By Chris Sanger, EY Global Tax Policy Leader, Ernst & Young LLP
Two multilateral organizations — the European Commission (the Commission) and the Organisation for Economic Co-operation and Development (OECD) — have been simultaneously studying options and recommendations for potential future tax regimes that would address the challenges of taxing digitalized businesses.
On March 21, 2018, the Commission revealed its plans, proposing new rules for the taxation of the digitalized economy to correct what it views as a mismatch between where taxation of profit currently takes place and where (and how) value is created by certain digital activities. A few days earlier on March 16, the OECD issued an interim report on the tax challenges arising from digitalization.
The Commission is focusing on a two-phased approach: an interim solution and a more comprehensive, long-term solution. The first phase would deliver the Digital Services Tax (DST), a 3% gross revenues tax that would not be creditable against corporate income taxes and would stay in place until a SDP solution is implemented. The second phase, the Significant Digital Presence (SDP) solution, focuses on a new concept of a digital permanent establishment (PE) along with revised profit allocation rules.
"For now, businesses should continue to monitor OECD and Commission developments related to the taxation of digitalized businesses and consider in detail how these proposals will affect them."
Under the SDP concept, EU Member States will be encouraged to amend their double taxation treaties with other countries so that EU and non-EU companies are subject to the same rules.
Decades past the dot-com bubble, governments around the world are still trying to determine how the profits of digital companies should be allocated to countries, and hence taxed. The current proposals seek to overturn the existing rules, which are argued to give opportunities for digital companies to organize themselves in ways to make certain that profits are taxed in low-rate locations rather than where their users reside.
The historic effective tax rate for digitalized businesses is, on average, 9.5% compared to 23.2% for organizations with traditional business models, according to the Commission. The EU believes that digital business activities will now be taxed “in a fair and growth-friendly way” under the new rules.
“The EU has embraced the development of the digital economy, which is making a great contribution to economic growth,” the Commission said in a press release on March 21. “But this has also created a major fiscal distortion.”
Brace for change
The EU’s proposed changes, which are scheduled to come into effect as of January 1, 2020 (but which could also be brought forward) pose significant challenges to policymakers and business alike.
The DST, for example could potentially have a lengthy life-span. The long-term SDP solution is seen as fitting neatly into the Commission’s plans for a Common Consolidated Corporate Tax Base (CCCTB), a measure it has been trying to secure since 2010. Despite successive attempts to drive CCCTB forward (including removing the consolidation element in 2016, taking instead a phased approach to implementation), success has not yet been achieved.
The Commission notes that “only after a Member State has renegotiated its double taxation treaty with a third country should the DST cease to apply to businesses from such third country.” That may well take several years to occur.
Gross revenue taxes do not generally represent good tax policy. Turnover taxes can be penal in nature, the DST could also undermine the potential to invest – or may even halt sales in particular markets within the EU.
The argument for such a tax is that it can be a proxy for the profits that are made on sales. But making sales isn’t the same as making profit, particularly when you consider the high number of loss-making start-ups in the digital space. There remain large companies which continue to invest such that they are not yet in profit. These businesses in theory will be helped by a de minimis turnover test.
Setting a “one-size-fits-all” rate or approach that would apply to all the different digital business models that it will need to cover will be difficult because margins in businesses varies significantly. Indeed, in another context, Her Majesty’s Revenue and Customs (HMRC), the UK tax authority, has estimated that the margin of food retailers is less than a third of that of financial services firms.
With such variations, a tax at one rate that might be deemed fair to some would be penal to others. For low-margin businesses, a high rate might make sales unprofitable and result in prices having to increase, rather than generating the profits that the Member States are trying to tax.
Double taxation may also be an issue within the EU. Given that the new tax would apply equally to revenues derived from the provision of digital activities not only in cross-border scenarios but also purely domestic ones, there is a risk that double taxation may arise where the same revenues are taxed under both the new tax and existing corporate income tax rules.
Fixing this (by removing the gross revenues tax where there is a PE in that Member State) may be discriminatory, and hence this level of double tax may need to remain even in wholly domestic situations – something clearly not in line with the desires of policymakers.
A key question remains whether the Commission is able to deliver a gross revenues tax given the need for unanimity in tax matters. Given the number of Member States supporting this issue, however, and the ability for the proposal to proceed if nine or more Member States support it (under the EC’s enhanced cooperation process), it seems likely that this will continue.
Multilateral or misaligned
In the meantime, the OECD is continuing to work on a consensus-based solution that addresses digitalization-related issues for taxation by 2020. This has been a multi-year undertaking and is part of the OECD’s broader global tax reform plan, the Base Erosion and Profit Shifting (BEPS) Project.
The OECD report analyzes the features commonly found in highly-digitalized business models, provides an overview of unilateral measures introduced by countries in this area, and includes a framework for interim measures, as well as possible long-term approaches to address the tax challenges of digitalization. Members of the OECD’s Inclusive Framework on BEPS have also agreed to pursue a review of the nexus and profit attribution rules in light of the digitalized economy.
But even among OECD members, there is no consensus on next steps. The OECD notes that some countries believe they should act quickly and introduce interim measures, while other jurisdictions oppose such actions as they are worried about adverse consequences and prefer to wait for a long-term solution. The International Monetary Fund, meanwhile, has also joined the debate, noting that “as the whole economy becomes digital, global solutions are required”.
The fact that governments disagree fundamentally about the approaches to take poses a potentially risky and complicated situation for businesses. After so many years of consensus-building on some of the biggest international tax challenges, it will be regrettable if governments take a step backward to a world of misalignment and double taxation.
For now, businesses should continue to monitor OECD and Commission developments related to the taxation of digitalized businesses and consider in detail how these proposals will affect them. With a broad understanding of how the Commission and OECD plan to tax the digital area, businesses should assess, quantify and plan for digital taxation via both multilateral as well as national initiatives.
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