How will dig­i­tal busi­ness mod­els be taxed in the future?

Svet­lana Schiel – Pho­to: Daria Pushkina

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.

About me and my guest

Dr Maria Cristina Caldarola

Dr Maria Cristina Caldarola, LL.M., MBA is the host of “Duet Interviews”, co-founder and CEO of CU³IC UG, a consultancy specialising in systematic approaches to innovation, such as algorithmic IP data analysis and cross-industry search for innovation solutions.

Cristina is a well-regarded legal expert in licensing, patents, trademarks, domains, software, data protection, cloud, big data, digital eco-systems and industry 4.0.

A TRIUM MBA, Cristina is also a frequent keynote speaker, a lecturer at St. Gallen, and the co-author of the recently published Big Data and Law now available in English, German and Mandarin editions.

Svetlana Schiel

Svetlana Schiel is a certified tax advisor and specialist in international tax law. She heads the tax department of a German telecommunications company. Furthermore, Ms. Schiel also advises private clients on international tax strategies.

Dr Maria Cristina Caldarola

Dr Maria Cristina Caldarola, LL.M., MBA is the host of “Duet Interviews”, co-founder and CEO of CU³IC UG, a consultancy specialising in systematic approaches to innovation, such as algorithmic IP data analysis and cross-industry search for innovation solutions.

Cristina is a well-regarded legal expert in licensing, patents, trademarks, domains, software, data protection, cloud, big data, digital eco-systems and industry 4.0.

A TRIUM MBA, Cristina is also a frequent keynote speaker, a lecturer at St. Gallen, and the co-author of the recently published Big Data and Law now available in English, German and Mandarin editions.