Uber, the world’s largest taxi company, owns no vehicles. Alibaba, the most valuable retailer, has no inventory, and Facebook, the world’s most popular media owner, creates no content. While we used to look at these companies and their activities as distinct from traditional and domestic businesses and economic activities, it is increasingly difficult to do so. This is particularly so for taxation purposes. The OECD in its 2015 Action 1 Report acknowledges that it would be difficult, if not impossible, to ‘ring-fence’ the digital economy from the rest of the economy for tax purposes because of the increasingly pervasive nature of digitalization. Instead, it considers “digitalization as a transformative process affecting all sectors brought by advances in ICT”. Thereby the “digital economy” is becoming the economy itself.
In this context of convergence, governments are increasingly concerned with tax revenue losses arising from multinational tax planning by MNEs that result in base erosion and profit shifting (BEPS) and other, broader tax challenges. Tax revenue losses resulting from BEPS have been conservatively estimated by the OECD to amount to US$100-240 billion per annum globally. BEPS is not a new problem – MNEs have always pursued tax minimization strategies – but certain features of the digitalized economy exacerbate the issues. These features have created a mismatch or disconnect between where profits are made, taxes are paid and where value is created. Also, this mismatch has repercussions at the local level, and can lead to distortions along the digital value chain and across different economic sectors. Therefore, the international community such as the OECD and leading jurisdictions such as the EU are examining how the international tax framework is being challenged by changes in how global businesses are managed and structured and are undertaking efforts to identify - for the long term - how the international taxation framework can be adjusted to cater better to an increasingly digitalized world. In the short term pending an international solution, individual countries are moving unilaterally, such as the UK, India or Slovakia, but also the EU, putting forward and implementing proposals to ensure that digital businesses pay tax that reflects the value they derive from users located in consumption countries. Such measures include digital services taxes, digital transaction taxes, digital platform taxes, equalization levies and changes to concepts of permanent physical establishment.
The article briefly examines the key features of the digitalized economy and the key issues that arise from them for taxation under current international tax rules, their repercussions at the local level, and summarizes what countries are doing to address the issues identified.
The way in which businesses carry out their global activities has been fundamentally changed by digitalization and technological advancement. With borderless digital infrastructures, such as the Internet, new business models have emerged that facilitate the creation of global digital companies that are much more flexible and have instant global reach. These digital companies create economic value by relying on platform economics (e.g. network effects, economies of scale and market power), intangible assets and user-generated data, with suppliers, consumers and marketplaces often located in different tax jurisdictions. Where once companies had a physical establishment in the country of consumption, digital companies / platforms now have greater flexibility over where they locate their business activities with the ability of connecting employees in different countries through their online platforms and accessing different geographic markets with ease from a limited number of remote locations, without the need for a material local presence. Moreover, for many digital businesses that operate in markets through an online platform, the users of the platform (which may or may not be identical to a business’s consumers) play a more integral role in the pursuit of revenue and create material value for a business through their sustained engagement and active participation. In addition, new multi-sided business models have emerged that are far more flexible and allow for much greater reach. These business models used by e.g. over-the-top businesses enable much easier connection of geographically distinct user groups to maximize value on each side, where for example, resources designed to collect data can be located near individual users, whereas the infrastructure necessary to sell this data to paying customers can be located elsewhere.
The OECD within its Base Erosion and Profit Shifting Project (“BEPS”) has identified several key features of the digitalized economy that are potentially relevant from a tax perspective. These include mobility, reliance on data, network effects, use of multi-sided business models, tendency towards monopoly or oligopoly and volatility. Mobility has significantly increased as it relates to intangible, users and customers, as well as business functions. Digital companies rely on and invest heavily in the exploitation and development of intangibles (e.g. software), which are a core contributor to value creation and economic growth. The OECD Report 2015 finds that under existing tax rules, the rights to those intangibles can often be easily assigned and transferred among associated enterprises, with the result that the legal ownership of the assets may be separated from the activities that resulted in the development of those assets. In addition, digital companies also serve a much more mobile user- and customer base than traditional businesses.
INFOBOX on BEPS – what does it mean, and why it is relevant to the debate?
Base erosion and profit shifting concerns (BEPS) are raised by situations in which taxable income can be artificially segregated from the activities that generate it, or in the case of VAT, situations in which no or an inappropriately low amount of tax is collected on remote digital supplies to exempt businesses or multi-location enterprises that are engaged in exempt activities. These situations undermine the integrity of the tax system and potentially increase the difficulty of reaching revenue goals. In addition, when certain taxpayers are able to shift taxable income away from the jurisdiction in which income producing activities are conducted, other taxpayers may ultimately bear a greater share of the burden. BEPS activities also distort competition, as corporations operating only in domestic markets or refraining from BEPS activities may face a competitive disadvantage relative to MNEs that are able to avoid or reduce tax by shifting their profits across borders.
The February 2013 OECD report “Addressing Base Erosion and Profit Shifting” (February BEPS Report) identifies a number of coordinated strategies associated with BEPS in the context of direct taxation, which can often be broken down into four elements:
BEPS is relevant in the context of a digitalized economy, as certain features of the digitalized economy exacerbate the issues of BEPS and create other, broader tax challenges.
The mobility of users and customers relates to users’ ability to purchase services in one location and consume these services in other locations, when e.g. travelling. In a digitalized economy, where the location of a user may be concealed, difficulties can arise to determine the location of an ultimate sale which has repercussions for e.g. VAT collection. Moreover, entire business functions can easily be managed over long distances from one central location and with a minimum need of personnel present, where operations are carried out in one location and suppliers and customers are located in another location, enabled through improved telecommunications, information management software, and personal computing. This has improved the capacity of businesses to manage their global operations on an integrated basis and adopt global business models that centralize functions at a regional or global level, rather than at a country-by-country level. This enables individual group companies to exercise their functions within a framework of group policies and strategies set by the group as a whole and monitored centrally. This way, companies can achieve “scale without mass”, which has also enabled SMEs to become “micro-multinationals” that operate and have personnel in multiple countries and continents.
Figure 1: Key Features of Digitalization potentially relevant for taxation
Digital companies also heavily rely on user generated data and user participation in their value creation. This has been facilitated by an increase in computing power and storage capacity and a decrease in data storage cost. This, in turn, has greatly increased the ability to collect, store, and analyze “big data” at a greater distance and in greater quantities. Whereas companies have always relied on data regarding customer preferences to improve products and services, the scale and complexity of data collection, storage and processing is exponentially greater in the digitalized economy. The OECD 2015 report highlights that traditional data collection for utility companies was limited to yearly measurement, coupled with random samplings throughout the year. With smart metering on the other hand, the measurement rate could be increased to 15 minute samples, which would equate to a 35 000 time increase in the amount of data collected. This capacity to collect and analyze data will continue to rapidly increase as the number of sensors embedded in devices that are networked to computing resources increases.
Network effects are also a key component of new digital business models as they relate to user participation, integration and synergies: a product or service gains additional value as more people use it, e.g. social networking, instant messaging, chat services, or a widely-adopted operating system and corresponding software written for it, resulting in a better user experience. Network effects are positive externalities, where the welfare of a person is improved by the actions of other persons, without explicit compensation. Leveraging these network effects, multi-sided business models have emerged as another key feature of the digitalized economy, in which the two sides of the market may be in different jurisdictions. A multi-sided business model is based on a market in which multiple distinct groups of persons interact through an intermediary or platform, and the decisions of each group of persons affects the outcome for the other groups of persons through a positive or negative externality. In a multi-sided business model, the prices charged to the members of each group reflect the effects of these externalities. If the activities of one side create a positive externality for another side (e.g. more clicks by users on links sponsored by advertisers), then the prices to that other side can be increased.
It should be noted that multi-sided business models are more prevalent in a cross-border context and feature two specific characteristics: flexibility and reach. Digital businesses are able to flexibly use resources (content, user data, executable code), that don’t expire due to their ability to be stored. These resources can create value for a company long after they have been produced and can be dynamically adapted based on evolving technology. They can also be used to enhance the value to one side of a market of the participation of the other side of the market. Moreover, digital businesses such as over-the-top platforms have much greater reach through the ability to more easily connect two sides that are located far from one another to maximize value on each side.
Taken together, the OECD 2015 Report finds that the prevalence of network effects and multi-sided business models that are often cross-border, coupled with reliance on intangible assets such as IP have a tendency toward creating monopolistic or oligopolistic structures. Where network effects are combined with low incremental costs, a company can quickly achieve a dominant position. The effect is exacerbated, where a company holds a patent or other intellectual property rights, so that is can seamlessly innovate. The OECD highlights that the impact of these network effects tends to lead to such structures, for example, where companies provide a platform or market in which users on one side of the market prefer to use only a single provider, so that value to those users is enhanced when a single standard is chosen, and the price that can be charged to the other side is enhanced because the platform becomes the only means of access to those users. Moreover, given low barriers to entry for Internet-based businesses due to progress in miniaturization and a downward trend in the cost of computing power, coupled with rapid technological development, digital markets can be volatile. While volatility could provide a check on monopolistic structures, it is strategically counteracted by long-term successful digital companies through vertical and horizontal integration and acquisition of start-ups with innovative ideas (e.g. Facebook, who bought WhatsApp and Instagram to complement its social networking site). This enables digital companies to stay relevant, launching new features and new products, and continually evaluating and modifying business models in order to leverage their market position and maintain dominance in the market. Figure 2 shows the Web World and Who owns Who.
Figure 2: The Web World and Who owns Who 2018
These new features of mobility, reliance on data, network effects, use of multi-sided business models, tendency towards monopoly or oligopoly and volatility as described above, are said to enable economic actors to operate in ways that avoid, remove, or significantly reduce, their tax liability within traditional tax bases. They may also generate base erosion and profit shifting concerns in relation to both direct and indirect taxes. The OECD 2015 Report states, for example, that the importance of intangibles in the context of the digitalized economy, combined with the mobility of intangibles for tax purposes under existing tax rules, may generate substantial base erosion and profit shifting opportunities in the area of direct taxes. It also highlights that the mobility of users may create substantial challenges and risks in the context of the imposition of value added tax (VAT). Furthermore, the ability to centralize infrastructure at a distance from a market jurisdiction and conduct substantial sales into that market from a remote location, combined with the increasing ability to conduct substantial activity with minimal use of personnel, may generate potential opportunities to achieve base erosion and profit shifting by fragmenting physical operations to avoid taxation.
So, in how far do these features affect taxation? Why do these features create issues with current international tax rules and make governments worry about losing corporate tax revenue, collecting VAT, or broader issues such as their effect on local competition or the creation of asymmetries vis-à-vis other economic sectors? To understand why the features as identified above create problems for the current international tax framework, we need to understand what the international tax framework is based on and designed to do.
Cross-border taxation issues are regulated using domestic tax law, tax treaties and other international law instruments, such as international tax rules and standards. Whilst the classic example is a tax treaty that resolves double-taxation issues, there are also rules and standards relating to matters such as transfer pricing, dispute resolution mechanisms and tax information exchange. The OECD’s Model Tax Convention on Income and on Capital serves as a basis for more than 3500 bilateral tax treaties, along with the United Nations Model Double Taxation Convention between Developed and Developing Countries. The OECD has also developed Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Furthermore, the Global Forum on Transparency and Exchange of Information for Tax Purposes (Global Forum) is a framework where OECD and non-OECD member jurisdictions are working together to promote standards in the international exchange of tax information between tax administration bodies.
The current international tax framework was developed in the 1920s and determines how business profits from cross-border activities are taxed. It allocates taxing rights based on the location of physical assets, capital and labour, the source of income and the residence of taxpayers. It is based on two key concepts, namely (1) the nexus rule to determine jurisdiction to tax a non-resident enterprise and, (2) the profit allocation rule, based on the arm’s length principle. It does not take account of the extent to which businesses have become globalized and digitalized. Because digitalization and its new business models have created a mismatch between where profits are made and where value is created, questions are arising with regards to the relevance and effectiveness of these two key concepts. To examine the question of why the two key concepts of nexus and profit allocation may no longer hold in the digitalized economy, we need to first understand how highly digitalized businesses are taxed.
Figure 3: Key principles of the International Tax Framework and its “digital” shortfalls
In most jurisdictions, highly digitalized companies are normally subject to the market country’s domestic tax framework, just like traditional businesses operating in the consumption country. Their consumption country sourced profits will be subject to the consumption country’s domestic income tax, and the goods and services consumed by the consumption country’s consumers will generally be subject to VAT. However, problems arise because many foreign-based, highly digitalized companies have relatively small consumption country sourced profits, because the majority of their profit-generating assets and labour are located outside the consumption country. Moreover, the development of new digital products or means of delivering services creates uncertainties in relation to the proper characterization of payments made in the context of new business models, particularly in relation to cloud computing. Also, companies gather and use information across borders to an unprecedented degree, which raises the issues of how to attribute value created from the generation of data through digital products and services, and of how to characterize for tax purposes a person or entity’s supply of data in a transaction (e.g., as a free supply of a good, as a barter transaction, or in some other way). Further, the fact that users of a participative networked platform contribute user-generated content, with the result that the value of the platform to existing users is enhanced as new users join and contribute, may raise other challenges.
As identified above, a common characteristic of most digital businesses is the ability to access a market via technological means without necessarily having a physical presence or a significant number of employees in that market, i.e. they have the ability to achieve “scale without mass”. Because the current international tax framework relies on nexus based on physical assets, a mismatch is created between “consumption” and “production” countries, as profits are taxed where digital companies hold their physical assets, but not where they generate most of their value through e.g. user participation and data generated through digital services and products. Moreover, digital businesses often rely heavily on highly mobile, intangible assets. These assets, such as algorithms, can be located anywhere in the world, and usually only require a network to be established for them to be accessed. As a result, a digital business may have a significant economic presence in one jurisdiction, while the majority of its profit-generating assets and labour can be located in a different jurisdiction. In this way, under the international tax framework and the consumption country’s corporate income tax systems, only a relatively small amount of the global profits of a highly digitalized multinational company may be sourced in the consumption country. It should be noted that a multinational enterprise’s capacity to have a significant economic presence in the consumption country, but pay a small amount of tax there is not a new challenge. For decades, foreign businesses in a range of sectors of the traditional economy have operated business models where the majority of profit-generating assets and labour have been located offshore. However, increasing digitalization and increasingly mobile intangible assets intensify this challenge, particularly in sectors of the economy most affected by digital disruption.
Taxation is essentially about managing the interests of governments, industry stakeholders and consumers, which often lie at opposite ends of the spectrum: governments need to ensure that they have enough revenue to finance their expenditures for public services; businesses need to make sure they are incentivized and have sufficient funds available for investment, and consumers must have enough income to consume. It is therefore essential to understand what the implications are from addressing those interests through taxation.
Figure 4: Distortive Effects of taxes in the Digital Ecosystem
Taxes can bring these interests into imbalance when they affect the choices of stakeholders made over and above what would happen in the absence of them. Therefore, in principle, taxation should attempt to be neutral and equitable across all sectors of the economy. At the global level, this principle should also hold and it should be ensured that the interests of “consumption” and “residence” countries are managed in a neutrally balanced manner. Ensuring this principle in the digital economy, however, is a lot more complex than it used to be in the analogue world and has created new and more systemic challenges for tax policymakers and tax administrators. As a first step, however, the international tax framework must be in line with domestic corporate income tax systems, which should reflect the changed way of doing business based on the new features of the digitalized economy, to avoid distortive effects at the local and global levels. Figure 4 shows the distortive effects that can arise when tax effects are not neutral and when the international tax framework and domestic tax systems are not aligned.
The OECD Interim Report 2018 finds that from a strategic tax policy perspective the uptake of digital technologies may potentially constrain the options available to policymakers in relation to the overall tax mix. For decades, companies have contributed to public expenses via a broad range of taxes in addition to corporate income tax. These taxes include employment taxes, environmental taxes, property and land taxes. These fall to the wayside, with less businesses requiring physical presence and serving markets from remote locations. This, in turn, may increase the pressure on a smaller number of taxpayers to compensate for the related loss of revenues, e.g. increases of taxes and fees imposed on the telecommunications sector vis-à-vis other economic sectors to bridge the revenue gap. This can negatively impact investment incentives and uptake through increased costs. A study by the European Commission found that the average effective tax rate for tech businesses was only between 8.5%-10.1% —less than half of the 23.2% for traditional businesses.
Figure 5: Effective average tax rate in EU 28
To address the high-level tax challenges relating to the international tax framework, the OECD and the EU have been working to drive the development of an international solution to digital economy taxation issues, with the focus on “nexus” (namely, addressing the disconnect between tax jurisdiction and the location of value creation by expanding the definition of PE to encompass “digital presence” as determined by the location of a service’s users), and reallocating profits (namely, reallocating taxing rights among the “countries of residence”, the tax havens, and the “countries of consumption” by modifying the formulas for allocating taxable income with the users’ contribution in mind (boosting the share taxable by the countries of consumption)).
Individual countries do not want to wait, pending globally agreed solutions, and are moving forward with short-term gap-stop measures, including the UK, Australia, France, Italy, Slowakia, India, and many others,. Australia is currently consulting on its corporate tax system in the context of the digital economy and is specifically consulting on the questions whether taxing rights should change to reflect user-created value and value associated with intangibles; whether existing profit attribution rules should be changed; whether existing nexus rules for determining which countries have the right to tax foreign resident companies should be changed; and lastly, whether changes can only apply to highly digitalized businesses. The consultation closes on 30 November 2018. While the UK government remains committed to reform of the international corporate tax framework for digital businesses, pending global reform, it is undertaking interim action, to ensure that digital businesses pay tax that reflects the value they derive from UK users. The UK government has therefore announced that it will introduce a Digital Services Tax (DST) from April 2020, which is estimated to raise £1.5 billion over four years. French President Emanuel Macron proposed a new tax on internet companies in April 2018, although without providing any detail. Other examples of unilateral action include Italy, which established a 3% web tax on digital transactions, effective January 1, 2019; Slovakia, which amended its income tax in January 2018 to add a tax on providers of services on digital platforms; Hungary, which proposed an internet tax in October 2017; and India, which introduced an equalization levy on online advertising revenue in 2016 and a revised permanent establishment concept in 2018.
(Source: UK HM Treasury Digital Services Tax fact sheet)
The UK government, pending international efforts, decided to introduce a Digital Service Tax to ensure that the corporate tax system is sustainable and fair across different types of businesses, i.e. that digital businesses pay tax that reflects the value they derive from UK users. The tax will come into effect in April 2020 and will apply only to digital businesses that are profitable and generate at least £500 million a year in global revenues.
In June 2012, more than 110 countries and jurisdictions came together to deal with these and other international tax issues within the OECD/G20 Base Erosion and Profit Shifting (BEPS) project. The OECD-G20 BEPS project aimed to respond to identified weaknesses in the international tax framework which were frustrating the principle of aligning profits with value creation and creating opportunities for multinational groups to break that alignment through artificial structures. The process produced a series of multilaterally agreed recommendations and best practice approaches. This included steps to protect the definition of a permanent establishment against avoidance, act against groups shifting taxable profits overseas through interest payments and revise the transfer pricing guidelines to put greater emphasis on real economic activities in determining how profits are allocated between countries. The BEPS project’s “final report,” released in the fall of 2015, fell short of a concrete agreement on measures to address the tax challenges of the digital economy. Since then, talks have continued under the OECD/G20 Inclusive Framework on BEPS, with the goal of issuing another final report in 2020.
The Inclusive Framework’s interim report, “Tax Challenges Arising from Digitalization,” was released in mid-March 2018 and presented to the G20 finance ministers and central bank governors at their March 19–20 2018 meeting. While none of the fundamental long-term taxation solutions advocated by the “countries of consumption” found their way into the report, the members did agree to review the “nexus” and “profit allocation” rules for determining tax jurisdiction and assigning business income, raising hopes of a decision that would substantially broaden the definition of PE and facilitate the taxation of business profits where they are generated. It was also agreed that any indirect taxes on digital services imposed by individual jurisdictions in the interim should be compliant with existing tax treaties and the rules of the World Trade Organization.
Spotlight: OECD Base Erosion and Profit Shifting (BEPS) Project, BEPS Package, BEPS Package implementation, the Inclusive Framework on BEPS, Interim Report
Background: With political support of G20 Leaders, the international community has taken joint action to increase transparency and exchange of information in tax matters, and to address weaknesses of the international tax system that create opportunities for BEPS. The internationally agreed standards of transparency and exchange of information in the tax area have put an end to the era of bank secrecy. With over 130 countries and jurisdictions currently participating, the Global Forum on Transparency and Exchange of Information for Tax Purposes has ensured consistent and effective implementation of international transparency standards since its establishment in 2009. At the same time, the financial crisis and aggressive tax planning by multinational enterprises (MNEs) have put BEPS high on the political agenda. With a conservatively estimated annual revenue loss of USD 100 to 240 billion, the stakes are high for governments around the world. The impact of BEPS on developing countries, as a percentage of tax revenues, is estimated to be even higher than in developed countries.
Development of a comprehensive Action Plan: In September 2013, the G20 Leaders endorsed the ambitious and comprehensive BEPS Action Plan, developed with OECD members. On the basis of this Action Plan, the OECD and G20 countries developed and agreed, on an equal footing, upon a comprehensive package of measures in just two years. These measures were designed to be implemented domestically and through tax treaty provisions in a co-ordinated manner, supported by targeted monitoring and strengthened transparency.
The BEPS Package: The BEPS package provides 15 Actions that equip governments with the domestic and international instruments needed to tackle BEPS. Countries now have the tools to ensure that profits are taxed where economic activities generating the profits are performed and where value is created. These tools also give businesses greater certainty by reducing disputes over the application of international tax rules and standardising compliance requirements.
Implementing the BEPS Package: The BEPS package was agreed and delivered by OECD members and by G20 economies, and subsequently endorsed by the G20 Leaders Summit in Antalya on 15-16 November 2015. Effective and consistent implementation of the BEPS package requires an inclusive implementation process.
The Inclusive Framework on BEPS: The Inclusive Framework on BEPS brings together over 115 countries and jurisdictions to collaborate on the implementation of the OECD/ G20 Base Erosion and Profit Shifting (BEPS) Package.
Interim Report March 2018: On March 16, 2018, the OECD published its interim report regarding taxation of the digital economy under the title “Tax Challenges Arising from Digitalization”. The OECD interim report, which is the result of a consensus reached between more than 110 member countries, presents an in-depth analysis of the different digital business models and how they create value.
The European Commission does not want to wait until a global solution has been agreed for fear that current structures will manifest and more public revenue is lost, and has put forward its own proposals of how to address the issues in the long-term and in the short-term. As a first step in late 2017, the EU Commission and Council officially identified various possible avenues to make the taxation of digital activities fairer. It put forward a long-term solution, which proposes to embed the taxation of the digital economy in the general international tax framework, and a short-term solution in the interim, such as an equalisation tax on turnover of digitalised companies, a withholding tax on digital transactions or a levy on revenues generated from the provision of digital services or advertising activities. On 21 March 2018, the Commission advanced two Directive proposals, namely (1) a long-term solution to reform corporate tax rules so that profits are registered and taxed where businesses have significant interaction with users through digital channels, and (2) a short-term solution of an interim tax which covers the main digital activities that currently escape tax altogether in the EU.
The long-term solution is aimed at setting out a comprehensive solution within the existing EU corporate tax systems to tax digital activities in the EU. The proposal lays down rules to determine a taxable nexus for digital businesses operating across border in case of a non-physical commercial presence or “significant digital presence”. The concept of “significant digital presence” is meant at creating a taxable nexus in a jurisdiction where the digital business does not have any physical presence. Secondly, the proposal sets out principles for attributing profits to a digital business. These principles should better capture the value creation of digital business models which highly rely on intangible assets. As regards profit attribution, the rules will be built on the current principles for profit attribution and be based on a functional analysis of the functions performed, assets used and risks assumed by a significant digital presence. Transfer pricing rules are explicitly referred to. In determining the attributable profits, due account shall be taken of the economically significant activities performed by the significant digital presence relevant to the development, management and exploitation of intangible assets (see Infobox on the EU Proposals for further detail.)
In the short-term, the EU Commission has proposed a Digital Services Tax (DST) for adoption by EU member states. The measure is meant to prevent unilateral, non-coordinated actions by single EU member states (e.g. Italy, Slovakia, other). The DST is a 3% levy on gross revenues that would be levied alongside corporate income tax. The DST is charged annually and will also apply to domestic transactions to avoid being in breach of the provision of the freedom of providing inter-EU services. In relation to this solution proposed, there is a need to assign taxing rights. To that extend the focus is placed on user value creation: for example, in the case of sale of advertisements space, the focus will be on where the advertisement is placed; in the case of sale of data, where the user whose data are sold used a device to access a digital interface, whether during that tax period or any previous one; and in the case of availability of digital platform / marketplaces to the user, where the user uses a device in that tax period to access the digital interface and concludes an underlying transaction on that interface.
Figure 6: Where EU Member States stand regarding the EU Commission proposal
Europe is split regarding the European Commission’s proposals. While EU governments agree that tax rules should be changed to increase levies on digital services that are currently undertaxed, they want to pursue different strategies to get there. Smaller states with lower tax rates such as Luxembourg and Ireland, home to large American multinationals, want EU changes to come together with a global reform of digital taxation, which has been under discussion for years to no avail. Larger states, such as France and Italy, which claim to have lost millions of euros of tax revenue due to digital giants’ shift of taxable profits to lower-tax countries, want a quick solution and support the proposals. Figure 6 below shows where EU member states stand regarding the EU Commission’s proposal.
Austria, as the current EU’s rotating presidency holder, highlighted in a document for a meeting scheduled to take place in September 2018, that in the context of eleven of the 28 members states already considering their own national measures, reaching a uniform agreement was important so as to not undermine the EU common market. Under the current proposal, only firms with a global annual turnover of 750 million euros and EU revenue of at least 50 million euros a year would be taxable. Some 200 companies would fall within the scope of the new tax proposed by the Commission, with an estimated additional annual revenues of about 5 billion euros ($5.7 billion) at EU level. To overcome some of the criticism of the measure by the strongest opponents, Austria proposed to reduce the scope of the tax, which would no longer be applied to the sale of users’ data as in the Commission proposal. Only revenue from online advertising services (e.g. Google, Facebook), and from virtual marketplaces, such as Amazon, would be subject to the new tax, under the Austrian plan. A final decision and adoption of the EU proposal is pending, but likely to be carried over into 2019.
Spotlight: EU Commission proposal
On March 21, 2018, the European Commission presented a series of measures aimed at ensuring a fair and efficient taxation of digital businesses operating within the EU. The package includes both interim measures, in the form of a 3% Digital Services Tax on revenues, and a long-term solution, introducing the concept of a digital permanent establishment.
Introduction of a Digital Services Tax
The proposal for a Directive on the common system of a digital services tax on revenues resulting from the provision of certain digital services intends to avoid potential disparities arising within the EU as a result of the implementation of unilateral initiatives by Member States and proposes a coordinated approach to tax revenues from certain digital services.
The new Digital Services Tax (DST) would apply as of January 1, 2020, and would be levied at the single rate of 3% on gross revenues:
Introduction of a Digital Permanent Establishment
The proposal for a Directive laying down rules relating to the corporate taxation of a significant digital presence has a broader scope than the Digital Services Tax and is designed to introduce a taxable nexus for digital businesses operating within the EU, with no or only a limited physical presence. It also sets out principles to attribute profits to businesses having such “significant digital presence”:
The article sought to briefly examines the key features of the digitalized economy and the key issues that arise from them for taxation under current international tax rules, their repercussions at the local level, and provide a summary of what countries are doing to address the issues identified.
At the high level, the challenges brought about by the digitalized economy relate to the inability of the current international tax framework to ensure that profits are taxed where economic activities occur and where value is created. This is so because the two key concepts that the international tax framework is based on, namely the nexus rule based on physical assets and the profit allocation rule based on the arm’s length principles are outdated and do not take account of the features that a digitalized economy exhibits. These features include mobility, reliance on data, network effects, use of multi-sided business models, tendency towards monopoly or oligopoly and volatility. These new features are said to enable economic actors to operate in ways that avoid, remove, or significantly reduce, their tax liability within traditional tax bases. They may also generate base erosion and profit shifting concerns in relation to both direct and indirect taxes.
In terms of challenges for the tax policy makers, the international tax framework must be in line with domestic corporate income tax systems, which should reflect the changed way of doing business based on the new features of the digitalized economy, to avoid distortive effects at the local and global levels. To address the high-level tax challenges relating to the international tax framework, the OECD and the EU have been working to drive the development of an international solution to digital economy taxation issues, with the focus on “nexus” (namely, addressing the disconnect between tax jurisdiction and the location of value creation by expanding the definition of PE to encompass “digital presence” as determined by the location of a service’s users), and reallocating profits (namely, reallocating taxing rights among the “countries of residence”, the tax havens, and the “countries of consumption” by modifying the formulas for allocating taxable income with the users’ contribution in mind (boosting the share taxable by the countries of consumption)). While global solutions to fix the international tax system are pending, individual countries such as the UK, Australia, France, Italy, Slowakia, India, and many others are moving forward with consultations, proposals and implementation of short-term gap-stop measures, including digital services taxes, digital transaction taxes, digital platform taxes, equalization levies and changes to concepts of permanent physical establishment.
In summary, taxation should manage the interests of stakeholders at the domestic but also at the global level, and its effect should be neutral across different sectors of the economy and countries. The advent of the digitalized economy exacerbates issues, some of which were already present with global activities of MNEs prior to the extent of digitalization that we face today. This is currently not reflected in the international tax framework. It is therefore important that countries continue the dialogue and jointly identify solutions to adjusting the international tax framework to reflect technological and economic advancement and societal development and thereby minimize global asymmetries and local distortions.
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