European Commission issues draft Directives on the taxation of the digital economy
On 21 March 2018, the European Commission issued two draft Directives on the taxation of the digital economy. Under the proposed new comprehensive solution, companies would have to pay corporate income tax in each Member State where they have a significant digital presence. In the interim, the Commission proposes a 3% revenue-based Digital Services Tax on specific digital services where the main value is created through user participation.
The EU Commission said that EU Member States are under increasing political pressure to act now on taxing the digital economy and an increasing number are considering unilateral action. The proposal for an EU-wide Digital Services Tax would generate revenues estimated to be worth up to €5 billion a year across the EU and help avoid a patchwork of unilateral actions which could fragment the Single Market and create uncertainty for businesses.
Some of the distortive effects of gross level taxation have been mitigated in line with the OECD’s guidelines on interim measures e.g. the use of thresholds and focus on targeted activities where users play a major role in value creation. The tax is intended as a temporary measure while a common EU solution in respect of significant digital presence is being discussed, developed and implemented by Member States.
The proposed significant digital presence concept builds on existing international tax principles to create a new category of permanent establishment in respect of a broad range of digital services. Further guidance will be needed in respect of valuation and how to apply the profit split method to allocate profits (and losses), although potential profit splitting factors are suggested. Businesses and tax authorities will need to identify the number of users in each jurisdiction and their corresponding value, which is likely to raise practical challenges. In the absence of a global revenue threshold, smaller businesses with a large digital footprint in the EU could be in scope. The proposal would apply between EU member states and with countries where there is no tax treaty in place. Re-negotiation of treaties and widespread international agreement would be needed for any further changes since the law defining taxable presence is set out in the world’s 3,000 double tax treaties.
Unanimous approval by all Member States is required for the adoption of Directives and some EU countries have already expressed views against gross basis taxation. It is possible that a smaller group of countries could use the ‘enhanced cooperation’ route to enact the proposal, although it would need to be clear this is permissible in view of the general prohibition on turnover-based taxes, other than VAT. There are a number of complex technical issues to be resolved in respect of the significant digital presence concept, and it seems unlikely that these could be addressed in time for proposed implementation from 1 January 2020.
The EU would prefer rules agreed at the global level but considers that an unacceptable amount of profits is currently untaxed and has therefore proposed solutions at an EU level. The EU proposals were released within days of the OECD’s Tax Challenges Arising from Digitalisation: Interim Report 2018, and the Commission intends that its latest proposals will contribute to the ongoing work at the OECD level to influence international discussions on a global solution.
It is essential that ultimately governments are able to agree a consensus solution over a framework for countries to tax digital businesses based on their profits, in order to minimise double taxation and potential distortions that could affect businesses’ commercial decisions.
Interim proposal – Digital Services Tax
Pending multilateral, international solutions to taxing the digital economy, the Commission is proposing a 3% Digital Services Tax (DST) on the gross revenue resulting from the supply of certain digital services characterised by user value creation:
• online placement of advertising;
• sale of collected user data; and
• digital platforms that facilitate interaction between users, who can then exchange goods and services directly via the platform.
Provision of digital content, payment services, online sales of goods or services, and certain regulated financial and crowdfunding services are specifically excluded from the new tax.
The measure is targeted at businesses with:
• sufficient scale that established strong market positions which allow them to benefit relatively more from network effects and exploitation of big data – total consolidated annual global revenues in excess of €750 million, and
• a significant digital footprint in the EU – annual revenues from taxable digital activities in the EU in excess of €50 million.
The tax will apply irrespective of whether a business is established within the EU.
In line with the concept of user value creation, the tax will be payable to the Member State where the users are located. Where users are located in different Member States, one Member State will be responsible for collecting the tax and allocating it to the other Member States, based on allocation keys.
A single EU-wide payment and reporting portal will be established, based on the One Stop Shop model currently used for VAT. Businesses will be required to self-assess the tax liability, payable on an annual basis. Consolidated groups will be able to nominate one company to deal with compliance and payment. It is proposed that Member States will allow resident businesses to deduct Digital Services Tax paid to any Member State from the corporate tax base. The tax is intended as a temporary solution while the common EU solution is being discussed, developed and implemented by Member States.
Comprehensive solution – significant digital presence
In a separate draft Directive, the Commission proposes common EU rules to allow Member States to tax profits generated from a significant digital presence in their jurisdiction, regardless of physical presence. The proposal would extend the current permanent establishment rules by establishing a taxable nexus for digital businesses operating across borders where at least one of the following conditions is met with respect to a tax year:
• revenues from digital services provided to users located in a Member State exceed €7 million;
• Number of active users of digital services located in a Member State exceeds 100,000; or
• Number of business contracts for digital services concluded by users located in a Member State exceeds 3,000.
These thresholds apply by reference to the activities of the services supplied by the entity itself aggregated with those supplied by any associated enterprises. The associated enterprises test is widely drawn and includes cases of significant influence through participation in management, a direct or indirect holding that exceeds 20% of voting rights, or participation in the capital through a direct or indirect right of ownership that exceeds 20% of the capital.
A digital service is defined in line with the existing VAT rules as ‘a service that is delivered over the internet or an electronic network and the nature of which renders their supply essentially automated and involving minimal human intervention’. Services which can and cannot trigger a significant digital presence are listed, and the sale of goods or services online is specifically excluded.
The proposed transfer pricing principles for allocating profits (or as the case may be, losses) to the significant digital presence follow the established methodology of determining profits that would have been earned by a ‘separate independent enterprise’ taking into account the functions performed, assets used and risks assumed through a ‘digital interface’. A number of additional data and user-related criteria are proposed to recognise the value of user participation and data, including: the collection, storage, processing, analysis, deployment and sale of user-level data; the collection, storage, processing and display of user-generated content; the sale of online advertising space; the making available of third-party created content on a digital marketplace; and the supply of any other digital service. The functions related to the development, enhancement, maintenance, protection and exploitation of intangible assets should be taken into account even if these are not linked to people functions in the same Member State.
The profit split method should be used to attribute profits to the significant digital presence, unless the taxpayer proves that an alternative method based on internationally accepted principles is more appropriate. Possible profit splitting factors could include expenses incurred for research, development and marketing as well as the number of users in a Member State and data collected per Member State.
The Directive would apply between Member States (overriding tax treaties between them) and where a business established in a non-EU country operates through a significant digital presence in a Member State and there is no tax treaty in place. The Commission recommends that Member States update existing treaties with non EU countries to include corresponding rules on a significant digital presence and profit allocation in line with the proposals.
Timetable and next steps
Each of the two separate draft Directives requires unanimous agreement by Member States for adoption. If agreement is reached, Member States must adopt and publish legislation to comply by 31 December 2019. The measures would then apply from 1 January 2020. The EU also recommends that Member States re-negotiate existing tax treaties with non-EU states in line with the significant digital presence provisions.