The Digital Economy and “Fair” Taxation: The time to act was yesterday

by Dina Scornos

Following the informal meeting of the Economic and Financial Affairs Council (ECOFIN) of the European Union held in Tallinn on 15 and 16 September 2017, the European Commission (hereafter referred to as the “Commission”), published the Communication on a fair and efficient tax system in the European Union for the digital single market (the “Communication”).[1]

Dina is a PhD fellow at the Institute for Tax Law at KU Leuven (Catholic University of Leuven, Belgium). She is conducting research in the field of the Digital Economy and International Taxation. She previously worked for a large tax advisory firm and a US law firm in Brussels, specializing in transfer pricing issues.

Context

The OECD report on Action 1[2], published in October 2015, acknowledged that the spread of the digital economy poses challenges for international taxation. However, despite the extensive length of the report, due to a lack of political consensus, no uniform recommendations were made. In effect, approaches to tackle the challenges faced were discussed but only in a very limited form.

Two years later, because of a lack of significant further developments in this area and EU member states seeing tax revenues disappear before their eyes, policy holders put this issue high on the political agenda during the informal ECOFIN meeting in Tallinn where the Commission was asked to put forward a uniform proposal to tackle the tax challenges resulting from the digital economy.

In its Communication, the Commission has proposed a two-step approach, embedding long-term objectives but also short-term objectives.

Long-term Objectives

The Communication states that a fundamental reform of the international tax framework is needed, bearing in mind that the underlying principle for corporation tax is that profits should be taxed where the value is created. In this respect, the critical questions that will need answering are the following:

  • Where to tax? (nexus): In this respect, the Communication puts emphasis on designing new nexus rules that would result in the “fair” taxation of all businesses. This should be achieved by reforming the permanent establishment rules on an international level;
  • What to tax? (value creation): In a digitalized world, it is not straightforward to determine what the value is, where it is created and how it should be measured. This should be mitigated by reforming transfer pricing and profit attribution rules on an international level.

At an EU level, the Commission is of the opinion that the Common Consolidated Corporate Tax Base (CCCTB) Proposal[3] is the ideal way forward to address the direct tax challenges faced by the digital economy. Although there is scope within the current CCCTB proposal to examine further enhancements to capture digital activities, the Commission believes that it provides an EU framework for revised permanent establishment rules and profit attribution rules using the formulary apportionment approach based on assets, labor and sales that should better reflect where the value is created.

Short-term Objectives

The Commission understands that revisions of the corporate tax framework through the CCCTB proposal will take time, taken into account the current lack of political consensus on the matter. Therefore, short-term objectives will also be considered to ensure that Member States do not continue to miss out on significant tax revenues. This is often referred to as the “quick-fix” solutions.

The following alternative short-term solutions are being considered:

  • An equalization tax on turnover of digitalized companies: This tax aims to capture income, generated from all internet-based business activities, that is currently untaxed or insufficiently taxed. This tax would be creditable against corporate income tax or would function as a separate tax;
  • Withholding tax on digital transactions: A standalone gross-basis final withholding tax would apply on certain payments made to non-resident providers of goods and services ordered online;
  • Levy on revenues generated from the provision of digital services or advertising activities: This would apply to all transactions concluded remotely with in-country customers where a non-resident entity has a significant economic presence.

The Commission is aware that further work is needed in this respect to ensure compatibility of these solutions with tax treaties, state aid rules, fundamental freedoms and international commitments under the free trade agreements and WTO rules.

Interestingly, at the ECOFIN press conference[4], the Deputy Secretary-General for Tax and Customs Policy pointed out that member states proposing the “quick-fix” solutions also supported the long-term solution, which means that they are ready to abandon them when they are no longer needed. As such, this seems to suggest that these solutions are temporary and will be revised or even abolished once the Commission presents its final proposal (presumably in the context of the CCCTB proposal (see above)).

What’s next?

The objective of the Commission is to present by the end of this year Council conclusions setting out a coordinated EU approach. These conclusions would be used to put forward proposals during the international discussions that are due to take place in April 2018 at the G20.

However, the Communication also clearly states that, in the absence of global progress, EU solutions should in any case unilaterally be advanced within the European Union and the Commission stands ready to present legislative proposals in this respect possibly by spring 2018.

Initial observations

Non-EU states/corporate representatives will most likely not welcome unilateral actions of the EU with open arms. As an example, Amcham EU[5] recently published a statement[6] on the Communication whereby it expressed that unilateral actions of the EU will threaten economic growth. From an economic perspective, their biggest concern seems to be with the concept of turnover (or equalization) taxes. Since they do not tax profits but revenues, these kind of taxes can result in a substantially reduced amount of company profits available for investment or reinvestment, with a negative impact on jobs and growth. In addition, there is criticism as to the inclusion of the digital taxation in scope of the CCCTB Proposal if this does not coincide with internationally agreed rules on value creation.

From an international tax law perspective, the Commission will need to consider whether newly developed taxes (such as the quick-fix solutions) will fall (or not) within the scope of existing tax treaties. It seems, at first glance, that both a withholding tax on digital transactions and an equalization tax on turnover of digitalized companies aim at taxing income (or at least certain elements of income) earned by non-resident companies.

Assuming that existing tax treaties contain article 2 of the OECD Model Tax Convention,  a new tax would fall within the scope of the treaty when (i) it can be considered as identical or substantially similar to a tax listed in the tax treaty or (ii) it can be classified as a “tax on income or capital”, irrespective of the way it is levied or the name that is attributed to the new tax. If a newly imposed tax would fall within the scope of existing tax treaties, it would need to be designed as such that it would comply with articles 7 (i.e. taxation of business profits only in case of a permanent establishment) and article 23 of the OECD Model Tax Convention (i.e methods for eliminating double taxation) if such provisions are included in the treaty under review.

From a European tax law perspective, if the Commission intends to introduce quick-fix solutions through secondary EU law (which seems to be the case), this should, in principle, rarely result in incompatibility with primary EU law since secondary EU law is assumed to be in line with primary EU law unless there is proof to the contrary.

It will be interesting to see how the Commission will further design the quick-fix solutions (that are intended to be temporary), adapt its CCCTB Proposal to include digital taxation and how this will interact with further proposals made at the OECD level.

[1] https://ec.europa.eu/taxation_customs/sites/taxation/files/1_en_act_part1_v10_en.pdf

[2] http://www.oecd-ilibrary.org/docserver/download/2315281e.pdf?expires=1507794895&id=id&accname=guest&checksum=FB28C1DE46A0DB5F9C858C3D1BC34343

[3] https://ec.europa.eu/taxation_customs/sites/taxation/files/com_2016_683_en.pdf

[4] https://www.eu2017.ee/political-meetings/ECOFIN

[5] The American Chamber of Commerce to the EU

[6] http://www.amchameu.eu/sites/default/files/press_releases/20170926_press_digitaltax_final.pdf

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