Horizon 2020

Countries act to tax digital goods and services

Under the old model, “market” countries – that is, economies that are net consumers of remotely provided services and goods whose value depends on intangible assets – often find themselves unable to tax the profits that multinational groups derive from sales in their jurisdictions. In response, they have begun to respond by unilaterally implementing new levies.

For example, in July 2019 France enacted a new digital services tax (DST) of 3 percent on revenues from “digital services” earned by large multinational companies operating within its borders. In 2015, the United Kingdom adopted a 25 percent “diverted profits tax” (DPT) on profits that the UK tax authorities determine to have been diverted from the UK through “contrived arrangements” that erode the country’s tax base. Elements of the 2017 US tax reform were also aimed at transactions that shift profits from doing business in the US to related foreign parties. In particular, the “base erosion anti-avoidance tax” (BEAT) limited US companies’ deductions for base-eroding payments to non-US affiliates, effectively insuring some US tax on the profits used to fund these payments.

The OECD’s "two pillar" model

To forestall such unilateral action by individual countries, the Organization for Economic Cooperation and Development (OECD) and the G20 have been working to build a new consensus model for international taxation. In 2019, the OECD engaged in a major project to develop an international consensus on new principles for the taxation of multinational enterprises. Its proposals fall into two broad categories, known as Pillar One and Pillar Two.

Pillar Two contains proposals for global anti-base erosion taxes, that is, new rules to prevent tax evasion and ensure that profits are taxed at a minimum level in at least one jurisdiction. It proposes a minimum tax similar to the new US levy on “global intangibles low-taxed income” (GILTI), and a rule denying deductions for certain cross-border payments comparable to BEAT.

The more far-reaching changes however are in Pillar One, which proposes a new taxing right not based on physical presence. Under this system, a portion of a multinational group’s “deemed residual profit” would be taxable in market countries, regardless of the group’s physical presence there. The amount subject to tax would be determined based on a pre-agreed formula (e.g. a percentage of sales). The deemed residual amount would be profits above a baseline level. However, most of the detail of Pillar One – including, critically, the methods for determining deemed residual profit, baseline profit and the scope of applicability of the proposals – is yet to be determined.

US approaches proposed changes warily

The US is actively participating in OECD discussions on the Pillar One and Pillar Two proposals, but appears to be approaching any potential changes warily. It has also reacted strongly against the imposition of some unilateral tax measures, for example imposing trade sanctions on France in response to its DST. The risk of such uncoordinated responses to unilateral action by market countries is driving international cooperation. Thus, the OECD intends to finalize an agreed multilateral approach by the end of 2020. This will not have the force of law, but is likely to strongly influence law-making in many countries.

Cloud computing: how US rules are adapting

US rules for taxing cross-border transactions have similarly struggled to keep up with the digital economy. The increased importance of e-commerce and intangible assets make it easier for multinational groups to determine where their income is treated as earned, facilitating the shifting of profits outside US taxing jurisdiction. In partial response, the government substantially revised its international tax rules in 2017 as part of the Tax Cuts and Jobs Act (TCJA), adopting new provisions such as the global intangibles low-taxed income (GILTI) rules, foreign-derived intangibles income (FDII) rules and the base erosion anti-avoidance tax (BEAT). Each of these mechanisms addresses the incentives for multinational groups to move intangibles and profitgenerating functions offshore.

The US Treasury has recently proposed new rules to help protect US taxing jurisdiction over income from an increasingly important form of e-commerce: cloud computing. Sourcing rules are critically important in the US tax system, and these provisions would change how the US tax system determines whether cloud computing income is treated as “US source” rather than “foreign source”. For foreign taxpayers, income is generally only taxed if it is treated as “US source”, although for US taxpayers (who are in theory subject to tax on even non-US source income), sourcing rules are also important. If their income is treated as foreign source, creditability of foreign taxes is increased and the burden on income earned through foreign subsidiaries is reduced.

Proposed rules cover broad range of digital services

Historically, the US tax system has applied different source rules to income from services, sales, leases and use of intangible property. These mechanisms do not work well for e-commerce transactions (which often don’t fit into one category alone), making determination of source unclear or easy to manipulate.

The proposed cloud computing regulations would provide new rules for determining the source of income from digital content and transactions. What constitutes a “cloud computing transaction” is broad and includes not only infrastructure as a service (IaaS), software as a service (SaaS) and platform as a service (PaaS), but also streaming digital content (including books, movies, music and games), access to online databases and downloads of digital content.

The proposed rules do not change the importance of classifying a transaction in working out what source rules apply, but they do provide new guidance for making that classification. They determine whether transactions are leases or services with a multi-factor test; IaaS and PaaS would generally be classified as leases, whereas digital streaming or access to digital content would generally be treated as a service.

Plan changes tax profile of non-US businesses

Income from such leasing would be US source where property is used in the US; the source of services income is left unclear but under existing law it would presumably be non-US if the services are provided outside the US. However, the most important of the new rules in practice would be the one that applies where digital content is treated as sold (rather than leased or provided as a service); the sale will be deemed to occur where digital content is downloaded (i.e. where the end-user’s device is located).

Thus, non-US businesses that offer downloadable content to US customers will have US source income and thus potentially be subject to US tax. While treaty-eligible US sellers may be unaffected so long as they lack a physical presence in the United States, many non-US providers of digital content will not be eligible for treaty relief. As a result, this change will increase tax on offering downloadable content to US customers.