How might your business be taxed under current digital tax proposals?

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By: Will Morris, PwC’s Deputy Global Tax Policy Leader (Originally published on Medium on March 30, 2018)

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)

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:

Turnover Tax, AKA Equalization Taxes

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:

  • If — as many modern businesses do — you have a supply chain which passes ownership of goods from one company to another as the goods are worked on, each change of ownership will trigger the turnover tax, so it “cascades,” potentially applying multiple times.
  • If your business model relies on selling a lot of product with a very low margin, then a 2% turnover tax will hit you much harder (even wiping out your profit, and more) than it would a luxury goods manufacturer with low turnover but very high margins.
  • And what if you are already running a loss? Well, obviously there would be no profits tax because you have no profit. But you still have turnover which would be taxed — and which would add to your losses unless you could pass it on to the consumer.

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.

Digital Permanent Establishment (PE)

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?

  • Well, first there is no agreement among countries on whether the entire concept is appropriate, far less agreement on what the standards should be. That could be overcome by international agreement, but that currently looks unlikely.
  • Second, by extending the concept away from physical presence into digital “presence”, the whole concept could be undercut. If a country can assert a digital PE exists, why would it bother to argue about the complexities (and protections mentioned above) built into the physical PE rules?
  • But, most importantly, changing these rules increases the likelihood of disputes, without providing any solutions.

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!

Formulary Apportionment

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:

  • We really have no idea whether raw data has value or what that value is. But it is clear that its value is certainly not a straightforward number like sales or salaries, and
  • There is no agreement about what gives data value — whether that’s when you collect it, or analyze it, or link it to another product, or something else — or where that value is added.

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:

  • Could you truly limit this apportionment factor just to “digital” companies — what, for example, if a consumer goods company collects personal data from its consumers?
  • Is all personal data used to create independent value, or, instead, does it help produce better products, or faster service? How is that reflected in profit?
  • Is it conceivable that this could be limited to personal data? Why not industrial data? And where’s the boundary? That’s important because the business models for IoT (Internet of Things) type data may be very different.

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.

OECD April Report

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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William Morris

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