Background to the taxation of digital services
As previously reported on MediaWrites (click here), the digital economy has become a concern for tax authorities at an international level. The BEPS Project, which was set up by the Organisation for the Economic Cooperation and Development (“OECD“) to address international tax issues, has identified the need to reform the taxation of the digital economy (Action 1 of the BEPS action plan published in 2015), acknowledging that the current international tax system is ill-adapted for digital businesses.
Further to Action 1 of the BEPS action plan, in March 2018 the OECD published an interim report (link) analysing the main features of highly digitalised business models in the digitalised age, as well as the potential implications for the international tax framework. OECD Members have now agreed to undertake a further review of the “nexus” and “profit allocation” rules as there are currently divergent views on how to tax digital businesses. A final report is due to be published in 2020, with an update to the G20 in 2019.
Acknowledging that it may take some time before a global agreement is reached, the EU has decided to take action prior to the final outcome of BEPS Action 1 consisting of specific proposals relating to digital businesses.
These proposals relating to digital businesses are:
- a new Directive laying down rules relating to the corporate taxation of a significant digital presence (“Digital Presence Directive“); and
- a new Directive for a common system of taxation on revenues resulting from the provision of certain digital services ( the “Digital Services Tax (DST) Directive“).
Target – The Digital Economy
Traditionally the taxation of companies has taken more of a “bricks and mortar” approach, i.e. the company had to have a physical presence. However, in this digital era, companies can make large profits through their user base, data and advertising without such a physical presence. Users of these services provide value via the data that platforms can then sell onto third parties, but with the outdated tax system, there is no way to apply corporate tax to this value.
Understandably, the taxation of revenue derived from the exchange of data is not straightforward, particularly due to the issues of valuation and the determination of where such revenue should be taxed. The Commission’s proposals look to address these issues.
The Digital Service Tax (“DST“) is a tax on revenue derived from the supply of certain digital services, and has been proposed as a short-term interim solution. Businesses caught by the DST are those which rely on user participation in digital activity, for example by:
- collection of data that can be used for targeted advertising; and
- users’ active and sustained engagement on multi-sided digital interfaces whereby the value of the service increases with the number of users using the interface.
The DST will be at a rate of 3% on gross revenue (net of VAT) and will apply to those digital service providers that meet one or both of the following criteria:
- the total worldwide revenue for a financial year exceeds €750 million; and/or
- the total amount of taxable revenue obtained by the entity within the EU during a financial year exceeds €50 million.
An entity that meets these criteria will be deemed a “Taxable Person” under the proposal.
There are certain digital services which will fall outside the scope of the DST, for example digital interfaces that supply digital content which is either owned, or has the right to be distributed by that service provider. This is different to services where users upload and share video content, which would be caught by the DST.
The Digital Presence Directive
This Directive provides for the taxation of digital businesses based on their “digital” rather than “physical” presence, and will apply to all entities irrespective of where they are resident for corporate tax purposes. A “significant digital presence” shall be deemed to exist in a Member State if in a given tax year, a business supplies digital services through a digital interface and one of the following conditions is met:
- the proportion of total revenues from the supply of those digital services to users in that Member State exceeds €7,000,000;
- the digital service has over 100,000 users in that Member State; or
- more than 3,000 business contracts for the supply of those digital services are concluded by users in that Member State.
A “user” will be deemed to be located in a Member State during the relevant tax period if he/she uses a device in that Member State during the tax period to access the digital interface through which the digital services are supplied. This would be determined by IP address or potentially other more accurate methods of geolocation.
Digital Services include services that are:
- delivered over the internet or an electronic network;
- where the supply is essentially automated and involves minimal human intervention; and
- that cannot be provided in the absence of internet technology.
Examples include the supply of digitised products such as software and software upgrades and online marketing sites (such as auction sites).
The proposed Digital Presence Directive applies to all cross-border activities within the EU and as such the Commission recommends that Member States extend this proposal to their double taxation treaties with non-EU countries. This would need to be done outside the BEPS multi-lateral instrument (“MLI”) process under which a single instrument is being ratified to change tax treaties of all participating countries to be compliant with the outcome of the BEPS project.
On 13 March 2018 HM Treasury released an updated report on the taxation of the digital economy (link). The paper highlights the need for change to international tax policy as a result of digitalisation, and whilst it does not set out the government’s final position, it does contain the latest thinking in response to questions raised in its original positon paper (link). In particular, the UK is adopting a procedurally similar approach to the EU, consisting of an interim measure (revenue based tax determined by the number of users in the UK) and a long term measure (taxing profits by reference to the value added by such participation) albeit the outcomes may differ.
HM Treasury has invited feedback from businesses and stakeholders to answer outstanding questions such as: how should user-created value be identified and measured? For example, if users frequently cross borders, then how will value be allocated amongst different jurisdictions and how will the user location be tracked/determined?
Media industry impact
The draft EU legislation primarily targets search engines and social media platforms, and so has the potential to impact tech and media giants that rely on users to generate revenue. In order for the legislation to be implemented, all 28 Member States will need to agree to the new tax proposals. As currently drafted, the proposal of the Commission is that the Directive will apply from 1 January 2020. Given that the UK is following its own approach, we do not anticipate that it will be implemented in the UK. Nevertheless this is subject to any finally negotiated withdrawal and transitional agreement with the EU.