Andrew Cousins Published in TP Week: A UK Digital Tax Risks Unintended Consequences for Businesses

Speaking to the Conservative Party conference in Birmingham on October 1, 2018, UK Chancellor Philip Hammond reiterated the statement that in the absence of international agreement “the UK will go it alone with a digital services tax of its own”. His comments reflect the widely-held perception that the existing tax system is ill-equipped to assess highly digitalized multinational companies such as Facebook, Amazon and Google. 
 
The warning adds to the growing sense that a UK digital revenue levy is on the government’s cards. Since the Autumn Budget in November 2017, when the government announced changes to withholding tax targeted at digital multinationals, it has called for an update of the global tax standards to reflect the value of user contribution on digital platforms, as well as setting out a plan to explore interim measures to increase tax revenues from digital businesses. Then, as now, the message was: “If necessary, the government is prepared to act alone in the absence of sufficient international progress”. 
 
Released the same time as the Autumn Budget, the Treasury’s position paper on corporate tax and the digital economy, subsequently updated in March 2018, explained how the government would like to explore ways in which user contribution can be better reflected in existing rules through possible changes to both the permanent establishment and the transfer pricing rules. In the absence of such reform, the paper stressed the need to consider interim measures such as revenue-based taxes and stated the government’s receptiveness to work with other countries on their design. 
 
Mel Stride, financial secretary to the treasury, stated to The Guardian in August that “we have a strong preference for moving multilaterally” but that “in the event that that doesn’t move fast enough for us then this is something we could consider doing unilaterally, or perhaps with a smaller group of other tax authorities”. Also, in August, commenting on the European Commission’s parallel proposals for a digital tax package, including an interim digital services tax, Hammond stated to Sky News: “The EU has been talking about a tax on online platform businesses based on value generated. That's certainly something we'd be prepared to consider”. 

The upcoming budget 

This mounting chorus has led some to speculate that the UK may introduce its own interim measures in this year’s Autumn Budget. However, with the specter of Brexit looming large, many are concerned at what a unilateral digital revenue levy in the British market would do for the UK’s global competitiveness. Hammond has set an earlier date for the budget this year, bringing it forward to 29 October, to steer clear of a clash with the final stages of Brexit negotiations, which are expected to culminate in a European Council meeting on November 17 and 18. 
 
A cautious budget might be expected from Hammond, given the doubts over Britain’s future trading relationships. The EU member states have still not reached an agreement on the introduction of an interim digital services tax within the EU, although the Austrian presidency is keen to have measures agreed on by the end of the year. At the very time the UK is in the throes of disentangling itself from the EU and looking to strike new trade deals, some might question what advantage would be gained from the unilateral introduction of a tax that is in reality primarily targeted at the US multinationals that dominate the internet, notwithstanding European assertions to the contrary. 
 
The US Treasury Secretary Steve Mnuchin has said before that gross taxes on internet companies are “not fair” and, in his statement in March this year on the OECD’s digital economy taxation report, he made clear that the US firmly opposes proposals by any country to single out digital companies, insisting that “imposing new and redundant tax burdens would inhibit growth and ultimately harm workers and consumers”. 
 
Nevertheless, at the meeting of EU Finance Ministers held in Vienna on September 7-8, Hammond once again recited the mantra that there was a need for the large technology companies to pay their fair share of tax. However, recognizing the potential impact of the recent US tax reforms on the digital giants, in particular the taxation of US multinationals’ offshore income that effectively sets a minimum global tax rate for the companies, Hammond is reported to have told his fellow ministers that the situation has “evolved”, and that it is no longer about avoidance but about “allotment”. 
 
It is notable that the US has reportedly been prepared to engage in the debate on taxation of the digital economy at the OECD, with a shift of focus onto marketing intangibles and other means of profit allocation. That, however, falls far short of the UK’s proposals for a shift in taxing rights based on user participation and, in the absence of international consensus on the taxation of highly digitalized businesses, the British government seems determined to be seen as taking action despite concerns around Brexit. 
 
Fears of limiting growth have not held back other jurisdictions from introducing their own unilateral measures for addressing taxation of an increasingly digitalized economy. These have taken various forms: India, Israel and the Slovak Republic have sought to apply an alternative domestic permanent establishment (PE) threshold and a number of countries have now taken action outside the framework of income taxes to assert taxing rights over non-resident enterprises, with turnover taxes targeting revenue from online advertising services, e.g. France, India, Italy and Hungary. 

DPT not enough to target technology giants

The UK has demonstrated a willingness to act unilaterally in the past, as it did in 2015 by introducing the diverted profits tax (DPT), even while the OECD was finalizing the BEPS project as a multilateral answer to the challenges of base erosion and profit shifting. Nicknamed the “google tax” from the outset, DPT was promoted as a measure to counteract the tax planning of the likes of Google and other global technology companies such as Facebook and Amazon, in artificially shifting profits offshore from the UK to low-tax jurisdictions. 
 
DPT appears to have had its successes as a deterrent against aggressive tax planning: Amazon announced in May 2015 that it would start booking sales from British online shoppers in a UK branch rather than in Luxembourg, as a means of avoiding DPT. However, the list of companies that have been publicly revealed as having faced a DPT inquiry from HMRC has been firmly based in the realm of bricks and mortar: the drinks multinational Diageo, the commodity-trading and mining company Glencore, the London Stock Exchange, Wi-Fi product manufacturer Netgear, and the Cooper Companies, manufacturers of contact lenses and surgical tools. The fact that the Treasury is considering the introduction of a digital revenue levy demonstrates the belief that DPT alone does not go far enough in raising tax from the internet giants. 
 
The introduction of DPT was a populist move undertaken by the government before a general election to undermine the opposition, albeit at a time before the Brexit referendum result led some to question the UK’s growth prospects. Hammond in his recent address to the Conservative Party conference expressed renewed concern at the challenge posed by the Labour Party and stressed that “we must answer their challenges with our own Conservative solutions”, a hint perhaps of further tactical tax measures designed to take the wind from the opposition’s sails. 

The scope of the digital levy

The digital levy would be designed to bring within the tax net a whole class of transactions relating to non-resident enterprises that are currently beyond the reach of the UK under existing tax treaties. While DPT is aimed at taxing profits that have been artificially diverted offshore through the avoidance of what is currently recognized as a permanent establishment, the justification for the digital levy has its origin in an entirely new concept. The British government’s view that user participation is an important value driver for certain types of digital business recognizes a source of value creation for business that has not been perceived to exist under established tax allocation rules. 
 
How the UK’s mooted digital revenue levy would work in practice remains to be seen. The Treasury paper envisages it as a tax on the revenues of digital businesses deriving significant value from UK user participation “to compensate for unrecognized user-created value” and as applying to such businesses wherever they are located and irrespective of the physical presence they have in the UK. The difficulties of designing such a levy are manifold. 
 
In the first instance, the UK must limit the effects of its tax to those digital businesses that it feels are constituted in such a way as to slip through the current tax net, in a way that improves the neutrality of tax borne by such businesses and other businesses, both digital and bricks and mortar. 
 
Complications arise from the fact that even the smallest bricks and mortar businesses are becoming increasingly digital, usually with some form of online presence. At the same time, larger businesses are making much greater use of digital data. For example, within the motor industry, by embedding Wi-Fi into their vehicles, allowing the vehicles to communicate with the internet, manufacturers are able to gather and analyse large amounts of data from their new models, which they use to improve their understanding of their customers’ behavior and to monitor the performance of their cars. 

The OECD recognized in its 2015 report on BEPS Action 1 (Addressing the Tax Challenges of the Digital Economy) that digitalization is a transformative process affecting all sectors brought by advances in information and communication technology. It acknowledged that it would be difficult, if not impossible, to ring-fence the digital economy from the rest of the economy for tax purposes because of the increasingly pervasive nature of digitalization. Any UK legislation that is too loosely drafted risks capturing unintended targets across a range of sectors and putting at a disadvantage the very British businesses that the government is seeking to boost. 

Three possibilities were outlined in the UK Treasury report for setting the scope of a levy on digital businesses deriving material value from user participation: 

Defining the channels through which users create value for a business by their participation and taxing the revenue streams of businesses for which such channels are most relevant.

Defining the categories of businesses deriving most value from user participation, e.g. social media platforms, search engines and online marketplaces, and taxing the revenue streams of businesses in those categories (e.g. respectively Facebook, Google and Amazon). 

Defining the revenue streams commonly generated from those categories of business, e.g. online advertising revenues or revenues from facilitating third-party transactions on an online platform and taxing any business in relation to such revenues. This presumes a clear definition of users, user participation and their identification, but the degree and character of participation by users varies significantly from one business to another and the belief that such criteria can form a coherent basis for taxation is far from universal. 
 
The government has expressed a desire to tax revenues that relate to users in the UK. While the relation to UK users of revenues from online advertising targeted at those same users is a simple link for the British government to make, when it considers a transaction through an online marketplace, it reaches no clear conclusion as to the identification of users and the allocation of taxing rights between the jurisdictions of buyer and seller. 

Double tax risks 

It is hardly surprising that the UK emphasizes its preference for a multilateral solution. If the suggestion for an interim measure were to be implemented unilaterally by the UK in anything like its proposed form, it would be contentious. The UK’s stance on the value of user participation is not widely shared by other countries and it is hard to imagine how double taxation could be avoided as the UK seeks to assert taxing rights over revenues of non-resident enterprises in third countries. 
 
The Treasury paper states that the government will ensure the tax is compatible with its double tax treaties and compliant with wider international obligations, but it is not clear how a tax that sits outside the framework of income taxes will be compatible with double tax treaties. Taxing rights on business profits under DTAs invariably tend to rest with the state of the enterprise’s residence unless the enterprise carries on a business through a permanent establishment in the other state. A unilateral digital levy on revenues associated with a concept of user contribution will inevitably impinge upon the taxing rights of countries applying a conventional approach to the taxation of income. It is hard to see how a digital revenue levy could fail to give rise to double taxation unless a relief mechanism is built in. 
 
Similarly, contentious issues could arise where users move from one jurisdiction to another. Aside from complicating the establishment of taxing rights between jurisdictions, the technical challenge presented to enterprises in tracking such movements are recognized by the British government, though it considers the challenges “manageable”. 
 
The government plays down the difficulties in collecting a revenue-based tax from businesses without any physical presence in the UK and yet the OECD reports that to date, based on admittedly limited information, the levels of revenue collected by other countries from turnover taxes appear to have been “quite modest”. The risk is that, far from leveling the playing field, the nature of the tax will mean that British businesses would bear the brunt of the levy rather than the non-resident multinationals. 
 
Given all these challenges, it would not be surprising if the UK preferred to wait for agreement on the EU’s proposed interim measure before going it alone. Were a unilateral digital services tax to be introduced by the UK, fears have been expressed that the losers would not be the avowed “global tech giants” described by Hammond, the likes of Facebook, Google and Amazon, but growing British tech businesses and entrepreneurs. 
 
The Treasury position paper sought to allay such fears with three suggestions for ensuring that the tax does not undermine its objectives for growth and innovation in the UK digital sector: 
 
The setting of a high de minimis threshold based on consolidated global revenues as well as revenues attributed to UK users, to ensure that the tax is focused on more developed digital businesses; Setting the rate of the tax at an appropriate level that recognizes that it will be applied to businesses with different profit margins and businesses that are making losses in trying to grow market share;

and 

The inclusion of safe harbor mechanisms to protect businesses with low profit margins or losses.

Even with those carve-outs, the fear is that a digital revenue levy risks unintended consequences if poorly designed. The digital giants that are the target of the levy are best placed simply to pass the additional cost on to the ultimate consumers, which may please retailers on the British high streets, but domestic digital businesses are likely to feel the cost and administrative burden of meeting such a levy more heavily, stifling growth and competitiveness. With the threat of disruption to trade that would be associated with a possible no-deal Brexit, and a desire to establish fresh trading links with the US, a unilateral digital levy from the UK is unlikely to be what British businesses need at this time. 

 
The digital levy also marks a significant departure from the arm’s length principle and belies a lack of confidence in HMRC and other tax authorities, acting alone or via the OECD, to address the taxation of the digital economy through existing means. 
 
A unilaterally imposed levy on digital services reveals a preference for a blunt instrument that can be implemented quickly, if not entirely effectively, over more sophisticated tools that would take longer to implement but might not have the digital levy’s negative effects. 
 
However, the real losers from a levy on digital services will be consumers of digital services, many of whom perceive non-digital services as vastly inferior and inconvenient, and who will simply pay the higher prices that will result from this levy rather than modify their consumption. This outcome would not surprise economists, but it might surprise more than a few voters. 
 
Presented as a policy intended to tax large and profitable digital service providers, Hammond’s digital levy might receive some popular support. However, seen for what it is – a policy that will inevitably increase prices of the most popular digital services – Hammond’s proposal will likely garner far less support, and might even incite more opposition, than he and his colleagues might have expected.

This article was written by Andrew Cousins, Director of transfer pricing and Ted Keen, Managing Director of transfer pricing at Duff & Phelps in London. Click here to read it on TP Week website.