The impact of digitalisation and the future of corporation tax

In late September 2018 a roundtable was held on the subject of the impact of digitalisation and whether or not corporation tax is fit for purpose in the 21st-century. The meeting was held directly after the KPMG European region Tax Summit in Rome and so the opportunity was taken to focus on tax leaders in attendance rather than to extend the invitation to wider stakeholders as is the norm with the on-going Responsible Tax Roundtables, including the recent one held at the OECD office in Paris in July.

In a fascinating discussion with nine international companies based in seven different European countries, the general conclusion reached was that it seems clear that new rules will be introduced (whether by international consensus or by local country unilateral actions) to address the taxation of digital transactions and that it is therefore important that all stakeholders engage to make these rules as effective as possible. There was agreement that new rules should not be ring fenced to certain industries or highly digitalised businesses. The solution may lie in finding a way to introduce elements of a destination or market access principle to give countries some taxing rights even when value creation cannot be identified under existing transfer pricing rules. Moving to a full destination-based principle, introducing formulary apportionment or abolishing corporation tax to replace it with other mechanisms were not considered the best way forward as each of these approaches would introduce their own complexities without clear additional benefits. Any changes should involve taxing profits - not turnover -, and avoid double taxation.

Is indirect tax the future?

The opening comments were given by Lachlan Wolfers (KPMG in China, Asia Pacific Region Leader, Indirect Tax) in order to stimulate the discussion, and included the following points.

Indirect tax is not the solution to the difficulties facing corporation tax as VAT is a tax on the consumer and, politically, it is necessary for there to be a tax on corporate income - even though it is debatable to what extent it is actually economically borne by the shareholders rather than employees or customers. Nevertheless some change will be necessary. The issue with direct taxes is that there is not unanimous agreement about where value is created and how taxing rights should be split between different states. By contrast, in the indirect tax world, everyone now agrees tax should be charged on the end consumer at the destination of consumption.

There are a number of principles which could be applied in the debate. First, it is important is that the discourse shifts to “if you’re going to tax me, what are the economically equivalent activities that also need to be taxed to ensure neutrality?” Companies effectively providing the same goods and services should be taxed in the same way. Further, any changes to direct tax rules should focus on profits, not turnover, and should avoid double taxation. Finally, there will need to be some kind of destination element in apportioning taxing rights.

An area where learning in indirect tax can be of assistance to direct tax is around data collection and analysis. Tax authorities are asking for more and more data and sometimes on a real-time reporting basis. This trend is likely to continue in direct tax especially as tax authorities try to extend taxing rights over data usage and user interaction or if there is a move towards a destination principle. Yet many corporates have difficulty accessing all the data and are spending an increasing amount of time sorting and analysing it before putting it into returns. There needs to be greater integration between the finance function, the tax function, information technology and data managers. And this is an area where indirect tax is leading direct tax.

While there were different perspectives in the room, the discussion that followed can be summarised under the following themes:

The issue is not limited to highly digitalised businesses; there is no such thing as the “digital economy”. Any changes to tax rules therefore should look at the whole spectrum of international corporate tax and not just focus on ring-fencing certain digitalised businesses. However, abolishing corporation tax or replacing it with something like formulary apportionment is not the way forward

All of the participants agreed that the pressure on corporation tax regimes is wider than just the effect of certain highly digitalised businesses. All businesses are digitalising - whether in terms of actual products and services or in how they do business. The way in which companies generate value is changing. Even traditional “heavy industries” such as the steel industry are providing new services and it would be impossible to draw a realistic line between what is a digitalised and a traditional business which would not be constantly shifting.

It was noted that corporation tax is an inefficient tax and one suggestion was to abolish it and replace it with something that was simpler and harder to manipulate. However the majority view was that politically it is necessary to maintain corporation tax irrespective of the alternatives that could be proposed. Formulary apportionment and the common consolidated corporation tax were briefly mentioned but thought to introduce new complexities.

As value chains become more complex and there is an increasing reliance on intellectual property it becomes harder to determine precisely where value is created which is putting pressure on the allocation of taxing rights between countries

Corporation tax was introduced in an “industrial economy” when tangible assets drove value and resided within clear national borders. As multinationals operate across border and value creating assets are becoming more intangible it is necessary to reshape corporation tax. It was commented that companies that carry out a value chain analysis often cannot come to a precise conclusion on where value is created: is the value in technology which is being developed, processes, the customer or the content which is being sold?

The key issue therefore is how to apportion taxing rights between countries when there is such fundamental change in business models and complexity in how and where value is created. Tax competition between countries and regions was cited as another complexity although there was general agreement that there is not a race to the bottom which would mean corporation tax would tend towards zero – the proliferation of new direct taxes and avoidance rules were noted as evidence of this.

Some in the room thought that public country by country reporting may not help the debate. The rationale being that the value which is created in any location does not necessarily correspond to the value of assets or employees or the turnover. In some industries – such as banking - the value of different types of customers can also vary greatly which can have an impact on profitability depending on what location they are serviced from. Country by country reports therefore need to be analysed technically with other information. Nevertheless there was general agreement that a better explanation of the role of corporation tax and value creation as the basis of taxing rights is needed.

Digital services taxes and turnover taxes are not a favoured solution but if they are introduced there may be some ways to mitigate the negative impact

It was agreed that even raw data does have value as there are instances of companies being willing to purchase it, although the real value is in structured data which raises the question of the respective value in the algorithms and where these are created. It was noted that tax is not always charged on profits - for example in some countries in as regards extractive industries - and so it is possible to think of some form of tax on the value of data or a separate class of business. However, it was generally agreed that there are significant issues in terms of double taxation, horizontal equity, impact on start-ups and loss-making companies and complications in collection if this route were followed.

If a digital services type tax were to be introduced one possibility that was discussed as a measure to mitigate the double tax impact would be for countries to allow a super deduction (for example 150% of the foreign tax paid) in calculating the domestic tax base. Other safe harbours would be needed, for example to exempt loss-making companies.

Even a digital PE concept or the EU’s significant digital presence proposal would still only impact certain sectors and highly digitalised companies

A wide range of industries were represented at the roundtable including insurance, banking, logistics, steel, retail, telecommunications and information and publishing. Only one thought they might be covered by the proposed EU significant digital presence concept which demonstrates that, even though it is wider than the digital services tax, it might still have a relatively limited impact and only target specific sectors.

Moving to a full destination based tax system is over simplistic and would create new distortions, but some destination element may need to be introduced into the current corporation tax rules

A question was raised as to whether an overly heightened focus on value creation might be a way of restricting countries’ domestic taxing rights. Is the argument that a state can only tax the value created in that country really saying it has no right to tax remote businesses with no physical presence? In other words it may be a political rather than a purely technical question. Michael Lennard of the UN had made the point during the main Summit that, as a matter of international law, countries do have the right to tax market access. Participants agreed with this and noted that some countries, such as India, are now exercising those rights. In many cases, however, the domestic rule will be overridden by a double tax treaty. Modifying corporation tax to take account of digital business models may therefore involve a paradigm shift to allow greater taxation on a destination principle. Indeed in the US there has been some support for adopting destination-based taxation as seen with the original border adjustment tax proposal.

A full destination principle would introduce new distortions and be over simplistic. For example if all the intellectual property is developed and financed in one state but sold in another, the first would not be remunerated for the risk and assets located there. A full destination principle would shift the global tax base to large wealthy countries to the detriment of small open economies and poorer countries.

Nevertheless, it may be possible to create a concept of “doing business” in another country even where there is no traditional permanent establishment. The question could then be whether some kind of ‘market access’ intangible concept could be developed to operate in conjunction with traditional arm’s length transfer pricing principles - ie profits could be allocated to the market country even if there were no company assets, risks and functions located there under a traditional functional analysis.

We thank all participants for their thoughts during the discussion and welcome continued input through comment and blog submissions at kpmg.com/responsibletax