Taxing the digital economy – a nettle the government is determined to grasp

Tue 13 Mar 2018

International tax systems inevitably lag behind changes in business practices, and the question of how the profits of digital businesses should be taxed between different jurisdictions is a thorny issue.  Indeed, in the UK, there has been considerable media attention given to large international businesses that pay little UK corporation tax, some of these businesses operating in the digital sector.   The current international tax system has set rules for how and where the profits of businesses should be taxed – but these are based on countries being able to tax the profits generated from a physical presence in the country concerned, which many digitalised businesses will not have.

At the Autumn Budget, the government published a position paper in which it put forward proposals for taxing the digital economy.  In that paper, the government argued that in a number of different digital business models, value is actually created as a result of the active participation and engagement of users of digital platforms.  This could include revenue generated from advertising targeted at individual users of social media platforms, or commissions generated form users of online marketplaces.

The government has now published an update on its position paper, reiterating its commitment to address what it perceives to be a clear misalignment between where digital businesses are taxed and where value is created.  The preferred long term option is to arrive at an international consensus, and some suggestions are made as to how the OECD model treaty should be updated.  However, there is also a clear indication that the UK is prepared to take unilateral action if necessary.  As an interim solution, the proposal is for a revenue based tax to be introduced.

Set out below is a summary of key points in the government’s updated position paper.

User created value

The international tax framework is based on the principle that profits should be taxed in the countries where value is created.  The UK continues to support that principle, but believes that digital businesses have important value drivers that are not currently recognised, in the form of user participation.   The government has identified a number of different business models where value is derived from the active engagement of users. Indeed, the core business may be the content which is actually generated by users, so that the nature of users’ contributions underpins the business’ ability to generate revenue.  An example given is a company that generates advertising revenue on a platform which allows users to upload and promote their own videos and audio content.  Such a business relies on users actively contributing content and interacting with other users, but this value is not taxed in the jurisdiction where the users are resident under the current international tax framework.  ‘Users’ are contrasted from ‘customers’ on the basis that there is a significant difference in the level of engagement and participation that users have with the underlying business.

Several different business models are considered in the paper, the common feature being that all raise revenue in local markets without the need for a physical presence. The business models considered include social networks, search engines, intermediation platforms, and online content providers.  Further work will be undertaken to look at other business models and to ensure that any tax is targeted at those businesses for whom user participation makes a significant contribution.  Businesses which have limited user participation may therefore be outside the scope of any such tax.

Having identified that value is being generated by users, the next problem is how that value should be measured.  The paper puts forward the idea that the measure should be a percentage share of the residual profit of principal companies in the group (i.e. profits after routine functions).  The suggestion is that it might be possible to include within OECD guidance set parameters for the share of residual profits for different types of businesses.  These profits would then need to be allocated between different jurisdictions in a way that recognises not only the number of users, but the activities of those users in the different jurisdictions.  The challenge will be to reach consensus on the manner in which profits can be fairly identified and split between jurisdictions in order to avoid double taxation.

Interim measure – revenue based tax

Given the complexity of the issues, it may be some time before an international consensus can be reached.  Therefore, the UK is keen to explore short term measures to increase the amount of UK tax being paid by those businesses deriving significant value from UK user participation, irrespective of any physical presence of the business in the UK.

At the broadest level, the proposal is for a revenue-based tax targeting the income generated by UK based users. The Government is clearly wrestling with a number of different approaches to appropriately define the scope of these fluid and dynamic business models. The Government have set out three different potential legislative approaches, but acknowledges that each has merits and possible pitfalls. Therefore, they are clearly looking to engage further with stakeholders in this sector to identify an appropriate combination of methodologies as well as a potential de minimis threshold to ensure that this targets the relevant audience.

Conclusion

Clearly the latest publication from the Government indicates that the UK intends to take a leading role in addressing the difficult question of taxing digital businesses. However, it is less clear as to how it should best go about establishing these new legislative principles while meeting the competing ambitions of protecting the UK’s status as a leader in this sector, but continuing to operate with the current restrictions of the international tax framework. It may be the case that the UK ends up going it alone and imposing a tax unilaterally – the UK has some form on this, having previously introduced the diverted profits tax.