A new European Commission (EC) proposal to impose a temporary 3 percent excise tax on certain digital services “characterized by user value creation” of large social media and platform companies raises a number of important issues. The EU proposal release comes a week after an excellent OECD interim report on Tax Challenges Arising from Digitalisation. The OECD report notes the current lack of an international consensus on a long-term solution to international tax rules dealing with the ability of countries to tax (“nexus”) foreign companies and the attribution of global profit from certain digital activities between countries.
The EU proposal is intended to better measure the location of a multinational company’s income where “user generated contents and data collection have become core activities for the value creation of digital businesses.” Although the OECD/G20 BEPS project addressed the potential of double non-taxation from digital services, the project did not address to which countries the appropriate income tax on digital services should be paid. The new OECD report outlines a dozen countries, including the United States, that have imposed unilateral measures affecting cross-border digital services. The 113 countries participating in the BEPS Inclusive Framework all agree to work towards a consensus based long-term agreement on the tax treatment of digital services but are currently split on whether and which type of long-term agreement is needed and whether interim steps are needed before a long-term agreement is reached.
The EU digital tax proposal is a further manifestation of tax policy arguments to allocate some global income based on the location of consumers. The EU proposal for a Common Consolidated Corporate Tax Base would allocate corporate income tax within the EU based on the location of consumers, tangible assets and employees. The EU comprehensive proposal on digital services suggests a different profit split allocation for function with a significant digital presence (e.g. R&D and marketing expenses, number of users and digital data collected). The U.S. and Canada at the subnational level allocate corporate income between states and provinces based on sales, payroll, and/or tangible capital. China has argued in transfer pricing cases that more income should be allocated based on the use of IP in the domestic market. India was the first to introduce an equalization levy on digital advertising revenue attributable to Indian consumers.
The OECD report provides a thorough analysis of the types of digitalization activities that give rise to both income and consumption tax issues. These include two-sided markets, where a social media platform can earn additional advertising revenue as a result of the personal data provided by users benefiting from “free” digital services. The user data is an important intangible capital asset of digital companies but is generally not recognized as a factor in whether a company has a “permanent establishment” in the country to justify being subject to tax. The intangible capital from user data is not included in the current profit allocation of the arms’-length transfer pricing rules based on assets used, functions performed and risks assumed.
Most of the focus on the BEPS project has been on its efforts to stop double non-taxation of corporate income. In addition, the BEPS project included significant improvements in the consumption taxation of cross-border service supplies in both the business-to-business (B2B) and business-to-consumer (B2C) markets. The EU is now collecting an additional 3 billion euros annually in Value-added Taxes (VAT) as a result of implementing the BEPS recommendations of revised International VAT/GST guidelines, which more effectively applies VAT to cross-border digital services.
Neither the EC proposal nor the OECD report discuss lost consumption tax revenues from the significant value of “free” digital services. Lost VAT revenue at an average EU OECD members’ VAT rate of 22% on gross receipts is significantly greater than any lost corporate income tax (CIT) revenue at an average EU OECD members’ CIT rate of 23% on net income (even if the net income is 40-50% of gross receipts). No explanation for the EU’s choice of a 3% tax rate on gross receipts was provided.
Although it is difficult to impose tax directly on “free” services, such as employee fringe benefits or bank checking services, public finance economics concludes that in many cases it doesn’t matter whether the tax is imposed on or collected at the seller or consumer level. Thus, a tax at the company level may be a rough proxy for the income tax and/or consumption tax that ideally would be collected on the barter income of digital users and/or on the value of “free” consumer services. The August 9, 2016 blog described an appendix in the BEPS Action 1 report prepared by the Tax Sages on the incidence of taxes on foreign sellers (without permanent establishment) of digital services.
A final OECD report on tax issues from digitalisation is due in 2020, with the goal of moving closer to a long-term international agreement to international tax rules for digital services. The OECD/G20 BEPS Country-by-Country reports will also be reviewed and potentially changed in 2020. Greater transparency on where companies are operating beyond total revenues, tangible capital and employees would help assess the location of income by country not only for tax administrations but for assessing cross-border digital services as well as national income statistics.