Despite the fact that digital business models have created an unprecedented amount of shareholder value in the last decade, they are taxed at a surprisingly low level in the countries where they have the most customers. This has become the subject of heated public debate and has led to a number of regulatory initiatives, such as the OECD’s ‘Base Erosion and Profit Shifting’ (BEPS) 2.0 project. What impact will that initiative have on the relationship between digital service providers, consumers and tax authorities? Will the use of blockchain technology bring new opportunities to corporate tax enforcement by using real-time information from shared trusted data sources?
In the latest of her Duet series, Dr Caldarola, author of Big Data and Law, and tax expert, Svetlana Schiel, consider new developments in corporate tax laws as well as related future challenges.
Let us start by briefly introducing BEPS to our readers as well as by providing them with an overview of the current challenges due to today’s corporate tax law, national unilateralism and its consequences.
Svetlana Schiel: In recent years, the triumph of the digital economy has triggered ‑albeit with a slight delay- fundamental changes in international corporate tax law. One important challenge is that the ‘place of value creation’ is less easily identified in digital services in comparison to traditional services. For this reason, should we be looking at the location of the provider or the place of residence of the consumer of digital services? Or the place where the servers are located? The interpretation of these questions has a massive impact on whether and where digital businesses- which are now among the most valuable and profitable companies in the world- tax their earnings.
As early as 2015, the OECD identified special “challenges in the taxation of the digital economy” (“BEPS 1.0”). Since then, numerous countries have introduced unilateral digital taxes, which have done little to solve the underlying problem. This situation has led to heated debates – for example in Germany – about the local tax rates for companies such as Google (3.6 percent in 2020) or Netflix (0.3 percent in 2020)- as seen in the media.
In order to avoid a ‘patchwork’ of national unilateral efforts, the OECD initiated the BEPS 2.0 project at the beginning of 2019. A major goal has been to develop a globally coordinated taxation concept that could address the challenges of the digital age. At the same time, it cannot be in the public interest to create a huge tax bureaucracy, thus endangering the evolution of new digital business models. Therefore, smart concepts are needed to render the taxation process as efficient, fair and feasible as possible. Two large thematic blocks of the OECD initiative were brought together: Pillar 1 and Pillar 2.
I think it is important for us to first consider “data-driven business models” in connection with Pillar 1 and Pillar 2 from the OECD initiative and discuss past and future corporate taxation. In my opinion, business models based on data can be summarised in 3 categories. (a) trading data and trends – also known as self-interest and brokerage, (b) providing IT infrastructure for storing, processing and analysing data – also known as data facilitators and (
c) providing services based on data, predictive maintenance, etc. What challenges did corporate taxation face before the OECD initiative and what triggered its development?
The growing integration of national economies and markets in recent years has put a strain on the international tax framework that was conceived more than a century ago. Weaknesses have been revealed in the current rules that create opportunities for deliberate base erosion and profit shifting, thus requiring bold steps by policymakers to restore confidence in the system and ensure that profits are taxed where economic activity takes place and value is created.
Estimates suggest that global corporate tax shortfalls could be between 4% and 10% of global corporate tax volumes, i.e., USD$ 100 – 240 billion annually. There are many reasons for these losses, notably, the astute tax planning of some multinational companies, inconsistencies between the various national tax rules, a lack of transparency and coordination between tax authorities or limited resources for tax law enforcement in some countries. The fact that subsidiaries of multinational companies in low-tax countries report significantly higher profits (relative to assets) than their global corporations, demonstrates that tax optimisation can lead to real economic distortions.
Current double taxation treaties often define the profits of a foreign company to only be taxable if the respective company has a permanent establishment in that country to which the profits can be attributed. The definition of permanent establishments included in double taxation treaties is, therefore, crucial in determining whether a non-resident company is liable to paying taxes in another jurisdiction. For this reason, changes to what defines a permanent establishment are now also being used to address inappropriately circumventing the tax nexus, including the use of commission agents and the artificial separation of business activities.
We have also witnessed a patchwork of national solo efforts. Can you describe them and explain what problems they have caused?
Countries like Belgium, France, Italy, Austria, Spain, the Czech Republic, Great Britain and Hungary have started unilateral digital tax initiatives.
The UK, for example, introduced the so-called Digital Services Tax (DST) for companies that make their profit from search engines, social media and online marketplaces. What was the reaction to the new tax? Amazon simply passed the tax on to UK merchants in the marketplace.
This example shows that unilateral initiatives are only causing new problems: double taxation for companies, passing on costs to consumers, international political conflicts, to name a few.
Many countries – in particular the USA – have been suggesting that national digital taxes be abolished in favour of multilateral rules. In a joint framework statement of the USA, UK, Austria, France, Italy and Spain it was agreed that existing digital taxes be abolished, that no new taxes be introduced and that digital taxes already introduced are to be continued until multilateral rules come into effect – but that the digital taxes paid up to that point would be credited a later date. Observers emphasise that this measure only affects companies that are subject to the profit allocation of the OECD initiative, which is yet to be implemented.
Could you briefly describe the OECD initiatives Pillar 1 and 2?
G20 leaders endorsed a comprehensive BEPS action plan. This package of measures includes new or strengthened international standards and specific measures to help governments address base erosion and profit shifting. Interest and participation in the work of the OECD has been unprecedented, with more than 60 countries directly involved in technical groups and many more contributing to the processing of the results by means of regionally structured dialogues. Regional tax organisations, such as the African Tax Administration Forum (ATAF), the Center de rencontre des administrations fiscals (CREDAF) and the Centro Interamericano de Administraciones Tributarias (CIAT) have all participated, along with international organisations, such as the International Monetary Fund (IMF), the World Bank and the United Nations (UN).
Currently, participating states have agreed on implementing two main aspects of the OECD initiative. Hence, one refers to the ‘two-pillar approach’ to taxing digital businesses. In short: While Pillar 1 addresses the question where taxation is taking place, Pillar 2 covers the aspect of how much is being taxed.
Pillar 1 aims at the cause-based redistribution of taxable income between the participating states, supplemented by measures to avoid and settle tax disputes. It is intended to ensure that not only countries where digital businesses have registered offices receive taxes, but also countries where value creation or consumption of digital services takes place. The central question of Pillar 1 is: Where is taxation taking place? It is currently estimated that the provisions of Pillar 1 will allow a reallocation of taxable income of €125 billion per year.
The new taxation rights are based on the so-called ‘Amount A’. Amount A is used as a term outside of the existing transfer pricing system. It assigns a taxation right to countries even if digital businesses operating in these countries have neither a subsidiary nor a permanent establishment there. Amount A suggests that a portion of profits should be taxed in those market states. ‘Market states’ are countries in which goods or services are used or absorbed by consumers. The term ‘consumers’ in this context includes end customers (B2C) and suppliers (B2B).
While Amount A of the Pillar 1 represents a new starting point for the taxation of income outside of the existing transfer pricing logic, another new taxation right – ‘Amount B’ – addresses and simplifies the arms lengths comparison within the existing transfer pricing framework. Amount B gives countries a fixed taxable return when it comes to marketing or distribution activities.
Pillar 2 provides for a global minimum level of taxation through so-called Global Anti-Base Erosion Rules (“Globe Rules”). The central question of Pillar 2 is: How much is being taxed? The aim is to limit global tax competition. As expected, and despite some resistance, the states have agreed on a minimum tax rate of 15%. To ensure compliance with the minimum tax rate an ‘effective tax rate’ has been determined at the national level which can then augmented by so called ‘top-up tax’ instruments. The top up tax instruments will ensure a minimum taxation rate, e.g., through controlled foreign corporation (CFC) rules, rules about non-deductibility of operating expenses, or tax withholding rules. Pillar 2 is expected to generate additional tax revenues of €150 billion per year globally.
Pillar 2 is to be completed and implemented in 2022. Most regulations are expected to come into force in 2023.
Which companies are affected by the two-pillar approach? Will only the big and well-known tech giants be affected or will it be applied to every company that has implemented digital business models? In other words: Will small fish also end up in the net?
The application of the two-pillar approach depends on the volume of sales and the profitability of the corporations.
Pillar 1 affects global companies with a consolidated annual turnover of € 20 billion and a profitability of more than 10% (based on earnings before taxes). Any impact analysis is to be carried out at the segment level. The only exceptions are producers and processors in the raw materials industry and regulatory financial services.
Pillar 2 affects companies that have a group turnover of more than €750 million. The various cooperating states are said to be free to apply a minimum taxation (Income Inclusion Rule)- even for lower sales. The EU has not yet made a decision on the application of the minimum tax rate for lower sales.
Each state is fundamentally autonomous in how it wishes to design its own tax laws. If a state renounces its right to tax or its ability to tax, resulting in avoiding double taxation – what is wrong with that?
The appropriate taxation of digital business models is indeed a difficult balancing act between avoiding double taxation and avoiding non-taxation. Both scenarios, double and non-taxation, are detrimental to the global economy and the cause of both can be traced back to conceptually inconsistent tax systems.
Double taxation is commonly understood to mean the levying of comparable taxes in two or more jurisdictions on the same taxpayer for the same taxable object in the same period. This is a serious challenge, and the OECD has long been concerned with avoiding double taxation. The spirit of Pillar 2 and its minimum tax rate requirements is, however, designed to also prevent non-taxation resulting from the tax competition of some countries.
I would like to give a few practical examples. In the case of cross-border transactions, the countries concerned often apply different rules for the tax classification of certain financing instruments and legal entities. The tax effects of these different qualifications can – in addition to double taxation – lead to the following results if designed accordingly:
- “Tax deduction without corresponding taxation of income”: A payment qualifies as a tax-deductible expense in the country of the paying company, whereby this payment is not subject to any corresponding taxation in the country of the recipient.
- “Double tax deduction”: A specific payment can be deducted twice for tax purposes.
- “Indirect tax deduction without corresponding income taxation”: A certain expense is tax-deductible in the country of the paying company. However, the income in the recipient’s country is offset against an expense resulting from a separate hybrid arrangement.
In order to counteract tax advantages resulting from hybrid structures, the OECD has developed a series of linking rules and specific recommendations to coordinate the tax treatment of such structures in the countries concerned and to bring about one-off taxation.
What measures has the OECD foreseen under Pillar 1 to avoid the risk of double taxation?
The OECD wants to use mechanisms that have been already established in many double taxation agreements. For example, two countries are entitled to tax Amount A. To avoid double taxation, one state may waive taxation, i.e., allows exemption from taxation, so that taxation would take place in the other state (the so-called exemption method). Alternatively, one country credits the tax due in the other country accordingly (the so-called credit method). The decision to use one of these methods is ultimately at the discretion of the country of residence (usually the place of management).
The first results since Pillar 1 and Pillar 2 have come into effect have been the subject of intense discussion. What have been the biggest practical issues since their implementation?
A number of challenges are related to political feasibility as well as practical implementation.
The political challenges in question result from the need to coordinate and establish a truly global framework that goes far beyond the adjustment of double taxation agreements. This is particularly complex since the framework will also apply to countries, where a double taxation agreement is currently not in place.
The practical challenge faced by both companies and tax administrations, is to implement complex changes in tax legislation for new digital business models. A specific practical challenge being discussed with regard to Pillar 1 is the concrete definition of the (segmented) tax assessment basis.
Moreover, the minimum tax foreseen in Pillar 2 only works when a tax base has been consistently defined. Otherwise, it may – again – lead to double taxation if two states have different methods of calculating the amount of taxable profit.
A pragmatic approach is meant to use a consolidated financial statement as a basis while adding a few adjustments as needed. It is, however, not yet clear which exact adjustments will be required.
How will digital business models be taxed in the future?
The digital age is reshaping the world of taxation completely. Not only is the relationship between taxpayers and tax authorities affected but also how taxes are paid globally and what information is accessible to whom. Using Pillar 1 as a model, profit reallocation leads to digital business models being taxed where consumers live.
Of course, the availability of trustworthy information about the consumption of digital services at the place of residence for tax assessment purposes still represents a major challenge for national tax authorities. It is, therefore, very exciting to see how blockchain technology, for example, could offer a completely new approach. While the providers of digital services would now have to report local usage data to the local tax authorities, a blockchain-based approach, for instance, would allow access of transparent and real-time accessibility of trustworthy data to the provider, the users as well as the tax authorities.
We are already familiar with this concept from the wage tax system (but without blockchain technology) where an employer automatically withholds wage taxes from the salary payment so that the employee in question does not necessarily have to submit a separate income statement to the tax authorities. Apart from that sort of situation, tax administrations having access to these kinds of blockchains could also conduct real-time tax audits and verify transfer pricing against actual transactions.
My opinion is:Svetlana Schiel
“Digital business models demonstrate the need for a truly global tax system. Exciting innovations like blockchain technology may become key enablers for that.”
Ms. Schiel, thank you for sharing your insights on the new developments in corporate tax laws which enable a much needed new system.
Thank you, Dr Caldarola, and I look forward to reading your upcoming interviews with recognised experts, delving even deeper into this fascinating topic.