Thanks to digitalisation, businesses such as social media companies, sharing platforms and online content providers are making a major contribution to economic growth worldwide.
Indeed, in terms of performance, digital companies are clearly gaining on those that adhere to more traditional models. In 2006, only one digital company was listed amongst the top 20 EU companies, with 7% market share, while in 2017, the top 20 included nine technology companies which accounted for 54% of the market.
Unfortunately, however, the current tax rules are not suited to this new business model, pursuant to which companies operate worldwide but almost exclusively online, with limited or even no physical presence on the ground. Consequently, digital companies are often not taxed in the jurisdiction where they generate most of their revenue, which usually allows them to benefit from a lower effective tax rate than traditional companies.
The "permanent establishment" (PE) concept is no longer adapted to the digital economy
Current corporate tax rules are determined by national tax law and international tax treaties which allocate authority to tax amongst the contracting states. These international rules are designed however for companies with an effective physical presence on the territory of one or more states, other than their state of residence, where they exercise an economic activity.
Thus, tax treaties typically refer to a “permanent establishment” (or “PE”) to allocate taxation rights when a company established in one state derives profits in another. In that case, the state where the company has a PE and derives a portion of its profits has the authority to tax the profits attributable to the PE.
The PE concept was clearly adopted at a time when physical presence was required in order to derive business profits in a country and is thus no longer adapted to the modern digital economy in which companies engage in cross-border online trade and data collection and user-generated content are the main ways of creating value. As a result, the current corporate tax rules, including the PE rules, lead to a mismatch between the place where value is created by certain digital activities and the place where taxes are paid.
OECD initiatives and European Commission proposals to provide an international solution?
In this context, several initiatives have already been taken at the EU level and by the Organisation for Economic Cooperation and Development (“OECD”). The main aim of these initiatives is to create a system of fair taxation, with companies paying taxes in each country where they operate, create value and thus realize profits.
As mentioned above, the current tax rules are unable to achieve this goal and, therefore, changes to the rules and fundamental tax principles appear inevitable. At the international level, the OECD examined this issue in its 2015 BEPS Action Plan, Action 1 of which addresses the tax challenges posed by the digital economy.
As a follow-up to the BEPS Action Plan, the OECD adopted in March 2018 an interim report on the tax challenges arising from digitalisation, which mainly analyses the features of highly digitalised business models and their way of value creation, as well as the potential implications for international tax rules. The report discusses a number of options for taxing the digital economy (for instance, a withholding tax, a virtual PE or a revenue-based tax) but does not reach a clear conclusion and merely states that countries have divergent views on the issue and should work towards a consensus-based solution.
Given the desire by countries to retain sovereignty over tax matters and the clear disadvantage of some jurisdictions that are more technologically advanced and hence can only lose tax income, it is highly unlikely that an international solution will be reached in the near future.
Given the difficulties encountered at international level, the European Commission adopted on 21 March 2018 two proposals for Council directives intended to establish a fair system of digital taxation within the European Union. Although the Commission acknowledges that a multilateral global solution would be ideal, it expressed a wish to take action sooner rather than later and to adapt the rules at EU level in order to prevent Member States from adopting unilateral and uncoordinated measures which would lead to fragmentation of the Single Market and the distortion of competition.
Two proposals from the European Commission could significantly impact the digital economy
The first proposal sets out a long-term solution for corporate taxation of a significant digital presence while the second proposes an interim measure to determine a common digital services tax.
1. Introduction of a virtual PE
The first proposal reforms the EU's corporate tax rules for digital activities and establishes an additional type of PE for digital businesses, pursuant to which companies operating on a cross-border basis are deemed to have a taxable nexus or "significant digital presence" in a country when they meet certain criteria.
These criteria are based on indicators of digital economic activity, such as the level of revenue realised from the provision of digital services and the number of users of digital services. Thus, a company will be deemed to have a significant digital presence, or “virtual PE”, in a Member state if one or more of the following criteria are met in a tax period:
- revenue from the provision of digital services in excess of EUR 7,000,000;
- more than 100,000 users of digital services; and
- more than 3,000 business contracts for digital services.
Once a company is deemed to have a significant digital presence in a Member State, it will be necessary to determine the profits that should be attributed to the virtual PE and are thus taxable in that Member State.
First, the Commission reiterates the currently applicable general principles for the allocation of profits to a traditional PE which are based on the risks managed, the functions performed and the assets used by the PE. Then, in keeping with the rationale behind the new rules, it states that these allocation principles should be revised in order to better reflect the creation of value in digital activities in a Member State. In this regard, the Commission proposes a number of additional tests focussing on economically significant activities, including those relating to user-generated content, user-level data and the sale of advertising space.
2. Digital services tax
In addition, the Commission proposes a common digital services tax as an interim solution. In this way, Member States will be able to immediately collect a portion of the tax revenue which currently slips through their fingers due to inadequate tax rules.
The tax will be set at a rate of 3% and calculated based on the gross revenue resulting from the supply of digital services by large digital companies. It should be noted, however, that the tax targets only services whereby user participation in the digital activity is inherent to value creation, such as:
- the placing on a digital interface of advertising targeted at users of that interface
- the transmission of user data generated from the user’s activities on digital interfaces; and
- the making available of multilateral interfaces that allow users to interact with each other and exchange goods and services directly via a platform.
In keeping with the importance of user participation, the tax is due in the Member State(s) where the users are located. However, not all companies providing qualifying digital services will be subject to the tax as, in addition, certain revenue thresholds must be met. In this regard, a company will only qualify as a taxable person, for purposes of the digital services tax, if its worldwide revenue for the last (available) financial year exceeded EUR 750,000,000 and its revenue within the EU exceeded EUR 50,000,000 for that same financial year. If the entity is part of a consolidated group, these thresholds must be met at group level.
The purpose of these thresholds is to exclude small companies and start-ups for which the tax would represent a major burden. A business that provides digital services and exceeds the abovementioned thresholds will qualify as a taxable person, regardless of whether it is established in an EU Member State or outside the EU.
The Commission’s proposals are undeniably bold and would significantly impact the digital economy. As mentioned in the BEPS Action Plan, however, the digital economy cannot be ring-fenced and hence the proposals could potentially impact all companies active in the digital sphere. The new proposals also represent an increased compliance burden. The proposals have been sent to the European Council for approval and to the Parliament for consultation. As tax reforms require the unanimous agreement of all 28 Member States at EU level and certain states have already expressed doubts or concerns about the proposals, it will certainly be challenging to reach an agreement in the near future.
In this respect, two major concerns are the impact of the digital services tax on US companies operating within the European Union, which are estimated to make up approximately half the companies that would be hit by the tax, and the deterrence of high-tech investment in the EU.
If the Member States cannot reach a consensus, a smaller group of states could still decide to enter into an enhanced cooperation procedure and adopt legislation. Nonetheless, an agreement at the international (OECD) level remains the best solution and should thus be pursued by the Commission.