The European Commission has released draft proposals outlining its proposed approaches to taxing profits of digital businesses in the European Union.
The Commission's proposed plan, released on March 21, 2018, envisages two approaches: (i) a comprehensive solution, which is intended as a long-term solution in the form of a proposed EU Directive; and (ii) a targeted solution − an interim measure to fill in the gap until a comprehensive solution has been agreed and put into place.;
It is proposed that the new measures shall be transposed by the member states into their national laws by December 31, 2019 for application from January 1, 2020.
Comprehensive solution: digital PE definition and profit allocation rules
Under the comprehensive solution, the proposed Directive sets forth common EU rules, for establishing a digital permanent establishment (PE) and for allocating profits to digital activities of such PEs.
The proposed Directive allows member states to tax cross-border digital businesses based on the notion of "significant digital presence." A "significant digital presence" is deemed to exist in a member state "if the business carried on through it consists wholly or partly of the supply of digital services through a digital interface" and at least one of the conditions below is applicable:
- the entity derives realized revenues from digital services in a member state exceeding €7 million in a tax period or
- the number of users of the digital service in a member state in a tax period exceeds 100,000 or
- the number of online business contracts for the supply of business service that are entered into in a tax period by users located in a member state exceeds 3,000.
Under I, revenues derived by associated enterprises of the taxpayer will be relevant. The proposed Directive defines "digital services" as an inclusive term encompassing a variety of services which are delivered over the Internet or electronic network, the nature of which renders their supply essentially automated with minimal human intervention. This definition leverages from the definition of the term "electronically supplied services" in the VAT Directive.
The proposed Directive envisages that the proposed rules will apply not only to situations between member states (thereby overriding double tax treaties between member states) but also to situations between member states and third countries where there is no applicable double tax treaty. The Directive would not apply to situations between member states and third countries with an existing double tax treaty. For such cases, the Commission recommends that member states should update their double tax treaties to incorporate the notion of "significant digital presence" in relation to all third countries.
Renewed criteria for profit allocation rules
The Commission views the current PE profit allocation rules, based on an analysis of risks assumed, functions performed and assets held, to be largely ineffective in case of businesses with digital activities.
The proposed Directive advocates the use of profit split method in determining the attributable profits to a digital PE. It proposes to look, for the purpose of profit allocation, to the following factors: (i) where value is created; (ii) the users' engagement and contributions to the development of a platform; (iii) the data collected from users in a member state through a digital platform; (iv) numbers of users; and (v) user-generated content.
Interim solution: introduction of digital services tax
The interim solution envisages introduction of a new tax for certain digital activities − activities which are heavily reliant on user value creation, such as:
- services supplied for consideration consisting in the valorisation of user data by means of making available advertisement space or the sale of such user data
- services supplied for consideration consisting in the making available of digital platforms/marketplaces to users, also called intermediation services, and where such users supply goods and/or services directly between themselves.
The digital services tax would apply to businesses that cumulatively meet the following conditions:
- carry out supplies of the digital services falling within the scope of the tax and
- have, in the preceding financial year, a total worldwide revenue exceeding €750 million at the level of the multinational group to which the business belongs and
- have annual revenue from the provision of digital services in the EU exceeding €50 million.
A uniform tax rate of 3 percent, applicable at a single rate across the EU member states, has been proposed for cross-border transactions between member states and between third countries and an EU member state, as well as in purely domestic scenarios (within an EU member state).
A simplified mechanism for the declaration and collection of the tax at EU level is expected to be made available based on the one-stop-shop model.
The structure of the European Commission's proposal is largely in line with the solutions that have been implemented or are being contemplated by many countries, as outlined in the OECD's interim report 2018.
In a sense, the new tax contemplated as an interim solution is largely similar to the so-called "equalization levy" and similar taxes that India and other countries have adopted. What is important to note is that the new digital services tax will apply only to digital businesses where there is a user-based value creation (such as online marketing or online market places). Services supplied for consideration consisting in the making available of digital content/solutions to users would not be covered within the scope of the new tax.
Interestingly, the proposed Directive does not mention the deductibility of digital services tax for corporate tax purposes, a topic that found its way in the widely reported leaked document. This means, presumably, that member states would be free to decide whether such taxes paid are deductible or not under their domestic law.
The digital PE proposal based on a "significant digital presence" is also consistent with the virtual PE idea that some countries outside of the EU are contemplating. In this regard, the proposed EU Directive would have far-reaching consequences, as the rules are expected to override all tax treaties entered into among the member states.
It will be interesting to examine the practical implications of the profit attribution rules that are being contemplated in relation to the digital PE, because the factors being contemplated as a basis for profit allocation are substantially different from existing OECD rules based on the arm's length principle. These proposed factors, if adopted, would be a departure from the arm's length principle embedded in many existing international tax rules, including those that may apply to conventional PEs and subsidiaries of digital businesses.