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Stefano Giuliano CMS Italy
Stefano Giuliano, Partner, CMS Law, Italy
In the first in a series of articles looking at all aspects of the digital economy, the author considers whether income taxes are the most effective and efficient way to tax this economy. Do we need a revolution in the tax system?
It is always challenging to write about something knowing that there are more questions than answers. With the comfort of being just some of the many facing the same problem, in this first of a series of articles we will provide a general overview on the status of the debate about taxing the digitalized economy. In the next parts of the series we will dive into some of the tax implications of technologies that are at the forefront of the digitalization process.
In the last few years there has probably been more discussion around the taxation of the digital economy than any other tax matter. Yet, notwithstanding the amount and depth of discussion, we are still facing a situation where there is no consensus on how it would be fair to approach the digital economy from a tax standpoint.
As part of the work carried out on the Base Erosion and Profit Shifting (“BEPS”) Project (in particular in the 2015 Action 1 Report), the Organisation for Economic Co-operation and Development (“OECD”) has recognized that digitalization, and some of the business models that it facilitates, present important challenges for international taxation and that some of these challenges, mainly nexus, data and characterization, are of a very broad nature.
At the same time, an important conclusion reached by Action 1 is that digital, or digitalization, is not something that should be ringfenced, but rather is a transformation that is affecting all business sectors. In the journey towards the identification of a fair tax system for the future, this should shift the focus from “the digital companies” to “the digitalization of the economy.” It is a matter of fact that, in discussions about these issues, and not only at OECD level, reference has increasingly been made to the latter and not to the former and, if there is any truth in the Latin saying nomina sunt consequentia rerum (“names are the consequence of things”), there must be a reason for that.
A further confirmation that this should be the right approach comes from the way “digital” is looked at in non-tax discussions. When recently asked, “What do we mean by the digital economy?” Vitor Gaspar said “The answer is—as the XXI century unfolds—the economy itself.”
In its Action 1 Report, the OECD analyzed three options to tackle the challenges raised by digitalization:
Ultimately, none of these options were recommended; however, it was concluded that, as additional safeguards against BEPS, countries could introduce any of these options either in their domestic laws (provided they respect existing treaty obligations), or in their bilateral tax treaties. Such conclusion was reached also under the assumption that the measures developed in the BEPS Project would mitigate some aspects of the broader tax challenges and that the implementation of the measures to address the value added tax/goods and services tax (“VAT/GST”) challenges (particularly the International VAT/GST Guidelines), would lead to a more effective and efficient collection of these taxes in the market jurisdiction.
Fast forward to the month of March 2018, and the OECD has issued its Interim Report on the challenges arising from digitalization. The Report reflects the work done by the Task Force on the Digital Economy and, overall, the progress made by the Inclusive Framework since the 2015 Action 1 Report.
Not surprisingly, there is little or no doubt on the need to continue to monitor how the digital transformation might impact value creation. However, there is a high level of uncertainty around the impact that data and user participation have on the creation of value. This has resulted in a lack of consensus on the need to change the existing tax rules as a consequence of the features that seem to be common to certain highly digitalized businesses.
The prevailing current of thought inside the Inclusive Framework can be described as follows:
Given the different views inside the Inclusive Framework, the conclusion reached has been to work towards a consensus-based solution on the rules on allocation of profits to the different activities carried out by multinational enterprises and on the rules on allocation of taxing rights between jurisdictions.
No consensus has been reached also with respect to the need for interim measures. On one side, a number of countries consider that an interim measure will give rise to risks and adverse consequences, irrespective of any limits on the design of such a measure. On the other, there are countries that, due to the lack of consensus on a global solution, are in favor of the introduction of interim measures, and believe that the possible adverse effects of such measures could be mitigated.
While the OECD was announcing the need for further work before reaching a conclusion, the European Union (“EU”) issued a “digital tax package” that includes proposed legislation, with the goal of reforming existing rules to tax the digital economy in a fair, growth-friendly and sustainable way; and, at the same time, proposed interim measures to generate immediate tax revenues.
In this sort of race to find a solution to the challenges posed by the digitalization of the economy, the EU thought that being a first adopter would put it at the forefront in shaping the global response.
The long-term solution proposed by the EU is to tax companies in each EU member state where they have a significant digital presence. According to the proposal, companies would become taxable if they reach one of the following thresholds:
As a short-term fix, the EU is proposing the introduction of an interim tax of 3 percent on revenues generated by companies with annual revenue of more than 50 million euros in the EU and more than 750 million euros worldwide. The tax would be applied to revenues arising from three main types of services, where the main value is created through user participation:
It seems that the key characteristics of the digital economy that are behind the EU proposed legislation are that digital companies are growing fast, rely less on physical presence and pay lower tax rates.
In addition, the EU looks at the existing rules as old and designed for “brick-and-mortar” businesses; and therefore inadequate to effectively tax profits generated by the digital economy.
In the middle of all of this, governments are proceeding with uncoordinated unilateral initiatives. At a high level, these initiatives generally fall into one of the following categories:
Although the EU has been working closely with the OECD, there seem to be differences between the ways they look at the issue.
It might just be semantics but the EU tends to refer more to “digital companies,” while the OECD is of the view that the “digital economy” is the economy itself.
It is a fact that “digital” is growing fast and does not need big plant or bulky machines to carry on business, but “digital” is not just “digital companies.” At the same time, the figures show that there are companies that pay low, or lower, taxes, but they are not exclusively those identified as “digital.”
In an environment where “street debate” is, at times, driving political actions, or reactions, roles and responsibilities should not be confused. Companies do not decide tax policies or tax rates, governments do. Companies choose where to go and, if there are countries that have set low corporate tax rates, should entrepreneurs be prevented from establishing their businesses, or companies from moving their operations, there? Make no mistake, we are not talking about “artificial” structures (those deserve a different discussion and should be the target of a different type of rules) but real business. We cannot forget, however, that in today's world real business is more and more likely to be something that relies less on physical presence, and grows rapidly.
Although very sensible, the decision of the OECD to take more time for the identification of a solution (the proposed deadline is 2020) is not working in favor of a quick, consensus-based, answer that would be beneficial for businesses, governments and consumers.
On the other hand, the EU move might create a number of issues that would be difficult to deal with. The lack of coordination of the proposed actions (interim and long-term) with the existing treaty network is likely to generate double taxation, and we know that double taxation is as bad as double non-taxation. There is a significant risk that the burden (all or part of it) generated by the interim solution might be shifted to consumers. Last but not least, interim solutions have often become permanent.
Uncoordinated initiatives would inevitably contribute to the creation of tax arbitrage and disparity, not only between companies, but also between consumers located in different parts of the world.
What seems to be happening is that the traditional tax framework is being shaken and the current way of thinking about tax is coming under a lot of pressure. With the pace at which the economy is reinventing itself accelerating ever more rapidly, corporate income taxes might be playing a catch-up game that they will never win. The result could be that at some point corporate income taxes (as we think of them today) would become residual and new forms of tax will be introduced.
The concept of residency, with the PE rules working as a sort of “modified residency”, has been the pillar of corporate income tax systems to establish taxing rights. This worked almost flawlessly in an environment where there was a substantial overlap between residency (primary or modified), functions and risks. In that environment, it was generally accepted and fair to allocate profits to the jurisdiction where functions were performed and risks were borne.
The digitalization of the economy seems to force reflection on the need to shift part of the value to where the customers/users are, irrespective of whether that is the place where functions/risks are.
One way of looking at it could be to challenge the concept of residency as the pillar of corporate income tax systems. Depending upon the solution adopted, however, this could lead to a different discussion: would the “to-be” tax still be an income tax? Would shifting value away from where functions and risks are change the nature of the tax?
If we wanted to be more aggressive, we should probably ask ourselves if corporate income taxes still make sense in a digitalized global economy? Not only whether they are technically the right answer, but, arguably more important, are income taxes the most effective and efficient way to tax the new “digitalized economy”?
This is not just a discussion about the use of data collected through social networks. There are endless types of “exchanges” that are being executed every second. Just to mention an example that usually would not capture the attention: car and aircraft engine manufacturers are today collecting data real time to improve the performance of existing products, fix problems or develop new products. Irrespective of where the legal entities collecting and/or using the data are, the data providers and the service recipients move around, sometimes to different countries, while data are being exchanged and services being rendered. Is the users' participation (and its value creation) in these transactions different from that happening through social networks? Should this type of “exchange” be treated differently? Where are those legal entities carrying out their R&D work? Where are services being rendered? Where should they pay income taxes? Is an income tax the best form of tax for these typed of transactions?
Some of the above might sound provocative but allow us to close this introduction with a further “unconventional” thought.
No matter how we look at this, reaching consensus on a long-term solution seems difficult; and, no matter how smart and talented the people working at this, the legacy of “traditional” income tax concepts seems to inevitably complicate the identification of a fair, neutral, effective, efficient and sustainable solution.
An interesting experiment would be to create a think tank made of young individuals with no legacy of everything that has been written and said on residency, permanent establishment, double taxation or double non-taxation, and see what they would come up with if they were asked to design a system to collect the money to run a country in a highly digitalized economy … or more correctly, in today's world.
Stefano Giuliano is a Partner with CMS Italy.He may be contacted at: email@example.com
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