Digital businesses have come under increased scrutiny from tax authorities around the globe ever since the OECD published its position paper on “digital economy” taxation and other anti-base erosion/ profit shifting measures in October 2015, and HMRC is no exception.
While the OECD and the US take the view that the “digital economy” cannot, and should not, be ring-fenced from the broader economy in shaping international tax policy, the UK has nevertheless decided to press ahead with its own digital economy-specific tax in the form of the 2% digital services tax (DST).
It has also introduced some changes to the UK tax treatment of intangible assets, including intellectual property (IP), which will also be relevant for digital businesses as they hold significant amounts of IP.
The UK is by no means the first country to have introduced a tax specifically aimed at digital businesses. Other countries, notably France, Italy, Hungary and India have already done so, albeit in different ways, and for different business models in some cases.
A similar 3% digital services tax is also being considered at the EU level, but its progress thus far (or lack of) suggests that it is unlikely to receive the required unanimity from all Member States.
Some US politicians have already criticised these UK developments, which comes as no surprise given their earlier objections to the proposed EU equivalent on similar grounds. In addition, the US may well consider retaliatory measures to address what it sees as an unfair targeting of large US parented tech multinationals by the UK and other countries.
Digital services tax (DST)
The most significant UK tax development affecting digital businesses is undoubtedly the new DST. In his 2018 Budget speech, the Chancellor announced the introduction from April 2020 of a 2% DST for social networks, search engines and online marketplaces with global revenues of at least £500 million.
The government expects to raise around £1.5bn over four years from the DST, which more or less coincides with the expected timeframe for its duration (approximately five years). The announcement made headlines after a year-long consultation with various stakeholders on an appropriate tax solution to address the challenges posed by a range of digital business models.
The DST is intended to be a temporary tax until a global international solution is reached, which will likely take the form of a corporate income tax on “virtual” permanent establishments (PE) of foreign tech companies.
It is not yet known when this will occur, but a review will be conducted in 2025 to see if the tax is still necessary in the light of any OECD-level developments that may have occurred in the interim.
Until then, the DST will apply from April 2020 to (i) revenues generated by social media platforms from targeting adverts at UK users, (ii) revenues generated by search engines from displaying advertising against the results of key search terms inputted by UK users, and (iii) commissions generated by online marketplaces through facilitating transactions between UK users.
The DST will not affect e-retailers, e-payment services providers, or online content providers; nor will it affect software-as-a-service (SaaS) providers, cloud computing businesses, financial services or TV/ broadcasting services.
Nor will it apply to the first £25m of relevant revenues, meaning that small businesses will remain unaffected. Low-margin businesses will benefit from a “safe harbour” in which they will either pay a reduced DST rate or, if they are loss-making, will not pay any DST at all. Thus, in practice, it is expected that the majority of businesses that might otherwise be caught should not be significantly impacted, if at all.
The DST will also be deductible for UK corporation tax purposes, although naturally this will only benefit larger tech groups with UK companies or UK-based PEs.
However, it will be outside the scope of the UK’s double tax treaties, meaning that if a non-UK resident company with a UK user base is taxed on its profits by another country, or another country imposes its own turnover-based tax on the same revenues, the DST will not be able to be credited against those foreign taxes.
What search engines, social networks and online marketplaces have in common, according to the government, is the fact that they all derive significant value from user participation.
Some might argue that this is an unconvincing technical justification for what is ultimately a political move to make sure that the larger tech multinationals are paying their “fair share” of tax.
In addition, the government’s policy of targeting user participation as a value creator per se will likely create uncertainty for businesses which rely on user interaction to some degree, thus giving rise to the question as to whether they would meet the criteria for an “online marketplace” for DST purposes.
So far, the proposals appear to be consistent with OECD recommendations for temporary taxes in that they are narrowly targeted in scope and limited in duration.
In a similar vein, the government intends to consult on how the DST can be proportionate and not unduly burdensome for affected businesses. However, it will also need to address other issues, such as how the DST will interact with other taxes (such as VAT) in order to address any double taxation issues, and also how DST will be reported and collected – particularly if a degree of administrative co-operation between tax authorities is required.
We anticipate that the government will address the proportionality issue and any unresolved areas in its forthcoming consultation on the design and detail of the rules, which is expected to be released in the next few weeks.
Income tax on offshore intangible income
From 6 April 2019, a new UK income tax will be directly imposed on offshore IP owners in respect of any intangible income referable to UK sales. This means that the offshore IP owner in receipt of such income will have to file a self-assessment UK tax return in order to declare such income instead of having the tax deducted at source by the payer of the income. This measure replaces HM Government’s earlier proposal for a royalty withholding tax in similar circumstances.
The tax will apply, for example, to royalties paid to an IP-holding entity in a low-tax jurisdiction by a (related or unrelated) foreign distributor for the use of the IP in selling products and services to UK customers.
The tax will not apply where, for example, sales are less than £10m in a given UK tax year, or where the non-UK tax paid by the offshore IP owner is at least 50% of the UK income tax that would otherwise have been imposed, or where the offshore IP owner has sufficient local substance and business activity, or is in a “good” treaty jurisdiction with the UK. A targeted anti-avoidance rule will apply to arrangements entered into on or after 29 October 2018 to avoid this new tax.
The new legislation is aimed at multinational groups which generate significant income from intangible property through UK sales and which have also structured their arrangements to shift income to low-tax jurisdictions. As such, it is likely to have limited practical effect, as most of the planning opportunities afforded by these types of arrangements have already been closed down.
Corporation tax on intangible assets: upcoming changes
For accounting periods beginning on or after 8 July 2015, a UK company can no longer benefit from corporation tax relief for amortisation of goodwill or any expenditure incurred in connection with unregistered trademarks, customer lists or customer relationships. The government intends to partially reinstate this relief with respect to acquisitions of goodwill in certain circumstances.
The government also intends to modify the UK tax regime for IP to ensure that any “exit” tax charges that crystallise in IP-holding UK companies on being sold out of a group will be able benefit from an exemption that normally applies to sales by UK companies of substantial (i.e. over 10%) shareholdings in certain circumstances. Further guidance on these changes is expected on 7 November.
Changes to Entrepreneur’s Relief
The Chancellor also announced some forthcoming changes to Enterpreneur’s Relief (ER). Although not specific to digital businesses, the measure will be relevant for UK resident executives and senior employees with a minimum 5% stake in one of their group companies, so it will be likely relevant for owners of smaller digital business groups and startups, rather than larger multinational groups.
Broadly, the new measures will ensure that the minimum 5% equity holding is a true material stake in the relevant company for a minimum two-year period (as opposed to one year under the current rules), and that the ER rules can no longer be exploited by, for example, having the company issue voting-only shares with no economic rights in order to attain the required minimum 5% threshold. An anti-dilution measure will also be introduced, with the intention that any external equity investment should not jeopardize the availability of ER.
An unusual feature of both the DST and the new proposed income tax on offshore intangible income is that they both seek to tax entities according to where their consumer markets are, rather than where they are tax resident, and are to be imposed on a gross income rather than a net income basis.
Such a feature raises questions of administration in terms of how the tax will be reported and collected, and possibly also whether there will be some sort of exchange of information mechanism between tax authorities to address the cross-border nature of the transactions involved.
Digital businesses should consider whether any of the above-mentioned new rules could potentially affect their operations. More generally, multinationals will also need to revisit their group structures to see if they are still capable of withstanding scrutiny from tax authorities in light of the evolving international tax landscape, of which the DST and the new income tax form a part.