Tax Challenges Arising from Digitalization
On 16 March the OECD released its Report “Tax Challenges Arising from Digitalization — Interim Report 2018” and on 21 March the EU Commission (EC) released two draft directives on the taxation of digitalized businesses. The first is an interim measure for a Digital Services Tax and the second is a long-term approach for taxing revenues from a Significant Digital Presence.
The purpose of this commentary is to try to offer a positive contribution to move the debate forward and to set out an initial reaction to the above proposals1. Our intention is not to propose a particular solution or outcome but to try to clarify the issues, comment on whether or not proposals meet their stated aims and highlight potential consequences.
This note first looks at the issues caused by digitalization and the different rationale put forward for changing the taxation of highly digitalized businesses. Then it looks at the OECD’s and the EC’s approaches to both a long term solution and interim measures.
Put at its simplest, the basic issue is that digitalization makes it increasingly possible for businesses to reach markets in jurisdictions in which they may have relatively little physical presence. This means that under existing international tax rules, which allocate taxing rights on business profits on the basis of physical presence, it is possible for a company that is resident in one state (Residence State) to generate significant revenues in another state (Source State) without paying a significant amount of corporation tax in Source State. The OECD and EU appear to take related, but different views on how to approach this:
- OECD: The Report focuses on taxing where value is created, and on understanding the impact that digitalization may have had on business models and value creation. Due to lack of consensus among the member countries, it does not reach any recommendations on whether or to what extent changes to international tax rules for dividing profits between source and residence countries may be required. Instead, it calls for further work to examine the existing international tax rules on nexus (e.g. should a digitalized business be deemed to have a taxable presence in a county where it does not have a traditional physical presence) and on how to allocate profit on the basis of that nexus.
- EU Commission: It appears that the EC considers the issue to be more a political one over taxing rights and the balance between source and residence taxation — as witnessed by the fact that the EC talks about digital companies “paying their fair share of tax”3. The draft directives released by the EC would allocate additional taxing rights to countries in which users of digital services are located, rather than the country of residence of the enterprise providing those services. While the interim Digital Services Tax is quite focused (taxing advertising, digital platforms and sale of data) the long term Significant Digital Presence proposal would tax a broad range of digital services — such as the provision of films, music, software, or cloud computing. In such cases it is much less obvious that the non-resident company is carrying on business or creating value in the Source State above and beyond generating revenues from residents.
It is unclear at this stage if agreement can and will be reached either over how to identify precisely where value is created in highly digitalized businesses or concerning changing the traditional balance of source versus residence taxation. Both approaches however will require a political consensus to be reached on a global basis: political because both require a change to existing international taxing rights; global because without agreement there will be double taxation of profits in Source State and Residence State.
It is therefore important:
- that clarity is reached on the perceived problem, in particular on whether the key rationale for any new rules would be to ensure tax continues to be levied where economic activity is performed and value is created or whether a more fundamental change to the balance of source versus residence taxation is contemplated;
- to understand how value is created in different business models, including the role of data in that process, before arriving at a solution to the problem;
- that a consensus-based approach is adhered to in finding a long term solution; and
- interim measures, if deemed necessary, are approached with caution and dealt with in a coordinated fashion.
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Chris became Head of Tax Policy for KPMG UK in 2011. In this role he was a regular commentator in the press, as well as on radio and TV, led discussions on various representations with HMRC/HMT. In 2014 Chris spearheaded KPMG UK’s Responsible Tax for the Common Good initiative. In September 2016 Chris took on the role of Head of...