Taxation of the digital economy – update Progress at OECD/G20 level
The internet has changed the economy. Billions of emails are written, social networking and video conferencing every day. Existing tax rules are outdated in the face of rapid progress in digitisation. To ensure fair competition, tax rules need to be reformed.
The basic problem
The current tax rules were designed for traditional companies. The starting point for taxation is the physical presence of the company in a country. For example, if a company has several locations in different countries, the distribution of profits and thus the distribution of the tax base is based on the place of value creation. An allocation of profits only takes place if it is a permanent establishment. In order to affirm a permanent establishment, local substance is required. The concept of a permanent establishment is no longer suitable for covering all places of value creation. Companies that operate online and generate value added online, e.g. generating profits primarily from user data, cannot be taxed effectively in this way. In the digital economy, value creation often takes place through a combination of algorithms, user data, distribution functions and knowledge. For example, a user contributes to value creation by sharing his or her preferences (e.g. “Like”) in social media. This data is later used for targeted advertising and is profitably used. The profits are not necessarily taxed in the country of the user (who also sees the advertising), but rather in the country where, for example, the algorithm was developed. This means that the user’s contribution to the profits is not taken into account when taxing the company. There is a separation – an incongruity – between the place where value is created and the place where tax is paid.
If a fair distribution of profits is not possible, tax distortions arise. The effective tax rate for digital companies is currently around 9.5 percent; the tax rate for traditional companies is around 23.3 percent. Loopholes between different national systems, combined with the mobile and virtual nature of digital enterprises, are sometimes used to reduce the tax burden significantly. It can result in companies paying almost 0 Euro tax in countries where they have significant market shares.
The current approaches to solving the problem go back to a debate lasting several years on the taxation of so-called digital companies. The debate started with the BEPS project of the OECD and the G20 countries.
Developments at European level
In 2018, the European Commission had proposed Directive COM (2018) 148 final for the introduction of a digital services tax, which was intended to establish a comprehensive, turnover-dependent tax of 3 percent on turnover from digital services. After considerable criticism of this solution, the proposed directive was rejected by the EU finance ministers at the end of 2018. A second EU Directive proposal (COM (2018) 147 final) provided for the introduction of a so-called significant digital presence. As a result, the concept of a permanent establishment in the respective national tax law was to be extended (“Digital Permanent Establishment”). This proposal was also rejected.
However, the current strategy of the EU seems to be to wait for the further development of the OECD’s BEPS project, as a global solution is considered preferable. However, if an agreement at OECD level fails to be reached by the end of 2020, the EU reserves the right to re-enter the debate on taxation of the digital economy.
OECD/G20 two-pillar strategy
At OECD level, the “Policy Note” published in January 2019 brought new momentum to the tax policy debate. In January 2020, the OECD presented a statement on the reorganisation of the taxation of digital business models. The proposals are integrated into a “two-pillar strategy”.
Pillar 1 – Allocation of “taxing rights”
In future, the first pillar intends to distribute taxation rights among the so-called market or user states. These are the states in which the users of digital services or their sales markets are located. It is therefore to be based on the place of consumption. It would be necessary to establish a so-called nexus in the respective state, through which the profits generated would be allocated to the companies. In this respect, the policy note announced that various concepts would be compared, including that of “significant economic presence”or “significant digital presence”, which was already included in the EU proposal for a directive COM (2018) 147 final.
The aim is to combine the individual proposals of the OECD on the taxation of digital business models into a consensus-capable uniform approach (Unified Approach). All countries should be able to agree to this by the end of 2020. At the beginning of 2020, the Inclusive Framework and the G20 finance ministers already agreed to the OECD statement.
Pillar 2 – Minimum levels of taxation
The second pillar consists of setting a global minimum level of taxation on corporate profits (Global Anti-Base Erosion Proposal, GloBE). It aims to prevent the shifting of profits through different tax rates in different tax jurisdictions. For example, an extension of the often already existing additional taxation in a form that would be equivalent to a “withholding tax on outbound payments” is being discussed. In addition, there are considerations which, in the case of inbound payments (services to Germany), provide for a limitation of the deduction of business expenses for payments abroad, provided that a minimum level of taxation is not reached. Here too, the Inclusive Framework and the G20 Finance Ministers have already given their approval.
The OECD proposals will only affect large global companies that prepare country-by-country reporting (Section 138a AO).
An agreement on the two-pillar model has been announced for the end of 2020. It is not yet clear whether an agreement will be reached. For German globally active companies, it should be noted that the first pillar could lead to a situation where parts of their previously domestically taxed tax base are shifted from a high-tax country to market and customer countries abroad, which may have a lower income tax burden. Pillar one could therefore lead not only to an increase but also to a reduction in the effective group tax rate. All globally active groups of companies that prepare a country-specific report (§ 138a AO) should quickly carry out an initial analysis of their impact in order to identify possible effects on their effective corporate tax rate.