Tax in a digital economy



«Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate. Something interesting is happening».

-Tom Goodwin

Something interesting is indeed happening, and it has been happening for many years. The emergence of new intangible value drivers has revolutionized the way modern businesses are run, creating new business models typically characterized by the use of various digital products and services. These new business models are continuously challenging the existing "brick-and-mortar" based international tax rules on income, sparking debates on the suitableness of the rules in a modern global economy.

As information and communication technology has changed the way companies do business, the economy has changed accordingly. Although it can be difficult to distinguish between different types of economies with regards to tax purposes, the digital economy represents certain functions that could potentially be relevant from a tax perspective. This includes, among other things, the emergence of multi-sided digital platforms, as well as a dependency on customer and user data which can generate significant amounts of income through the sale of digital advertisements.

A common denominator for these functions – compared to functions in more traditional business models – is that the value is created digitally. This has been the source of many questions and global debates in connection to the determination of a market jurisdiction's right to impose taxes on digital business profits. Most tax treaties include an article stating that business profits shall be allocated to the state where the enterprise carries on business through a permanent establishment – a fixed place of business through which the business of an enterprise is wholly or partly carried on.

In this context, the billion-dollar question – quite literally – is what can constitute a fixed place of business when the business takes place digitally. 

Some guidance can be found in the OECDs commentaries on the articles of the Model Taxation Convention. According to the OECD, a distinction needs to be made between physical computer equipment which can be set up at a location so as to constitute a fixed place of business, and the data and software which is used by and stored on this equipment. This means that internet web sites for instance, which are made up of software and electronic data, are insufficient, while the physical location of tangible property like servers, which stores and facilitates access to the above-mentioned web sites, can constitute a "fixed place of business".

The use of servers as permanent establishments is, however, not particularly practical. Firstly, the enterprise needs to operate the server and have it at its own disposal through ownership or lease. It is not uncommon that an enterprise carries on business through the use of a server of an Internet Service Provider, which will typically fall outside the scope. Secondly, servers are highly mobile, meaning that moving them between different locations may prevent the place of business to be regarded as "fixed". Thirdly, the server does not necessarily need to be located in the market jurisdiction where the business income is derived, and can easily be used from another state.

In general, it is reasonable to assume that the international tax rules on income, as they are worded today, are unsuitable for allocation of digital business profits to the jurisdictions where the income is actually derived. This has been the basis for the OECD's extensive work to form a multilateral regulatory framework for cross-border taxation of digital business profits in recent years.

In October 2021 the OECD released a statement on a two-pillar solution to address the tax challenges arising from the digitalization of the economy. Nine months later, in July 2022, the OECD secretariat released a progress report on Pillar One Amount A, including a consolidated version of the comprehensive technical rules of the new taxing rights for market jurisdictions. These rules are meant to be implemented in a new multilateral convention expected to be in place in the course of 2023, and consist of the following components:

  • The scope rules, containing thresholds for ensuring that the provisions only apply to the largest and most profitable corporate groups through a quantitative and objective manner. Corporate groups with a revenue greater than EUR 20 billion during a 12-month period – adjusted proportionally to correspond to the actual length of the period – will be within the scope.

  • The special purpose nexus rules, identifying the market jurisdictions that are eligible to receive allocated business profits. This will be based on different quantitative thresholds, and is supported by detailed revenue sourcing rules which are meant to determine where a corporate group's revenue is actually generated.

  • The tax base rules, providing a methodology for calculating the profits (or losses) which will form the basis for allocation to market jurisdictions. A natural starting point will be the consolidated financial statements of the corporate group, followed by a limited number of book-to-tax adjustments, as well as a framework for carrying forward losses.

  • The profit allocation rules, containing a formula which is meant to allocate 25% of a corporate group's profits – that exceeds 10% of the revenues – to the eligible market jurisdictions. Allocation will be made in proportion to the amount of revenue that is generated in the jurisdiction in question, and will thereafter be adjusted for other taxing rights over the corporate group's residual profits.

  • The elimination of double taxation rules, eliminating any double taxation that might arise in connection to application of the new rules as an overlay to the already-existing allocation system.

Furthermore, the new multilateral convention will contain provisions requiring a withdrawal of all existing digital service taxes (DSTs) or relevant similar existing measures, as well as a commitment not to adopt said taxes or measures after ratification of the convention. Lastly, streamlined administration processes and innovative tax certainty processes will be included for the new tax rules connected to Amount A, and the basis for these rules are expected to be released in a separate report in October this year. Schjødt will continue to follow the development closely.

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