Should digitalized companies be paying more tax where their customers are based? What are the complexities?
Taxation of ‘digitalized companies’ — where we are at
The global community is currently engaged in a major initiative to over haulthe existing international tax rules.These efforts are being conducted by over 100 jurisdictions through the OECD Inclusive Framework (IF) on Base Erosion and Profit Shifting (BEPS),whose Interim Report, Tax Challenges Arising from Digitalisation, released on 16 March 2018, sets an ambitious timeline for these efforts. The IF members wish to arrive at a consensus solution, with possible modifications to jurisdictional nexus and profit allocation rules by 2020. These efforts are playing out in an environment where increasing numbers of countries are adopting unilateral measures to tax digitalized businesses and the provision of digitized services across borders, into their jurisdictions. As these are frequently incompatible with the existing global tax framework, a sense of urgency is felt among policymakers on the need to develop, agree and implement the global solution in the shortest possible time.
Two major fault lines between the IF members were identified in the Interim Report:
- Some countries think that modifications to international tax rules could ‘ring-fence’ certain highly digitalized business models for special treatment, while others consider this as inappropriate given the wholesale digitalization of the economy;
- Some countries consider that user data and participation is a key driver of value creation in certain highly digitalized business models,whereas other countries consider it merely a standard business input.
The Interim Report indicates an understanding among the countries that the aims of the OECD BEPS project launched in 2013 — which was to address the concern that some MNEs were using mismatches in countries’laws and artificially moving profits to 22 | Tax on the creation of wealth achieve low or non-taxation — are progressively being dealt with by the BEPS measures set out in the Final Report in 2015. To this extent the BEPS issue has been, or is being, largely addressed. However, the question of whether the allocation of taxing rights between countries is ‘fair’, in the sense that it reflects the location in which value is created, remains open. The BEPS project specifically did not set out to address this question, and the issue is the focus of the work on digitalization,with the value contributions from user data and participation at the center of the debate. This is the context for the question of whether ‘digitalized companies’ should be paying more tax where their customers are based.
Some argue digitalization means countries have lost their ability to effectively impose tax on cross-border business activity and on the value created within their borders.
Proposals to address digitalization tax challenges
National policymakers, as well as academic and business commentators,have been taking up positions on this question. The proponents of the position that ‘digitalized companies’ should,indeed, pay more tax where their customers are based, generally start from a particular understanding of the original 1920s compromise underlying the existing global tax rules. They argue that this compromise was based on the assumption that significant involvement in the economic life of a country,and large-scale selling of goods and services in that country, would require setting up a local subsidiary, a branch or other physical presence (Permanent Establishment or PE in tax language). The right to tax therefore followed the existence of such a physical presence.The sharing of taxing rights between countries, provided for under this compromise, is now ‘frustrated’ by the rise of the digitalized economy where significant sales can be made without a significant physical presence.Consequently, countries have lost their ability to effectively impose tax on cross-border business activity and on the value created within their borders.
At one level it can be said that, in the digital age, it is possible to do business in another country without having a physical presence there. The issue is sometimes framed by an assertion that value can be created in the locations where firms offer use of platforms and from which users share valuable information. There is therefore a need for a ‘digital presence’ tax concept and a modification of profit attribution rules to reflect the value from user data and contributions. It is argued that these changes would ‘restore’ the original 1920s compromise, otherwise undermined by digitalization.
This thinking is implicit in the papers,proposals and rules put forward by the UK, EU Commission and India,among others. Some proposals go wide, such as the EU’s proposed long-term solution, which catches all digital services on the basis that to more or lesser an extent user-created value contributes to all digital services.Alternatively, the proposals can go narrow; the UK paper and EU short-term proposal focus on certain business models that are highly reliant on user engagement, such as social networks supported by advertising revenue, or intermediaries for the sharing economy and e-commerce. It is asserted that these businesses simply could not exist without user contributions, and so there is a strong argument for taxing them in the user state on the basis of location of value creation.
Addressing digitalization, without knowing what it is…
Whatever the merits of these arguments and these policy proposals, in the rush to find the ‘how’ of new global rules to tax ‘digitalized companies’, the more fundamental ‘what’ question, on the meaning of digitalization, has not yet been addressed. The 2015 BEPS Action 1 report referred to features of digitalization and digital markets that are potentially tax relevant, such as mobility, reliance on data, network effects, the spread of multi-sided business models, a tendency toward monopoly or oligopoly, volatility,and so on. The Interim Report focused on certain features of highly digitalized business models that are problematic for existing tax rules, including scale without mass, high reliance on intangibles, and the high importance of user data and participation. However, despite this,neither report states explicitly what is meant by digitalization.
In a way this seems understandable,as there does not appear to be one single authoritative and generally accepted definition of digitalization. It can be conceived of from a social dimension; as the way in that many domains of social life are restructured around digital communication and media infrastructures. It can be viewed through the lens of changes to business models,with the use of digital technologies to provide new revenue and value producing opportunities in the move to a ‘digital business’. It can take a more operational focus, looking at processes of employing digital technologies and information to transform business operations, including automation and the emergence of the ‘digital workplace’. Some commentators assert that one should distinguish between digitalization and a more all-encompassing ‘digital transformation’. Against this backdrop,one can understand the hesitance of the OECD and others to define digitalization. However, the net result of this lack of clarity on what digitalization really means is proposals constructed as responses to certain consequences of digitalization,while leaving significant gaps and wide divergences on the conceptual bases.
The UK and EU short-term proposals,mentioned above, focus on the ability of out-of-market platforms to harness network effects in the country of the users, with possibilities to extract significant economic rent. The focus in these cases is on penetrating a market. But what about other digitalized businesses? What about the case of a one-off surgical operation, conducted on a person in a jurisdiction using local medical equipment, which is directed by a person outside the jurisdiction through electronic means? What about a case where a doctor is ‘projected’ into the operating theatre by use of augmented reality (AR) technology? Might these also be viewed as cases of significant involvement in the economic life of a country? Rules just focused on platform businesses and market penetration have nothing to say about these.
The existing international tax rules, weather-beaten as they are, were capable of application to all sorts of businesses. If global tax rules are adjusted for some of the new business situations arising from digitalization, but not for others, a very incomplete set of rules may result. This could result in certain profits either escaping tax or being taxed twice, or in tax-distorting business decisions.
Is it really all about ‘digitalization’?
An angle worth considering is whether the main issue at play for international tax rules is, in fact, digitalization. An increasing body of research and commentary considers that the major narrative in global economic change —which goes beyond the digitalization dynamic — is the shift of investment from tangible toward intangible assets.
In their 2018 book, Capitalism Without Capital, Jonathan Haskel and Stian Westlake argue that an intangible-rich economy and intangible-rich businesses exhibit different characteristics from tangible-rich ones, and this needs to be factored into public policy. They label the differences as the ‘four S’s’,being that intangible assets, relative to tangible assets, are more scalable, their costs are more likely to be sunk,they incline to have spillovers, and they exhibit synergies with each other. It is striking that many of the phenomena that the Interim Report describes as‘characteristics of digital markets’, or as features of digitalized businesses,can equally be described as features of intangible investment and intangible-led activity, and mapped to the ‘four S’s’.
A particularly notable point in Haskel’s book is on network effects as a force for ‘supercharging’ the scalability of intangible assets. It is observed that in markets where scalable investments are important, industry concentration arises, and the small number of dominant firms can potentially earn economic rents. It is also observed that some enterprises have proved adept at managing intangible spillover effects, and harnessing intangible asset synergies,through the building and controlling of ecosystems of businesses.
The whole thrust of the UK paper and the EU short-term proposal, with their focus on the ability of out-of-market platforms to harness network effects in the country of the users, seems to be directed at such cases. Should their rules be crafted more around investment in, and creation of intangible assets with these properties, rather than on digitalized market penetration, per se? Certainly some notable tax academics, such as Professor Wolfgang Schoen, have suggested that the focus in redesigning international tax rules should be on country-specific intangible investment.1
One might still craft rules that recognize the possibility of tax nexus without physical presence, but the question is whether this concept should be entirely shaped by the digital penetration of a market. From a tax perspective, what is of more interest is less the technologies associated with digitalization, and more the heightened importance of business phenomena such as network effects from harnessed user participation,the scale without mass phenomenon,as well as the possibility of ‘effect without presence’, as in the remote surgery example above. It could well be that future waves of technological change build upon the current wave of digitalization to heighten these phenomena, and it would certainly be best for international tax principles and rules to be in a position to deal with such further evolution.
From a tax perspective, what is of more interest is less the technologies associated with digitalization, and more the heightened importance of business phenomena such as network effects from harnessed user participation, the scale without mass phenomenon, as well as the possibility of 'effect without presence'.
In this context, crafting rules that tax businesses because they provide services in a digitalized form but not otherwise appears inadequate. The rules developed would best not fixate on the current crop of digital technologies or, indeed, on the existing business models enabled by them; this would be to excessively look at the future through the lens of the present. Rather, the rules should be robust enough, in the face of these emerging business phenomena,to maintain their relevance through future successive waves of technological advancement. Ultimately, no firm conclusions can yet be drawn on whether ‘digitalized companies’ should be paying more tax where their customers are based. Before policymakers reach a conclusion on this point, it would be highly advisable to further study (i) whether the challenge here is really about digitalization, or about intangible-ization more generally, and(ii) if the challenge really is digitalization, what exactly is that?
Download the full "What to Tax?' publication here.
Khoon Ming Ho is the Head of Tax for KPMG’s Asia Pacific region. Khoon Ming has been advising foreign investors on their investments and operations in China. He has also advised on issues related to investment and funding structures, repatriation and exit strategies, M&A and restructuring.