A Slice of the Digital Pie
Discussions about what governments want from digital corporations and what they can do about it.
A century ago corporations operated close to target markets to gain easier access to their customers. That is changing today, thanks to the internet. Through the infrastructure of the web, a business need not set up shop in the markets they service. The platform business model enables this structure.
Platform businesses facilitate interactions between multiple participants. Andrei Hagiu, (an Associate Professor of Information Systems at Boston University) refers to them as multisided platforms. He defines them as technologies, products, or processes that create value primarily by enabling direct interactions between two or more customer or participant groups. Imagine for instance the number of participants product platforms like Alibaba, Amazon, and eBay bring together, or asset sharing platforms like Uber and Airbnb.
With Amazon, for instance, the traditional business model would involve manufacturers listing their products in physical locations of store owners. However, with Amazon, buyers and sellers meet under one platform (over the web) that facilitates the exchange. The reward for facilitating this exchange is a commission from sales.
There are other revenue models used by platforms besides commission on sales. However, that is not the focus of this article.
Aleksandra Bal, a Senior Product Manager at Vertes Inc., has classified platform businesses into product platforms, service platforms, asset-sharing platforms, communication platforms, social media platforms, development platforms, and search platforms.
In these platforms, there are usually two or more players. We have the host of the platform, the customers and the users. The platform business operates in such a way that more value is derived by having more users and customers (termed "the network effects"). For instance, Facebook’s impressive number of active monthly users grew from 608 million in December 2010 to 2.23 billion in June 2018. Within that timeframe, Facebook’s advertising revenue grew from USD 655 Million to USD 13.038 billion. The reason advertisers are drawn to Facebook's platform is because of the large number of users to market their products.
Governments are increasingly interested in the platform business model especially because participants of the platforms come from their countries where the platform owners possibly have no physical structure. The current international tax rules operate in a way that without a physical structure in a country, a corporation is not subject to tax there. For instance, in the second diagram above, income Operating Co. receives from State B is not taxed there. State A taxes it. Although we can see a Local Sub in state B, its only business purpose is maintaining a warehouse for temporarily storing goods for onward delivery to customers. Under international tax rules, this function on its own is insufficient to make Operating Co. considered as doing business in State B.
State A has a preferential system of taxing entities like Sub 1. When Sub 1. Sublicenses the IP to Operating Co., Operating Co. gets a deduction of license fees from revenue made from State B online purchases. However the income at Sub 1. Level gets taxed at a low rate. Assuming Sub 1. licensed the same IP from Parent Co., the income received from Operating Co. is subject to a further deduction. If Parent Co. operates in a high taxed jurisdiction, there is more incentive to assign the IP to Sub 1 because Sub 1 will not have to pay license fees that will be subject to high taxes. Looking at the overall picture, the multinational enterprise's global revenue will have a lower effective tax rate by shifting income away from high taxed jurisdictions and putting the income in low or no taxed jurisdictions.
Going back to the above diagram the question governments around the world want to resolve is who gets to tax the resulting revenue from operating a platform business. Is it Parent Co.’s country where the company is registered? State A where Sub 1 is registered and owns the IP used in operating the platform? Or State B where the customers and users are resident?
In 2015, the OECD released a report on taxation of the digital economy. The report was part of 15 Action items designed to curb what is termed "Base Erosion and Profit Shifting" (BEPS). BEPS means actions taken by multinationals to leverage on the weaknesses of international tax rules by shifting profits from high taxed jurisdictions to low or no tax jurisdictions where they have little or no business activities. Countries expected that the OECD would address the physical presence requirement which is lacking for digital corporations. However, that was not the case. The OECD's focus was on tax avoidance strategies like for instance ensuring that maintaining a warehouse constitutes doing business where it is a core function in a corporation's business model.
Note that the question of taxation based on physical presence has to do with what country has the right to tax. Using the diagram above, if we say there is no physical presence in State B, it means business income isn’t taxable there. However, if countries decide to take the maintenance of the warehouse as constituting physical presence, it means that the business income resulting from sales to Country B residents is taxable in country B. Governments around the world want more than physical presence as a basis of taxation because digital platform corporations can easily circumvent it. For instance, the platform can operate in such a way that the products are not physical goods that need storage. In that case, Operating Co. can sell directly to country B residents.
The OECD has noted that countries could implement safeguards to avoid erosion of their tax base by digital corporations as long as they observe their international obligations under treaties. For instance, implementing a significant digital presence can make an entity taxable in a state regardless of whether it has a physical location there. Other safeguards include withholding tax on certain digital transactions or an equalization levy which is currently implemented by India. In India, resident persons are required to withhold 6% of gross payments ("an equalization levy") made to non-resident entities.
Country responses to platform businesses
Countries are implementing the safeguards discussed above in their local laws in two ways. The first is by expanding the meaning of doing business by introducing concepts like "significant digital presence" or "significant economic presence." The second is by applying a different type of withholding tax on digital transactions. This article will discuss a few countries' approach to taxing digital companies.
On March 21, 2018, the European Commission introduced two directives for taxing digital companies. The first directive introduced the concept of significant digital presence whereby digital companies are taxable in the EU when they have substantial interactions with users through digital channels. Affected companies are those exceeding EUR 7 Million annual revenue in an EU member state, or having more than 100,000 users in a member state, or executing over 3000 contracts for digital services with users in a member state. The second directive (which is intended to apply in the short term) introduces a 3% withholding tax on revenue derived from selling online advertising space, or performing digital intermediary activities, which facilitate the sale of goods and services between users, or selling data generated from user-provided information. Corporations affected by this second directive are those with annual worldwide revenues of €750 million and EU revenues of €50 million.
All EU Member states are required to approve these directives before implementation at the EU level. Denmark, Ireland, and Sweden were reported to oppose the directives, thus reducing the chances of implementing them at the EU level. However some countries decided to implement the directives at the national level. For instance the Spanish Government on October 19, 2018, presented a draft bill introducing a 3% DST in line with the EU directive. Spain reduced the threshold for application from €50 million to €3 million. In France the government has been under pressure by wide ranging protests opposing fuel tax increase. This perhaps necessitated the governments' urgency to introduce a DST as early as January 1, 2019. The Economy Minister Bruno Le Maire stated this on his twitter account.
In Australia, a Treasury discussion paper released in October 2018 floated the idea of implementing an EU styled interim measure for taxing digital companies.
The UK is also likely to introduce a DST effective from April 2020. Affected companies will have 2% of their UK revenues (derived from a significant value from user participation) withheld. A company is affected if annually it earns £500 million in global revenues from selected activities or £25 Million from selected activities linked to user participation in the UK. Selected activities are those conducted by platforms providing social media, search engine or online marketplaces. The first £25 Million of UK revenue earned is exempt from UK tax and companies have the option to elect an alternative calculation of DST.
As for India, the Lower House of Parliament passed a Finance Bill in March 2018. The Bill includes a proposal to amend domestic law incorporating the concept of “significant economic presence” through digital channels as constituting sufficient business connection to India. The government also intends negotiating India’s tax treaties to include this concept. Earlier in 2016, the Finance Act introduced a 6% equalization levy on advertising fees paid by an Indian resident to a non-resident when the latter received more than INR 100,000 (Approx. USD 1,390) the previous year.
In New Zealand, the Tax Working Group has recommended in an interim report that the government should consider implementing an equalization tax if many countries start moving in that direction.
These are just a handful of countries implementing various measures to tax digital companies with platform models.
Designing a strategy that addresses legislative changes
If digital corporations are to remain competitive, their business model must acknowledge the role changing tax rules play in their overall operations.
If various countries continuously apply interim tax measures, affected digital companies should consider the following:
1. Map out jurisdictions producing the most revenue
Countries are rolling out digital tax rules with variations. It is essential to know the countries whose users and customers bring the most revenue to a company. Such knowledge helps to determine what tax rules are in play. For instance, in the case of the UK, if Parliament eventually approves DST, a platform that receives significant revenue from online sales to UK customers will have 2% of its revenue withheld. A company can know this information by using technology that detects the internet protocol (IP) address of customers.
2. Consider the possibility of maintaining a physical presence
The target of the rules discussed above are corporations with no physical presence in a country. In India specifically, a Senior Tax official has noted that the equalization levy will not apply if a corporation registers a permanent presence. A corporation should consider weighing the tax cost of registering as a business in a country or not. If the profit margin is low, or an entity is in a loss position for various business reasons, it makes sense to register as a business and get the benefit of paying tax on net income rather than on gross income which does not consider business expenses. The model below gives you a high-level way of making that decision. It uses the proposed UK 2% DST withholding tax and 19% corporate tax to make the analysis.
In the first chart, we can see that a company with a medium to high-profit-margin will find it better to pay an equalization levy or withholding tax rather than registering as a business and paying tax on net business income.
In the second chart where the company has a low-profit-margin and could make losses in the future, it makes more sense to register as a business.
Note that the analysis changes depending on the withholding tax and corporate tax rate in a given market. Thus it is advisable to seek counsel from a tax professional.
3. Factor-in tax cost in contract sums
In most country rules, the responsibility of withholding usually falls on residents making payments to non-resident digital companies. To avoid surprises, it is crucial that digital corporations incorporate tax costs into the contract sum or include the same in standard contracts.
Modupe O. OTOIDE is an International Tax Consultant and licensed attorney in the State of New York and Nigeria. She has a graduate degree in International Taxation from the New York University (NYU) School of Law. With her vast knowledge of regulatory and tax law, she has worked assiduously to structure commercial and corporate transactions to ensure profitability of business enterprises in various sectors of the Nigerian economy and the US. She currently works with a Fortune 500 company where she researches, develops, and executes international tax planning strategies for taxable and tax-free mergers and acquisitions, divestitures, corporate restructuring, and cross border financing.
She researches and writes on the global economy and how changing tax rules affect competitiveness and profitability of businesses.
In her spare time she loves travelling and exploring different cultures of the world.
You can follow her on the following social media platforms.
LinkedIn: Modupe O. OTOIDE