INSIGHT: Taxation of the Digital Economy—Service Platforms

Sharing economy, “gig” economy, platform economy—these are all terms used to describe the business models of companies like Lyft or Airbnb, whose rapid advancement is disrupting various markets around the globe.

We will focus here on one aspect of the sharing economy, the taxation of service platforms. Service platforms are businesses in which a facilitator operates a web- or app-based platform, which connects buyers and sellers of certain services. In many cases, payment for the services is also facilitated through the platform.

The main distinguishing feature of service platforms is the way they create value.

Standard business models may be described as “supply chains” or “pipelines”companies operating this way create value by producing goods or rendering services and selling them to customers. In most cases they adhere to the usual chain of producer, wholesaler, retailer and consumer.

Platforms, on the other hand, create value by bringing together those who demand goods or services with others who have access to surplus resources and may put them on the market. In fact, in many cases the advancement of platforms is what made these surplus resources available in the first place (e.g. Airbnb made it far easier for homeowners to offer accommodation for travelers and as such significantly lowered the market entry barrier).

Further, service platforms operate on a particular revenue model that is far less common in the supply chain model. The vast majority of platforms earn their profits by way of commission (although different models also exist) with the majority of the revenue being received by the service providers.

This new model of value creation has proven difficult to tax and as a result is a complicated problem for both tax authorities and policymakers. Obviously, legal regulations always lag behind innovative companies, but in the case of service platforms this mismatch is particularly visible.

Moreover, the difficulty lies not only in taxing the service platforms themselves but also in taxing service providers who use the service platforms to offer their surplus resources to the public.

Subsidiaries and Permanent Establishments

A general principle of international tax law is that taxation should take place in the state in which value is created. In case of income taxes this principle is realized inter alia by way of taxing the local subsidiaries or “permanent establishments” of foreign companies.

The very nature of service platforms allows them to operate in various states without having a physical infrastructure, and in most cases contracts between clients and the service platforms are concluded online.

Consequently, service platforms rarely have the need to establish local subsidiaries in order to conduct business in a given state. If service platforms establish local subsidiaries, the actions of those companies are generally limited to marketing and similar services.

In compliance with tax regulations, the subsidiaries should receive market level remuneration from the parent companies for their services. However, as these services are not the platforms’ main source of value, the remuneration and corresponding tax is limited.

Further, as service platforms have no need for physical infrastructure and they conclude contracts online, they are not considered to have permanent establishments in the states in which they operate.

In a nutshell, under the current framework of the Organization for Economic Co-operation (“OECD”)-based bilateral double tax treaties, a foreign company that does not have a subsidiary in a given state and operates there itself has a permanent establishment in that state when its operations have sufficient substance.

Currently, a permanent establishment is created when a foreign company has sufficient physical infrastructure in a state or a dependent agent, which acts in the name of the company. In the case of service platforms, these criteria are seldom fulfilled and service platforms are generally considered to have no permanent establishments in the states in which they operate.

The situation is similar in case of turnover taxes. A good example of this is the EU value added tax (“VAT”) regulation, which includes the concept of a VAT establishment but at the same time requires this establishment to have inter alia a suitable structure in terms of human and technical resources.

This also leads to a situation in which under EU VAT law the service platforms are considered to have no VAT establishments in the states in which they operate.

Increasing political and public pressure has resulted in the drafting of regulations aimed at addressing this issue. A good example of this is the proposal for an EU Directive on the corporate taxation of a significant digital presence put forward by the European Commission. These new rules will provide new indicators of economic presence mandating the recognition of a permanent establishment.

Under the new rules a service platform will be deemed to have a taxable “digital presence” or a “virtual permanent establishment” if it fulfills certain criteria, e.g. it exceeds a threshold of 7 million euros ($8.1 million) in annual revenues in a state; has more than 100,000 users in a taxable year; or creates over 3,000 business contracts between the company and a user in a tax year.

Such “virtual permanent establishments” will be subject to income tax in the state in which they were created. This will give EU member states the right to tax service platforms on the income received from operating in those states.

Similar regulations are being developed and implemented by other states and organizations. Moreover, it is likely that similar regulations will also be adopted for turnover taxes like goods and services tax (“GST”) or VAT.

Withholding Tax

However, the fact that service platforms are not subject to income tax in the states in which they operate does not mean that their services are not subject to tax at all. Because the service platforms have no permanent establishments to which the service payments could be attributed, these payments may be subject to withholding tax.

Many states levy withholding tax on income derived from business operations of foreign companies. Consequently, under domestic tax law the payments made by citizens of these states to service platforms for services (e.g. matching fees or advertising fees) may be subject to withholding tax.

Simultaneously, these payments may be exempt from withholding tax due to the application of international tax law. Under the the current framework of the OECD-based bilateral double tax treaties, most of the service payments made by customers and/or service providers will be considered “business profits.”

Such profits are subject to taxation in the state from which they are derived only if the receiver has a permanent establishment in that state.

The result of these regulations is something akin to a “vicious circle,” i.e. where a double taxation treaty is applicable, the service payments being considered “business profits” are generally not subject to withholding tax and are generally not subject to tax in the source country in the absence of a permanent establishment.

However, this would be the case only if the state from which the payment is made does not require that the entity making the payment holds a certificate of tax residence of the receiver.

If the opposite is true—and the obtaining of a tax residency certificate is mandatory—then this may mean the customers and/or service providers should account for and pay withholding tax.

The requirement to obtain tax residency certificates may be especially arduous in the case of platforms that are mass-market and cover low-value transactions. In such cases, it is unlikely that the customers and/or service providers will make the effort of requesting a tax residence certificate from their contractor.

This is not the only practical issue associated with withholding tax. The service platform business model is usually based on commissions. Furthermore, the payments are usually facilitated and controlled by the service platforms. In fact, it is quite common for a customer to make the payment to the service platform, which after withholding its commission sends the rest of the payment to the service provider.

In most jurisdictions the application of this model does not change the fact that from a legal/tax perspective it is the customer/service provider who is making the payment (e.g. deductions and remittances are treated as actual payment) and therefore is obligated to account for and pay withholding tax. Which could be problematic, as such a person may not have access to the necessary data and the payments may be outside of his/her control.

At present, both of these issues seem to be unresolved and provide a good example of a mismatch between tax regulations and the business environment to which these regulations should apply.

Data Access and Compliance Among Service Providers

Another aspect of the taxation of service platforms is access to service provider data.

The continuing development of service platforms is causing more and more people to use their spare time or spare resources and become service providers on such platforms.

Most tax systems apply different taxes to salaried employees and business owners (in most cases business-derived income is taxed separately from salaried income, and owning a business usually entails paying turnover taxes like GST or VAT).

Further, it is nearly impossible to create a clear definition of what should be considered a “business activity” for tax purposes—due to the very nature of business activity lawmakers must use general terms, which are always subject to interpretation.

Under these broad definitions, it is very likely that certain service providers will be considered taxable business owners, both in terms of GST/VAT and in terms of income tax. Certain types of activities may also be subject to additional taxes, e.g. offering short-term rentals may result in a requirement to account for and pay some kind of tourist tax.

This rather complicated framework of tax regulations and administrative obligations (drafted with traditional businesses in mind) may lead to tax evasion—either voluntary or involuntary (when the taxpayer is not even aware that they should be paying certain taxes).

At the same time, the tax authorities are having serious problems combating this issue—the main problem being the availability of data. Generally, the activities of taxpayers that provide services on service platforms are only visible to clients of those platforms.

Without access to the service platforms’ data, it is very hard for the tax authorities to determine which taxpayers are not in compliance with tax law.

Increasing political and public pressure will most likely lead to the implementation of legislation that will force platform service companies to share the data they have about their users with the tax authorities. However, in this case serious concerns regarding data protection must also be addressed.

Alternatively, a voluntary method of cooperation is also possible—states and service platforms may enter into data-sharing agreements according to which the service platforms will help ensure that service providers comply with the law.

Going Forward

Current tax regulations are a mismatch for these new business models, both when it comes to taxing service providers and/or the platforms themselves.

The development of digital permanent establishments and the sharing of data between service platforms and the tax authorities is likely to address the most evident mismatches. However, due to the rapid growth of the sharing economy the current approach to taxation in general is likely to require even more change.

Tax regulations will have to adapt to this new economic landscape, for example by finding a way to evidence the tax residency of taxpayers without the use of tax residency certificates.

Planning Points

Generally, the new regulations will result in an increase of tax compliance costs for service platforms. These costs may be particularly high in case of EU- or OECD-driven changes, as the laws in many jurisdictions may be affected at the same time.

A good example is the introduction of the EU Directive on taxation of a significant digital presence, which will have an effect in the entire EU. Service platforms should start preparing for this, as they will be required to account for taxes in multiple jurisdictions in which they did not have to do so.

Simultaneously, the attribution of profits to these virtual permanent establishments may be a potential source of disputes with local tax authorities. Service platforms should be prepared to defend their positions in tax audits carried out by local tax authorities.

What is more, the introduction of regulations requiring data sharing with tax authorities will give these authorities not only data on level of tax compliance among service providers, but is also likely to result in a legislative push to make service platforms responsible for tax compliance of service providers.

Andrzej Pośniak is a Partner and Piotr Nowicki is a Senior Associate with CMS Cameron McKenna Nabarro Olswang.

The authors may be contacted at: andrzej.posniak@cms-cmno.com and piotr.nowicki@cms-cmno.com