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Taxing the digital economy

Rapidly changing technology and societal change present a relentless challenge to tax legislators across the globe. As with other laws, tax rules will tend to lag behind technological developments. Until recently, few if any tax laws were developed with specific application to or contemplation of the modern digital economy.

November 2018

The main body of tax law applies (as originally intended) to traditional 'bricks and mortar' businesses - with difficult and sometimes convoluted application to digital businesses.

The need to address the gap between the modern digital economy and the tax legislative framework is an important focus of the European Commission's Digital Single Market (DSM) project, and is also recognised by the UK authorities which have expressed impatience (also felt within the Commission) at the slow pace of progress of current digital tax reform under the OECD's Base Erosion and Profit Shifting (BEPS) initiative.

The EC recently commented that "today's international corporate tax rules are not fit for the realities of the modern global economy and do not capture business models that can make profit from digital services in a country without being physically present", also noting that the effective tax rate for digital companies (such as social media companies) "is around half that of traditional companies". Having recognised the issues, what exactly is it suggesting by way of solution?

EU proposals

Reforming the tax base

The EC is proposing that tax laws be amended such that Member States can tax profits generated in their respective territories even if the company generating such profits does not have a physical presence there. This will apply to companies deemed to have a taxable "digital presence" or virtual permanent establishment, which will be the case if the company fulfils one of the following criteria in respect of the Member State in which it has a digital presence:

  • it has revenue from supplying digital services exceeding €7 million annually;
  • it has more than 100,000 users in a taxable year; or
  • over 3,000 online business contracts for digital services are created with business users in a taxable year.

These proposals aim to counteract the fact that current tax rules fail to recognise the new ways in which profits are created in the digital world; namely, the role users play in generating value for digital companies through engagement and active contribution.

In the context of the UK, a non-UK company making profits from the UK would only typically be liable to UK corporation tax if it were trading in the UK through a "permanent establishment" (subject to certain exceptions where UK land is held by the non-UK company). A permanent establishment is a fixed place of business in the UK such as a place of management, an office or a factory (and can also arise in certain circumstances where the company's business is carried on by an agent in the UK). Many other jurisdictions' tax rules work on a broadly similar basis.

In this light, it is clear how non-UK businesses which operate mainly in the digital sphere and which engage with UK consumers online with no physical presence in the UK may not be subject to UK corporation tax – even where significant value derives from the actions or even the mere existence of UK users. The EC's proposals seek to allow Member States to tax companies such as these.

Interim tax

Until tax rules are substantively reformed such that digital businesses become taxpayers in jurisdictions in which they generate significant value, the EU is proposing as a stop-gap an interim digital services tax (DST) at a suggested rate of 3% which should generate immediate revenues for Member States.

The DST is intended to cover services where the main value created is by the use of user data; for instance, revenues from selling online advertising space or created from the sale of data generated by user-provided information. The DST would apply to companies with total annual worldwide revenue exceeding €750 million and revenue sourced in the EU exceeding €50 million. The DST would be collected in Member States where the users are located. In view of the financial thresholds it is obviously only the largest digital and online businesses that would be affected by the interim rules.

UK developments

In a consultation (which closed in early 2018), the UK government acknowledged that there appear to be inconsistencies in the application of international tax rules where there is a mismatch between the location in which business profits are taxed and the location in which business value is created. While the UK government has actively endorsed the EC's proposals, it has expressed frustration with the slow pace of reform. In the recent budget, the Chancellor announced a new Digital Services Tax to take effect from April 2020, pending global reform. Search engines, social media platforms and online marketplaces with a global annual revenue of at least £500m will pay tax of 2% on the revenues over £25m linked to the participation of UK users. 

In addition, the UK has recently introduced new rules which aim to address the challenges posed by digital businesses in the context of value added tax (VAT) collection. For instance, operators of online marketplaces can now be held jointly and severally liable with users of their online marketplace where such users have not correctly accounted for VAT payable on their sales to HM Revenue & Customs (HMRC) and the operators fail to remove such persons from the marketplace within a timeframe specified by HMRC. Operators of online marketplaces are also legally obliged to take certain steps to verify VAT compliance by third parties using their marketplaces – such as the verification of VAT registration numbers.

Ongoing issues

Digital businesses clearly pose a challenge to tax authorities which seek to tax the profits of such businesses in the jurisdictions in which they obtain the most value. The EC proposals dealing with "digital presence" or virtual permanent establishments may provide at least a partial solution to the challenges posed by digital businesses. The current concept of a "permanent establishment", despite having been considered at great length as part of the OECD BEPS initiative, is arguably still outmoded. It does not, and was not intended to, adequately capture businesses which may obtain value from certain jurisdictions without ever creating a physical presence there.

There remain a number of issues in applying the EC (or related UK) proposals outlined above which need to be resolved. Defining "value" is one such issue – as is keeping any such definition broad enough to capture the next wave of digital innovation. Similarly, international cooperation will be needed in order to tax digital businesses effectively. For instance, the concept of "permanent establishment" will need to be amended in any double taxation agreement which the UK has with any other jurisdiction such that it reflects the "digital presence" outlined above – if not, then relevant businesses may find themselves taxed not only in the jurisdictions in which they have a "digital presence" but also, on those same profits, in their jurisdiction of residence. This would clearly disincentive businesses and could stifle economic growth.

In addition, cross-border support may be particularly important in the context of enforcement mechanisms. For instance, the UK may need the support of the jurisdiction of residence of a non-UK company which owes UK tax in respect of digital activity in the UK in order to collect the tax. Given that the taxation rights of the UK would have (presumably) encroached on the taxing rights of the non-UK jurisdiction, the support of other relevant jurisdictions will be hard to guarantee. The need for pan-jurisdictional consensus (or at least cooperation) to address the taxation of digital and online businesses without causing double-taxation and distortion, increases the complexity and only extends the lag as tax laws struggle to keep up with changing business models and practices.

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abacus of coloured beads
Graham Samuel-Gibbon



 

Graham and Will look at EU and UK proposals for taxing the digital economy.

"The need for pan-jurisdictional consensus (or at least cooperation) to address the taxation of digital and online businesses….only extends the lag as tax laws struggle to keep up with changing business models and practices."