Corporate Tax » Digital tax could affect all businesses

There is public consensus that multinational businesses should pay tax on their profits. There is also a feeling that certain multinational businesses are not paying enough tax in the UK, because too small a proportion of their global profits is being allocated to the UK for tax purposes.

In the Budget, The Chancellor announced the introduction of a “narrowly targeted” Digital Services Tax. It is indeed narrowly targeted, focused only on businesses that provide social media platforms, search engines or online marketplaces and generate annually more than £500m of global annual revenues and £25m of UK revenues from these activities.

DST will be 2% of UK revenues from in-scope activities and is expected to raise £400m a year.  So the businesses to which it applies are each expected to incur quite significant tax bills. Most businesses probably think that DST is not something that affects them. And they would be correct, up to a point.

The problem with DST, however, is that it is going to be very difficult to define the scope of the new tax.  The consultation document issued by HM Treasury asked many of the questions that tax experts were asking when the DST was announced.

How should the in-scope business activities be defined?  What if a group also carries on out-of-scope activities?  TV and music subscription services are out-of-scope, but what about games?  If selling your own goods is out-of-scope, but providing a marketplace for third party goods is in-scope, how does a mixed business allocate revenues between the two activities?

The cliff-edge nature of the tax means that it will be essential that the method for calculating relevant revenues is clear.  But how does one calculate UK-generated revenues in relation to business models that rely on user participation or content, and derive most of their revenue from focused advertising and data collection, rather than fees payable by users?

Is a UK user someone resident in the UK, someone accessing content from the UK, or someone using a UK IP address?  What about advertising that is focused on attributes other than the location of the user?

DST is not going to be an easy tax to introduce.  And the fact that its target is so narrowly focused (for example, most of the targets are US groups) means that it could become a political hot potato.

The new tax will come into effect in April 2020, unless an alternative globally agreed solution emerges before then.  Herein lies the issue for all businesses.  DST is only meant to be a temporary fix, and it looks to be a pretty difficult one to implement.  Will the effect of its announcement lead to renewed enthusiasm for agreeing an alternative global profit allocation model?  If so, that will affect all multinational businesses.

Interconnected world

Profit allocation for tax purposes is currently determined by a complex matrix of international tax treaties which date back to the 1920s. These were simpler times, and the rules allocate profits in accordance with physical presence in the country concerned.

An important UK case concerned a winemaker selling champagne from his French vineyard to UK customers. It held that, as he was trading “with” the UK, not “in” in the UK, his profits should be taxed in France rather than the UK. Having UK customers does not of itself create a taxable presence. Of course, if he wanted to expand his UK market, in 1896 he would eventually have either opened a UK shop or appointed a UK agent, giving him a UK taxable presence.

How business has changed. In today’s digital economy our French winemaker need only set up an online presence to service the UK market. He might (particularly given Brexit) set up a UK warehouse, but storage of goods is not usually sufficient to amount to a taxable presence. There is no longer a need for a taxable physical presence in the UK to sell to UK customers.

We also now live in a market dominated by hugely valuable international brands. The arm’s length principle, which is used to determine how profits are allocated, therefore allocates a significant proportion of profit to brands and technology, but these are intangible assets which are unlikely to be located in the same jurisdiction as the customer.

The current tax system undoubtedly favours jurisdictions that develop intangible assets to be exploited internationally. There is understandable pressure to share more of the tax cake with to the customer’s jurisdiction, but developing a new internationally recognised formula for doing this will take time. It involves difficult negotiations between the jurisdictions where these intangibles are traditionally developed and jurisdictions with large markets of potential customers.

Getting a new allocation model right is not going to be quick or easy, but it is going to be important, not just for the digital economy, but for all multinational businesses.