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EU digital economy taxation proposal
By D P Sengupta
Mar 22, 2018

ALTHOUGH nothing new or revolutionary, some further developments have recently taken place in the area of taxation of the digital economy. The EU has been working on this for some time now and has come up with a plan. Interestingly, the document has been leaked and is now openly available in the public domain and there is no denial of the authenticity of this document.

[https://g8fip1kplyr33r3krz5b97d1-wpengine.netdna-ssl.com/wp-content/uploads/2018/02/taxation-of-digital-economy-2.pdf]

So, what's new in this document? Nothing very different from what India has already done despite a strong pitch by one member of the PM's Economic Advisory Council to wait for the Arbind Modi Committee Report on DTC. In this context it will be interesting to examine the plan proposed by the EU Commission. And the OECD is, very broadly speaking, EU minus the USA+ Japan and Korea. So, this is the view of the western market economies, excluding the USA.

Like India, the EU has also taken a long term and a short term view of the problem. In the long term, the EU proposes to move towards a digital PE concept. This has now been debated for a long time. Developing countries, particularly India have been advocating the same, mainly on the ground that the current rules of international taxation of business income are inadequate to tax the same in the source countries. And what does the EU think of the same?

According to the leaked paper, the post–BEPS consensus is that taxation should take place where value is created and that currently there is a mismatch particularly in the digital sphere regarding where value is created and where taxation of the profit takes place. As for the reasons of such mismatches, the paper identifies the following three factors

1) businesses can supply digital services where they are not physically established-(scale without mass (the newest buzzword);

2) the development of specific software such as social platforms which allow user interaction – reliance on intellectual property; and

3) the value from the business perspective comes from the participation of the users in the digital activities that they offer- the user value creation

India and China amongst other developing countries have been highlighting in the context of transfer pricing and profit attribution that some weightage should be given to the market which is not done in the current OECD obsession with functions, assets and risks. Ironically, this concern is also articulated in the paper although in a slightly different form. Ever since the paper by the French academics Colin and Collin, user value creation has been an aspect highlighted by the Europeans and in the digital context and it is interesting to note that the paper mentions as follows: “In particular, the problem is that input “user value creation” is located in a tax jurisdiction (market jurisdiction) where the company carrying out a digital activity is not physically established-nought established for tax purposes-and where the its activities thus cannot be taxed. This is so because the users' contribution to the value of a digital business is not sufficiently reflected in the current corporate tax framework.”

So, ideally, according to the paper, there should be a change in the rules agreed internationally. “The definition of a digital permanent establishment (PE) together with the rules for allocating profit from digital activities should be inserted into the OECD Model Tax Convention, which would then be translated into countries' tax treaties. This would ensure fairer taxation and a level playing field globally. The EU should encourage and support a move by global partners in this direction and set out the EU's vision to serve as an example to influence the influence international discussions in the direction we want to see.” Then, how different is the EU proposal from the significant economic presence test proposed and adopted in the Indian Budget of 2018?

It is also interesting to note what the EU proposes to do to bring in a coordinated response by the EU members to the long term problem as posited above. The EU is primarily focussed on the maintenance of the single market and for prevention of any action that disrupts such a market. It achieves that objective through the issue of directives that the member states then adopt in their national legislations. In the context of the digital economy, the EU Commission therefore proposes to issue a directive as follows:

“The commission should propose a Directive with common EU rules for establishing a digital permanent establishment (PE) and for allocating profits to digital activities of such PEs. Member States will have to implement the provision of these directive in the national CIT framework. The principle of the directive entails the application of corporate tax on profits resulting from providing digital services in the EU.

This Directive will address situations where there is a certain level of digital activity, but member states are currently prevented from taxing it, due to a lack of physical presence. This Directive will also address situations where there is currently a permanent establishment in a Member State but that permanent establishment is not taxed on the profits from the digital activity in that member state, due to limitations of the current profit allocation rules.” (Emphasis added)

The paper acknowledges that it will be difficult to implement the proposal in treaty situations. But if it is inter-EU member countries, the EU directive will override such treaties. No problem is also envisaged in situations where the transactions are between EU members and a third country with which there is no treaty. In other situations, to be effective, it will be necessary to renegotiate the tax treaties. One is not sure but this may be one of the reasons why there has been tepid response by most of the EU member countries to the whole hearted adoption of the non-optional articles of the MLI.

So, the EU proposes a digital permanent establishment rule which is not significantly different from the significant economic presence rule introduced in the budget in India although admittedly, its remit is not limited to the digital environment alone. As for the rules for triggering such digital PE, it has been proposed in the EU paper as follows:

1) Where a foreign company ,by itself or together with its associated enterprises, derives realised revenues from digital services in a member state exceeding Euro 10000000 in a tax year:

2) The No. of active users of the digital service in a member state in a tax year exceeds X; or

3) The No. of online contracts concluded exceeds Y.

Note that in the significant economic presence introduced in India also, the criteria are more or less the same. Here, the newly inserted definition of significant economic presence shall mean––

“(a) transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed; or

(b) systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means:

According to the EU paper, the fundamental principle for profit allocation should be that taxation takes place in the jurisdiction where value is created. The paper also states that sticking to the current rules for profit allocation, which are based on the risks managed, functions performed and assets held by the PE, is unlikely to offer effective solutions for digital PEs and would not lead to much additional tax on profits because a digital PE is unlikely to undertake these functions, risks etc. on its own. It is pointed out that a digital platform does not require people on the ground performing significant functions in that member state to provide digital services in that member state.

Therefore, the EU paper proposes setting out some additional criteria specifically and exclusively targeted at activating profit to a digital PE, for example:

1) the user's engagement and contributions to the development of a platform;

2) the data collected from users in a member state through a digital platform;

3) numbers of users;

4) user-generated content.

This is an interesting perspective and the Indian rule makers may do well to keep a tab on the developments before coming out with its own detailed rules in regard to the attribution of profits to the SEP.

The EU report also proposes a short term solution to the problem, perhaps partly because of the political compulsion in addressing its relevant constituency. The Short term solution is proposed as a tax with a targeted scope, levied on gross revenues (with no deduction of costs) of a business resulting from the exploitation of digital activities characterised by user value creation. It is explained that the targeted measure should cover the business models where the mismatch between taxation of profits and value creation is more acute: revenues stemming from digital activities heavily reliant on user value creation. Thus, advertisement services consisting of valorisation of user data by making available advertisement space will be covered. This will affect companies like Facebook, Google Adwords, Twitter, Instagram and free Spotify. The second group of digital services proposed to be covered will be digital platforms/market places that heavily rely on the participation of end-users. This will affect companies such as Airbnb, Uber etc. The proposed tax would be in the region of 1-5% of the gross revenue.

It is clarified that services supplied for consideration consisting in the making available of digital content/solutions to users would not be in scope of the tax. It is also emphasised that the tax should be apply to both domestic and foreign companies and that the tax would apply when both the following thresholds are crossed:

i. Annual worldwide total revenue above EIR (750) million, at the level of the multinational group (similar to the application of the CbCR).

ii. Annual revenue from the provision of digital services in the EU somewhere in the range EUR 10 to 20 million. The lower bound of the recommended range of EUR 10 million is in line with the EU definition of small companies.

In the meantime, just a few days back (March 16), the much vaunted inclusive framework piloted by the OECD has come up with another 213 page document which it was supposed to present before the G-20 Ministerial meet. The OECD has thus adhered to the deadline. The new report now titled – Tax Challenges Arising from Digitalisation-Interim report -is a further improvement of the 2015 report on the digital economy. It reiterates much of the problems identified earlier. It also elaborates on the value creation concept in the digital environment under different scenario. But, is there any concrete proposal that the OECD proposes? The answer unfortunately is no.

There is just too much of difference between the members of the inclusive framework. From afar, we do not know, who is adopting what position. As we have seen from the earlier discussion, the EU members are in favour of some concrete action. From a developing country perspective what I find interesting is the following paragraph in the interim report:

“Inclusive Framework members recognise that they share a common interest in maintaining a single, relevant set of international tax rules.  As part of the next phase of their work, they have agreed to undertake a coherent and concurrent review of the “nexus” and “profit allocation” rules - fundamental concepts relating to the allocation of taxing rights between jurisdictions and the determination of the relevant share of the multinational enterprise's profits that will be subject to taxation in a given jurisdiction. In exploring potential changes, members would consider the impacts of digitalisation on the economy, relating to the principles of aligning profits with underlying economic activities and value creation.” (Emphasis added)

But any hint of any change in the allocation of taxing rights is a red rag to the USA. Not surprisingly, Steven Mnuchin, the US Treasury Secretary immediately responded through a Press Release: “The US firmly opposes proposals by any country to single out digital companies. Some of these companies are among the greatest contributors to US job creation and economic growth. Imposing new and redundant tax burdens would inhibit growth and ultimately harm workers and consumers. I fully support international cooperation to address broader tax challenges arising from the modern economy and to put the international tax system on a more sustainable footing."(https ://home.treasury.gov/news/press-releases/sm0316)

So, Ekla Chalo Re. Let's look after our interests first, of course keeping a careful watch over what others are doing in this regard.

 
 
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