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Digital service taxes: Are they here already?

Amparo Mercader
Partner, Transfer Pricing, PwC US
Kartikeya Singh
Partner, Transfer Pricing, PwC US

Digital service taxes, or DSTs, have been in the headlines regularly in 2021. The COVID-19 pandemic in particular has increased the focus on DSTs because of the reliance on technology for working and e-commerce sales. DSTs can be viewed as a unilateral mechanism being used by ‘market’ countries to exercise greater taxing rights over the profits of tech-based multinational companies that sell into their local market, and collect data from and target advertisements at local audiences, regardless of their physical presence. (For further discussion of DSTs, see Morris and Brown, PwC blog, Digital service taxes: Are they here to stay?)

For our purposes, the most important ongoing development related to DSTs is an attempt at preempting such unilateral measures by adopting a multilateral consensus-based approach. This is being led by the OECD and G20 as part of the tax project related to digitalization and covers two interrelated issues:

  • First, how nexus and income allocation rules should be modified to address the unique challenges presented by digitalized businesses; and
  • Second, should there be a global minimum corporate tax in an effort to stop the so-called ‘race to the bottom’ on corporate tax rates by countries seeking to compete with each other to attract business investment.

The first issue, or Pillar, of the OECD project reflects a sentiment prevailing in certain countries that some prominent tech companies (mainly based in the United States) generate significant revenues from e-commerce activity that occurs in those countries without creating a commensurate taxable presence or tax liability. Under current international tax law principles, these companies are taxed mainly based on where they have a physical presence.

To address this issue, the OECD is proposing to grant countries taxing rights over a part of multinationals’ profits where their consumers or ‘users’ reside, regardless of the companies’ physical presence. This may present a viable alternative -- from the perspective of market countries -- to the type of DST they are seeking to impose. In short, the OECD’s plan would change where some of a company’s profits are taxed relative to the status quo without changing the overall tax base.

The second major part of the OECD negotiations, as noted above, is focused mainly on enacting a floor on international corporate tax rates, to end what is perceived to be a race to the bottom arising from tax competition among countries.

Here is where the two issues are intertwined: as part of a broad effort to forge an OECD agreement on a global minimum tax on multinationals, US Treasury Secretary Janet Yellen announced in February that the United States has dropped demands that Pillar One be implemented as a ‘safe harbor’ -- i.e., that companies voluntarily opt into Pillar One’s new allocation rules. This concession by the US generally is viewed as a serious step toward an agreement, although many political and technical issues remain unresolved.

The United States, meanwhile, has proposed, as a possible compromise, a new Pillar One proposal that would apply to roughly 100 large multinationals, using quantitative thresholds to reallocate a share of such in-scope companies’ profits to market countries. The new rules would apply to multinational enterprises that meet both revenue and profit-margin thresholds, regardless of their industry. This would address US concerns related to the subjectivity of the scoping criteria in the original OECD proposal and the potential for controversy given such subjectivity.

Note that while the United States has not expressed any interest in enacting its own DST at the federal level, there have been developments that are important for foreign-owned companies operating in the US market. The first development relates to the 2018 Wayfair decision, when the US Supreme Court ruled that a state could require out-of-state sellers to collect taxes on sales to in-state consumers even if the seller has no physical presence in that state. The 45 states that impose a sales tax followed the Wayfair case closely, and unsurprisingly reacted swiftly and favorably to their newfound authority to tax previously nontaxable transactions. To date, 43 of these states have enacted an economic nexus threshold in line with the particular state law the Supreme Court found constitutionally valid. Foreign-owned companies should evaluate the implications of this development in seeking to comply with state tax laws.

A more recent development took place in Maryland, which earlier this year enacted a gross revenue tax on digital advertising, although it has since delayed implementation of the tax to 2022. In the meantime, two different lawsuits challenging the state’s new tax have been filed. Other states considering such taxes -- including New York, Connecticut, and Indiana -- are watching to see if the Maryland tax can withstand these challenges before enacting digital taxes of their own.

Therefore, while the United States is seeking to generate consensus on the global stage, domestic subnational tax developments are taking place in light of the changing operating models of multinational corporations. Staying informed and understanding potential tax exposure because of US state developments is critical for foreign-owned businesses in the current uncertain environment.

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