Taxation of digital multinational enterprises - where are we now?

Background

It is widely acknowledged that for most governments and their tax authorities, the current international tax rules do not work particularly well for digitalised business models of multinational companies (MNEs). That’s not surprising. The rules were designed in a different era; designed to tax a non-resident company with a physical presence in a jurisdiction: what the international tax rules call a “permanent establishment” (PE). Typically, such businesses will also be taxable on the same profits in their home state, but will usually claim credit or exemption for the PE tax (normally under a double tax treaty).

Up until now, most digital businesses have been able to earn substantial revenue from a jurisdiction without creating a PE, and therefore without creating a taxable presence in the jurisdiction where their customers are based. The OECD describes this as the ability to have a significant economic presence in a jurisdiction without a major physical presence.

The typical generators of this economic presence or “value” are intangibles (often held in a low-tax or no-tax jurisdictions), the users (who indirectly create advertising revenue) and the users’ data (which can be monetised) - referred to by the OECD as “user-generated value".

The largest of these types of business often have complex business structures (sometimes referred to as “multi-sided”), where revenue accrues to a low-tax jurisdictions from customers based outside that jurisdiction.

Many jurisdictions argue that this “user-generated value” should be taxed in the countries where there is a significant economic presence, but not everyone agrees.

Hasn’t BEPS changed all this?

Not yet. The OECD is seeking an international consensus and is due to report back in 2020. There is some background to this timetable.

The primary focus of the work on Base Erosion and Profit Shifting (BEPS) was to eliminate complex arrangements which gave rise to “double non-taxation”. This has been very successful in discrete areas such as double tax treaty abuse, hybrid instruments and hybrid entities. Nevertheless, whilst it has been acknowledged by the OECD that certain of the BEPS changes have caused some digital MNEs to restructure their arrangements, others argue that the fundamental deficiencies of the current international rules remain.

As part of the original 2015 BEPS proposals, the OECD suggested methods to change the tax rules for digital MNEs. Suggestions included widening the international rules to tax non-resident companies in jurisdictions where they have a “significant economic presence”, a withholding tax on certain types of digital transactions, and an equalisation levy. No consensus was reached on these proposals.

The OECD went away to think about it again and published a brought-forward interim report on 16 March 2018.

The OECD’s 16 March 2018 interim report

The OECD’s interim report notes that there is no international consensus on the way forward. There are broadly three camps: those jurisdictions that think BEPS has done its job and no changes are needed; jurisdictions (including the UK) that believe the rules should change to tax the “user-generated value” of digital MNEs; and jurisdictions that favour a wider review of the international tax rules that is not limited to digital businesses.

The OECD interim report notes that there is a need to revisit the rules for taxing non-resident companies and profit allocation and is pushing for global consensus.

In its updated 13 March 2018 paper "Corporate Tax and the Digital Economy", the UK Treasury sets out its current thinking on the OECD initiative. It hopes to both lead and inform the OECD debate for the case for taxing digital MNEs on their residual profits referable to "user generated value”.

Some countries have called for an interim tax on digital MNEs. The OECD notes that there is no consensus on the need for interim measures and that such measures may lead to conflict, complexity, and increased uncertainty and with these the risk of double taxation.

The OECD recognises that interim measures are inevitable, so sets out some ground rules for jurisdictions who propose to implement interim taxes, including that such taxes comply with existing treaty obligations.

What are we likely to see in the OECD’s final report in 2020?

That is very difficult to answer. The prospect of an international consensus by 2020 is looking unlikely. This is a mammoth task. This is not just because of differences in philosophy and approach but due to the potential for winners and losers from any such change, the issue is also very political.

The United States is unlikely to agree to a widening of nexus and profit allocation rules for digital businesses as its own tax take would go down (through double tax relief it would be forced to grant to US-headquartered groups). There are also jurisdictions that benefit from being engaged in MNE’s complex multi-sided business structures, often through their own favourable tax regimes.

Then there are jurisdictions that see the digitalisation of business models as a long term threat to tax revenues.

In addition to the political and philosophical differences, trying to define which MNE digital business models should be subject to new rules and creating workable nexus and profit allocation rules is not an easy task. This is made even more difficult as the OECD itself acknowledges the need to monitor the evolution of new technologies and rapidly-evolving business models. Add to that the fact that there are over 100 jurisdiction members of the BEPS Inclusive Framework in different camps, and the whole task looks akin to nailing jelly to the wall.

Unilateral and interim measures

While the OECD grapples with this, some jurisdictions have implemented or announced unilateral measures, including India and Israel’s respective new nexus rules on “significant economic presence”, the UK's and Australia’s Diverted Profits Taxes (DPT) and Italy’s levy on digital transactions. The UK’s DPT, which has been in place since 2015, is partly designed to tax digital MNEs who avoid creating a UK PE, but also (intentionally) targets other structures and arrangements which exploit weaknesses in the international tax rules.

Further, the UK announced that it is to introduce its own (novel) extraterritorial withholding tax targeted at digital MNEs' intra-group arrangements that achieve an artificially low effective rate by holding intangible assets in tax havens (although the promised draft legislation was missing from the recently published draft Finance Bill clauses).

The UK had also announced that, pending a global consensus at OECD level, it was considering an interim tax on the revenues of digital businesses deriving significant value from user participation. The UK had stated that it would prefer international coordination on an interim measure, but would in the absence of such agreement go it alone. However, the UK appears to have moved away from introducing such an interim measure (see further below).

European Commission’s proposals of 21 March 2018

The latest player to wade into the debate is the European Commission. Why? Because it is concerned about the revenue lost to EU jurisdictions and about the problems which may arise if EU Member States go their own ways with unilateral measures. The Commission therefore believes an EU-wide solution is needed.

Seizing on the lack of progress at OECD/G20 level, the Commission set out draft proposals for both a longer-term solution and an interim measure, in the form of two draft directives.

The “long term solution”: the digital permanent establishment

The first proposed directive lays down rules extending the concept of a PE, so as to include a “significant digital presence” through which a business is wholly or partly carried out. New indicators of such a presence are proposed, which include:

• revenues received from the supply of digital services;

• the number of online users; or

• the number of business contracts for digital services.

This proposed directive also establishes certain principles for attributing profits to or in respect of a significant digital presence for corporate tax purposes.

The Commission's intention is to integrate the proposed directive into the proposals for a Common Consolidated Corporate Tax Base (CCCTB).

The “interim” solution: a Digital Services Tax

The second proposed directive would establish an “interim” Digital Services Tax (DST), with a rate of 3% applicable on the gross taxable (digital) revenues originating from providing certain digital services to users in the EU.

The DST would be applicable to companies or consolidated groups having total worldwide revenues exceeding Euro 750 million and over Euro 50 million in taxable (digital) revenues in the EU. The DST would be applicable on the following services (the “taxable revenues”):

• Advertising: the placing on a digital interface of advertising targeted at users of that interface;

• Multilateral interfaces: the making available to users of a “multilateral digital interface” which allows users to find other users and to interact with them, and which may also facilitate the provision of underlying supplies of goods or services directly between; and 

• Selling user data: the transmission of data collected about users and generated from users’ activities on digital interfaces.

Each proposed directive is intended to be implemented in Member States’ domestic law by 31 December 2019 at the latest, so that the new rules would become effective as of 1 January 2020. The chances of this happening, however, look to be very remote (see below).

Are the Commission's proposals likely to be implemented?

Any directive would require unanimity of Member States. Even when the proposals were launched, there was a group of Member States that were not in support.

Absent unanimity, there is the possibility of Member States still in favour using the "enhanced cooperation procedure" for the rules to apply just to those countries, but that, by definition, would not be an EU-wide solution.

There are also technical legal complexities with the Commission's proposals. The EU may be able to enforce Member States amending their intra-EU double tax treaties but it is not clear that it can  influence on Members States' treaties with third countries (which would have to be individually negotiated, which could take years, even assuming the treaty counterparty agrees to changes). This compares to the OECD which, despite not yet firming up on its proposals, does have experience and clout in influencing its members to make changes to their treaties through a single multilateral instrument.

Initially, the UK said it would engage constructively with the European Commission on the EU proposals. The UK Chancellor of the Exchequer made a statement in Parliament in which he confirmed that the UK is supportive of the EU proposal for a temporary interim tax on the revenues of digital MNEs and had been working closely with the French and German governments on this.

However, a few weeks later, it was reported that, wary of retaliatory action from the US, the UK Chancellor was in now in favour of global approach to digital taxation through further dialogue at the OECD (but noting that if this takes too long the UK would consider a temporary tax on revenues). The same reports noted that other EU Member States were also becoming less keen on the idea of an interim EU tax on revenues.

Further, more recently, Finland, Norway and Sweden announced a position similar to the revised UK position, rejecting an interim tax on revenues and instead recommending that the OECD accelerate their work on a thorough analysis of value creation in digital business, with a view to the taxation of the profits from that value creation.

France, Germany, Spain and Austria now appear to be the main champions of the EU proposals, with Spain looking like it may introduce its own Digital Services Tax on revenues similar to the proposed EU interim measures. Italy has also indicated it may go the same way as Spain.

Although at one point it appeared that Germany had cooled on its support for an EU-led solution, recently Angela Merkel and French president Emmanuel Macron made a joint call for “an EU agreement on a fair digital taxation by the end of 2018”.

In July 2018, Austria indicated that it would use its EU presidency to push through the EU proposals for an interim tax on revenues. At the September informal ECOFIN Council meeting, the Austrian Finance Minister said it was realistic for an agreement to be reached on the interim DST by the end of the year. Further, the Austrian Finance Minister confirmed that the EU Member states will seek to arrive at a position which is aligned with the OECD proposals on the matter. However, the reality is that with only some EU Member States seemingly in full support of the EU proposals the prospect of an EU-wide interim or long-term solution is not certain.

Osborne Clarke comment

A global solution is undoubtedly a gargantuan challenge for the OECD, but one should not underestimate what the OECD has achieved so far on BEPS and what it is capable of achieving in the future.

It looks likely that the EU proposals for a long-term solution will be folded into the OECD debate rather than the EU going it alone (but that could change if the OECD does not come up with a solution in 2020).

The OECD is due to produce an updated report in June 2019 before its final report in 2020, which will hopefully contain more concrete proposals on taxing the profits from user generated value. The big question is whether the US will ever agree to any rewrite of the international rules for digital MNEs.

For digital MNEs, the message is that despite the rhetoric, radical new tax rules seem unlikely to be put in place any time soon, but this is nevertheless an area that will continue to be scrutinised closely and has the potential to require significant changes if an international consensus is ever reached. If no consensus is achieved at OECD level in 2020 there is more likelihood of some form of EU solution and other countries implementing unilateral measures.