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Daily Tax Report: International

INSIGHT: Who is Afraid of the Digital Services Tax?

Dec. 9, 2019, 8:00 AM

Negotiations on overhauling the international framework for business income taxation have hurtled along in Paris at dizzying speed in recent weeks. The Organization for Economic Cooperation and Development (OECD) launched a public consultation in October regarding a “Unified Approach” for dealing with “the tax challenges arising from the digitalization of the economy.” A meeting with over 400 participants from many nations was convened on November 21 and 22, 2019.

Under the Unified Approach, at least some multinationals will begin to be subject to income taxes in countries in which they have neither subsidiaries nor physical presence. And at least some portion of many other companies’ profits will be allocated to countries in which their customers reside, in a manner that substantially deviates from the traditional “arm’s length principle” of transfer pricing. Profit will be split according to formulae that reflect customer (or user) bases or marketing expenditures.

Which companies will be affected by these new rules, how much of their profit will be reallocated, and how these reallocations will be implemented, remains to be seen.

Many observers—perhaps even most—are skeptical about whether the OECD can deliver a “consensus solution”: yet many also assert that decisive action is necessary. Without a multilateral agreement brokered by the OECD, it is claimed, chaos would descend in the international tax arena; an unstoppable arms race of unilateral tax measures would break out.

What kind of unilateral tax measure is capable of wreaking such havoc?

Ironically, what is referred to is not the U.S.’s Base Erosion and Anti-Abuse Tax (BEAT), introduced at the end of 2017. The BEAT, surely, is the largest unilateral international tax policy measure in recent memory. Instead, the catalyst for the high-stakes negotiations at the OECD is a set of much smaller and much more targeted tax proposals, exemplified by the digital services tax (DST) that France enacted last July. Indeed, to borrow a phrase from Marx, the OECD has become a kind of holy alliance for exorcising the specter of the DST.

Two Reasons the DST Will Not Go Away

Yet there are two basic reasons why the idea of the DST may not be so easily conjured away. First, not only are DSTs not uniquely unilateral (as the BEAT example reminds us), they are not really unilateral at all. The EU first proposed a DST Directive in March 2018 to be adopted by all EU member countries. The proposed Directive was strongly supported by France, Italy, Austria, Spain, the Czech Republic and other countries, all of which are likely to be prepared to coordinate with one another on DST adoption. The U.K., anticipating leaving the EU, proposed its own DST in 2018, but in implementation guidelines proposed in 2019 explicitly provides for coordination with other countries that also enact DSTs.

In other words, the EU’s failure to secure unanimous agreement among its member countries in adopting the DST is what made currently enacted and proposed DSTs “unilateral.” The OECD, now being tested on its ability to create a global consensus with sufficient substance, faces the same risk of failure.

Accusations of unilateralism directed at countries adopting the DST attempt to obscure an obvious fact. When a large country like the U.S. adopts unilateral policies such as the BEAT, few countries can retaliate on their own. Consequently, there is no “arms race,” no “war,” threatening global tax order. DSTs, by contrast, are unusual in that they are measures pursued by relatively small (albeit advanced) economies. The U.S., being a much larger economy, may feel that it is in a position to retaliate, but it is also not clear (at this point) that the smaller countries will back down. The threat of global disorder thus issues not from unilateralism—unless that term just means “without the agreement of the U.S.”—but from a policy conflict between smaller economies (which can easily coordinate among themselves) and the U.S.

There is a second basic reason for thinking that DSTs have set in motion changes in the international tax system that will not be contained by a present OECD solution. Negotiations now carried out at the OECD rest on one fundamental premise: in exchange for allocating more of multinationals’ profits to market countries for taxation—which would indeed represent a large shift from the existing international tax paradigm—businesses would get certainty in rules, as well as coordination among governments in dispute resolution and the prevention of double taxation.

Governments are asked to reveal how much they prefer to shift taxing rights to the countries of users and consumers. Based on such revelations, a bargain is to be struck, and countries would adhere to it in the foreseeable future. This, of course, critically assumes that a significant number of countries are motivated to adopt this new approach to allocating taxing rights.

Is this assumption warranted? The evidence is rather mixed. After all, the U.K. government and the EU first promoted the DST purportedly because it better allocates taxing right to “where value is created.” That last phrase has been roundly criticized for its vagueness. But if such criticism is valid, what confidence do we have in reading into that phrase a desire to allocate taxing right to market jurisdictions? Similarly, how certain are we that when India introduced an Equalization Levy on online advertising in 2016, its motive was to allocate greater taxing right to itself as the place where consumers reside?

It is worth noting that until fairly recently only a few academics advocated reforming international taxation by permitting greater allocation to consumer jurisdictions. They did so primarily on the ground that such allocation would constrain multinationals’ tax planning—not because they thought countries would find it fair. In all, it is not clear that countries’ preferences for allocating taxing rights to consumer jurisdictions is what have driven calls for reform, nor that one should bet on such preferences to sustain international consensus going forward.

Three Major Facts about Digital Commerce

There is a very different, as well as plausible, way to interpret the appeal of DSTs to various governments: DSTs are responses to three facts about emerging global digital commerce, which have begun dramatically to shift the grounds of international taxation. None of these facts is specific to consumer-facing businesses: they can just as easily be found in business-to-business transactions, such as cloud computing services.

The first fact is that digital goods and services can be produced and delivered at (close to) zero marginal cost. This basic economic fact undergirds many of the metaphors (e.g. “scale without mass”) that currently populate the international tax debate. It is also why the DST, as a tax on revenue, can be far less distortionary than previous cascading taxes: when marginal cost is zero, a tax on revenue is a tax on marginal profit. But most importantly, zero marginal cost implies that the producers must rely on some kind of market power—whether legal monopolies created by patents or copyrights, or natural monopolies created by network effects or economies of scale—to profitably sell such goods or services.

In such circumstances of imperfect competition, it is theoretically plausible that a country importing digital goods or services could, through a tax on the foreign provider’s revenue, extract a share of the foreign provider’s profits without hurting their own firms and consumers too much. This is the basic idea of the DST. Whether this theoretical prediction will work out in real practice is hard to say, but the chances of success are much better than taxes imposed on goods produced at positive marginal cost, such as steel, cars or wine. Assertions that the DST is a patently terrible idea like all previous taxes or tariffs on business revenue ignore this basic fact of zero marginal cost.

The second fact about global digital commerce that may be motivating DSTs is that digital goods and services can often be delivered simultaneously to multiple countries. This requires the marginal cost of production to be zero, but is a further and distinct fact. It implies that the profit earned by a multinational from selling goods or services to firms and consumers in a given country (Country X) is location-specific. That is, it is simply not true that the multinational, facing a tax in selling to Country X, can just leave and make a similar profit elsewhere. That profit elsewhere can already be made, regardless of what is sold to Country X. The profit to be made from Country X can be made only there.

This further strengthens the case of countries imposing “unilateral” taxes on foreign digital firms: if the profit earned arises from Country X, why should Country X not be able to tax it, and why does it have to seek the agreement of other countries?

The third and rather unusual fact about global digital commerce is that such commerce may be asymmetrical, and may become increasingly so in the future. The talents, entrepreneurship and, most importantly, data required for advances in digital technology may be concentrated in a very small number of countries. Taxes imposed on digital goods and services provided by firms from these countries may look discriminatory now, but in the not-too-distant future, we may come to see such targeting of particular countries not as the result of jealousy or spite, but as the inevitable consequence of asymmetrical technological development.

It is thus rather fitting to see the U.S. (and U.S. companies) trying to blunt the asymmetrical impact of DSTs on U.S. firms by offering the concept of “marketing intangibles” as the basis of new allocations of taxing rights: marketing intangibles are much more evenly distributed across nations than digital technology. The trouble, however, is that a new international agreement based on giving weight to marketing intangibles may turn out to be an agreement that has ignored a future of technological asymmetry.

Foes of the DST have rallied around the slogan that the digital economy should not be ring-fenced. In theory, caution against ring-fencing is sensible: the features of zero (or low) marginal cost, non-rival deployment, and asymmetry in trade may be found in existing and future businesses other than those currently targeted by the DST.

However, judging from the way the DST has been demonized in the recent international tax debate, it is not clear how interested DST critics are in these fundamental, non-ring-fencible patterns pervading the globalized digital economy. This, arguably, is what raises the greatest risk that a new international tax framework will be ushered in without any lasting purpose.

Wei Cui is a Professor at the Peter A. Allard School of Law, the University of British Columbia. His scholarship on international taxation can be found here.

The author may be contacted at: cui@allard.ubc.ca

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

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