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INSIGHT: U.K.’s Digital Services Tax—Where Are We?

Oct. 21, 2019, 7:01 AM

The last few years have seen numerous countries proposing the introduction of a digital services tax (DST). As yet, however, relatively few have made it into law, at least in Europe—the major exception being France, which passed legislation for its own DST during the course of the summer.

Of the taxes still on the drawing board, the U.K.’s proposal is one of the better developed. It has been through several consultation exercises, which led to draft legislation being published in July 2019.

Brexit

The principle of imposing a greater tax burden on digital businesses appears to enjoy considerable support across the leading political parties, and in the normal course one would expect this legislation to proceed rapidly into law and to take effect, as scheduled, from April 2020.

Ostensibly, this is still the government’s intention. In practice, there is now a considerable chance that the proposal will be delayed or ditched altogether. The reason? Brexit, which casts its shadow over this issue as it does over virtually every area of public policy in the U.K.

One of the ironies is that the proposal being pursued by the U.K. government is very similar to that being propounded by the European Commission for an EU-wide DST.

Both proposals are premised on the idea that user participation is a new value driver for digital businesses that is not properly reflected by the international corporate tax system as it stands.

A DST is therefore needed to redress this balance until international agreement can be reached on changes to that system—which would necessarily involve reforms to transfer pricing principles and reforms to the permanent establishment concept allowing countries to assert taxing rights over certain digital businesses which do not have a traditional physical presence in their territory.

Despite the efforts of the Organisation for Economic Co-operation and Development (OECD) to present proposals in this area by early 2020 and reach international agreement later in the year, the U.K. government has committed to introducing a DST with effect from April 2020 as an interim measure.

The U.K. has taken a slightly different approach from that taken by the European Commission in its draft directive for an EU-wide DST.

EU Proposal

The EU original proposal would have applied to defined revenue streams—specifically, revenues from targeted digital advertising, online intermediary services, and transmission and generation of user data. The U.K.’s approach is to define in-scope activities—social media platforms, search engines and online marketplaces—and to tax all revenues from those activities that are attributable to U.K. users.

The U.K.’s DST is therefore rather narrower in scope than the original EU proposal, and considerably narrower than the EU’s “significant digital presence” proposal for a permanent solution, which would have extended to a wider range of digital services, including online content providers. The U.K.’s proposal is, however, broader than the March 2019 compromise proposal from the Presidency of the Council of the European Union, which advocated restricting the EU-wide DST to revenues from targeted digital advertising.

EU member states have been unable to reach consensus on the EU proposal, meaning that it is unlikely to proceed for the foreseeable future. This has led many member states to bring forward proposals of their own.

The U.K.’s proposal is not only narrow in scope relative to the EU’s original proposal; it is set at a lower rate (2% as opposed to 3%), and also contains an alternative basis of charge for businesses with a lower profit margin. Under this approach, the taxpayer calculates their revenue from the relevant digital activities and multiplies it by an amount equal to 0.8 of the group’s operating margin from the relevant activities in order to arrive at the taxable revenues to which the 2% charge applies.

Conceptually, therefore, the tax is something of a hybrid—a tax on revenues, but which allows taxpayers the option to be taxed by reference to gross profits if that produces a more favorable result.

The thresholds for the application of the DST—500 million pounds ($645 million) of worldwide revenue and 25 million pounds of U.K. revenue—are slightly lower than the thresholds specified in the draft directive of 750 million euros ($834 million) for worldwide revenue and 50 million euros of in-country income. However, they are sufficiently high to ensure that the DST will only affect a relatively small number of businesses.

The government forecasts that the introduction of the DST will bring in additional revenues of around 440 million pounds by 2022–23—a figure which is no more than a rounding error when compared to the U.K.’s overall corporation tax receipts, which exceed 55 billion pounds.

It is therefore hard to escape the conclusion that the DST represents a political gesture—a desire to be seen to be tackling the digital giants, rather than a serious attempt to reshape the tax system in response to the digital economy. In this respect, the DST is analogous to the additional taxes levied on banks after the financial crisis and the windfall tax on privatized utilities in the late 1990s, which were also driven at least as much by political calculations as economic logic.

In normal circumstances, a measure such as the DST might expect a smooth passage onto the statute book, whatever the rights or wrongs of the measure. It is aimed at a politically tempting target, has support from across the political spectrum, and has been the subject of a reasonably detailed consultation process which would be expected to iron out any major technical flaws. The U.K. is, however, in anything but normal circumstances, and it is possible that the DST may become less politically expedient than it is at present.

The U.K. is scheduled to leave the EU on October 31, 2019, although at the time of writing, it remains unclear whether this will happen, or whether there will be a further delay. The government’s stated policy is to leave on schedule, deal or no deal. In addition, the government will present its annual budget on November 6, 2019. This will be followed by the introduction of the annual Finance Bill into Parliament.

In the U.K., income tax and corporation tax are temporary taxes, renewable every year, meaning that a Finance Bill must be introduced every year to reimpose them.

A typical Finance Bill will also include numerous other changes to the tax code—the draft legislation for this year’s Bill runs to over 100 pages. The longer the Finance Bill, the greater scrutiny it will face. With Parliament bitterly divided over Brexit and the government lacking a working majority in the House of Commons, it is highly unlikely that it would be able to push a complex Finance Bill through Parliament without suffering defeats and having to accept amendments it does not wish to accept.

There is also a significant risk of the government losing a vote of no confidence and being forced to call a general election—which would result in the Finance Bill falling if it has not completed its Parliamentary passage.

There is a strong chance that the government may try to minimize this risk by bringing forward a short Finance Bill—one which merely reimposes income and corporation tax for next year and possibly introduces entirely uncontentious changes.

In any event, a general election seems increasingly likely over the next few months, meaning that there would probably be insufficient time for a full-length Finance Bill to complete its Parliamentary passage.

Might a new government then reintroduce the DST legislation following an election? This is what “normally” happens, particularly where an existing government is returned to office. The DST is scheduled to come into force from April 2020 and it seems entirely possible that an election could delay passage of the DST legislation until around then.

Any new DST will require digital service providers to maintain detailed records of where their users are located in order to calculate their liability. Understandably, they may be unwilling or unable to put systems in place to capture this information until the legislation is set in stone. Any significant delay to the passage of the DST legislation may mean that the government is forced to delay implementation of the charge until 2021.

By that stage, the DST may be overtaken by events. The OECD may have reached agreement on a new model for taxing the digital economy, meaning that the U.K. can move directly to legislating the outcome of those discussions. The consultation document released by the OECD on October 9, 2019 indicates that it is making steady progress in that direction, and may achieve consensus on a fully-formed plan within months.

The Future

But before that happens, the U.K. may have left the EU without a withdrawal agreement. In that situation, the government is likely to be prioritizing trade deals with important trading partners outside the EU—and in particularly with the U.S.

DST proposals have generally received a hostile reception in the U.S., where the administration and legislators from both parties view them as being unfairly targeted against U.S. companies. The Office of the U.S. Trade Representative has initiated an investigation into whether the recently-enacted French DST discriminates against U.S. businesses—a process which could lead to retaliatory tariffs being imposed against France. A U.K. DST structured, as the current proposal is, along similar lines, can probably expect a similar response from the U.S.

The U.K.’s new Prime Minister, Boris Johnson, has indicated on several occasions that he is in favor of a DST or a similarly targeted tax, but has also indicated that the structure of this tax would be on the table in any trade negotiations with the U.S.

It would therefore be no surprise if the DST plans were quietly abandoned as a quid pro quo in any trade negotiations, on the pretext that they will shortly be superseded by an internationally-agreed approach. Conversely, a government formed or supported by the main opposition parties would be likely to negotiate a softer Brexit or no Brexit at all, and may be more inclined to proceed with the DST.

Underlying the Brexit debate is a fundamental tension over whether the U.K. should retain close ties to the European economy and its social model, or whether it should be more closely aligned with the U.S. What happens with the DST may provide an early clue as to how this tension will ultimately be resolved.

James Ross is a Partner at McDermott Will & Emery UK LLP

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