The taxation of digitalised businesses continues to be a hot topic for the OECD and jurisdictions such as the UK. The perceived problem is that large, global, highly digitalised businesses are paying less tax than they should, and market jurisdictions e.g. where a high volume of sales take place or value is otherwise generated through 'users' do not get their slice of the tax pie.
Whilst discussions are ongoing at OECD level, a number of countries, including the UK, are looking to introduce an 'interim' digital services tax (DST). The UK's DST is a 2% tax chargeable on the gross revenues of large digital services businesses which are attributable to an "in-scope activity" and are linked to UK users. It will apply to revenues earned on or after 1 April 2020.
At OECD level, a 'programme of work' was endorsed by the G20 in June 2019 which promised to look further at the two "pillars" underpinning a proposed long-term solution which is ambitiously targeted to be agreed by the end of 2020. This was followed up with public consultations on the two pillars in Autumn 2019 which included further details of the proposals.
Pillar 1 looks at when a taxable presence could be created in a market jurisdiction where there would not otherwise be one e.g. because there is no physical presence in that jurisdiction (a "digital PE") together with the allocation of taxing rights to market jurisdictions and the interaction with existing transfer pricing rules.
Pillar 2 is concerned with having an overall minimum level of taxation for large digital businesses that operate globally. This minimum tax could be achieved in a number of ways including allowing jurisdictions to tax 'undertaxed' amounts and/or imposing withholding taxes on payments that would otherwise be 'undertaxed'. However, the thinking around this pillar is less developed than under pillar 1.
What is a digital business?
The UK's DST targets certain types of business activity, being social media platforms (including dating websites), search engines and online marketplaces. Revenues derived from these activities will be taxed in the UK if (i) the global business has more than £500 million of global revenue from the activities and (ii) more than £25 million of that revenue is linked to the UK i.e. generated as a result of 'UK users'. There will be a safe harbour election if the group has low UK profit margins allowing an alternative method to calculate the tax due.
However, the OECD is taking a much wider approach, with a broader focus that includes consumer-facing businesses e.g. "businesses that generate revenue from supplying consumer products or providing digital services that have a consumer-facing element". This could catch large retailers and other businesses that operate digitally from remote locations. Certain carve outs are expected to be introduced e.g. for extractive industries and possibly financial services (which the consultation says will be considered further). An overall global revenue threshold e.g. of €750million that would prevent smaller businesses being caught by the new rules will also be considered.
How will profits be allocated?
The proposal under Pillar 1 suggests three possible amounts that could be allocated to market jurisdictions which go further than amounts currently allocated under the arm's length principle.
Amount A – there will be a new taxing right for those jurisdictions in which a 'digital PE' is created. Whether or not a digital PE is created will be largely based on sales; there will be country-specific sales thresholds to make it fairer for jurisdictions with smaller economies. A proportion of deemed residual profit (i.e. after the allocation of deemed routine profit) would be allocated to the digital PEs using a formula based on sales.
Amount B – the arm's length principle currently used to allocate profits to certain functions such as distribution functions that comprise the 'baseline activity' in a market jurisdiction may be replaced with fixed remunerations for these functions. This could result in more being allocated to a market jurisdiction in respect of these functions.
Amount C – a market jurisdiction may seek to tax additional profits if extra functions (above the baseline activity taxed under Amount B) are carried out in its jurisdiction. This would be subject to a binding dispute prevention and resolution mechanism (which is being considered further by the OECD).
The US-shaped spanner in the works
The US has been consistently critical of digital services taxes and threatened to impose tariffs of up to 100% on wine and handbags in response to France's implementation of a 3% DST in July last year. The UK government has so far remained committed to introducing its new DST but in a climate of negotiating trade deals with the US this is one to keep an eye on.
More generally, in early December the US sent a letter to the OECD expressing "serious concerns regarding potential mandatory departures from arm's length transfer pricing and taxable nexus standards – longstanding pillars of the international tax system upon which US taxpayers rely". The proposed solution was to introduce a 'safe harbour' effectively allowing US companies to opt-out of the proposals. The OECD response to the letter noted that the safe harbour suggestion had not been mentioned previously, and that its suggestion could make it harder for a consensus to be reached in 2020.
The US went on to say that it broadly supports Pillar 2, provided it aligns with similar US rules.