Reproduced with permission from Daily Tax Report, 49 DTR 13 (Mar. 13, 2018). Copyright 2018 by The Bureau of National Affairs, Inc. (800–372–1033) http://www.bna.com.
By now, I hope, you’ve come to agree that we should all care about the issue of digital taxation, and how that may impact businesses across not just “tech”, but manufacturing, pharmaceuticals, household goods, financial services, and others. In this article, I’d like to dive a bit deeper into the non-tax technical details of some of the proposals that have been made, particularly, but not exclusively, in Europe.
Within each of the three major proposals on the table — turnover taxes, digital PEs, and so-called “formulary apportionment” — there are a couple of variations, so let’s take a look at each in turn:
A turnover tax, as the name implies, is on turnover, sales, gross receipts and the like, rather than on profits. This matters because turnover (gross) is usually orders of magnitude greater than profit (net), and turnover taxes hit different business models in very different ways. Let’s look at that:
Turnover taxes were abandoned for all of these reasons in the 1960s, and the intervening 50 years and the variations suggested — such as gross withholding taxes on payments outside the country in question — have not made the idea any better. Sure, sales can be taxed to capture some of that value. But the battle here is for not just a sales tax, but also a share of the profits of non-resident digital businesses. And it seems very likely that anything that is digital could be in scope at some point. So, turnover taxes can be problematic.
The second idea is the so-called “digital Permanent Establishment” (PE). Again, a PE arises when activity in another country contributes so much to the profit of the company that the second country gets the right to tax not just the sale, but some of the profit as well. PE is a concept that has been successfully applied to physical activity (sales of goods, performance of services, construction sites, etc.) for decades. The relatively clear test for when a PE exists, protects both businesses from governments claiming that even the slightest contact with a country leads to a PE; and protects governments from businesses claiming that even substantial activity creates no value to be taxed. The rules were tweaked a couple of years ago to squeeze out what governments felt was aggressive planning, but they still work relatively well.
However, in the past year or two the idea of a “digital PE” has been proposed to allow countries to tax digital income which they believe (we’ll come back to that) arises in their country. The first problem is that there is by definition nothing physical going on — so you either have to stretch the terms (for example, one country has said a PE arises when a cookie is installed on a computer in their country), or you have to significantly expand the definition. There have been various proposals, but most of them focus on the number of active users in a country, the length of time the operation continues (for example, the website) and some other thresholds intended to carve out smaller businesses.
So, what are the issues with this idea?
So, how does it increase disputes but still provide no solutions?
Well, even when you say there’s a PE, a bigger second question then has to be asked: how much profit can the second country tax in relation to that PE? To be able to figure that out you need to know where the profit is earned — in other words, where the value is created. But in digital, the thinking on that is still emerging — and most countries tend to think it’s in their country!
Lastly, Europe is considering an EU wide tax system based on what is called “formulary apportionment”. Here profit is divided between countries based on a “formula” — several factors that are held to be linked to the profit creation. The U.S. states do a variant of this based on some or all of the amount of employee payroll paid, property owned, and sales made in that state. However, in a twist on that original U.S. model, the European Parliament has suggested a fourth factor for the formula, based on the collection and use of personal data. However, this idea raises a number of thorny issues:
The two points above make this a recipe for disagreement, almost guaranteed to lead to more disputes. Additionally, any tax on data will be a potential dampener on the collection of useful data.
But beyond all of these is a question around whether — as their supporters suggest — these taxes can be limited to “digital” businesses and to “personal data”. There are good reasons to think not. Here are a couple of questions to think about:
So, really, is data the “super factor” that creates value, profit, over other digital factors?
All of these seem to make this another route to more conflicts. And we should think very carefully about that.
Let me be clear: Despite the disagreements that exist about these current proposals, change is coming. But falling back on yesterday’s ideas, or rushing into untested new ones is not the answer. And in doing that we could suppress growth, damage existing tax rules, and penalize certain types of businesses.
What we need — and what the OECD has proposed in their interim report released on March 16 — is an invitation to governments and businesses and others to engage in a conversation about where profit is created in these new and increasingly diverse business models, and how that should be taxed. There are big questions around the ability to earn income without being physically present, and around the value of data — but also around the vital role that investment (capital) still plays in value creation, as well as the value of innovation, taking financial risk, etc. These are big questions, and a lot hangs on the answers. But it’s time to start thinking — carefully, thoughtfully and with an eye to growth — about what a tax system for the digital age might look like. And business needs to get involved.
Will Morris is the Deputy Global Tax Policy Leader at PwC and the Tax Committee Chair of the Business and Industry Advisory Committee — a business group devoted to advising policy makers at the OECD. The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of PwC or BIAC.
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