On 21 March 2018, the European Commission (EU Commission) presented its proposals regarding the taxation of the ‘digital economy’ in the EU. The EU Commission pursues a binary strategy: a comprehensive reform, introducing the concept of ‘significant digital presence’ (often referred to as ‘digital permanent establishment’, and hereafter referred to as Digital PE), and an interim measure consisting of a digital service tax (DST) of 3% on the revenues from certain digital services. The EU Commission proposes two standalone Council Directives to ensure a harmonised approach within the EU and aims for an entry into force on 1 January 2020. The EU Commission also published a recommendation to implement the digital economic presence in tax treaties between EU Member States and third countries and will propose amendments to the CCCTB proposal.

To whom this is relevant

  • The DST targets companies that derive revenues from the supply of certain digital services characterised by user value creation, and that have a worldwide turnover in excess of EUR 750 million and revenues from the relevant digital services in the EU in excess of EUR 50 million.
  • The Digital PE will have a much wider impact, as it does not comprise turnover thresholds like the DST. Furthermore, it will cover a wider range of digital services.

The EU Commission suggests to stop applying the DST to taxpayers that would be taxed under the comprehensive option, once implemented, i.e., taxpayers resident in the EU or in non-EU countries that do not have a tax treaty with the EU Member State of the Digital PE. By the same token, this means that the ‘interim’ DST will become a permanent tax for companies that are not subject to the Digital PE rules.

This note summarises below the key features of the DST and subsequently of the Digital PE, as proposed by the EU Commission, and provides some initial observations to the proposed measures.

The Digital Services Tax (DST)

Scope

The ‘digital economy’ cannot be ring-fenced and ‘digital’ business models can differ significantly. Sidestepping these issues, the DST targets user participation and data as a key source of value creation through ‘digital interfaces’, i.e., software such as websites and apps.

Digital services providers with annual worldwide revenues exceeding EUR 750 million and revenues from the provision of digital services in the EU exceeding EUR 50 million could be affected. The DST targets both corporate taxpayers and tax transparent entities. These entities would be taxed on the gross turnover (net of VAT) derived from the following digital services provided in one or more EU Member States:

  • Placing advertising targeted at users of a digital interface (this primarily targets operators of search engines and social media networks);
  • Transmitting data about users that has been generated by their activities in the digital interfaces; and/or
  • Intermediation services by making available multi-sided digital interfaces in which users may find other users and interact with them, and which may facilitate the sale of goods or services between these users (i.e., marketplaces).

The supply of digital content / solutions (streaming services, cloud computing, online gaming) would also not be covered. IT solutions such as payment services are also excluded, as users have already established contacts by other means than the digital interface. Finally, online retail (where the website operator is also seller of the goods/services) and digital services provided to another entity of the same consolidated group for financial accounting purposes is also out of scope.

At first sight, the DST’s scope appears to be a fairly narrow number of mainly US headquartered tech groups, though all groups with multiple branches of activity (including a digital services activity) will need to assess in detail whether they could fall within the scope.

Compliance

The DST would be paid on the total revenues from these digital services and would then be allocated to the various EU Member States where the users of the services are located (based on their IP address or another appropriate method of geolocation). The allocation key of DST revenues between different EU Member States would depend on the type of service:

  • In the case of advertising services: the number of times an advertisement has been displayed on a user’s device in the relevant EU Member State;
  • In the case of a multi-sided digital interface: the number of users concluding transactions (if the interface involves an underlying supply of goods or services) or holding an account allowing them to access the interface;
  • In the case of transmission of data: the number of users in the relevant EU Member State whose data has been transmitted.

The place from which the payment is made and where the underlying transactions (if any) takes place is disregarded.

To minimise the administrative burden on taxpayers, a One-Stop-Shop will be made available: the DST return would be filed, and the DST would be paid, in one EU Member State only and that EU Member State would then exchange the information and transfer the appropriate portion of tax receipt to the other EU Member States where the taxpayer provides digital services.

Affected taxpayers would have to comply with the General Data Protection Regulation (GDPR) to collect and process the data required for purposes of the DST.

Impact for affected taxpayers

By taxing gross revenue rather than profits, the DST disregards the contribution capacity and triggers a tax liability for loss-making businesses or businesses with low margins. Some companies or business models may disappear. Also, companies that meet only one of both thresholds could be inclined to not develop further.

Companies in the scope of the DST would face an increased tax liability. The EU Commission “expects Member States will allow” affected taxpayers to deduct the DST as a cost for corporate tax purposes (instead of crediting it against corporate tax). There is, however, no binding provision proposed to that effect. Secondly, the corporate tax reduction, if any, would not match the turnover tax liability. Thirdly, non-EU countries cannot be forced to accept to treat the DST as tax deductible expense. Companies would also face an increased administrative burden.

Moreover, external factors, such as the mobility of users, may complicate the allocation of income to jurisdictions. An affected company would also need to appropriately split the income even if taxable and non-taxable activities are strongly embedded.

Finally, the proposed DST could trigger a tax liability in the EU for companies that currently have no physical presence at all in the EU, e.g., a US manufacturer buying advertising space from a US social media platform provider to target an EU market.

Technical / legal observations

The proposed DST raises a series of legal concerns, including:

  • The risk of incompatibility with the EU economic freedoms and WTO rules;
  • The violation of the subsidiarity principle and of the sovereignty of Member States in tax matters; and
  • The introduction of apportionment criteria to allocate the right to tax, which implies a departure from the arm’s-length principle, which currently underpins the international tax system.

Reactions and next steps

The OECD, which has published an interim report on its own progress on the taxation of the digitalising economy, has warned the EU against unilateral actions while a global consensus is sought. Several EU Member States share the desire to act only at global level to prevent a competitive disadvantage. Furthermore, the US has expressed strong opposition against taxation of digital companies on a gross basis.

The EU Commission and the Member States supporting the initiative hope for a swift approval process and a subsequent implementation in domestic law by 31 December 2019, so that the DST would start applying as from 1 January 2020.

For the proposal to be accepted, however, EU Member States would need to approve it unanimously. Considering the expected limited scope of the tax (an estimate suggests about 100 companies, including a few European companies, should be affected), it remains to be seen whether small EU countries hosting the European headquarters of the main digital economy actors would raise their veto right on a stand-alone basis. It cannot be ruled out, though, that EU Member States would be willing to do so acting in concert with other EU Member States, supported by the lack of global consensus observed by the OECD and the opposition expressed by the US.

The Significant Digital Presence (Digital PE)

Scope

Although there appears to be a general consensus to tax profits “where value is created”, defining what creates value and where this value creation process takes place remain two key tax policy questions on which no consensus has yet been reached on global level.

The EU Commission takes the view that users’ engagement / contributions and the collection of their data creates value for businesses in the digital economy. Consequently, it proposes to define a significant digital presence in an EU Member State, during a given tax year, based on three alternative criteria:

  • Revenues from supplying digital services to users in that EU Member State in excess of EUR 7 million;
  • A user base of more than 100,000 in that EU Member State: or
  • The conclusion of more than 3,000 contracts for digital services in that EU Member State.

The proposal would only apply to taxpayers subject to corporate tax (or an equivalent tax) in an EU Member State.

Importantly, for purposes of the comprehensive reform, the concept of “digital services” would be much wider than for purposes of the interim DST.

The proposed directive’s definition focuses on the following characteristics: digital services are (i) delivered over the internet or an electronic network, (ii) largely automated, requiring minimal human information, and (iii) impossible to provide without technology.

The definition gives several examples, including the supply of digitised products, including software, services providing or supporting electronic presence, and marketplace services. A more extensive list of 26 examples is provided in an annex to the proposal.

The proposed directive also includes a 19-item list of excluded services, amongst which radio and television broadcasting services, services of professionals who advise clients by email, certain teaching services and access to the Internet and World Wide Web.

In order to actually attribute tax base to the Digital PE, a shift in the international tax rules on profit allocation and allocation of taxing rights would be required. Therefore, the rule would only apply intra-EU (because the Commission alleges the directive would override tax treaties between Member States) and when the company resides in a third country that does not avail of a tax treaty with the EU Member State in which there is a Digital PE. The EU Commission therefore recommends EU Member States to amend their tax treaties with third countries.

Compliance

As the Digital PE is intended to fit into the framework of corporate taxation, we anticipate that compliance requirements would be aligned with the ordinary corporate tax compliance system of the relevant EU Member State. As the recognition of a Digital PE in a certain EU Member State is based on digital criteria, affected companies may become subject to tax compliance requirements in more EU Member States, resulting in a higher administrative burden.

Affected taxpayers would have to comply with the GDPR to collect and process the data required for purposes of establishing the significant digital presence and the allocation of profits.

Impact for affected taxpayers

Unlike the proposal of the DST, which appears relatively targeted, the introduction of a concept of ‘digital economic presence’ would affect many more taxpayers than the US tech giants. In particular, the providers of numerous IT services / solutions (as diverse as online automated installation of firewalls, software to block ads, website statistics, etc.) would be affected. The online entertainment services providers would also be affected, as services including downloading of games, films, music and ringtones would be considered digital services in the scope of the directive. Online news providers would also be in scope if they meet the criteria to qualify their digital economic presence as significant.

In the absence of a global solution and / or a coordinated approach to prevent double taxation, the reform could have an unintended impact on the continuing digitalisation of certain sectors of the economy.

Technical / legal observations

The functional analysis and the OECD authorised approach (to split profits between the head office and one or more permanent establishments) would remain cornerstones, but the EU Commission proposes to supplement the traditional criteria of functions, assets and risks with criteria reflecting value creation in the context of digital activities. Hence, activities through a digital interface, which relate to data and users, should be considered economically significant. The Commission’s non-exhaustive list of such activities refers to:

  • The collection, storage, processing, analysis, deployment and sale of user-level data;
  • The collection, storage, processing and display of user-generated content;
  • The sale of online advertising space;
  • Making available third-party created content on a digital marketplace; and
  • Any digital service other than the above four.

Furthermore, the development, enhancement, maintenance, protection and exploitation (or DEMPE) functions in the performance of economically significant activities should be allocated to the Member State of the Digital PE rather than the country where the people or the company are physically located.

As regards the transfer pricing methodology, the EU Commission proposes to use the profit split method as a general rule (in this context of the digital economic presence), leaving a taxpayer the right to choose another internationally accepted method if justified. Splitting factors could include expenses for R&D and marketing attributable to the significant digital presence, the number of users in a Member State and the data collected per Member State. This departs from ‘traditional’ transfer pricing, which is based on the arm’s length principle, for which both the EU Commission and the OECD have indicated a preference for direct transaction methods, in particular the CUP/CUT method.

Reactions and next steps

The OECD, which has published an interim report on its own progress on the taxation of the digitalising economy, has warned the EU against unilateral actions while a global consensus is sought. Several EU Member States share the desire to act only at global level to prevent a competitive disadvantage.

For the proposal to be accepted, EU Member States would need to approve it unanimously. Some EU Member States that host the European headquarters of large digital economy companies are likely to resist the proposal, as it would reduce their tax base to the benefit of large countries, which are more likely to provide a large user base and a relatively high frequency of digital transactions.

The EU Commission and the EU Member States supporting its initiative hope for a swift approval process and a subsequent implementation in domestic law by 31 December 2019, so that the DST would start applying as from 1 January 2020.