On November 30, UK Chancellor Philip Hammond announced a new digital services tax as part of his Budget proposal. In doing so, he seemed to be issuing a warning to the tech giants who have recently been criticised for failing to pay what many consider their fair share of corporation tax. The Chancellor’s announcement is the latest development in what many hope will become a cross-border consensus on how to appropriately tax rapidly developing digital markets.
Between 2006 and 2017, the number of tech companies in the global market capitalization top 20 rose from 5% to 45%. But while more traditional companies had an effective tax burden of 23%, digital companies (before aggressive tax planning) were getting away with paying only 10%, thanks to longstanding physical-presence tests in many national tax regimes. Where a company’s services are entirely online and revenue is derived mostly from intellectual property rights and “user value” added by online consumers, they have been able to avoid paying corporate taxes, in some cases completely, in all jurisdictions but the one where they are headquartered.
There is international consensus that a problem exists here, but a solution has heretofore been elusive. New and developing tech industries have been watching closely for what this may mean for them.
The international debate
The legislative challenge has been taken up by the Organization for Economic Co-operation and Development (OECD), which earlier this year announced what it hopes will be a “consensus-based solution” for its members by 2020. It has recommended that any interim measures implemented at the national level should take heed of:
- Exemptions for micro, small and medium sized enterprises (SMEs), on the basis that targeting specific digital sectors with no exemptions for SMEs risks slowing down investment and innovation;
- Tax incidence on consumers: where the higher incidence of taxation is passed on to consumers; and
- Over-taxation:where, for example, e-services are subject to both a targeted tax and general corporation tax.
2018 EU Commission Proposals
Meanwhile, in March 2018, the EU Commission launched an interim proposal, with the backing of Germany, Spain, France and Italy, for a 3% tax on revenue derived from digital services. The tax would apply where global revenue exceeds €750 million, or EU-based revenue exceeds €50 million, and is targeting digital advertising, online user-to-user marketplaces for goods and services, and transactions involving user data.
A further long-term proposal, projected for implementation in 2020, advances a “significant digital presence” test, which aims to measure tax by allocation of profits derived from digital activity. Although the revenue thresholds in this proposal leave SMEs with EU-based customers untouched, the EU Commission’s further proposal captures enterprises with revenue exceeding €7 million, those with an annual customer base in excess of 100,000 in any EU member state per annum, and those who have entered into 3,000 or more business contracts in any EU member state in a given year. If an enterprise falls within these thresholds, it is subject to corporation tax, or an equivalent, in the relevant EU member state. This could considerably affect SMEs by narrowing the gap in competitive tax advantages of operating on digital platforms.
The proposed UK digital services tax
The digital services tax proposed by Chancellor Hammond appears to emulate the EU Commission proposal, with:
- a 2% tax rate for companies with UK-generated revenue of £500 million or greater;
- liability being a deductible expense against UK corporate tax; and
- a tax-free initial bracket of up to £25 million.
The proposal specifically targets digital advertising, on both social media and search engines, and online marketplaces. The Chancellor was clear the new tax, which is expected to be implemented in its current form in April 2020, is aimed not at SMEs nor most British companies, but rather US giants such as Facebook, Google, Amazon, eBay and Twitter.
Sales Tax versus Tax on Revenue
One important distinction here is between tax on sales and tax on revenue. Tax on sales obliges an enterprise to pass on charges to its customers and clients, and forward the returns to the relevant tax authority. A tax on revenue, by contrast, is collected directly from its revenue. Chancellor Hammond has assured that the proposed digital services tax is a tax on revenue, and not a sales or consumer tax.
How would digital services taxes be calculated?
It is currently unclear how the digital service tax will be calculated, in particular where it is based on a measure of the value derived from the online activity of customers based in a particular jurisdiction. Furthermore, there remains a lack of consensus over the method of determining the geographic, and therefore jurisdictional, base of consumers engaging with digital service providers.
Overarching international tax treaty reform may be required before national laws can be implemented
A country proposing a unilateral digital services tax cannot do so in violation of existing international tax treaties that protect against dual or multiple taxation across jurisdictions. As a result, hastily proposed national tax frameworks may have to wait until consensus is reached at the international level, with any requisite treaty amendments, in order to accommodate reform at the national level. Even post-Brexit, any fleshed-out digital services tax framework following Chancellor Hammond’s proposal would still have to abide by international tax agreements of which the UK remained a part.
What this means for digital SMEs
The EU Commission’s longer-term proposal, which, with its lower revenue thresholds, would likely capture the activity of digital-focused SMEs, demonstrates a general shift away from physical-presence tests and the introduction of new tax frameworks reflecting technological developments. As several EU member states, including the UK, move to follow the EU Commission’s proposals, SMEs should consider how their present online activities might, in the future, be captured by new or increasingly robust digital services taxes.
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