Making sense of conflicting tax rules for online and digital service providers
Even though each digital service provider differs from the next, all DSPs are forced to navigate a complicated, evolving and non-harmonized set of tax rules that govern their businesses around the world.
The most common DSP businesses that are impacted by such rules include online search engines, social media platforms, online learning and education platforms, digital content streaming, online gaming, cloud computing services and online advertising services.
The most common fact pattern here is a DSP who physically operates in one jurisdiction and provides digital services to persons, customers and clients residing outside that jurisdiction. My practice has experienced the impact and operation of these rules on a global basis and found that many of the issues are common for DSPs of all sizes. Here I hope to share those that are most common. The issues discussed below are not intended to be an exhaustive list, and it’s critical to understand that all of these rules continue to evolve.
Taxable presence or permanent establishment: Whether a company resident in one country has sufficient activities in another revenue source country to give rise to a taxable presence in that source country is governed by source country local tax laws. While each country uses its own laws to determine taxable presence, most trading countries around the world have entered into formal tax treaties with each other that specifically address, amongst other things, when a resident of one country has created a taxable presence in the other country. These treaties usually take precedent over source country laws governing taxable presence, which makes them the first and primary point of reference on the issue of taxable presence.
The language in international tax treaties that address the issue of taxable presence are known as “permanent establishment,” or PE, provisions. PE is a concept that is the cornerstone of any income tax treaty. PE provisions are generally standardized, as they are usually taken from model treaty language drafted by the Organization for Economic Cooperation and Development. The OECD provides draft treaty language, which usually serves as a starting point in international tax treaty negotiations and, as such, this model treaty PE language has become standard text in most tax treaties.
In general, if a resident entity in one country has a PE in the source country, all of its business profits connected with that PE may be taxed by the source country. Absent a PE, the source country cannot tax the nonresident business profits at all. Whether a taxpayer has sufficient presence in the source country to constitute a PE is determined by that specific treaty’s PE language. It’s important to note that PE language is only important if there’s a tax treaty currently in effect between the DSP’s jurisdiction and the source country. Some countries have either no treaties or few treaties. In these cases, the source country’s local laws govern the issue of taxable presence. It’s also important to know that even if a treaty exists, it’s very important to understand how the source country’s courts have interpreted the treaty’s PE language when applying it to a specific set of facts.
If a PE is deemed to exist, then transfer pricing rules are invoked to determine the appropriate allocation of profit. That’s not terribly bad if there’s a tax treaty with a named competent authority to prevent double taxation, but it can be extremely difficult if this dispute arises between non-treaty countries. The point is that PE for any DSP is something that must be anticipated and not dealt with retroactively.
Digital services tax: Over 120 countries are participating in an OECD- and G20-led effort to reach a consensus on updating antiquated PE rules via a digital services tax (DST) platform that equitably addresses the digitized economy. The G20 has basically agreed to let the OECD draw up detailed proposals by the end of 2020 which, if approved, would then be introduced into national tax systems and related tax treaties. Major trading countries are behind these measures because they very much wish to avoid unilateral DST measures that many European countries, such as France, have proposed. They fear, and rightfully so, that rushing to implement a mixed bag of conflicting DST rules could aggravate global trade tensions.
The OECD’s efforts focus on two “pillars” of reform. Pillar One addresses nexus issues by creating a new taxing right, or reallocation of taxing rights, for countries where a DSP has consumer interaction but little or no physical presence. It also seeks to address issues around complexity and dispute resolution. Pillar Two is the proposal for a new Global Minimum Tax Rate on Multinational Enterprises.
The logic is that these two pillars will operate together to eliminate the widely publicized methods that multinational DSPs employ to shift profits around the world to minimize their tax bills. These pillars are also designed to reduce the incentive for countries to lower their effective tax rates in an effort to attract DSPs interested in tax avoidance.
The primary issue with Pillar One, besides U.S. objections that it unfairly targets U.S.-based DSPs, is which DSP industries need to be included in Pillar One’s scope. Consensus must be created among countries that all wish to retain (or increase for those that are cynical) their existing income tax base. The conflict is to tax income that they might not currently be taxing but, at the same time, also make sure they don’t lose out disproportionately on taxing income from their strongest local taxpaying DSPs.
There is certainly a lot to sort out with DST as it evolves. It has also not been made clear how DST would interact with existing tax treaties that don’t envision the interaction of the DST with traditional PE concepts. As of the date of this article, the application of the DST is unclear. However, it will be very important for every DSP to stay up to date because, even if it does maintain a level global tax, the complexity will certainly stress systems and business plans to deal with it. There is now renewed momentum for the OECD to achieve a solution by the end of 2020, so stay tuned for developments.
Value added tax: The European Union as well as various non-EU taxing authorities have issued VAT levies on online services. These rules are not generally harmonized, but they do carry common features. The most common feature seems to be that the service is provided entirely digitally with no human involvement. An example of this in its purest form is a local country resident streaming entertainment from a server located outside their country. The DSP’s only presence in the resident’s county is digital.
Generally speaking, these rules shy away from levying a VAT on a digital service with a human component. These activities are often considered to be adequately addressed by existing VAT rules. For example, an attorney who is advising a client in another country would already be subject to that country’s VAT rules on service providers even if the attorney/client communication is entirely digital.
A related issue is local country VAT registration. When one is considered to be levying online services subject to VAT, one must register in that country in order to be legally permitted to continue doing business there. However, there are what are known as VAT “distance selling” thresholds. These are the enumerated income levels where VAT registration is required. For example, in Spain, this is €35,000 ($37,830) per year.
It’s very important for all cross-border DSPs to be keenly aware of these rules moving forward. Unfortunately, this will likely require a country-by-country review of VAT rules due to the existing lack of harmonization.
PE server issues: International tax rules regarding PE and server locations continue to evolve as well. OECD commentary offers the following general insights:
• Websites do not constitute a PE;
• Website hosting facilities should not produce a PE for the entity carrying on business through the website;
• Internet service providers should not represent an agency position and give rise to an agency PE; and
• Servers located in a jurisdiction for a suitably long period may be considered fixed and constitute a PE.
The OECD suggests that when an enterprise operates computer equipment at a particular location, a PE may exist at the server location even though no physical assets or personnel of the enterprise are present at the location of the server. Thus, at least in the OECD's view, fixed-place automated equipment that can perform important and essential business functions, such as a DSP server, may be sufficient to create a PE at the equipment location without the presence of a human asset.
Multinational DSP taxation is a complex topic, even without all the conflicting and non-harmonized rules. The fact that many of these rules, both in scope and practice, are largely unknown presents unwanted uncertainty. To avoid costly tax traps, especially non-resident country tax audits, a multinational DSP must be proactive in creating global expansion business plans that safely navigate the current tax and political environment.