The taxing question of the digital economy


Financier Worldwide Magazine

November 2018 Issue

The current international tax rules were not designed with today’s digital business models in mind. There is a strong global movement to update the rules but with, as yet, no consensus on how best to do this and how quickly it needs to be done. This article examines the problem of taxing the digital economy and the proposed interim and long-term solutions.

The problem of the digital business

During the 100 years or so that the international tax system as we know it has been around, companies have been, for the most part, subject to tax in the country in which they have a physical presence. But as technology has advanced, this system has struggled to keep up. The most obvious example of this is the digital economy, where digital business models may require little physical presence in a country (scale without local mass). The problem with these businesses is that there is no recognisable presence on which a tax authority can pin profit-generating activity.

This fact has not gone unnoticed. There is now a general consensus among Organisation for Economic Co-operation and Development (OECD) members that something needs to be done to the tax system to capture value generation properly. For the past decade, the focus has been on base erosion and profit shifting (BEPS) and how to eradicate stateless income, but there is a new kid in town, the digital business, and with it, the age-old question of nexus and profit allocation: what to tax, and where?

User participation

Digital business includes businesses that create value by user participation, usually data collection. Social media, search engines and online marketplaces are the three most obvious examples. In what is akin to a barter transaction, users receive free social or economic interaction in return for providing valuable data to the digital service provider.

But is this really that different from more conventional businesses? Is a free coffee for loyalty cardholders a digital business? What about rewarding customers who submit online product reviews? Plenty of ‘traditional’ businesses rely on collecting customer data. Is there really any difference between a store card which tracks spending, the store owner who posts free vouchers or offers tailored to your purchase history and a social media platform tracking and harvesting data from peoples’ ‘likes’ and time spent looking at posts?

The solution: unified or unilateral?

Although there is a strong global movement to update the international tax rules, unsurprisingly there is no unified view of how best to do this and how quickly it needs to be done.

Separate proposals for long-term change have been published by the UK, the European Commission and the OECD. The UK and the Commission have also proposed interim solutions where significant value is derived from user participation, the aim being to introduce a ‘quick fix’, pending long-term solutions being agreed.

Interim measures

The UK’s proposed interim solution is to tax revenues of digital businesses which derive significant value from UK-user participation. This would be aimed at particular categories of business (such as social media platforms, search engines and online marketplaces) and/or particular revenue streams (for example, from online advertising and digital intermediary platforms).

The EU has gone further, and has worked-up detailed legislative proposals. It proposes a new 3 percent digital sales tax (DST) to apply from 1 January 2020 on revenues created from activities where users play a major role in value creation, such as online advertising and sales of data generated from user-provided information. Worldwide and EU-minimum annual revenue thresholds would apply, and so companies with an annual worldwide turnover of more than €750m and total annual revenues from digital activities in the EU of more than €50m are expected to be hit.

In September, the European Parliamentary Committee on Economic and Monetary Affairs went further, recommending that the rate of DST be increased to 5 percent and its scope broadened to include supplies of digital content, such as video and audio, and online sales of goods or services via e-commerce platforms. It also proposed a ‘sunset’ clause so that the interim measure lapses on implementation of longer term solutions. Otherwise the concern is that, once countries are deriving revenue from DST and other interim measures, it may be difficult to abolish them.

Long-term solutions

The UK’s long-term proposal is for the reform of the international tax framework to tax profits attributable to user participation. Profits would be allocated to user jurisdictions only where there is a material user base being monetised by the business.

The Commission’s proposal is not just focused on value creation, but instead suggests fundamental changes to the profit allocation rules. Within the EU, taxable profits would include those of a digital platform which has a ‘significant digital presence’ in a Member State. A ‘significant’ presence is measured by reference to any of the annual revenues from digital services supplied to users in the Member State (which exceed €7m), the number of annual users of those digital services in the Member State (which is more than 100,000 users) or the number of business contracts for digital services concluded by users in the Member State (which is more than 3000). The proposal essentially introduces a new concept of a ‘digital permanent establishment’, which would give a country taxing rights over a company’s digital business carried on in that country, even if the company has no physical presence there.

The Commission’s approach has not been welcomed by the OECD. In the OECD’s view, what is needed is a ‘coherent and concurrent review’ of the international profit allocation and nexus rules. In its March 2018 interim report, the OECD noted that members had no clear view as to whether the digital economy could be ring-fenced for different treatment or if wholesale reform was needed, and thus it recommended no interim measures. The OECD stressed that any unilateral measures should be temporary, targeted and compliant with members’ international obligations.

The international reaction

Within the EU, the reaction to the proposals has been mixed. Generally, countries with large populations which stand to benefit are in favour. Smaller countries which do not have as many potential ‘users’ and those, like Ireland, which are net exporters, stand to lose out on revenue and, understandably, are less keen. Is a tax on turnover, rather than profit, fair on smaller exporting economies? Is the use of the number and location of users of digital services a robust and accurate measure on which to base taxing rights? Should the EU be going it alone, or should it work to develop new principles for profit attribution and nexus with its trading partners? With so many digital businesses headquartered in the US, is there a risk of US retaliation?

Next steps

There is mounting political pressure to ‘do something’, which means there will certainly be some change in the long-term. The US, which had previously been reluctant to support any reform of the taxation of digital business, is reportedly now on-board with the OECD’s review of the international tax framework. Pascal Saint-Amans, director of the OECD’s Centre for Tax Policy and Administration, described this as a ‘significant and important’ shift in opinion. The OECD is working toward a consensus report to be published in 2020. In the meantime, it will publish a further interim report on progress in 2019.

Although Austria, the current president of the European Council, has made it clear that the Commission’s work on the digital economy is a priority, and is reportedly pushing for a deal on the DST by the end of 2018, the key stumbling block is the need for Council unanimity on tax matters. President Jean-Claude Juncker is trying to solve that and has instructed the Commission to work-up plans for qualified majority voting on tax matters or, if that is not acceptable, on a list of particular tax issues, including the digital economy. That change would itself require a unanimous vote, however, which may not be forthcoming.

The UK, for one, is chomping at the bit to introduce an interim solution. In October, Chancellor of the Exchequer Philip Hammond said that if an international agreement cannot be reached, the UK will go it alone with a ‘digital services tax’ of its own. The justification for this is that “too much power is being concentrated in too few global technology businesses” and “the stalling [on a digital services tax] has to stop”. However, critics point out that any rash moves run the risk of hampering the UK’s growing number of tech start-ups, as they will be less able to shoulder the increased tax burden than their fellow ‘tech giants’, such as Amazon or Google, which are really in the government’s line of sight.

The ideal outcome

The rush to implement interim solutions is understandable, but worrying. The proposals put forward to date are blunt instruments driven by the desire to act fast and get a piece of the pie that is the digital economy. The OECD is right to instead focus efforts on long-term, consensus-based solutions.

Proposals for how and where digital businesses are taxed do not only affect technology companies. Any move away from the arm’s length standard for digital business could be the start of a slippery slope for other industries, and the idea that only technology companies are digital businesses is a myth. With century-old fundamental tax concepts at stake, reform should be carefully considered so that the new rules are robust and relatively future-proof.

While the attraction of immediate unilateral interim measures to tax authorities is obvious, their introduction would be complicated, unfair, carry a high risk of double taxation and may be difficult to repeal. The preferred solution must be the development of a long-term, consensus-based approach to profit allocation and nexus. But with that inevitably taking time, will and can countries wait?


Rose Swaffield is a tax associate and Zoe Andrews is a senior professional support lawyer at Slaughter and May. Ms Swaffield can be contacted on +44 (0)20 7090 3694 or by email: Ms Andrews can be contacted on +44 (0)20 7090 5017 or by email:

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