Taxing the digital economy fairly

"In the digital economy, companies are not creating permanent establishments in the countries in which their users are based and all profits are often being collected and taxed in low tax jurisdictions."
David Gibbs, Chair of Alliott Group's International Tax Services Group

David Gibbs, corporate tax partner at London accounting firm Alliotts (and chair of Alliott Group's International Tax Services Group) explains in this short report that the OECD and the European Commission (EC) have both issued publications with their respective latest analysis and proposals to tackle the issue of taxing profits and income earned from within the digital economy. So where are we now in terms of concrete proposals? Read David's views below. 

The OECD issued an interim report arising from Action 1 of the Base Erosion and Profit Shifting package of measures which were delivered to the G20 Leaders in November 2015. The report is very much an analysis of the issues, with a ‘do nothing now’ approach and a commitment to a two year project for final delivery in 2020. The EC takes a more proactive view and appears keen to support interim measures being implemented while a full global solution is found.

What is the digital dilemma?

The recent case of Facebook giving access to its data to Cambridge Analytica neatly describes one of the core areas of the digital economy that governments want to seek to tax. Until this data issue came to the fore, most people were simply enjoying social networks for free and, other than a bit of advertising, didn’t perceive that they or their data was creating any value. The phrase which emerged was “if you’re not paying for the service, you are the service”. Essentially, individuals’ personal data has become a valuable intellectual property asset that digital companies such as Facebook can directly use to generate revenues. The users of the digital media themselves are creating value for the digital companies. This is categorised into three areas by the report:

1. User engagement– this can be bookmarking pages, giving 'Likes', commenting in on-line debates etc
2. User data– core demographic, social background, education etc, to purchasing profiles, web browsing history and social networks
3. Actual users' generated content– for example, uploading videos toYou Tube, contributions to articles and forms.

Digital media and content is expanding at an incomprehensible rate with more than 44 zetta bytes of data expected to have been produced by 2020. This growth is reflected in the world’s most valuable companies where nine of the top 20, are digital companies compared with 1 in 20, ten years ago.

What is the tax issue?

So, with all these digital interactions translating into wealth for large global companies, governments want to trace where the value is being created and seek to tax it.

In the ‘traditional economy’ we have the concept of Permanent Establishment and profit nexus to identify if a company is generating profit in a particular territory and, if so, seek to tax it. The concept and definition of what creates a Permanent Establishment is fairly multilateral and the treaty network provides for the avoidance of double tax. However, in the digital economy, companies are not creating permanent establishments in the countries in which their users are based and all profits are often being collected and taxed in low tax jurisdictions.

The OECD report notes and accepts that the digital economy is an accelerator for global growth and there are risks of stifling investment and further growth if it is over taxed or encumbered with excessive reporting and filing requirements. The EC report specifically says:

“Digitalisation brings countless benefits and opportunities. But it also requires adjustments to our traditional rules and systems. The amount of profits going untaxed is unacceptable. We need to urgently bring our tax rules into the 21st century by putting in place a new comprehensive and future- proof solution.”

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What is the solution?

Neither report sets out to provide a long term solution to the issue. The OECD is very reserved with the mood of the report keen to deter governments from implementing unilateral solutions which could damage the global tax project. 

The EC though published two formal Draft Directives within its tax package. The first proposes changes to the status of permanent establishment where digital services are provided.

This is measured by revenues generated from users in a state, the number of actual users in a state and the number of online contracts for supplying digital services to users. The proposal suggests a profit split method should be used to attribute profits from the overarching group to the particular state in question.

The Second Directive proposes a Digital Services Tax at the rate of 3% on revenues generated from advertising, making available multi-sided platforms for users and from the sale of data. This measure is targeting at large groups with revenues of €750 million and above.

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What's next?

The EC has taken a much more proactive stance however, within the EU, unanimous agreement is needed to implement any proposals. The OECD in contrast only needs consensus to bring about change.

There is real risk of leaping from no taxation to over taxation if unilateral measures are implemented. For example it is very easy to see two countries tax the same revenues if they are using different measures of value creation. Additionally, the current treaty framework does not provide for double tax relief where such new taxes are levied. This is evidenced by the Diverted Profits Tax introduced in the UK, which is not corporation tax and hence has no basis for double tax offset.

All parties involved are keen to stress that the digital economy is the economy and the desire therefore is not to create a separate set of rules to tax profits from digital businesses but to update the tax framework itself so that such profits are naturally and fairly taxed.

We now await the OECD interim report in 2019.

For help or advice on taxing the digital economy and any other cross border tax matters

Contact David Gibbs, corporate tax partner at Alliotts in London.