Not long ago, selling a product into a country often required a multinational company to have a meaningful physical presence—in the form of people and/or assets—located in that country. A country’s right to tax the profits of a company selling into its jurisdiction was logically, therefore, largely dependent on the company having such a physical presence.
But advances in information and communications technology (ICT) have since empowered “born digital” companies and “digitized” traditional companies alike to supply goods, services, and intangible property globally to a network of customers without having any physical presence at all in the countries in which their customers reside.
For example, let’s say an individual in Country A accesses a social media platform and shares his or her personal information, which is then used by the social media company in Country B to deliver the user a personalized advertisement for an online e-book store in Country C. The user clicks on the advertisement, which leads to a third party website in Country C from which the user purchases and downloads an e-book. All of this commercial activity can take place without the social media company or the e-book distributor having a physical presence in Country A.
The two fundamental questions that tax administrations around the world are now trying to answer are the following:
- Which country (or countries) should have the right to tax these transactions and/or profits?
- Once jurisdictional taxation rights have been established, what is the proper transfer pricing mechanism to ensure arm’s length allocation of global profits (or losses) to each jurisdiction?
Multilateral conversations on the taxation of the digital economy are ongoing, as countries attempt to reach global consensus on the best long-term approach. In the meantime, many countries are not waiting for global consensus, instead opting to impose unilateral digital tax measures.
With so much uncertainty around the future of digital taxation, it’s essential that multinational organizations are as prepared as possible for what’s to come—and that begins with keeping up with ongoing efforts by the Organization for Economic Cooperation and Development (OECD) to reach a global consensus on digital tax.
In this article, we’ll look at taxation of the digital economy and review the global efforts to address taxing digital business across borders.
OECD’s Take On Taxation Of The Digital Economy
Following the Base Erosion and Profit Shifting (BEPS) project, in 2017 the OECD released updated Transfer Pricing Guidelines for multinational enterprises and tax administrations. Action 1 of the BEPS Action Plan, Addressing the Challenges of the Digital Economy, was not fully addressed in these updates, as policymakers could not reach a consensus on the best approach. Since then, the OECD has taken steps to address taxation of the digital economy—and there’s more to come in the next few years.
The following is a timeline of recent OECD digital economy efforts:
- January 2019: The OECD released a Tax Policy Note, which described two pillars for discussion on taxing the digital economy and how the OECD plans to roll out changes.
- February 2019: The OECD released a more substantive public consultation document to expand on January’s note and requested comments from the business community.
- March 2019: The OECD held a public hearing and published the comments that were received on a public consultation document.
- May 2019: The OECD published a “Roadmap for Resolving Tax Challenges Arising from the Digital Economy.” The report detailed two pillars for discussion: Revised Nexus and Profit Allocation Rules and the Global Anti-base Erosion pillar, each of which we review below.
It bears noting that the purpose of this article is not to examine the details of the OECD’s Roadmap for Resolving Tax Challenges Arising from the Digital Economy. While the following sections briefly describe the contents of the OECD document, we intend to address this topic in more detail in a subsequent article.
Pillar One: Revised Nexus & Profit Allocation Rules
The first pillar in the OECD’s roadmap proposed new nexus rules for determining taxing rights (Note that nexus is essentially a taxable presence in a country). It also focused on proposals for identifying non-routine business profits, allocating a portion of profits to market jurisdictions, allocation of total global profits between jurisdictions, and distribution-based approaches that use baseline profit margins for marketing, distribution, and user-related activities. The first pillar also emphasized the need to begin exploring business line and regional tax segmentation, to design scoping limitations, and to develop rules on the treatment of global profit losses.
Pillar Two: Global Anti-base Erosion Proposal
The second pillar of the OECD’s roadmap report reviewed the Global Anti-base Erosion (GloBE) proposal, which specifies that a global minimum tax should be applied on outbound payments of multinational organizations. This pillar also discussed an income inclusion rule, which suggests that profits should be taxed no later than when included for financial reporting, as well as the exploration of simplifications. This suggests that taxes would be determined based on the rules jurisdictions already use for calculating the income of a foreign subsidiary.
Let’s work together on a forward-thinking transfer pricing strategy to optimize your policies and protect your business from risk in a changing environment.
Countries Implementing A Unilateral Digital Services Tax
The OECD’s digital economy proposal won't be in place until 2020. In the absence of an OECD consensus report, several jurisdictions are implementing their own “ring-fenced” interim digital services tax (DST). (A ring-fence is a virtual barrier that segregates a portion of an individual's or company's financial assets to reserve them for taxes or another expenditure.) The majority of countries implementing a unilateral digital tax are doing it on a transactional basis. They are targeting digital transactions that occur in their countries—regardless of whether the company has a physical presence in their respective jurisdictions—and applying taxes to the transactions themselves, as opposed to the profits generated from those transactions.
The following countries have already approved some form of unilateral DST:1
In addition, numerous countries have announced proposals that are in varying stages of development.
Unlike the OECD’s work, in many cases the unilateral digital services taxes are not intended to be holistic and permanent solutions. Rather, they are viewed as a temporary “fix” until the OECD’s work is completed. (Tweet this!)
With that said, a disjointed series of local country taxes poses significant new challenges—from potential double taxation to trade wars—in an already complex and evolving global tax environment. For example, on July 11, 2019, the French Senate approved a plan to apply a 3% DST on the gross revenues of certain digital transactions. The bill was signed into law by French President Emmanuel Macron on July 24, 2019. The Office of the United States Trade Representative has already announced the initiation of an investigation, under Section 301 of the Trade Act of 1974, into the French DST to determine whether it is an unfair trade practice. Such an investigation could form the basis for retaliatory actions, including tariffs.
It is important to note that many unilateral DST measures (like the French DST noted above) are being implemented on a transactional basis, meaning that they operate more like a sales tax or a value added tax (VAT) than an income tax. As a result, a company may be subject to DST in a given jurisdiction even if its operations do not yield profits in that jurisdiction.
While it’s too early to fully understand the long-term implications, unilateral measures are undoubtedly further complicating the digital tax landscape. The OECD is trying to act deliberately and responsibly as it tackles such a large challenge. In doing so, the organization has been patient in its attempt to reach a consensus regarding how to structure a DST (i.e., whether it will be transaction-based or profit-based in its application). As individual countries lead the path forward in the interim, it becomes more and more likely that the OECD approach will not be aligned with existing DST measures.
The OECD has committed to providing an update before the end of 2019 and a final report in 2020 aimed at providing a consensus-based long-term solution.
The best course of action for taxpayers in the meantime is to monitor the OECD’s work as well as individual DST measures, and ensure compliance as they are enacted.
Navigate The Taxation Of The Digital Economy
With so many changes on the horizon, multinationals need a solid tax strategy in place to minimize risk—and a knowledgeable partner to help guide the process. Valentiam’s seasoned advisors are trusted by the world’s leading corporations to optimize their transfer pricing policies and help them comply with ever-evolving global guidelines. Let’s talk about your company’s current transfer pricing challenges and how we can develop a unique plan to address them.
1Note: this list refers to countries where a DST has been approved. In some cases, countries that have approved a DST (e.g., Italy) have delayed the implementation of the tax until a later date. The list of countries that have announced and/or enacted DST proposals is continuously evolving. This list should be relied upon for general informational purposes only.