Global Taxation Of The Digital Economy.

22 November, 2019

 

In light of the increasingly digitalised economy, key issues and concepts underpinning global tax systems are under review.

 

The key issue here is the taxation of cross-border flows and profits.  In particular, when should jurisdiction A subject an entity from jurisdiction B to tax on the profits attributable to jurisdiction A? And if jurisdiction A does seek to exercise such taxing rights, what is the right measure of "local" profits on which to impose tax? 

 

Those two questions are at the very heart of the current attempts to reshape the global tax system.  

 

Although the proposals for change currently under consideration ostensibly relate to the digital economy, this begs the wider question of where the boundaries – if any – of the digital economy lie.

 

It may help to consider the current position so as to understand the context for the current system and the perceived issues with it. 

 

Global Taxation of the Digital Economy

 

While each country has its own rules, there are some common principles that pervade the global tax system. Those principles evolved in the days before the internet and underpin the current global tax system. Back then, it was relatively difficult to sell overseas without having "boots on the ground" (or in tax-speak a "permanent establishment"). So a system evolved where jurisdiction A would not seek to tax profits of overseas entities unless they had a "permanent establishment" in jurisdiction A. However that nexus test has not kept up with changes to the way in which business is done. In particular, new business models enable companies to generate significant income in a given jurisdiction with little or no physical presence (and thus no permanent establishment and little or no local tax).

 

The other major theme governing the global tax system is that, at least currently and hugely over-simplifying, profits are generally taxed where value is created rather than where customers are located. That in turn led to the development of the so-called "arm's length principle". That principle requires affiliates to charge each other arm's length prices for the services they provide. That is a sensible starting point but can lead to the design of supply chains where the services provided in high tax jurisdictions are minimised (for example, so-called "limited risk distributors").

There has also increasingly been public criticism of a system that allows global digital businesses to pay fairly low effective rates of tax in many of the foreign markets in which they operate.  

Reshaping that system and the answers to the two questions above are now firmly on the radar in every major jurisdiction.

 

Effecting change

 

There is widespread recognition that an approach which is relatively consistent globally has a range of benefits to both business and governments. 

 

The Organisation for Economic Development (OECD) which is a group aiming at improving global trade, has put itself at the centre of that discussion.  

 

It has already recommended a large number of other changes to the global tax system through the so-called Base Erosion and Profit Shifting (BEPS) project.  That project, in effect, parked the two questions above insofar as they relate to digital businesses but they are now firmly at the forefront of the international tax agenda.  

 

A number of governments, for example those of Germany, Switzerland, Canada and Sweden, have made public announcements that they have no plans to implement an interim tax on digital services and are awaiting global consensus.

 

However, many others are losing patience with the search for consensus on these issues and are initiating their own solutions, some by way of direct taxes and others by extending their indirect VAT or GST rules. 

 

For example, France, India and Italy have already amended existing rules or enacted specific direct digital services taxes, with the UK, South Korea, Spain, Poland, Austria and the Czech Republic being among those with new direct tax laws in the pipeline. Australia and South Korea have extended or introduced their indirect tax regimes to cover digital services along with a huge number of other jurisdictions which have or will do similar (sometimes in conjunction with a proposal for a direct tax on digital services).

 

There is a very real danger, therefore, of a patchwork of similar taxes – overlapping in some areas and leaving gaps in others – undermining the OECD's attempts to create a more globally cohesive and fair tax system.

 

What can businesses do?

 

It is more important than ever for any business undertaking cross-border activities, whether obviously within the digital sphere or not, to be aware of new taxes on the horizon and to begin assessing the application of them to their business and their potential impact. 

 

Where possible, businesses should look to add their voices to any consultations or other opportunities to input into the design of these measures to ensure that the key issues are considered by the policy makers.

 

In the UK, that process is relatively transparent with clear time frames and contact details for engaging with HM Revenue & Customs while the draft legislation is being consulted upon. Similarly, in the US, the period for comment on proposed regulations on digital content transactions runs until 12 November 2019. It is less clear what stakeholders in Spain can do, since proposals there are in abeyance pending governmental change. Similarly, the BEAT and GILTI rules in the US, and the new French and Australian rules are all past the point of inviting comment. 

 

The introduction of new measures almost always throws up unexpected consequences, all the more so where there are multiple interactions across borders. Whatever degree of involvement businesses choose to take at this stage, these changes cannot be ignored for long.