The taxation of the digital economy is part of the European Commission’s fair taxation agenda. From what we hear, the European Commission plans to tax large digital companies‘ revenues based on where their users are located. As a temporary measure, revenues from digital transactions are to be taxed at a common rate of between 1% and 5% until a more comprehensive solution is established for a new digital tax nexus within the existing corporate income tax framework. This EU proposal would not only distort corporate decisions but also hinder digital innovations.
Forthcoming EU action
The EU is convinced that there is a mismatch between where the profit is taxed and where value is created for certain digital activities, because the users‘ contribution to the value of a digital business takes place in a tax jurisdiction (market jurisdiction) where the company carrying out a digital activity is not physically established and where its activities thus cannot be taxed under the current corporate tax framework. The EU is expected to respond by:
- Implementing a digital permanent establishment (PE) as a new tax nexus, which is seen as a comprehensive solution for the taxation of profits in the digital economy.
- Introducing a new tax on certain digital activities as a temporary measure for the taxation of revenues from certain digital activities in the EU.
In so doing, the EU aims to prevent EU Member States from unilaterally adopting measures. Specific measures to tax digital companies have been taken in Hungary, Italy and the United Kingdom, for instance. These measures commonly aim to define taxable income or to levy surcharges on digital transactions. Such unilateral measures might hamper the development of the digital economy and the Single Market, and their respective effects on corporate decisions and tax revenues are still unclear.
However, establishing new nexus rules and new taxes EU-wide, all based on digital activity-related thresholds, contradict the idea of not ring-fencing the digital economy for tax purposes. The political aim should be an administrable taxation of corporate profits that does not distort corporate decisions and that paves the way for digital innovations.
Expected comprehensive solution: new digital permanent establishment
The EU regards the current definition of a permanent establishment (PE) and rules for attributing profit to PEs, which are based on the current OECD approach, as insufficient to deal with taxation of the digital economy, due to a lack of physical presence. To apply corporate tax to profits resulting from providing digital services within the EU, the EU seems to be considering the following approach:
- Implementing a new standalone directive with common EU rules for establishing a digital PE and for allocating profits to digital activities of such PEs in intra-EU situations between Member States (this would override the double tax treaties between Member States) and situations between Member States and third countries where no applicable double tax treaty is in place.
- Recommending to EU Member States that they update their income tax treaties in the same way in relation to all third countries.
A covered company would trigger a digital PE in an EU Member State, and therefore be subject to taxation on its digital activities, if it meets one of the criteria below:
- Realizing by itself or together with its associated enterprises revenues from digital services in a Member State annually exceeding a specific amount (EUR 10,000,000 is under discussion).
- Having active users of the digital service in a Member State whose number annually exceeds a threshold that has yet to be set.
- Concluding online contracts whose number annually exceeds a threshold that has yet to be set.
A definition of digital services for the purposes of the revenue criterion might be inspired by the definition of electronically supplied services that exists for VAT purposes.
The EU intends to deviate from the current rules for profit allocation, which are based on the risks managed, functions performed and assets held by the PE. Instead, the EU seems eager to propose setting out some additional criteria specifically and exclusively targeted at attributing profit to a digital PE, such as
- the users‘ engagement and contributions to the development of a platform
- the data collected from users in a Member State through a digital platform
- numbers of users
- user-generated content
Expected temporary measure: new tax on digital activities
The EU is also aiming for interim temporary targeted solution until the comprehensive solution is agreed on. This solution is likely to be the introduction of a new tax with a targeted scope, levied on aggregated gross revenues (i.e. no deduction of costs) of a business resulting from the exploitation of digital activities with a high involvement of users.
Revenues included in the scope of the new tax could be those derived from:
- Services supplied for consideration consisting in the valorization of user data, by means of making available advertising space or the sale of such user data (e.g. Facebook, Instagram).
- Services supplied for consideration consisting in the making available of digital platforms/marketplaces to users and where the users supply goods and/or services directly to each other (e.g. Airbnb, Uber).
The EU currently does not intend to include services supplied for consideration consisting in the making available of digital content/solutions to users in the scope of the new tax. This potentially excludes any electronically supplied service other than those referred to above, such as electronically supplied media, streaming, online gaming, IT solutions and cloud computing services (e.g. Netflix, Spotify with subscription). Considering the need for this new tax to be simple and applicable, the exclusion of making available digital content/solutions to users appears reasonable, given that user involvement is a grey area and it would be very difficult to ring-fence and to define which electronically supplied services should be in or out. This should prevent some legal uncertainty for businesses and tax administrations.
A covered digital activity could trigger the new tax if a business exceeds both of the following revenue thresholds:
- Annual worldwide total revenue above EUR 750 million, at the level of the multinational group to which the business belongs.
- Annual revenue from the provision of digital services in the EU (rather than in each Member State) somewhere in the range of EUR 10 million to 20 million.
The new tax is expected to apply to cross-border transactions between Member States and between third countries and an EU Member State (i.e. a business established in a third country supplying digital services in an EU Member State). However, it should also apply to pure domestic transactions within one EU Member State in order to respect the freedom to provide services and freedom of establishment according to the EU Treaties.
In the view of the EU, the new tax should be levied on the gross revenues (with no deduction of costs) of a business resulting from carrying out the covered digital activities during a given period. It will not be a transaction-by-transaction tax, but instead calculated by the business’s aggregated gross revenues.
There will be a single rate across the EU in the range of 1% to 5%.
It has to be noted that the combination of gross taxation and a relatively high tax rate can have a significant distortion effect. For instance, for companies with a 10% profit margin, a tax rate of 5% corresponds to a profit tax of 50%, i.e. an excessive taxation.
It is obvious that double taxation arises where the same revenues are taxed under both the new tax and the existing corporate income tax framework. The EU wants to mitigate double taxation only by deducting the new tax paid by a business in any Member State as a cost from the CIT base in its residence country. Apparently, it has discarded the option to credit the new tax against CIT, or the other way around, because it could be difficult to credit taxes with different tax bases (CIT is calculated on the basis of all revenues, not only those derived from certain digital activities). However, such tax credits or even tax exemptions are feasible and necessary to avoid double taxation.
With respect to third countries, the targeted measure should be applied to non-EU persons carrying out digital activities where EU users are involved, even after the agreement of a comprehensive solution (i.e. permanent new tax in third-country scenarios). Only after a Member State has included the digital PE in its income tax treaty with a third country should the new tax cease to apply to businesses from that third country.
A simplification mechanism based on the one-stop-shop model for declaring and collecting the tax at EU level could be introduced to minimize compliance burdens. This means that a taxpayer can register, declare and pay the new tax due in several EU Member States via one Member State, as is the case for VAT.