A digital tax for a digital economy?

Digitalisation affects all businesses to varying degrees.

Smart contracts, high speed broadband, digital networking… as the 'digital economy' provides ever-evolving ways of doing business, countries are increasingly seeking ways to tax non-resident companies that derive revenue from within their borders. Governments are in the process of consulting on changes to tax law at a national, European and global level, changes which could include unilateral digital taxes in the absence of a multilateral approach.

Tax challenges of digitalisation

Where the supplier and customer are in the same country, then the exploitation of the latest software or network and a smart contract or two in the supply chain probably has little impact on the corporate tax analysis.

However, for businesses making cross border supplies, digitalisation can radically alter the tax take of a particular country. The use of digital platforms to penetrate foreign markets in countries where a business has no people or tangible assets confounds existing international tax rules which, with notable exceptions, such as the US, generally tax a business where it has a physical presence (known as a 'permanent establishment'), be that buildings or employees. 

The different ways in which digital business models operate and generate value stress test these rules. For example, under the current system, a business generally does not pay tax in a country where it simply rents a local computer server and pays minimal tax in a country where smart contracts require only a couple of local employees. Whatever the economic arguments, this has caused international unease and governments are increasingly seeking a way to tax any company that derives revenue from within their borders.

Long-term reform

In Spring 2018, the OECD will present a report to the G20 setting out policy options. In advance of this, both the EU and UK government have published papers which recognise the tax challenges posed by the digital economy and analyse potential solutions. The detail varies but essentially both the EU and UK papers support the concept of a 'virtual permanent establishment' together with looking at a refinement of the way in which cross border business price their goods and services and attribute profit within a group of companies.

In particular, three key changes are advocated:

1. Countries should have the right to tax foreign companies on the value derived from a user base within their jurisdiction, even where there is no physical presence.
2. The rules determining how profits are allocated within a group should be 'updated' to recognise the value companies generate from user participation.
3. An amount of the profits of foreign companies should be allocated to countries in which they have a user base, based on a formula that approximates the value that user base generates.

Interim measures - a digital tax?

Anticipating slow multilateral progress however, both the EU and UK are contemplating jumping the gun with the introduction of unilateral digital taxes. The EU has just completed a consultation on the following potential taxes (or combination thereof):

1. Equalisation tax on all untaxed or insufficiently taxed income generated from internet based business activities, to be operated as either a discrete tax or creditable against corporate income tax.
2. Digital withholding tax on digital transactions where payments are made to non-resident providers of goods and services ordered online.
3. Levy on revenues generated by non-resident businesses from the provision of digital services to resident customers or in-country advertising.

The UK government has already published its preference for implementing the third of these three options in the absence of swift progress by the OECD. It should be noted however that both the EU and UK contemplate a de-minimis threshold which ultimately may exempt SMEs from any potential digital tax.