What is a digital business?
The UK's DST targets certain types of business activity, being social media platforms (including dating websites), search engines and online marketplaces. Revenues derived from these activities will be taxed in the UK if (i) the global business has more than £500 million of global revenue from the activities and (ii) more than £25 million of that revenue is linked to the UK i.e. generated as a result of 'UK users'. There will be a safe harbour election if the group has low UK profit margins allowing an alternative method to calculate the tax due.
However, the OECD is taking a much wider approach, with a broader focus that includes consumer-facing businesses e.g. "businesses that generate revenue from supplying consumer products or providing digital services that have a consumer-facing element". This could catch large retailers and other businesses that operate digitally from remote locations. Certain carve outs are expected to be introduced e.g. for extractive industries and possibly financial services (which the consultation says will be considered further). An overall global revenue threshold e.g. of €750million that would prevent smaller businesses being caught by the new rules will also be considered.
How will profits be allocated?
The proposal under Pillar 1 suggests three possible amounts that could be allocated to market jurisdictions which go further than amounts currently allocated under the arm's length principle.
Amount A – there will be a new taxing right for those jurisdictions in which a 'digital PE' is created. Whether or not a digital PE is created will be largely based on sales; there will be country-specific sales thresholds to make it fairer for jurisdictions with smaller economies. A proportion of deemed residual profit (i.e. after the allocation of deemed routine profit) would be allocated to the digital PEs using a formula based on sales.
Amount B – the arm's length principle currently used to allocate profits to certain functions such as distribution functions that comprise the 'baseline activity' in a market jurisdiction may be replaced with fixed remunerations for these functions. This could result in more being allocated to a market jurisdiction in respect of these functions.
Amount C – a market jurisdiction may seek to tax additional profits if extra functions (above the baseline activity taxed under Amount B) are carried out in its jurisdiction. This would be subject to a binding dispute prevention and resolution mechanism (which is being considered further by the OECD).
The US-shaped spanner in the works
The US has been consistently critical of digital services taxes and threatened to impose tariffs of up to 100% on wine and handbags in response to France's implementation of a 3% DST in July last year. The UK government has so far remained committed to introducing its new DST but in a climate of negotiating trade deals with the US this is one to keep an eye on.
More generally, in early December the US sent a letter to the OECD expressing "serious concerns regarding potential mandatory departures from arm's length transfer pricing and taxable nexus standards – longstanding pillars of the international tax system upon which US taxpayers rely". The proposed solution was to introduce a 'safe harbour' effectively allowing US companies to opt-out of the proposals. The OECD response to the letter noted that the safe harbour suggestion had not been mentioned previously, and that its suggestion could make it harder for a consensus to be reached in 2020.
The US went on to say that it broadly supports Pillar 2, provided it aligns with similar US rules.
If you would like to know more about the proposals and/or be kept up to date with the latest developments over the course of 2020 please contact Madeline Gowlett.