How much I tax you, let me count the ways
ME PoV Fall 2019 issue
The Digital Service Tax proposal introduced by the European Commission has far-reaching impact in the Middle East.
We live in a digitalized economy and the Middle East is no exception. Consumers in the region apply their smartphones for online research, GPS navigation, and make purchases online; their lives are inextricably connected to digitalization and data. And digital transformation will further impact our daily lives.
As the digital economy grows, there is a perception among global consumers and tax administrators that digital companies pay substantially less tax than non-digital businesses.
It is true that most international tax rules were enacted at a time when the internet did not yet exist. To mitigate this, the Organization for Economic Cooperation and Development (OECD) launched a project in 2015 to address base erosion and profit shifting (BEPS) by enacting 15 action plans. One of them is BEPS Action 1 that addresses the difficulties and tax challenges arising out of the digital economy and is looking to find a solution to solve the international tax issues in the digital world. In order to minimize double taxation and the controversy posed by the digital economy, the OECD’s view is to first seek consensus-building among all its member countries that have joined the BEPS inclusive framework.
However, the European Union and many other individual countries have been taking matters into their own hands, introducing legislation and proposals to address the issue. France, for example, has enacted a legislation to impose a 3 percent tax on revenue generated in France by multinational companies such as Google and Facebook. Similarly, the UK proposed a legislation to introduce new digital service tax on providers of social media and search engine companies that derive income from UK user participation.
On a broader scale, the European Commission (EC) expressed concern that there is a mismatch between where profits are currently taxed versus where certain digital activities create value. There is a review underway as to whether taxing rights should flow from the location of revenue and not profits (see box below).
Overview of the new Digital Service Tax proposal by the European Commission:
The European Commission introduced two proposals/directives on 21 March 2018 in this regard.
- The first proposal is described as an “interim” 3 percent digital service tax (DST) on gross turnover (revenue) derived from activities in which users are deemed to play a major role as regards value creation. This applies to companies with total worldwide revenues of €750 million (note the consistency here with the threshold for country by country reporting under BEPS Action 13) and that have an annual EU taxable revenues of €50 million. The activities would include placing advertising on digital platforms that would facilitate users to shop online, transmission of data collected about users, etc.
- The second longer-term proposal also known as “significant digital presence” (SDP) would enable European member states to tax profits that are generated in their territory, even if a company does not have a physical presence there. This will redefine the concept of digital permanent establishment, and will be applicable if it meets certain thresholds such as it exceeds a threshold of €7 million in annual revenues in any member state, or it has more than 100,000 users in a member state in a taxable year, or over 3,000 business contracts for digital services are created between the company and business users in a taxable year.
The objectives of these directives are to ensure that digital economies are fairly taxed in Europe. If eventually approved by the European Parliament, they will probably come into effect from January 1, 2020. If that happens, it will fundamentally change the landscape of how companies incur taxation in EMEA.
What does this mean for the Middle East?
The EC proposals could impact multinationals operating in the Middle East in the following ways:
- Encourage global groups (in particular U.S. technology giants) to favor Middle East consumer markets when compared to mainland Europe (assuming that the Middle East territories do not introduce similar regulations);
- The OECD consensus review could result in Inclusive Framework territories implementing a similar digital taxation on sales;
- Locally headquartered groups will be impacted by virtue of their operations and digital sales in Europe.
One of the fundamental questions at the center of digital taxation is how (and where) the value is created by the data. The OECD’s interim report on the tax challenges arising from digitalization identifies three characteristics that are frequently observed in certain highly digitalized business models:
- Scale without mass,
- Heavy reliance on intangible assets, and
- The role of data and user participation.1
There are different views as to what extent these features represent a contribution to value creation by enterprise. For example, U.S. companies can argue that the majority of the investments in research and development (R&D) and capital expenditure in intangible assets occur in the United States. As such U.S. companies can claim to have more revenue allocated in the United States rather than the resident country of the user. It will certainly be helpful to see how OECD/G20 nations plan to address this issue as they seek to finalize their Inclusive Framework report by 2020, which will include consensus among all 129 member states.2
Key takeaways for Middle East based multinationals
As there has been an appetite for growth of technology-based companies in the Middle East, following in the footsteps of U.S. and European technology giant companies, multinationals based in the Middle East are encouraged to keep a close watch on the developments in the digital service tax proposals including BEPS Action 1 in the international tax community.
To the extent that the new rules are applicable, digital-based multinationals need to consider their existing corporate structure and evaluate it both, from a commercial as well as a tax optimization viewpoint.
by Shiv Mahalingham, Partner, Middle East Transfer Pricing Leader and Abi Man Joshi, Principal, Tax, Deloitte Middle East