Narrow Focus on Digital Taxes Could Mean Cascading Consequences

The global tax community is in a battle of time and will to come up with a workable solution for taxing multinationals in the digital economy.

But the Organization for Economic Cooperation and Development, United Nations, and unilateral legislative initiatives are narrowly focused on the scope and mechanics of implementing this new “tax” regime that would satisfy most stakeholders.

As a result, there seems to be reduced attention to the implications a digital services tax may have on double tax treaties, foreign tax credits, and accounting rules for income tax provisions—partly due to the complexity of the interplay.

If the specifics are not hammered out—such as whether a digital services tax is covered by double tax treaties or is given a foreign tax credit mechanism—multinational enterprises worry about paying more than their “fair share” of tax in one or more jurisdictions around the world. They would have to deal with separate and dissimilar avenues of appealing any double tax disputes that arise, which would be difficult to successfully navigate.

But before the current discussion over digital services tax legislation began, the U.K. was already finding novel ways to tax multinationals as early as 2015. That tax—the diverted profits tax, or “Google tax” as it’s commonly known—came to life April 1, 2015, and also conflicted with double tax treaties.

U.K. Diverted Profits Tax

The diverted profits tax was a surprise legislative maneuver for avoiding the double tax treaty.

The tax was meant to deter the avoidance of a U.K. permanent establishment and was meant to remedy mismatches between the use of arrangements and entities that lack economic substance in the country and the resulting profits that were or weren’t subject to U.K. tax.

HMRC, in its updated guidance in December 2018, stated that the DPT is an important new tool to be used to counter profit shifting. Most importantly HMRC also stated: “As a tax in its own right, not corporation tax, DPT has its own rules for notification, assessment and payment.”

The tax enables HMRC to recharacterize the supply chain of multinationals and recompute profits that would have been earned in the U.K., even though no U.K. income tax would otherwise have been payable.

Thus, the diverted profits tax was envisaged, drafted, and legislated as a unique arrangement that did not align as a “tax” for which treaty protections or recourse would be available. Accordingly, it was introduced as a tax not formally recognized in a double tax treaty.

Digital Services Tax

Several countries have proposed or enacted unilateral digital services tax legislation that have similar characteristics regarding the tax base upon which a tax would apply, but haven’t addressed key questions on preventing double taxation.

For example, Austria’s DST legislation, effective from Jan. 1, 2020, has a 5% tax imposed on the turnover from online advertising services rendered to providers in the country. The turnover calculation is one methodology by which tax administrations have been proposing unilateral legislative proposals, although the tax base is much broader in other countries, such as France.

The tax base calculation achieves the simplification checkmark, apart from identifying the relevant components in a multinational’s enterprise resource planning system and internet access documentation.

However, the simplification of a tax base for calculation also introduces complexity in trying to address questions such as:

1. Is it a tax that receives protection from double tax treaties?
2. Is it an “income tax” that is reported in the income tax provision for U.S. GAAP financial statements?
3. Is it a tax that is creditable for foreign tax credit rules under U.S. tax law?

Let’s try to tackle those questions.

Tax Treaties

Summarily, from a double tax treaty perspective, the DST is different than a company’s taxes subject to the relevant tax treaty. The DST is also not a tax on income (after relevant deductions from turnover) and generally would fail to qualify as a covered tax.

If a digital services tax is not considered a tax on income, then the benefits of a double tax treaty, such as a formal appeal process or mechanism to avoid double taxation, are foregone.

The U.S.-Austria double tax treaty provides, in Article 2 (Taxes Covered), item 1: “This Convention shall apply to taxes on income imposed on behalf of a Contracting State.” Item 2 provides the taxes which would apply are U.S. Federal income taxes, or the Austrian income or corporation tax. Finally, item 3 would correlate a treaty tax to any identical or substantially similar tax that would be imposed after the Convention in addition to, or in place of, the existing taxes.

Notwithstanding other arguable provisions by which a DST would be challenged for double tax treaty application, it seems clear that if a DST is not based on income, or substantially similar characteristics thereto, double tax treaties do not provide a safe harbor for treaty inclusion.

Based on the tax treaty rules, would an analogous result apply for U.S. GAAP financial statements?

Income Tax Under U.S. GAAP

The principles of Accounting Standards Codification (ASC) 740 are applicable to “taxes based on income.” However, there is no clear guidance in this area.

The ASC Master Glossary defines income taxes as “domestic and foreign federal (national), state, and local (including franchise) taxes based on income.” Taxable income is defined as “the excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the governmental taxing authority.”

A tax based on income, reduced by some expenses, would qualify for ASC 740 inclusion, whereas the general methodology of a DST would thereby not qualify as an “income tax” for ASC 740 interpretation.

The DST, for U.S. generally accepted accounting principals, would generally be reported as a component of pre-tax income or loss, and not as a component of income tax for the effective tax rate calculation.

Accordingly, the DST would not receive treaty protection, and is not inclusive in the income tax provision section for U.S. GAAP. As a result, it would directly impact the earnings before interest and taxes and earnings before interest, taxes, depreciation, and amortization calculations since it would not be added back as an “income tax.”

Would the DST also fail to qualify as a tax that can be included as a U.S. foreign tax credit to avoid double taxation?

U.S. Foreign Tax Credit

A foreign tax generally must meet a net income requirement, in which the tax base is computed by reducing gross receipts to permit recovery of significant costs and expenses attributable to such gross receipts.

A foreign tax is also reviewed to determine if it operates as a tax imposed in substitution for, and not in addition to, an income tax otherwise generally imposed.

A foreign tax whose base is gross receipts or gross income generally does not satisfy the net income requirement.

The DST, in general, would not meet this test, and therefore this foreign tax is in addition to foreign income taxes that would be subject to eligibility as foreign tax credits.

That leads us to the OECD and the UN, both of which have wide-reaching DST proposals that seem to be on the brink of a new digital taxation era and could allow for ways to prevent double taxation.

OECD Pillar One Blueprint

The OECD is working to overhaul the worldwide tax system by getting nearly 140 countries to agree on a new way to tax multinationals.

Part one of the two-part plan, known as Pillar One, seeks to apply a new right to tax multinationals via an allocation of global residual profit to market countries. Comments on the blueprint are due Dec. 14, with headway expected in 2021.

The OECD appears to have its own dispute resolution process for Pillar One, which could help to eliminate double taxation issues that may arise.

Pillar One’s Amount A, the profit reallocation measures, represents a new taxing right for multinationals that meet two thresholds: annual consolidated group revenue (about 750 million euros similar to the threshold for country-by-country reporting) and a de-minimis threshold for foreign in-scope revenue.

And Pillar One’s Amount B represents an arm’s length principle approach for remuneration of related party distributors.

The Amount A tax base will be profit before tax, as derived from consolidated group financial accounts. The profit allocation will be a process whereby residual group profit in excess of a profitability threshold is determined, and a relevant portion of residual profits are allocated to market countries.

Most importantly, the Amount A liability allocated to paying entities will be relieved via an exemption or tax credit mechanism to eliminate double taxation. A new mandatory and binding dispute resolution process would also be made available to increase tax certainty regarding transfer pricing and permanent establishment issues.

Mandatory or elective binding dispute resolution rules will also be available for Amount B.

The dispute resolution process and elimination of double taxation are formidable challenges to be met, although the risk of dissimilar EU or unilateral DST rules seems insurmountable, in contrast.

UN Digital Service Tax Proposal

The UN, meanwhile, has introduced a proposal to a new Article 12B—Income from Automated Digital Services, focusing on developing countries.

Article 12B has a unique approach for the basis of taxation, as it provides an option to the beneficial owner to pay tax in the source country on a “net basis” versus the default “gross basis.” The net basis approach may come within double tax treaty rules, whereas the gross basis approach might not.

Article 12B, with the net tax basis option, contrasts with Article 12A—Fees for Technical Services, which are only applied on a gross basis.

The net basis approach presents an interactive dynamic model for discussion as it compares tax treaty benefits, accounting characterization, and foreign tax credit considerations against the default gross basis of tax for applying DST principles. However, this dichotomy has not been fully explored or aligned as part of the proposal.

Moving Forward

Inasmuch as the DST proposals are technically challenging to implement with a majority of consensus, the additional prongs of dispute resolution, tax treaty benefits, accounting characterization, and achieving parity via foreign tax credits adds considerable complexity for the new digital era of international taxation.

Still, these areas of the global tax sphere are important to consider to avoid cascading consequences for multinationals and tax administrations and double taxation disputes worldwide.

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

Author Information
Keith Brockman is a CPA, CGMA, and authors a Best Practices international tax blog at strategizingtaxrisks.com. He is a frequent presenter at international tax conferences, having over 30 years of experience as a corporate tax executive. He has served on tax committees in the U.S. and Europe with Tax Executives Institute and Manufacturers Alliance for Productivity and Innovation.