Digital transformation is rapidly accelerating. It continues to reshape all facets of our lives from how we do banking, order coffee, or book travel. Not only is it ubiquitously permeating all industries across the board, but it is doing so globally. This globalization and the increased integration of national economies and markets, have already put a strain on international tax rules that were developed over a century ago. The advent of the world-wide web and the amassing of big data coupled with the emergence of new digital business models, have further exacerbated the issue.
Businesses today can conduct international cross-border transactions "virtually", without the need to be physically present. These services can be delivered without human intervention due to technological advances like cloud computing, big data analytics, and artificial intelligence. Also, company personnel are more mobile and working remotely and virtually as companies are finding that talent is becoming more scarce and they need to deploy resources in real time where they are needed. Taxing a moving and virtual target is hard. These are the challenges for tax rules that were established based on fixed geographic locations and traditional concepts of value creation. Whereas this is business as usual for digital companies, traditional companies are also quickly adapting digital technologies and adapting to this way of doing business.
In the last 6 months, the international tax policy debate over taxing the digital economy has escalated with the Organization for Economic and Cooperative Development (OECD), European Commission (EC) and countries like the UK issuing position papers on how to tax digital business models. This is all based on the perception that the digital economy is not contributing its "fair share" of tax revenues.
There is no doubt that there are new value drivers in the digital economy and business models are transforming but there is no clear evidence to suggest that digital companies are not paying their fair share of taxes relative to traditional companies. If that is not the case today, then it can't be supported in the future as the line between digital and non-digital companies will become less evident. Despite the need to stand back and truly understand what is changing in the digital economy, governments seem to be moving forward with short term measures to impose additional taxes on digital transactions. Multinationals need to keep up with the new and proposed developments not only to preserve the returns on the digital investments they are making but also to contribute their views and perspectives to the policy debate.
Significant changes to the taxation of the digital economy have already been legislated and multinationals should be thinking about the immediate and long term impacts on their business. Never before has Tax been such a strategic business consideration.
Although not directly aimed at the digital economy, key elements of US Tax Reform1 will certainly strengthen and accelerate digital investments and digital business models in the US. The ability to repatriate offshore earnings at a low tax cost, will provide US companies with a significant one-time cash infusion to further invest in digitalization and the Global Intangible Low Taxed Income (GILTI)2 provision will keep that IP in the US. This will, rightly or wrongly, stoke the fire that US companies are exploiting foreign markets without compensatory tax revenues.
Additionally, Action 1 of the OECD Base Erosion and Profit Shifting initiative proposed a new VAT regime to tax transactions at the place of consumption. Many countries are adopting this new policy to apply VAT on electronic services at the place of consumption for B2B and B2C transactions. Navigating these new VAT rules as they proliferate globally is challenging for multinationals but critical. With application on gross revenues, missing VAT liabilities could easily erase any profits or returns in a country.
Finally, the digital tax global landscape is also peppered with unilateral country measures that need to be tracked and evaluated as there are nuances in many of them in how revenue or profit is taxed and when they become effective. Some examples include:
- India – 6% equalization levy on advertising revenue effective from 2016
- Israel – VAT payable on digital services from 2016
- Russia – VAT payable on B2B digital services from 2017 (+ B2C expected from 2019)
- Saudi Arabia – VAT payable on digital services from 2018
- Taiwan – deemed local source for e-commerce services, issued January 2018, but effective from 2017
When it comes to proposals, there are generally two approaches to configure the tax system to digital transactions and business. Recent publications outlining these considerations, challenges and proposals include:
- OECD Interim Report – "Tax Challenges Arising from Digitalization", Mar 16 / 2018
- European Commission (EC) Proposal – "Digital Tax Package", Mar 21, 2018
The first approach applies tax on gross revenues and is widely considered an extremely bad idea for many reasons including the real possibility of double tax and the penalty it places on digital start-ups who are not yet profitable. The second approach aligns more with the current permanent establishment (PE) concept. However, it turns the concept on its head to conclude that a PE exists for certain "digital" activities where no real presence or fixed base exists. Hence the notion of a "digital PE" has emerged and is gaining traction despite its practical challenges of how such a "digital presence" would be established, and what profit would be attributed.
The EC proposal includes an interim Digital Services Tax (DST) of 3% on revenues for 3 main types of services, when value creation requires interaction with users in the EU. This tax applies even if users do not pay for such services.
- Specifically, it would apply to revenues created from:
(i) Placing online ads
(ii) Transmitting data collected from users
(iii) Digital platforms which allow users to interact with each other, including for the facilitation of the sale of goods and services between them
- The proposed DST would be in force starting January 1 / 2020
- Tax revenues would be due to the Member States where the users are located (but paid through a one stop shop), and would only apply to companies with total annual worldwide revenues of €750 million or more, and EU in scope revenues of > €50 million or more
For digital permanent establishments, this proposal would enable Member States to tax profits that are generated in their territory, even if a company does not have a physical presence there. The EC feels the new rules would ensure that online businesses contribute to public finances at the same level as traditional 'brick-and-mortar' companies. A digital platform will be deemed to have a taxable 'digital presence' or a virtual permanent establishment in a Member State if it fulfils certain criteria based on revenues, or number of users or number of business contracts.3
The new rules are intended to change how profits are allocated to Member States in a way which the EC feels better reflects how companies can create value online: for example, depending on where the user is based at the time of consumption. Ultimately, the new system purportedly secures a link between where digital profits are made and where they are taxed. The measure could eventually be integrated into the scope of the Common Consolidated Corporate Tax Base (CCCTB) – the Commission's already proposed initiative for allocating profits of large multinational groups in a way which they feel better reflects where the value is created.
The proposed changes are controversial, with divergent views across countries on how taxation should change to accommodate the digital economy. Although the digital economy broadly applies to all industries across the board – including both tech and non-tech companies – some argue that certain international policymakers appear to be targeting (or ring-fencing) "US tech-giants" only. In fact, a recently leaked draft proposal from the EC (entitled "Taxation of Digital Activities in the Single Market") called out a number of American firms directly by name, including Uber, Airbnb, and Netflix.
Value Creation in the Digital Economy
The foundational principle of the international tax system today is to tax profits in the location of value creation. The discipline of transfer pricing has evolved to assess key value drivers in a multinational's value chain and attribute that value to the location(s) which contributed that value. Although some of the value drivers have changed in the digital economy, assessing their relative value contribution and how this value is created still remain the relevant considerations.
At the core of digital value creation is big data and artificial intelligence (AI), which is not well understood from a tax and accounting perspective. Companies are increasingly using predictive analytics and new technologies, to monetize data, create deeper and lasting relationships with customers, extract business insights, and deliver cost efficiencies.
Predictive analytics has widely been used by mainstream companies since the 1970's, across many fields including actuarial science, marketing, financial services, insurance, travel, retail, and pharmaceuticals, to name a few. It is an area of statistics that deals with extracting information from data and using it to predict future trends and behavior patterns. It has gained greater adoption more recently with the availability of big data.
The relatively recent convergence of key forces / digital drivers have created the "perfect storm", dramatically revolutionizing the value that can be extracted from predictive analytics:
1. Technological Advances: The advent of new super-computing technologies combined with the application of machine learning and AI, enable huge volumes and varieties of big data to be analyzed at high velocity, giving rise to an entirely new era of predictive analytics.
2. User Contributions: Couple that with the "information explosion" attributable to the massive volumes of data being generated through multi-channels including the internet, digital platforms, and mobile devices. Users are actively adopting digital mediums, and openly sharing product preferences, posting customer feedback, and contributing personal data, at unprecedented rates.
3. Platforms / Networks: Finally, consider the fact that new digital business models have emerged, where users are "instantly interconnected" through platforms / networks, social media, and the Internet of Things (IoT), allowing data to go "viral" – in real time. Companies have the ability to create partnerships with suppliers and even competitors to offer consumers new functionalities and customer experiences using digital ecosystems.
The common thread across these key digital value drivers is "data". Data lies at the heart of digital business models, fueling value creation. Data can create significant value when harnessed and translated into business insights, algorithms, or apps.
Some data may even create negative value (due to costs associated with data collection, storage, security, privacy, regulatory compliance, etc.) For example:
- If data is not actively used, then value is not extracted. Therefore, the costs of data capture, maintenance and storage are actually a hit to the bottom line.
- The same goes for data that is not adequately protected. Data breaches incur costs for clean-up; they can also damage brand, reputation, and stock price, thereby detracting from value.
The challenge for tax is that data is a unique asset that is not recognized on the balance sheet. Unlike other assets that depreciate in value with use, data is "regenerative". It can be used and re-used across multi-purposes to unleash new value. It is also "non-rivalrous" – it can be consumed by multiple parties at the same time, without being depleted.
The "types" of data that create value are vast, vary by context, and are much broader than just "personal" data. Different types of data that create value could include: personal or "user profile" data (i.e. name, address, age, gender, etc.), behavioral data (i.e. data about user interactions such as customer browsing / search activities, number of times users clicked an ad, amount of time spent on a site, etc.), transactional data (i.e. products purchased, dollar amount spent, method of payment, etc.), unstructured (non-numerical) data such as social media feeds, customer feedback, videos, or photo, locational data, IoT real-time data (i.e. information captured by embedded sensors across supply-chain ecosystems, and interconnected through the internet) etc.
Not all data is created equal. For example, studies have shown that behavioral data is significantly more valuable than personal data.
Currently, the proposals focus on personal data or user data with little differentiation in value between different user contributions or other types of data.
How can we determine the value created by data?
This brings us back to the question of value creation. If data is core to value creation in digital business models then plotting the value of data over its life cycle can be a useful framework for trying to understand how data can add value and generate profits or losses. As outlined by the OECD Interim Report (referenced earlier), this process can be described as a value cycle involving several interconnected phases:
- The starting point is the capture of "raw" (or unprocessed) data, which has relatively low value.
- Data collection processes then lead to increasing volumes of big data being maintained and stored. However, without further manipulation or analysis, the economic value of this type of data typically remains limited.
- Data analysis and interpretation by skilled data scientists and / or automated algorithms then become the basis for the generating economic value through the value cycle.
- Finally, data-driven decision making, using knowledge gained from previous phases is then used to inform business decisions. This effectively transforms the data into actionable insights, creating economic value.
This makes the challenge of assessing value more manageable for multinationals as they can undertake analysis to understand how data is used in their companies and the process of value creation. A complete analysis would include a similar process for other digital value drivers, namely technology platforms and the customer experience and how this may create a valuable user base.
There is no doubt that emerging business models in the digital economy pose challenges to the international tax framework. Currently, the tax environment for digital businesses is unstable, with some countries focused on imposing new taxes for "digital transactions" such as DST on digital services, levies on digital revenues, and tax obligations where no physical operations exist. The challenge to understand is whether our current international tax system needs tweaking to make it fit for the future or whether it needs replacing. At this time, not enough analysis has been done to address the challenge.
In the meantime, companies need to address the new proposals as they could be the difference between preserving hard won returns on digital investments or eroding them. Tax needs to be involved upfront, as part of the digital strategy discussion, to help business partners understand the tax implications of their strategies. Tax can proactively help shape tax-optimized business models and integrated global value chains, to help mitigate tax risks, and maximize ROI on digital investments by applying established principles of value creation and modelling the unfolding digital tax landscape.
- BEAT: The new Base Erosion and Anti-abuse Tax (BEAT) on large US-based and non-US-based MNCs, is calculated as a percent of modified taxable income less the regular tax liability (reduced by certain tax credits). The tax rate is 5% in 2018, 10% in 2019 – 2025, and 12.5% thereafter.
- GILTI: The effective tax rate is 10.5% for 2018 – 2025, and 13.125% starting 2026.
- Criteria for Digital PEs: A digital platform will be deemed to have a taxable 'digital presence' or a virtual permanent establishment in a Member State if it fulfils one of the following:
- It exceeds €7 million in annual revenues in a Member State
- It has over 100,000 users in a Member State in a taxable year
- Over 3,000 business contracts for digital services are created between the company and business users in a taxable year