Taxing the digital economy: find the answer to how new rules might affect your business
Global tax regulations for companies to fit the modern, digital economy used to share the fate of nuclear fusion. It was something that would soon become a reality and fundamentally change how things operated – and that had been the case for the last many, many years.
Then 2019 arrived, and several countries started to announce unilateral tax regulation updates aimed at closing perceived loopholes. Other countries reacted with warnings of potential tariff wars.
Caught in the middle were – and remain – companies across the globe, many of whom may still be looking for answers to questions like:
I hope to provide answers to those, as well as other, questions in this FAQ-style article.
What does taxing the digital economy mean?
Taxing the digital economy is an umbrella term for initiatives aimed at addressing tax-related issues created by our increasingly digital world.
The Organization for Economic Cooperation and Development (OECD) estimates that countries lose out on $100 billion to $240 billion a year under traditional tax rules. While countries around the globe have already addressed some of these issues, a consensus solution related to digital revenue generation largely remains elusive.
Examples of issues created by the digital economy include where revenue generated by a given software solution, or by clicking on a given online advert, should be taxed. These types of offerings may directly or indirectly grow large amounts of revenues in a country without the requirement for a physical presence (such as property or employees) — a phenomenon referred to by the OECD as “scale without mass”.
Wait, are there no international rule sets in place to address this?
At the moment, the answer would be no. Traditional principles that have governed the cross-border taxation of activities largely require some kind of physical presence in a jurisdiction in order to be subject to income taxes there. Revisions to address the changing dynamics have been slow to come. However, after EU efforts to create digital tax rules failed, 2019 saw several countries launch unilateral rule sets aimed at taxing the digital economy. 2019 was also the year when the OECD’s approach for addressing these issues saw rapid advances after having seemingly stalled for several years.
The OECD’s current proposal contains two “Pillars” that would be applied to the in-scope activities. While still in the development phase, the OECD’s suggestion for Pillar One would give countries the right to tax multinational enterprises’ selected revenues arising in that specific country through a calculation of up to three separate pools (or buckets) of profit. Pillar One would override the traditional nexus and profit allocation models that are widely in use for those selected activities by default. Pillar Two features a global minimum tax with which would seek to counter profit-shifting by multinationals to low-tax jurisdictions.
What are the three separate pools of profit under Pillar One?
The three, separate pools of taxing rights for jurisdictions are referred to by the OECD as Amount A, B, and C.
Amount A is a new taxing right where a given country has the right to tax part of the profit generated by a multinational enterprise based on the amount of sales the company generates in that specific country – whether or not the company has a physical presence in that country.
Amount B consists of a taxing right for countries that applies under existing rules to revenues generated by a specific company with a physical presence in that given country that are attributable to routine distribution and marketing functions. It aims to simplify transfer pricing by specifying the return that a company should earn on routine distribution and marketing activity.
Amount C can be viewed as a ‘top-up’ mechanism that corresponds to a company’s in-country functions exceeding the baseline activities associated with Amount B. Little specificity has been provided regarding Amount C.
The OECD has expressed their intention that Amounts B and C rely upon existing profit allocation rules, and do not create a new taxing right. Amount A is the revolutionary change.
Who will be affected by the potential new rules?
The OECD proposal suggests Amount A is to apply to two main groups: “automated digital services” and “consumer-facing businesses.” However, there is still much work left to be done, including defining what constitutes a consumer-facing business, what rules will apply to intermediary service providers, and how to deal with suppliers of component products for consumer-facing businesses.
For now, the non-exhaustive list of “automated digital services” includes:
- Online search engines
- Social media platforms
- Online intermediation platforms (including online marketplaces)
- Digital content streaming
- Online gaming
- Cloud computing services
- Online advertising services.
The OECD suggests that services which involve a high degree of human intervention and judgement may be out of scope, including many professional services.
The inclusion of a consumer-facing businesses category appears to be aimed primarily at those that sell goods and services directly and indirectly (through third parties) to consumers. It also targets businesses that generate revenue from licensing and similar rights, such as under franchise models. For this category, the non-exhaustive list includes:
- Personal computing products
- Personal items (clothes, toiletries, cosmetics and luxury goods)
- Branded consumables
- Restaurant and hotel franchising models
Excluded from the definition of consumer-facing businesses are extractive industries and other producers and sellers of raw materials and commodities, airlines, shipping businesses, and financial services (e.g., regulated banks and insurance companies). However, unregulated fintech companies may be within scope.
While it is still uncertain who will ultimately be affected, it is likely that any technology company or consumer-facing company with revenue models that involve online-sales or online use will be in the front line. In other words, technology companies, companies in the related media and telecommunications sectors, and many traditional consumer products companies may be caught in the web of Amount A.
Secondly, it seems likely that there will be a size limitation for Amount A. The OECD has suggested that it may be limited to companies with €750 million or more in group annual revenues, similar to the revenue threshold established by the OECD under its BEPS Action 13 recommendations for country-by-country transfer pricing disclosures. Furthermore, there may be de minimis thresholds related to a company’s gross revenue and profit from in-scope activities.
So, is this proposal – and the three pools – a done deal?
No, and it is not certain what the exact nature of the final rules will be. For example, an alternative global safe harbour system to Pillar One, supported by the United States, will also be considered during the coming months. However, at this stage, it is still largely conceptual, with little in the way of details available. Some are concerned this will permit companies to effectively opt out of Pillar One.
However, negotiations are moving a lot faster than they have in the past, in part, because some countries have prepared – and in some cases launched – unilateral tax rules to fix some of the perceived issues. Without consensus, these rules threaten to trigger additional trade wars and unlevel the playing field, as they would almost certainly result in companies being subject to some form of double taxation.
Therefore, it is now much more likely than ever before that negotiations will lead to agreements on new, international tax rules within the coming year - especially considering the most recent media reports. But then again, optimism should be tempered, as the United States has generally viewed digital taxes to be inherently discriminatory, insofar as they largely target American companies like Google and Facebook.
In any case, it appears more than likely that companies with online-based revenue streams should monitor events and contemplate some of the changes that are afoot. The current timeline anticipates an agreement on key policy features of Pillar One to be achieved by July 2020, with a final consensus to be achieved by yearend.
And what about Pillar Two?
Fewer details are out on Pillar Two, also referred to as the Global Anti-Base Erosion, or “GloBE”, proposal. In concept, it seems to mimic a global minimum tax that was introduced by the United States as a main feature of its 2017 tax reform to combat the migration of profit-attracting intangibles and the use of controlled foreign corporations in low tax jurisdictions. It achieved this by subjecting the U.S. shareholders to a supplemental tax that, in combination with locally imposed taxes, forces them to pay a minimum overall tax rate.
Pillar Two’s income inclusion rule would operate similarly in requiring a shareholder in a corporation to top-up to a tax rate stated as a fixed percentage. The OECD proposal could also apply to foreign branches. Pillar Two also currently features rules which would call for the denial of tax deductions for certain related-party payments that are deemed to improperly reduce taxable income, or the imposition of withholding taxes or the denial of Treaty benefits on payments not otherwise subject to tax at a minimum rate.
Some countries are launching unilateral rules – what does that mean?
For companies, the answer lies somewhere between a resounding ‘it is really hard to tell’ and an equally robust ‘potentially, a lot.’
Europe provides a good example. Austria, Poland, the Czech Republic, United Kingdom and Italy have all either confirmed plans for unilateral taxation schemes aimed at the digital economy or are considering such options. That said, after the United States threatened to impose a tariff on luxury goods in retaliation for a planned French digital tax, President Macron agreed to suspend collection of that tax until the end of this year, pending continued progress on the OECD initiative.
It all leaves companies with a risk of having to comply with different sets of tax rules in every market where a unique rule set for taxing the digital economy exists, which may diverge greatly from the OECD proposal. One example is India’s tax on digital advertising, which features a revenue threshold of only INR 200 million (approximately $2.8 million).
Will these new OECD rules apply to my company?
If you are a small to medium-sized enterprise (SME), then part of the answer is a no. Your company is likely not going to be liable for new taxes falling under the Amount A of OECD’s proposal. However, if you are a larger multinational with the requisite revenue streams from targeted activities, it is likely that you are going to be directly affected by the new rules.
Developments are still ongoing, and the intricacies of future rules and regulations may be complex. You may want to establish ongoing consultations with tax experts to gain a detailed understanding of the situation – and what you could or should do to prepare for the coming changes.
How can I prepare for the coming changes?
While many aspects remain unclear, the new rules will likely lead to increased documentation requirements, especially relating to where revenue is generated. It may well strain existing systems and, in some cases, force companies to upgrade. Analysis of your company’s ability to manage such increased requirements is a good first step.
Transfer pricing is another area where coming rules will likely modify the manner in which companies ensure compliance. The current plan anticipates the tax base used for Amount A to be the profits before tax, determined from the consolidated financial accounts rather than the traditional legal entity approach. Some form of loss carryover will be permitted.
In both cases, and other, similar areas, the process may well require consulting with outside experts and could require enhancements to existing systems to track separate streams of income in compliance with the new tax regime.
What are some likely challenges that I – and the authorities - will need to address?
Some challenges have been addressed above, but further complications may arise due to the nature of digital revenue streams.
For example, it remains uncertain how revenue streams where the geographic location remains unclear – if, for instance, a given user’s IP is indecipherable due to the use of an off-the-shelf VPN-service – should be classified.
Another area of doubt would be when multiple areas may lay claim to a given revenue. For example, if a Brit travels to France and uses a service there, on the person’s own device, which country can then claim the digital tax?
Other possible situations could include taxation on gross revenue when, for example, a party receives a software royalty from Country A, but at the same time, some significant element is being sub-licensed from a third party. In that case, the question might be whether there would be a deduction permitted from the taxable gross revenue associated with the sub-license. And if so, would the third party be obligated to track and report that revenue, and subject to tax in Country A.
What is your advice to help prepare for the digital taxation changes?
One would be staying abreast of developments as much as possible. Furthermore, consulting with experts and planning potential risk mitigating activities (for example, detailed analysis of your transfer pricing setup) will enable you to be prepared as well as possible.
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