The EU Commission has published two proposals on the taxation of the digital economy and digital business models. Will the reform of corporate tax rules and the second measure of an interim tax lead to a fairer taxation of digital activities in the EU? Since the economic crisis of 2008-09, we live in a different world. Countries started to prioritize “taxation” in their financial agenda for sound public funding sources. Both developed and developing countries have increased the direct tax base on business profit. In this environment, important initiatives were developed by the G-20, and G-20 countries started amending their local laws and regulations. A recent example relates to the taxation of the digital economy. The OECD and EU agree that the current international taxation rules are insufficient because digitalization enables businesses operating with no physical presence.
Even though the OECD and EU agree that the current international taxation rules are outdated, their way of addressing it is different. The OECD does not conclude any recommendation because there is no consensus among the members. On the other hand, the European Commission approach digital companies differently by taking a short-term (interim) and long-term stance. While the EC’s short-term stance is 3 percent digital service tax focused on taxing advertising, digital platforms and sale of data, the EC’s long-term stance is based on “significant digital presence” focused on a broad range of digital services, i.e. the provision of films, music, software, or cloud computing.
However, “taxing digital businesses” needs a global policy consensus to be successful and eliminate double taxation. Otherwise, pre-BEPS “double non-taxation phenomenon” would result in double taxation.
Why is the Work of Tax Administrations Challenging in a Digital Economy?
Business models have changed in the digital economy. The following companies are an example of new business models being used:
* Airbnb does not possess any real estates;
* Alibaba does not carry inventory;
* Booking.com does not possess any hotels; and
* Twitter and Facebook do not produce content.
Airbnb and Booking.com provide intermediary services and Twitter and Facebook offer advertising services and acquire their revenues from these activities.
They operate without a physical entity (i.e. building, factory) based on the business models. Taxation rules based on a nexus of a business applied prior to the digital economy makes taxation difficult in the new economy.
According to public opinion, these companies do not pay a fair tax, which is proportional to their earnings, in order to provide for the state expenses. Because of this, governments have to take action in order to provide justice in their tax systems.
About 75 percent of EU citizens expect the EU to struggle against tax evasion. In a public opinion poll, 75 percent of the participants believe that the current international taxation rules allow companies operating under digital business models to benefit from specific taxation regimes and pay lower taxes.
What Types of Works are being Carried out Concerning the Taxation of the Digital Economy?
An international standard and cooperation of the countries are required in order to tax companies. The most important organization with respect to this is the OECD and the OECD’s initiatives are supported by G-20.
Digital economy models complicate the place and ratio of payment of the corporate tax accrued over income. This is because it is very challenging to determine the extent of an income acquired from a certain country, which should be referred to such country, without a nexus.
Consequently, Action 1 of the OECD’s Base Erosion and Profit Shift (“BEPS”) Action Plan published a temporary report addressing the tax challenges of the digital economy (“temporary report”). However, the OECD does not propose a taxation method in this interim report. It determines what the alternatives may be and makes evaluations.
Finally, in the meeting held in Buenos Aires on March 19-20, it was declared that the Ministers of Finance of G-20 will publish an updated Temporary Report on Tax Challenges Arising from Digitalization and will work towards a consensus-based solution by 2020. The implementations of the countries in the short-term are determined in the report. However, the actual purpose of the OECD is declared as formation of the grounds for progress toward a long-term multilateral solution in the next stage.
Accordingly, many countries express that digital companies acquire high income in their own markets in the digital economy and that they are required to pay corporate taxes over these incomes. Consequently they are taking actions in order to collect tax. For example, Turkey collects 18 percent VAT over the digital services offered to the individuals by the companies residing abroad, which was brought into force as of January 2018.
The reason for the countries to make legal arrangements is that they want to collect tax over such earnings without any delay, although they do not have any taxable assets in their countries according to the current international taxation frame.
However, the common opinion in the U.S. is that the taxation right on the income is taxable in the U.S. since all the value added and the intellectual property rights are created in the U.S. This is based on an old adjudication in the U.S. related to the economy (SALT Alert, 2018-01: U.S. Supreme Court Grants Certiorari in South Dakota Case Seeking to Overturn Quill-http://src.bna.com/x6V).
In the Quill Corp. v. North Dakota case in the U.S. which is related to the distant sales, there is the Supreme Court’s decision dated 1992, stating that North Dakota does not have any authority to collect sales tax in the products delivered to North Dakota where the company does not have a physical presence.
However, the subject of “economic presence (nexus)” is again on the agenda and has been since 2016 but nowadays, the subject of “physical presence (workplace)” is being discussed and should be re-evaluated. The states enacted laws to implement the principle of economic nexus in order to apply the sales taxes against the Quill decision. In 2016, South Dakota included its own economic nexus principle in the law. With the law, the sellers, without any physical presence shall be taxpayers in South Dakota for the sales tax based on an economic nexus principle. The threshold for the tax payment obligation is determined as at least “performing 200 separate sales or sales with a total of US$100,000.”
With respect to the case litigated concerning this issue, the Courts of First Instance of South Dakota decided that the Court is bound by the Quill decision and decreed in favor of the claimants. While reaching this decision, the thesis of the state that the principle of the physical presence of Quill “was out of fashion under the light of the developments in the software and technologies,” which was the reasoning of the state Supreme Court, was rejected.
It was decreed that it was based on the reasoning of the Quill case. However, on September 14, 2017, the Supreme Court of South Dakota upheld the decision allowing South Dakota’s opposition to the Supreme Court of USA. The opposition is expected to be submitted in Spring 2018. The decision is expected to have a significant influence on taxation and the economy.
About one week after the publication of the Temporary Report, the EU made a press release on March 21. According to the EU bulletin, the current “international corporate tax rules do not comply with the realities of the global economy” and do not comprehend the business models which may acquire profit from digital services in a country where one is not physically present. The current taxation rules were not successful in defining the new methods of the digital economy for creation of the profit, and specifically, the role played by the users in creation of value for the digital companies. In the current system, there is disconnection or noncompliance between the place where the value is created and the tax is paid.
The EU’s digital taxation package key areas are as follows:
* For taxation of the digital economy, it enables member states to collect taxes from the earnings acquired in their own regions, even if a company does not have a physical presence. The new rules shall provide online entities to contribute to the public finance at the same level with the companies which are connected to traditional physical workplaces.
* This proposal includes a recommendation to the member states for modifying the Avoidance of Double Taxation Treaties with the third countries. Accordingly, same rules shall be applicable both for the EU member and EU non-member companies. The Commission also recommended to provide assistance to the member states in the determination discussions with respect to the application at the international level for the digital corporate tax updates.
* It recommends a temporary digital services tax until the new rules are created for the taxation of digital services.
In compliance with the new rules recommended by the EU, the member countries shall be able to collect taxes from the earnings produced in their own regions, even if such companies do not have any “physical presence/connection” there. These rules constitute a proposal which is expected to be permanent.
Details are as follows: If a company possesses any of the following criteria, then it shall be accepted to possess a “significant economic digital presence” in a Member State:
* Exceeding the threshold of an income of 7 million euros from the digital services in an accounting year, in a member state (for example, acquiring income from advertisement placement based on the user data);
* Having more than 100,000 user access to the digital services in a member state in an accounting year (for example, sharing economy and acquiring income from the services that provide access to the users on online markets); and
* Conclusion of more than 3000 business contracts between the company and the work users for the digital services in an accounting year (for example, acquiring income from providing broadcast stream to the subscribers).
With this reform recommendation of EU, a solution is provided for two of the main challenges encountered by the Member States when taxation of the digital activities is discussed:
* Firstly, “physical presence/connection” in a member state shall not be required any more in order to apply tax to the earnings of a company. A significant digital presence shall permit the member states to apply tax to the earnings acquired within the borders of its land.
* Secondly, the factors such as user data shall be taken into consideration in distribution of the earnings since these become more important gradually in formation of the company data and play a significant role.
The other proposal of the EU which is identified to be temporary is the new digital services tax (“DST”); and it shall take effect as of January 1, 2020 and shall be applied at a fixed rate of 3 percent over the gross income:
* The DST shall be applied to specific digital services including providing an advertisement area, presentation of market areas facilitating the direct transactions between the users and transmission of the user data collected, while offering digital content or payment services.
* The entities achieving certain thresholds cumulatively shall be subject to DST. DST shall be applied to the entities with annual global income over 750 million euros and annual revenue over 50 million euros in the EU originating from digital services. If this economic presence belongs to a consolidated group, then the mentioned thresholds shall be assessed on the group level.
* DST shall be in the member states where the users are. If the users are in different member states, then the proposal will also enable the calculation of the tax base to be referred to the member states depending on specific distribution keys.
* The Directive also provides cooperation between the member states in a single-time mechanism and provides the tax payers to have a single contact point in order to fulfill all the administrative obligations concerning the new tax.
As explained above, both OECD and EU agree that the current international taxation rules are insufficient concerning the taxation of digital economy. Despite this, OECD members were not able to develop a new and concrete taxation rule with respect to this issue at the international level. As a short-term solution, OECD member countries adopt the method of taxation which is applied over the sales mostly. It is expressed that the long-term solution is targeted to be achieved in the year 2020.
The EU proposed draft directives concerning this issue. One of these is tied to having “a significant economic digital presence.” And the other is DST at the rate of 3 percent, which is planned to be collected over the gross income starting from January 1, 2020. However, the application of these depends on being adopted by the parliaments of 28 countries.
If a tax at the rate of 3 percent is applied within the direction of the proposal of the EU Commission, this means the probability of acquiring an income of about 5 billion Euros annually for the member states. When applied to the EU, this single rate tax will be able to provide help for avoiding “tax exchange” and “tax distortion” in a single market. The tax of 3 percent will be applied only as a temporary measure until the corporate tax rules supporting digital economy take effect.
Are the Proposals “Fair or Protectionist”? Would the Other Countries take Counter-Measures?
Are the double taxation with the temporary tax of 3 percent and the international rules contradictory? With regards to BEPS Action Plan 1, it is observed that the governments prefer the alternative of “Reverse Charge VAT,” “withholding” or “balancing tax” as the authority concerning the taxation method with respect to the “digital economy.” Because of this, the method proposed by the EU does not constitute any contrariety to the third countries or the World Trade Organization rules and any double taxation agreement. This is because the OECD or UN member countries are yet to develop a common understanding of digital economy taxation principles. However, the proposal of the EU is parallel to the principle of “subjecting the profit to taxation where the value is created,” which emerges more apparently following BEPS and which is the basic principle agreed. As a conclusion, it is expected to remain to be in force until “final, permanent tax rules” are applied for the digital economy. The countries carried out arrangements for “VAT,” “withholding” or “balancing tax” as the authority concerning the taxation of the digital economy.
It is estimated that about 120 to 150 companies are covered within the scope of the European Commission’s proposal of 3 percent temporary tax, which means the probability of acquiring an income of about 5 billion euros annually for the member states. According to the European Commission’s Commission Staff Working Document (http://src.bna.com/xPv ) dated March 21, 2018, there is no reliable data regarding (see the European Commission’s Commission Staff Working Document, pp. 67-68, http://src.bna.com/xPw) the annual turnover of digital economy companies. But some two-thirds of turnover data is available by applying a revenue threshold of 750 million euros.
On the other hand, it is an issue of concern how the U.S. will react to the EU Commission proposals. This is because it is expected that 50 percent of the d 120 to 150 companies shall be the companies residing in the U.S. Since the U.S. discussed its concerns during the G-20 leaders meeting convened in Buenos Aires on March 19-20, 2018, it may decide to take counter-measures if EU countries adopt these proposals. However, if the arrangements brought by the U.S. tax reform are taken into consideration, we believe that such proposals of the EU are arrangements which are the subject of lesser discussions.
In response to the proposals of the EC, Business at OECD (BIAC) shared its opinion through a Media release (see The Business and Industry Advisory Committee, Media release, http://src.bna.com/xPx), dated March 21, 2018. BIAC warns against fragmentation in international taxation and calls for a broad consensus on a reliable tax framework for all companies. Unilateral action targeting certain businesses and deviating from established principles will reduce the potential for economic growth and job creation, particularly where these measures are based on the taxation of gross revenue rather than on profits. Additionally, the Chair of the BIAC Committee on Taxation and Fiscal Affairs, Will Morris, said:
“Business at OECD believes that the OECD/G20 Inclusive Framework is the most appropriate forum in which to advance tax policy addressing digital taxation. We strongly encourage the EC to work with the OECD/G20 Inclusive Framework to help develop global consensus through a broad multilateral process that includes business and all stakeholders.”
One of the main questions is whether these proposals, which require consensus shall be adopted or not by all the EU member states. Some member states expressed their concerns about DST. These concerns are, for example, DST possessing the characteristic of being an income tax since it is collected from proceeds. In other words, this is a tax collected from proceeds, not from net income and this tax shall be required to be paid even if the company is in loss. Moreover, DST shall not be considered as a tax paid abroad and this tax paid in a foreign country cannot be set off from the corporate tax calculated. However, it is understood that the probability that DST may be deducted as an expense may reduce double taxation risk at one point at a certain scale.
In today’s world, existing principles of international taxation is based on the “material permanent establishment” definition (Article 5/1 of the OECD Model Tax Convention). Therefore, the term “permanent establishment” means “a fixed place of business” through which the business of an enterprise is wholly or partly carried on, which is based on “a place of business,” “fixed” and “through which the business of the enterprise is carried on.” Therefore, an internet website does not constitute “tangible property in itself” and “not a permanent establishment in itself.”
In the post-BEPS world we live in the OECD recognizes “a shift in value creation” due to the digital economy. But there is no roadmap on how this should be reflected in tax policy.
In this environment, companies should identify potential foreign tax obligations (i.e. VAT or equalization tax) in cross-border sales of services and intangibles. In order to evaluate their existing indirect tax and direct tax status, companies can look at their existing structure as follows:
* Detailed functional analysis can give a first reflection with a focus on key assets and core activities;
* Where users and customers are located may constitute PE because data becomes a key resource to create value;
* Identify where real economic activities performed;
* Identify where countries at which sales are realized;
* Find out the person who is liable to comply with foreign VAT laws;
* Determine the definition of digital services;
* Find out what type of customer you have (“B2B” or “B2C”); and
* Be aware of the threshold for registration.
Finally, if the proposal is enacted, it will enter into force on January 1, 2020. Therefore, digital companies should be looking at their existing business models now.
Also, “taxing digital businesses” needs a global policy consensus. Otherwise, pre-BEPS “double non-taxation” phenomenon would result in “double taxation.”