Taxing the digital economy

Over 130 countries have reached agreement in principle on the changes but new rules will not be in force until 2023 at the earliest. Some countries, including the UK, France and Spain, have taken unilateral action and introduced their own digital services taxes, which should fall away when the new international rules come into force.

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) has been considering global solutions to the problem.

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. There are also concerns that some countries are engaging in a ‘race to the bottom’ by setting very low rates of corporation tax to encourage multinationals to set up operations there.

OECD

The OECD has been 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.

In October 2021 136 jurisdictions agreed in principle to a two ‘pillar’ solution.

Pillar one aims to ensure a perceived fairer distribution of profits and taxing rights among countries with respect to the largest multinationals. Multinational enterprises with global turnover above €20 billion will be subject to tax on a proportion of their profits in the countries where they operate. The €20bn turnover figure will potentially fall to €10bn after seven years. Extractive industries and regulated financial services are excluded.

Countries which will benefit from the new taxing right will be those in which the multinational derives at least €1 million in revenue. For smaller jurisdictions with GDP lower than €40bn, the threshold will be set at €250,000. 25% of the profit in excess of 10% of revenue will be allocated to ‘market jurisdictions’, which will be the countries where goods or services are used or consumed.

Where the residual profits of a multinational are already taxed in a market jurisdiction, a marketing and distribution profits ‘safe harbour’ will cap the residual profits allocated to the market jurisdiction.

The OECD estimates that under pillar one, taxing rights on more than US$125bn of profit are expected to be reallocated to market jurisdictions each year.

Pillar one will be implemented by a multilateral convention which the OECD hopes will be open for signature in 2022 and come into force in 2023.

Pillar one also introduces a ‘standstill’ on the introduction of new digital services taxes (DSTs), with no new taxes being imposed from 8 October 2021 until the earlier of 31 December 2023 or the coming into force of the multilateral convention implementing the deal. Signatories to the convention will agree to remove existing DSTs and not to introduce such measures in the future.

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 of 15%, regardless of where they are headquartered or the jurisdictions in which they operate.

The new minimum tax rate will apply to companies with revenue above €750m and is estimated by the OECD to generate around US$150bn in additional global tax revenues annually.

Under GloBE, countries would remain free to decide whether to have a corporate income tax and to set their own tax rate below the minimum rate, 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 parent entity on the income of a foreign branch or controlled entity if that income was subject to tax at an effective rate below the minimum rate; and an under taxed payment rule that would deny a deduction or impose a withholding tax if the income was not caught by the income inclusion rule. There will be a temporary exclusion from the under taxed payment rule for multinationals in the initial stages of their international activity – defined as multinationals with no more than €50m of tangible assets abroad and that operate in no more than five countries.

For developing countries, a subject to tax rule will apply to royalties, interest, and certain other payments made from a developing country to a country that applies a nominal corporate tax rate lower than 9%. The additional tax payable would be limited to the difference between the 9% rate and the tax rate that would otherwise apply to the payment.

There will be a de minimis exclusion for those jurisdictions where the multinational has revenues of less than €10 million and profits of less than €1m. The GloBE rules will also provide for a carve-out to exclude an amount of income that is initially 8% of the carrying value of tangible assets and 10% of payroll, although this will decline annually over the first 10 years.

GloBE 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.

Countries will not be forced to operate the GloBE rules, but where they choose to do so they must do so in accordance with what has been agreed. Countries which do not choose to adopt the rules must accept the application of the rules by other countries.

The OECD aims that pillar two will be brought into law in 2022, to be effective in 2023, with the under taxed payments rule coming into effect in 2024.

The US government had previously 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. It has now agreed to the proposals as part of a two pillar approach in conjunction with the minimum tax rate. However, the proposals will have to be approved by the US Congress, where opposition is expected.

Other digital taxes

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.

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.

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.

Austria imposes a 5% tax on gross revenues from digital advertising services provided in Austria.

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.

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. The EU put its proposals on hold to focus on the OECD proposal.