International Expansion Blog

What We Know Now About Taxing the Digital Economy

3/28/2018

By John Bostwick, Managing Editor, Radius

John Bostwick, Managing Editor, RadiusThis month, the Organization for Economic Cooperation and Development released an interim report on tax challenges arising from digitalization. A brief on the report says that the 113 countries that make up the OECD/G20 Inclusive Framework have different views on how to address taxation of the digital economy, but have agreed to “seek a consensus-based  solution” by 2020.
 
In a March 16 press release, OECD Secretary-General Angel Gurria called the interim report “an important step … towards resolving the tax challenges posed by the digitalization of the economy.” The step may indeed be important, but the rest of Gurria’s press-release remarks make clear that it’s a short step and necessarily the first of many. He says that the authors of the report have simply “underlined the complexity of the issues” and that the OECD “stands ready to accompany countries as they seek to build a common understanding of the issues related to the digital economy and taxation, as well as the long-term solutions.”
 
In other words, no one seems to agree on precisely what’s going on with the digital economy, where it’s headed or how to tax it — even the OECD experts who drafted the 200-plus page report on the subject. The director of the OECD’s Center for Tax Policy sums up the situation like this: “It’s complex, it’s really complex. … But we need to sit down and work together, and if we work, we will get it.”
 
Despite persistent uncertainties surrounding taxation of the digital economy, it’s worth summarizing the high points of the recent OECD interim report, if only to know what leading authorities are saying about the subject now.
 

Background

The interim report is an extension of the OECD’s 2015 Action 1 Final report, Addressing the Tax Challenges of the Digital Economy, the first of 15 actions, or measures, intended to curb base erosion and profit shifting, or BEPS (basically, tax avoidance by multinational corporations). It’s significant that the groundbreaking BEPS measures begin with tackling taxation of the digital economy. This is a contentious, evolving regulatory area, but a critical one to address and gain consensus on, given that many existing tax laws still don’t account for cross-border electronic commerce.

Last March, G20 finance ministers required that the OECD’s Inclusive Framework on BEPS members deliver an interim report on “the implications of digitalization for taxation” before April 2018. The result is the interim report published this month.

Amazon HQ Luxembourg

Report Highlights

The interim report addresses a number of areas, including how “highly digitalized business models” operate and the concept of value-creation in the digital economy, along with the “potential implications for the existing international tax framework.”

At the heart of the report are the concepts of nexus — or a tax connection to a jurisdiction — and profit allocation, or how much a multinational’s profits will be subject to tax in a given jurisdiction, as well as how profits should be allocated among countries. The Inclusive Framework members indicate that “at present, there are divergent views on how the issue should be approached."

The members have pledged to publish an update to the interim report in 2019 and a final report on the subject in 2020. During that time, they will “seek a consensus-based solution” to applying nexus and profit allocation rules “to the different activities carried out by multinational enterprises.”

The report indicates that there are a number of “areas of work that will be undertaken without delay,” such as enhancing cooperation among tax authorities in different countries in the age of big data. In particular, members want to ensure that participants in the gig and sharing economies pay taxes when they’re due. They’ll also look to examine how new advances like blockchain distributed ledger technology can be incorporated into the international tax system.

The subject of the report is deeply complex in part because of the evolutionary nature of the digital economy, and because business models of highly digitalized organizations vary significantly, as do the views of the countries that seek to tax related activities. On the business-model side, the report outlines three frequently observed characteristics of digitalized organizations: “scale without mass, heavy reliance on intangible assets and the role of data and user participation, including network effects.”

As for country perspectives on the tax challenges of digitalization, the report indicates that views can be separated into three groups. The first group of countries acknowledges there may be “misalignments between the location in which profits are taxed and the location in which value is created.” They feel, however, that these misalignments are limited to particular business models. As a result, they don’t “see the case for wide-ranging change” to the existing international tax framework.

The second group of countries believes the ongoing digitalization of the economy, combined with globalization in general, “present challenges to the continued effectiveness of the existing international tax framework for business profits.” These challenges, the second group believes, are not unique to highly digitalized business models. They therefore feel that “any changes should apply to the economy more broadly.”

The third and final group of countries believes that existing BEPS actions largely address concerns related to double non-taxation, at least for the time being. These countries “do not currently see the need for any significant reform of the international tax rules.”

In light of these differing viewpoints, the report concludes (a little gratuitously) that “developing, agreeing and implementing a global, consensus-based solution will take time.” In the meantime, some countries are calling for immediate interim measures to “address the tax challenges arising from digitalization.”

Predictably, other governments oppose the introduction of interim taxation. They believe that such measures could have “negative impacts on investment, innovation and growth, the possibility of over-taxation, distortive impacts on production and increasing the economic incidence of tax on consumers and businesses, and increased compliance and administration costs.”

Echoing these concerns, the report cautions that any interim measure “should be in compliance with existing international obligations, temporary, targeted and balanced, minimize over-taxation, as well as designed to limit the compliance costs and not to inhibit innovation.”

Additional Context, Including a European Commission Proposal

Reuters explains that the impetus for scrutinizing digitalized business models and related tax codes springs largely from “big digital companies like Google, Apple and Amazon [that] have for years been able to exploit current rules to legally slash their tax bills in some countries, leaving other governments furious.” Reuters adds that some countries such as India and Australia have begun implementing changes to close these loopholes. In a major move, the European Commission will — under pressure from Germany and France — propose that “large companies with significant digital revenues in the European Union … face a 3 percent tax on their turnover.”

While the European Commission’s proposal is not directly related to the OECD’s interim report, the two documents (of course) address the same contentious issues. The Wall Street Journal says that the European Commission’s proposal calls for “a short-term charge on the revenues, rather than the profits, generated by some digital companies, most of which are American.”

 
The proposal creates tension between Europe and the US, the Journal notes, and the tension is exacerbated by steel and aluminum tariffs being implemented by President Trump. The day the OECD’s interim report was released, the US government made clear its position on interim measures of the kind proposed by the European Commission. US Treasury Secretary Steven Mnuchin issued a statement that says in part, “The US firmly opposes proposals by any country to single out digital companies. Some of these companies are among the greatest contributors to US job creation and economic growth. Imposing new and redundant tax burdens would inhibit growth and ultimately harm workers and consumers.”
 
The New York Times explains that the European Commission’s proposal “is expected to hit Silicon Valley tech companies the hardest by forcing them to pay taxes to governments where they do business,” instead of to EU tax havens such as Ireland or Luxembourg, where many digital companies have their European HQs. The Times says that by European Commission estimates, digital businesses pay an effective tax rate of 9.5 percent, in contrast with the 23.3 percent paid by traditional businesses.
 
The Irish Independent points out that the OECD’s reluctance to endorse interim measures, and the US’s firm opposition to interim measures, are in line with Ireland’s own interests. It explains that under the European Commission’s proposal, “the digital turnover tax will be charged where customers buy products — so the lion's share will be collected by big countries like France and Germany,” not by smaller economies like Ireland.
 
The new levy on tech giants would, moreover, cut into the corporations' own profits, thereby reducing the amount of taxes they would pay from their corporate headquarters, many of which (to repeat) are based in Ireland. The Independent estimates that Facebook, for example, could be taxed 240 million euros under the proposal for operations across all EU countries. “All told,” says the Independent, “Ireland's tax income could drop by hundreds of millions of euros.” This explains why the European Commission will have difficulty getting the proposal passed, since it needs unanimous support from EU member countries.
 
There will be much more to say in the coming months and years on the subject of taxation and the digital economy. Many of us will continue to follow the evolving concepts and regulations, trying our best to make sense of them. We’ll probably do well to keep in mind that neat assessment from the director of the OECD’s Center for Tax Policy: “It’s complex, it’s really complex.”