The rising threat of digital taxes across the world, most recently in New Zealand, is raising the stakes to reform the international corporate tax system. In February 2019, the OECD outlined four proposals that will go through public consultations in the coming months. Of those, the “user participation” proposal has popular appeal, but seems least likely to succeed.
The user participation proposal would allocate taxing rights over “highly digitalised businesses” to countries where users are located, irrespective of whether those business have a physical presence there. The justification is that the sustained engagement and active participation of users is a critical component of value creation.
The first challenge for the user participation proposal to succeed is getting 125+ countries to agree on the specific industries to which reformed rules should apply. Determining when, where, and how much value is created by users for different businesses is depends on the business model (e.g., social media versus manufacturing businesses) and on the nature of user participation (e.g., active, via “likes” or posts, versus passive, via cookies). The OECD’s 2018 Interim Report provides the following illustrative chart—
The user participation proposal identifies social media platforms, search engines, and online marketplaces as “highly digitalized.” This idea seems uncontroversial, because without user data those business models fall apart. Nevertheless, countries that host large numbers of highly digital businesses, such as the United States or China, are unlikely to agree given the disproportionate impacts on businesses from those countries. What’s more, focusing on highly digitalised businesses is shortsighted: the role of user data is significant and growing for other types of business, even manufacturing (where user data can be collected offline, through sensors or AI-enabled products).
But let’s assume negotiators find agreement. The second challenge concerns establishing a legal nexus between countries and non-resident businesses. The principle in international corporate tax is that businesses pay tax on global profits in their country of residence—other countries gain the right to tax those profits if they have a nexus with the business. A nexus exists if a business has a permanent establishment (PE) in a country, which means either a “fixed place of business” or a “dependent agent”. If there is no PE, there is no nexus, and the other country has no right to tax.
The user participation proposal would render the location of users sufficient to establish nexus. Highly digitalised businesses would face tax liability in significantly more countries than at present—even if minimum thresholds regarding the size of the business (in terms of revenues or users) were included.
The third more significant challenge concerns the rules on profit allocation—once a nexus is established, how much profit should be subject to tax in foreign countries? Under traditional rules, a share of profits is allocated to a PE based on an assessment of the PE’s functions, assets, and risks assumed within the global corporate structure. Transactions between the PE and foreign affiliates are “priced” according to the arm’s length principle, which means in line with comparable transactions under comparable circumstances between unrelated enterprises. So how do you “price” user participation (in all its various forms)? Data marketplaces are inaccessible to the average user, and there is no transparency around the price of data bundles.
To avoid these complexities, the proposal suggests using a residual profit split method to divide profits between countries where users are located. But that also isn’t straightforward, particularly with multinational digital businesses. Calculating residual profit involves calculating the total (world) business profits remaining after accounting for routine business costs that fit into traditional rules. Because digital companies frequently rely on hard-to-value intangible assets in their routine business, this exercise is highly discretionary. Negotiators would also have to come up with a formula to split residual profits between countries, approximating the value and number of users.
But let’s imagine negotiators adopt the user participation proposal. One final challenge remains: how should governments spend the additional tax revenues? Because the new tax is justified based on user participation, it may be easier for the public to demand some kind of citizen rebate or at least that the revenues be earmarked for specific purposes—why should governments get to keep all the revenues and citizens, from whom the data was collected, receive nothing? This tension underscores why the user participation proposal has gained traction in the first place. There is an intuitive fairness to the redistribution of digital profits from large multinationals to countries where users are located—the users are a source of income, and the destination of consumption for online goods and services they pay for.
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