Daily Tax Report ®

INSIGHT: Taxing the 21st Century Economy—A Multilateral Approach?

Dec. 17, 2019, 8:01 AM

France’s decision to impose a digital services tax (DST) on U.S.-based tech firms such as Amazon and Google unleashed a new series of tariff threats on French goods by the U.S. administration. The U.K. is among several other European countries planning similar DSTs, raising concerns about how disagreements over the substance of DSTs will affect the transatlantic trade relationship, one of the most robust in the world.

The use of trade threats as a negotiating tactic between allies is always concerning but not that unusual. However, this particular episode raises important structural questions: Why are DSTs being increasingly considered by national governments? How should companies delivering services digitally, across borders be taxed? And to that end, what should the global community be doing to move forward with stronger and forward-looking tax policies?

The Back Story on Unilateral vs. Multilateral Solutions

There is increasing consensus that the rules governing corporate taxation, established in the first half of the 20th century, are not fit for an age where physical presence in a specific location is no longer a prerequisite for conducting business there. The rapid speed of digitalization internationally has posed challenges for tax policies, particularly for companies that have found new ways to generate value through digital means.

Digitalization makes it increasingly possible for businesses to reach markets in which they may have relatively little physical presence and to create value for their products based on the participation of users in those jurisdictions. Under existing international tax rules, which allocate taxing rights on business profits on the basis of physical presence, it is possible for a company that is resident in one country to generate significant revenues in another country without paying much, if any corporate tax in the latter. As evidenced by recent reports, this state of affairs is increasingly being challenged.

The debate here is about value creation and the division of tax rights among countries that consider that their citizens contribute to the profits made by some digitally focused companies, even if they do so via unconventional means. Everyone needs to understand that there is a real issue here. Companies and individuals that have no opportunity to arbitrage their tax liabilities into low tax jurisdictions are deeply resentful of companies that do. There should be no surprise that proposals to tax these international digital companies are popular with focus groups.

The issue of the value created from digital goods and services has been a discussion topic for G20 and OECD countries over the past decade. In March 2018, the OECD released a report on the challenges of taxing digital services, which was endorsed by 113 countries.

In 2018, the United Kingdom announced it would introduce a Digital Services Tax (DST) parallel to its efforts to support the development of an OECD framework. The draft legislation was published as part of the Finance Bill 2019-2020 and would come into effect on April 1, 2020.

With this and other unilateral approaches underway, in October 2019, an OECD Secretariat Proposal for a “Unified Approach” was released for public consultation, combining features of three separate proposals—from the U.K., the U.S., and the G20—and aiming to achieve compromise. This lays the groundwork for a potential agreement in 2020, keeping with the planned schedule.

The U.K.’s DST Proposal Carries Risks

Since this debate on how to tax digital services began, we have been a supporter of a multilateral solution that provides the highest level of consistency across markets, reduces fragmentation, and increases regulatory alignment. My organization, BritishAmerican Business, recently brought together stakeholders from the OECD, governments, the private sector, and academia to discuss this topic. The biggest takeaway was that the U.K.’s DST for one, is the wrong solution to a genuine problem—carrying considerable risk of contributing to regulatory fragmentation and double taxation—and that renewed momentum behind a global solution is ample reason to refocus efforts behind the OECD’s initiative.

Let’s first look at the U.K.’s DST proposal, a tax on gross revenues of 2% of specific business models, where revenues are linked to the participation of users based in the U.K. The draft mentions that “a user will be considered a U.K. user if they are normally resident in the U.K. and thus primarily located in the U.K. when participating with the relevant business activity.” There is little clarity as to how this is to be determined; instead, the burden is placed on businesses to identify user location.

The scope of the tax includes search engines, social media platforms, and online marketplaces. A group will be liable to pay the DST when (a) it provides a relevant business activity, (b) the worldwide revenues attributable to relevant business activities exceed 500 million pounds (about $650 million), and (c) more than 25 million pounds (about $33 million) of these revenues are attributable to U.K. users. There is also an allowance under which a group’s first 25 million pounds of revenues derived from U.K. users will not be subject to the DST.

The U.K. proposal is that this tax is meant to be temporary and is subject to formal review in 2025.

While the motivation in the U.K. for such a tax is well understood, the transatlantic business community has identified several issues with it. First, the U.K. DST was originally drawn up in reaction to stalled progress on the more unified OECD approach. However, given the recent Secretariat Proposal and renewed momentum behind a multilateral framework, the U.K. DST would come into effect at an uncomfortable time, raising uncertainty and sending the wrong signal to businesses: that the U.K. supports unilateral measures when global measures are possible.

In the absence of a global framework, the U.K. tax covering cross-border digital activity is bound to raise the cost of businesses operating across markets, as they must ensure compliance with different regulatory regimes—more simply put, a lack of alignment could risk double taxation. This risk is compounded by the U.K.’s impending departure from the EU. There is also the risk that the DST, which has been presented as an interim measure, will become permanent, and possibly encourage other individual states to pursue their own DSTs.

A unilateral DST will also work against the momentum of any bilateral U.S.-U.K. trade talks, as the U.S government has stood firmly against unilateral taxes. Additional trade volatility between the two countries is a real risk factor, as the U.S. views the DST as a targeted measure aimed at U.S. tech champions. The U.S. may decide to take action against the U.K., which would work against the political momentum for a U.S.-U.K. trade agreement.

Finally, the U.K. DST proposal fails to provide clarity for businesses on several key operational concepts, and instead places the burden on companies. For instance, the issue of a user’s location is central to the U.K. DST; however, the legislation does not provide clarity for situations where location is not actively tracked, where users move across borders often, or where users make use of rerouting tools such as Virtual Private Networks (VPNs). Much more clarity and certainty in both the legislation and the guidelines on implementation are needed.

A Multilateral Agreement Would provide Consistency

What should the U.K. do about its DST? I believe, given the renewed momentum behind the OECD’s “Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalisation of the Economy,” that the U.K. should refocus its efforts on supporting the development of a global, multilateral framework under the OECD umbrella. The transatlantic business community is calling for the consistency, stability, and certainty, which a global framework developed by consensus through the OECD can provide, and which will foster trade and investment in the transatlantic corridor. In contrast, unilateral tax rules based on multiple standards can affect competitiveness, create compliance problems, and raise the risk of double taxation, contrary to established global taxation principles.

And the British aren’t the only ones who should back down. I believe that the U.S.’s threat—should the U.K. go ahead with its DST—of imposing punitive tariffs on British products is equally counterproductive and must be avoided. The U.K. and the U.S. would both do better to engage with the OECD process and with each other in meaningful and constructive dialogue, to avoid friction and obstacles to their hitherto highly lucrative transatlantic trade and investment relationship.

In the event that the U.K. government decides, against business recommendations, to go forward with the DST legislation as it currently stands, they must make provisions for reimbursing companies as soon as an international framework is in place, and should also define precisely when such a framework fulfils the U.K.’s own criteria so the U.K. can transition to it. Needless to say, this approach would cause even more unnecessary work and confusion.

The OECD’s Secretariat Proposal—A Multilateral Way Forward

The recent OECD proposal, published in October 2019, is not an agreed solution, but rather the Secretariat’s own initiative to combine features of three separate proposals—the U.K.’s, the U.S.’s, and the G20’s—with the aim of achieving consensus. The proposal does not single out the digital economy, nor does it apply to all companies; instead, it focuses on all consumer-facing businesses.

A bit of explanation of this complex proposal is called for here. For businesses within the scope, the initiative creates a new nexus, not based on physical presence but on sales. The new nexus could have thresholds including country-specific sales thresholds calibrated to ensure that jurisdictions with smaller economies can also benefit. It would be designed as a new self-standing treaty provision.

It creates a new profit allocation rule applicable to taxpayers within the scope, and irrespective of whether they have an in-country marketing or distribution presence (permanent establishment or separate subsidiary) or sell via unrelated distributors. The profit allocation is likely to be proportionate to the revenues generated in that market as a percentage of the whole. This is the most detailed aspect of the proposal.

At the same time, the OECD’s approach largely retains the current transfer pricing rules but complements them with formula-based solutions in areas where tensions in the current system are the highest. In this regard, the proposal includes new rules for fixed returns for baseline distribution activities, an area where there have historically been significant tax disputes.

The Secretariat recognizes that more effective means of dispute prevention and resolution will be essential for implementation. Overall, the OECD intends to create certainty for taxpayers and tax administrations with this three-tier profit mechanism, which combines new formula-based rules and traditional transfer pricing and provides new dispute resolution approaches.

How Should the OECD Proceed From Here?

Some of these issues do not have easy solutions and will require compromise between parties. The proposed attempt to balance the existing transfer pricing system with simplified and formula-based features is one possible way forward towards an agreement. However, the OECD must also complement the work already done with mechanisms to prevent and resolve double tax disputes.

The OECD and participating countries need to provide clear rules regarding the scope of taxation and appropriate carve-outs, bypassing those sectors that do not raise the concerns identified by the process. Additionally, standards and monitoring must be implemented in various jurisdictions to ensure that, once there is an agreement, all participants follow through in a consistent and coherent manner that reflects the agreed solutions.

It is incumbent upon the OECD and participating countries to act with urgency and purpose in order to respect the agreed timeline and deliver a workable tax framework by the end of 2020. The OECD should continue to use the consultation approach as the proposal is further fleshed out, providing stakeholders the opportunity to provide feedback on details and specifics.

With the ongoing and active debate on how to tax the digital economy, new momentum is being built towards a multilateral solution at the OECD level. The Secretariat itself has acknowledged that the current framework will require significant work before being ready. The challenge of identifying and agreeing on a formula for the taxable deemed profit in each market, when there will be winners and losers, is fiendishly difficult. Regardless, the OECD’s proposals represent a much-needed development for encouraging consensus and achieving a multilateral solution. The alternative is an increasingly fragmented landscape with different regulatory requirements for companies operating across markets, an increased risk of double taxation, and a real roadblock to trade and investment in the transatlantic corridor.

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

Author Information

Duncan Edwards is CEO of BritishAmerican Business, a trade and policy advocacy association promoting transatlantic trade and investment. He can be reached at dedwards@babinc.org.

To read more articles log in. To learn more about a subscription click here.