How will dig­i­tal busi­ness mod­els be taxed in the future?

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:

“Dig­i­tal busi­ness mod­els demon­strate the need for a tru­ly glob­al tax sys­tem. Excit­ing inno­va­tions like blockchain tech­nol­o­gy may become key enablers for that.”

Svet­lana Schiel

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.