The world is at a crossroads. The early 1990’s saw the internet opening to the general public, followed shortly thereafter by online sales platforms (Book Stacks Unlimited—1992, Amazon.com—1994, and eBay—1995), and social media platforms in the 2000’s (myspace.com—2003, Facebook—2004, and Twitter—2006). In just a few short decades, entrepreneurs (and a few lucky bystanders) found new ways to sell existing products—like books—to entirely new audiences in entirely new geographies, while simultaneously creating entirely new products—like information about customers’ shopping preferences and habits when buying those books. The 20th and 21st centuries have heralded incredible changes to the global economy.
Meanwhile, taxing authorities of all flavors have been innovating too. In 2013, the Organization for Economic Cooperation and Development (OECD) and the Group of Twenty (usually referred to as the “G20”) recognized the need to address the shift from brick-and-mortar to digital commerce and the attendant shift in importance from the seller’s location to the markets in which the seller does business. They initiated a project of grand ambition: to reduce and eliminate the erosion of the tax base and abusive profit shifting schemes across the globe. This initiative, better known as the Base Erosion and Profit Shifting Project, or BEPS, created fifteen Actions (areas of focus for tax reform). The first of these Actions advances a framework for taxation in the global economy based on two pillars: (1) reallocation of authority to tax profits (usually referred to as “nexus”), and (2) establishment of a coherent, global mechanism to prevent base erosion.
After years of discussion on Action 1 without arriving at any agreed approach, taxing authorities across the globe took matters into their own hands. Around 2019, the digital economy collided with local laws when France enacted the first tax on “digital services.” Amid calls for a multilateral, unified approach among the nations, the steady advance of commerce continues unabated, although challenged by a hodgepodge of national, state, and local tax regimes targeting digital activities, including taxes on digital activity enacted by various U.S. states.
So, the world is at a crossroads. Many of the developed nations of the world recently agreed to coordinate and adopt a roughly uniform approach to the taxation of the digital economy, but until this is widely implemented, they continue to act unilaterally and create a regulatory patchwork that will create a further drag on economic progress. While most businesses are not able to influence the decision-making process, all businesses can take steps to prepare and respond to whatever may come.
Under the current principles of international taxation, multinational companies generally only pay taxes in jurisdictions where they have a physical presence. The classic example is the multinational that is taxed where their goods are produced; they are not taxed where the consumers of their goods are ultimately located. However, many countries and organizations raise concerns that these principles are outdated in today’s digital world. They argue that the digitalization of our economy allows businesses to target customers and generate value abroad without creating a physical presence. They want to allow foreign countries to tax businesses that are extracting value from their citizens, regardless of any physical presence.
Over the last several years, an increasing number of countries and organizations have developed proposals for taxing the digital economy. While the OECD has outlined recommended approaches for global adoption (including the elimination of unilateral digital service taxes), and many nations (including the U.S.) have agreed in principle to adopt these proposals, it remains unclear how these proposals will be implemented and whether digital service taxes will not survive in some form. As of October 2021, approximately 26 countries have taken unilateral action to pass digital services taxes or similar direct taxes. Even U.S. states see these proposals as potential revenue-raisers and have begun proposing and enacting digital services taxes within the U.S.
Generally speaking, digital services taxes are taxes on the revenues of multinational firms derived from certain digital activities in a particular jurisdiction. However, these taxes are implemented differently in every jurisdiction. For example, France’s digital service tax applies to gross income derived from intermediary services (i.e. platforms and marketplaces) and targeted advertising, including the sale of user data. Greece, on the other hand, only taxes income from short-term rentals found in the sharing economy through digital platforms. Meanwhile, Hungary broadly taxes income from broadcasting or publishing any advertisements in the country.
In many of these countries, the digital services tax only applies if certain thresholds are met. For example, France requires a multinational corporation to have global revenue of €750 million (approximately $870 million) and local (French) revenues of €25 million (approximately $29 million) before the corporation will be subject to the French tax. Other countries have lower monetary thresholds and digital services taxes may have no meaningful monetary threshold at all.
A few countries, like Israel and India, have taken a different approach to digital taxation. These countries have adopted a “digital presence” test, supplementing the traditional physical presence test for when a business is subject to taxation. Israel, for example, provides several factors that would create a taxable digital presence. Some of the factors include the company’s website being accessible to the Israeli market and highly used by Israeli customers, the company’s website being adapted for use by Israeli customers (in terms of language and currency), or the company collecting customer information and engaging in ongoing contact with Israeli customers. Once a business’s digital presence is established, Israel will tax any income generated by that business within its borders, even if the business has no physical presence in Israel.
The potential for raising revenue from new sources is not lost on the various states in the U.S. The nuances of state-specific digital service taxes are beyond the scope of this article, but are addressed in a second installment. For purposes of this discussion, it is enough to note that several, including Oregon and Washington, have proposed taxes on digital services or digital advertising and Maryland has already adopted the nation’s first tax on digital advertising.
Despite the ever-changing nature of the world of global taxation, there are some steps U.S. businesses may take to gain some sense of consistency and preparedness.
1. Monitor the legal landscape
With approximately 26 countries and an ever-expanding number of U.S. states having proposed or adopted digital services or similar direct taxes (each with a different monetary threshold and definition of taxable activity) there is a great deal of complexity, particularly for businesses engaging with customers in many jurisdictions. Further complicating matters is the existence of various trade and tax treaties between countries, some of which may (or may not) forbid the application of such tax regimes to business operating from “abroad.”
Additionally, there is no guarantee that these existing digital service tax regimes will remain the same in the future. For example, one proposal from the United Nations may open the door for countries to unilaterally create digital service taxes with any monetary threshold they want. Further complicating matters statements from the OECD in July and October of 2021 indicating that further action from the 130+ countries adopting the BEPS inclusive framework would render digital service taxes inconsistent with the adopted global approach, requiring further coordination to remove such tax regimes. Meanwhile, in October 2021, the U.S. and several European countries entered an agreement to permit a partial U.S. income tax credit for certain companies paying digital services tax in Austria, France, Italy, Spain, and the U.K. Although this is good news for some multinational organizations, this is not a complete or permanent solution and is only another square on the patchwork quilt.
Business decision makers should therefore recognize the existing (and future) complexity in the international community, and budget accordingly by allocating resources to identify and track customer base information and tax laws applicable in the jurisdictions where customers reside. Yet, allocating resources to identify the relevant jurisdictions and their respective tax laws is not enough. As businesses expand and contract, their client bases change and move, meaning that new geographies will become relevant and others will become less important. Governmental action will alter the landscape, as new taxes are enacted, old taxes are challenged or interpreted, and tax compliance requirements shift.
Legal departments, finance teams, and marketing and sales divisions will need to communicate and coordinate to allow businesses to adequately monitor changes to their internal operations, customer base, and regulatory requirements. Moreover, businesses should identify and periodically evaluate their activities for compliance with existing tax laws and to identify the activities that are likely to create compliance obligations or tax liabilities in the near future. This is particularly important for companies with operations that are near, but not quite over, relevant digital service tax monetary thresholds and for companies looking to acquire competitive or complementary businesses whose operations may push the acquirer into the scope of businesses subject to tax.
In short, all businesses offering digital services should engage good legal advisors and be prepared to increase their level of tax modeling and due diligence for internal operations, expected acquisitions, and long-term planning.
2. Collect adequate customer and operational information
Having conducted an internal audit as described above, firms should be able to determine which activities could constitute taxable digital services. Armed with this knowledge, they should adopt appropriate methods to capture the necessary information to comply with those tax regimes reasonably expected to apply to the company in the near future, including information needed to identify where their customers are located. Generally this has been done by billing address, but in the case of many digital services taxes, many taxing authorities have indicated that customer location will be primarily based on IP address, geolocation data, device registration, cookies, or other comparable information. In other instances, taxing authorities have attempted to tie tax revenues to the sale to a third party of information derived from residents of the taxing jurisdiction, meaning that, for B2B sales of digital information or advertising, the more relevant approach would be to track the location of persons from whom information is derived, rather than the identity and location of a purchaser of that information.
In short, businesses should adopt policies and procedures that track customer location data, how customers access data, and usage of customer data by third parties, so that the company may adapt that information to quantify their tax filing and payment obligations.
For bonus points, firms would do well to remember that many jurisdictions, including the European Union and the state of California, have adopted data privacy laws dictating what can and cannot be done with customer data. So, any data collection efforts should be done with an aim of satisfying any applicable data privacy laws as well.
3. Identify and substantiate approaches to mitigate and arguments to legitimately contest
As of the date of this writing, it isn’t entirely clear what recourse individual businesses may have. The U.S. has strenuously objected to the imposition of digital services taxes, and as noted above, recently entered an agreement to permit some limited federal income tax credits against such taxes. So, the first obvious recourse is to vocally and vehemently appeal to representative politicians, particularly at the federal level, to oppose the institution and perpetuation of digital service taxes, whether within or without the ambit of the BEPS inclusive framework. Secondly, businesses should evaluate each digital service tax to which they become subject to determine if the tax qualifies for a foreign tax credit against their U.S. income tax liability. They should also identify relevant income tax treaties and trade agreements to identify arguments in favor of reduced tax rates and recourse against double taxation. And, where applicable, businesses should engage with local legal counsel to identify potential avenues to contest or reduce exposure to digital service taxes.
The new approaches to taxing the digital economy are here to stay. As more nations join the discussion—or decide to act unilaterally—local and multinational business leaders should expect the level of complexity on the global tax scene to deepen exponentially. But, rather than being passive viewers of the developing spectacle, businesses should take a proactive approach to compliance and, where appropriate, lend their own voices to the dialogue.