Tax treatment of the digital economy Input from an academic perspective Prof. Dr. Niels Bammens Email: niels.bammens@kuleuven.be Drs. Dina Scornos Email: dina.scornos@kuleuven.be

To ring-fence or not to ring-fence? There is a general agreement that the digital economy should not be “ring-fenced” - One should not establish a specific tax regime for digital business models vs. traditional business models Arguments: Digitalization has affected all sectors of the economy which makes it difficult to single out the digital economy vs. the traditional economy Developing different tax rules for digital activities would not be in line with the economic concept of “neutrality” which generally states that business decisions made by taxpayers should not be influenced by taxation Legally, this translates into the concept of “equal treatment” While not wanting to ring-fence the digital economy might be based on legitimate grounds, attention must be paid to the fact that the principle of equal treatment only requires that similar situations be treated equally (requirement of “comparability”) Faculteit Rechtsgeleerdheid

To ring-fence or not to ring-fence? Not all digital business models are comparable. Amazon’s online retail business might be comparable to another traditional retailer’s business but it will not be comparable to cloud computing  a thorough analysis of business models/sectors is necessary to assess comparability and hence the necessity to apply the same or different rules In addition, designing particular tax laws for certain specific cases can be accepted in order to get appropriate (practical) outcomes For example, ring-fencing of particular sectors of the economy is not new and has been widely accepted in the following cases: Shipping/Aircraft: On an international level, the choice was made to tax shipping and aircraft companies solely at the place of residence to avoid the formation of multiple PE’s Construction business: the notion of physical presence to establish whether or not there is a PE applies in a specific way (i.e. 6 month threshold) which is not the case for other business sectors Faculteit Rechtsgeleerdheid

Who can tax? There seems to be some confusion on which issue(s) we are trying to resolve The debate started because of the observation that digital MNE’s paid minimal or no worldwide taxation on their income, something which was perceived as ‘unfair’ However, this observation resulted from (not one but) two fundamentally different issues that can be distinguished as follows: BEPS: Although the digital economy has not created additional BEPS issues, it has exacerbated BEPS risks. Since digital companies rely heavily on intangibles and their assets are easily movable, they can more easily shift profits to low (or no) tax jurisdictions (cfr. Google/Amazon)  This resulted in minimal or no taxation in the residence state Outdated international tax principles: International tax principles were designed before the era of digitalization and do not take into account the fact that economic activities can be performed in a jurisdiction without having any physical presence there  Digital companies have no PE in the market jurisdiction(s) and hence no taxation in the source state(s). Faculteit Rechtsgeleerdheid

Who can tax? Outdated international tax principles lead to fundamental tax questions Source vs. residence taxation? The legitimacy of taxing at source is traditionally embedded in the ‘benefit theory’ – According to the benefit theory, a state’s right to tax results from the fact that it provides services and benefits to taxpayers that interact within its borders However, in the context of digital economy, there is a perception amongst some source states that there is a distortion of the ‘balance’ between the taxing rights of the residence and the source state which is created by the ‘misalignment’ between the place where the profits are taxed and the place where ‘value’ is created Some source states are therefore claiming (back?) sovereignty to tax non-resident digital companies It is not clear whether residence states agree with this point of view Source states seem to assume that there will always be ‘profits’ to tax but what happens in the case of losses? Faculteit Rechtsgeleerdheid

How much can be taxed? While it is important to determine ‘who can tax’? it is equally important to determine ‘how much can be taxed?’ This has been evidenced by previous attempts to design rules in the context of the digital economy that failed to recognize substantial income in the source state(s) (cfr. OECD’s work on Server PE) The OECD, the EU and some legal scholars have stated that profits should be taxed where ‘value is created’ but there does not seem to be a consensus on what ‘value creation’ means. This applies not only with respect to the attribution of profits to a PE but also generally to TP There is an increasing awareness that there are new value drivers for some digital businesses vs. traditional ones such as for example data, network effects, consumers (?) but it seems difficult to attribute value to each component (if any) Faculteit Rechtsgeleerdheid

How much can be taxed? The EU proposal on ‘significant digital presence’ attempts to capture value created by data by stating that ‘economically significant activities’ include inter alia the following: “The collection, storage, processing, analysis, deployment and sale of user-level data” and that in principle the profit split method should be used The creation of value by the mere ‘collection’ of data seems mostly debated since this would result in the creation of PE’s at the location of all the consumers (at least for digital business models that heavily rely on customer data such as Facebook and Google) Criticism from the business side that raw data has no value. The value lies in the processing and the analysis <-> Data is the new ‘oil’ or ‘mineral’. Without data, no processing of data and thus no profits Criticism from the business side that two types of data should be distinguished (i) internal data that do not have any value and (ii) data that you can sell which have a certain value During the public consultation at the OECD on the 1st of November 2017, attention was also brought by BlaBlaCar to the fact that there should be no taxation on ‘non-existing income’ Faculteit Rechtsgeleerdheid

How much can be taxed? There is also a debate on the role of consumers in value creation: Consumers create value because if there are no consumers then there are no sales/service income What happens at the location of the consumer is not ‘value creation’ but ‘value exchange’ – significant value (e.g. a product) is provided to the market jurisdiction in exchange for money. ‘Value consumption’ is not the same as ‘value creation’. Value consumption is already captured by VAT Is there a solution to these debates? Ideally, a value chain analysis (VCA) should be conducted on a case-by-case basis to determine the value creating factors (not all businesses create value in the same way). The use of VCA helps to identify key value drivers of a business and to distinguish between important and less important functions However, if value creation needs to be determined on a case-by-case basis, will this lead to increased litigation? (cfr. Dispute resolution mechanisms) Faculteit Rechtsgeleerdheid

Some comments on the EU proposals 1 Some comments on the EU proposals 1. Short-term measure: Digital Services Tax Scope of application: only specific services and taxpayers See earlier comments: ring-fencing may be justified Double revenue threshold: improves legal certainty and proportionality Note: threshold in art. 4(1)(a) (worldwide revenue > EUR 750.000.000) refers to all revenue  threshold in art. 4(1)(b) (EU revenue > 50.000.000) refers only to revenue from digital services Place of taxation is determined on the basis of user involvement Recognizes that (certain) data has value and that (some) taxation should therefore occur where the data is collected The tax is arguably not covered by tax treaties and is not creditable in the residence state Risk of double taxation if the (non-EU) residence state does not offer relief (e.g. because the tax does not qualify as an ‘income tax' or a ‘tax in lieu of income tax‘) The DST is an ‘indirect tax’ but not a VAT: It does not comply with the first criterion of the CJEU case Banca Popolare di Cremona (C-465/03) – The DST is not a general tax (EC view) Faculteit Rechtsgeleerdheid

Some comments on the EU proposals 1 Some comments on the EU proposals 1. Short-term measure: Digital Services Tax Could it be said that the underlying objective is an intention to achieve a ‘single-tax principle’ (i.e. that businesses pay tax at least once and in a sufficient amount)? Does this go beyond merely ‘equalizing’ the tax burden on digital and non-digital activities? The fact that there is no credit mechanism for cross-border companies – proportionate to the aim? Sanctions for non-compliance? Left up to Member States (art. 18(3)) but presumably loyalty requires effective enforcement, i.e. in line with procedure for ‘domestic’ taxes Subsidiarity? Not an issue since the Directive does not rule out other actions by Member States (e.g. additional tax with broader scope of application)? Is there a risk that this ‘temporary’ measure becomes permanent if no agreement is reached on a long-term solution? – No sunset clause in the current proposal Faculteit Rechtsgeleerdheid

Some comments on the EU proposals 2 Some comments on the EU proposals 2. Long-term solution: Significant Digital Presence Absolute thresholds for establishing SDP More than EUR 7.000.000 revenue from digital services in a Member State, more than 100.000 users, or more than 3.000 business contracts for supply of digital services Justified given Member States’ different sized economies? Relevant for all business models in scope? Feasibility and impact difficult to assess given limited details Rules on profit allocation are still limited and preliminary; further guidance will be necessary No guidance on compliance and enforcement issues; problematic given mere virtual presence? No attention has yet been paid to other consequences of having a PE. E.g. how to attribute royalty income to a virtual PE? Faculteit Rechtsgeleerdheid

Some comments on the EU proposals 2 Some comments on the EU proposals 2. Long-term solution: Significant Digital Presence Differences with Digital Services Tax: Wider scope of application (more ‘digital services’) and different nexus (SDP) Same underlying justification, i.e. that market state should be able to tax because value is created there? Explanatory Memorandum: “These criteria are proxies for determining the 'digital footprint' of a business in a jurisdiction based on certain indicators of economic activity. They should reflect the reliance of digital businesses on a large user base, user engagement and user's contributions as well as the value created by users for these businesses” Relationship to tax treaties Not applicable if precluded by tax treaty with non-EU state Explanatory memorandum: “This Directive will apply to cross-border digital activities within the Union, even if the applicable double taxation treaties between Member States have not been modified accordingly” Faculteit Rechtsgeleerdheid

Questions and discussions Can ring-fencing be justified in particular circumstances? Which issue(s) are we trying to resolve? (BEPS/Outdated tax principles) Do the new proposed measures attain the objectives and are they proportionate? Is ‘value creation’ the principle on which new international tax rules should be based as an answer to both questions on nexus and profit allocation? Does it lead to appropriate practical results? Should states take unilateral actions if no consensus can be reached on a European or international level? Faculteit Rechtsgeleerdheid