Background – what is digital economy?
The world as we know it will no longer be the same and one of the fundamental drivers is digital transformation. Our global economy is driven by digital transformation and is moving to digital economy. Our daily economic activities are supported by online connections among people, businesses, devices, data, and processes. A connectivity which is based on the growing linkage of people, organisations and machines resulting from the internet, mobile technology and the internet of things (IoT).
The digital economy comprises a wide range of economic activities that use digitized information and knowledge as key factors of production and the provision of services. The internet, cloud computing, big data, fintech, blockchain and other new digital technologies are used to collect, store, analyse, and share information digitally, transform social interactions and, last but not least, generate revenues.
We all know the examples of Uber, being the biggest taxi company, without owning one cab; Alibaba, being a huge retailer, without any inventory or Airbnb, being the world’s largest accommodation provider, without owning any real property.
Up to recently, tax followed a quite clear model: Taxation took place at the location where a taxable presence arose. This was typically the place where the enterprise had a physical establishment. In the times of BEPS (Base Erosion and Profit Shifting) profits are more and more allocated to where the management of key functions, assets and risks of a company takes place.
In a digital world revenues are often generated in a jurisdiction without significant physical presence or without having the key functions, assets and risks in the country where the consumption takes place. Countries are no longer willing to renounce taxing such profits and are fighting the perceived mismatch between taxation and value creation for digital activities.
In March 2018, the European Commission has presented the following two proposals to develop the current tax regulations in view of the digitalization of the economy:
Taxable nexus for digital businesses: Extending the concept of a permanent establishment
A first new proposal for a EU Council Directive released by the EU Commission on 21 March 2018 (COM(2018) 147 final, (“Digital Service Directive” or “DSD”)) mainly targets large tech firms. A so called “significant digital presence” in a Member State exists if a digital service is offered through a digital interface and one or more of the following thresholds are met:
- The revenues from providing the digital services to users in a Member State exceed EUR 7 million in a tax period;
- The number of users of a digital service in a Member State exceeds 100,000 in a tax period;
- The number of business-to-business contracts for digital services in a Member State exceeds 3,000.
The list of potentially qualifying digital services in Annex II of the DSD is very detailed and includes (besides of the obvious digital services such as download of music, games and movies) for example online weather reports, desktop themes, traffic information, and virtual lectures. On the other hand, Annex III lists services that are explicitly not deemed digital services. This applies for example to radio and television broadcasting services, teaching services (with a physical teacher) or services of lawyers who advise clients by e-mail.
The relevant turnover from digital services for the existence of a significant taxable presence in a Member State is determined by the proportion to the number of times that devices are used in a tax period by users located anywhere in the world to access the digital interface (may be different to actual turnover generated in a Member State).
Due to the wide range of application it can be expected that almost all large technology companies will create significant digital presences in all Member States of the European Union. However, since the DSD targets the offering of digital services that can be accessed digitally through an interface, companies that sell physical goods / products online should not be affected.
The attribution of profits is built on the current framework applicable to permanent establishments (authorized OECD approach). A significant digital presence should be attributed the profits that it would have earned if it had been a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions. However, this framework should be adapted to reflect the way value is created in connection with digital activities. The criterion of significant people functions is considered as no longer sufficient to ensure a profit attribution that reflects the creation of value. For example, in the digital economy value is often created from a combination of algorithms, user data, sales functions and knowledge (such as a user who is contributing to value creation by sharing his/her preferences (liking a page) on a social media forum). Therefore, in case of digital services the activities relating to data, users or expenses for R&D or marketing should be considered economically significant and this could be a possible splitting factor among the Member States. However, if proved by the tax payer an alternative allocation method can be applied if it can be demonstrated that it is leading to more appropriate results.
The DSD further intents to set-up a new advisory committee on the taxation of the digital economy called “DigiTax Committee”. The DigiTax Committee shall examine questions on the application of the DSD raised by a representative of the Commission or at the request of a representative of a Member State.
Potential implications for Swiss based entities
The new type of PE in connection with a significant digital presence should not apply to entities that are tax resident in a non-EU jurisdiction with which the Member State of the significant digital presence has a Double Tax Convention (“DTC”) in force. Since Switzerland has DTC’s with all EU Member States in place, the new rules should not directly be applicable to companies domiciled in Switzerland. However, the Commission already recommended to renegotiate the DTC’s with third countries such as Switzerland. Thus, in the long run it may be expected that the new “digital PE” will also apply for entities domiciled in Switzerland offering digital services in EU Member States.
Short-term solution: Introduction of a Digital Service Tax
Already 10 Member States have introduced unilateral measures to tax digital services. To counter such growing intentions that fragment the single market and may distort competition, the European Commission intents to introduce a temporary Digital Service Tax (COM(2018) 148 final, (“DST”)) of 3% on digital revenues. The DST should already be applicable as of 1 January 2020 and should apply until a comprehensive solution is found.
The DST would apply to the following digital services:
Advertisement on digital interfaces;
- Services of digital interfaces that allow users to connect and interact with each other (the digital interface allows matching of users and interaction; different to for example instant messaging services where users have already established contact by other means);
- Services of digital interfaces that facilitate the provision of services or goods between users;
- Transmission of user data generated from activities of users on digital interfaces.
Generally excluded are the following digital services:
- Digital interfaces to provide digital content (e.g. music, games, applications, or videos), communication (e.g. instant messaging or e-mail services) or payment services to users;
- Trading venues; and
- Crowdfunding services.
An entity qualifies as a taxable person under the following requirements:
- The total amount of worldwide revenues reported by the entity for the latest complete financial year for which a financial statement is available exceeds EUR 750 million; and
- the total amount of taxable revenues obtained by the entity within the EU during that financial year exceeds EUR 50 million.
In particular with the first threshold of EUR 750 million of worldwide turnover, the EU Commission intends to target mainly companies of a large scale that can attract a high volume of users and that can benefit from network effects and the exploitation of big data. The Commission argues that such cases may lead to higher differences between where profits are taxed and where value is created. According to the Commission also “the opportunity of engaging in aggressive tax planning lies with larger companies”.
The DST would be due in the Member State(s) where the users are located. If the users are located in different Member States, the tax base has to be attributed between Member States based on certain allocation keys.
Potential implications for Swiss based entities
The temporary Digital Service Tax of 3% should (if accepted by the EU Member States) also apply to entities that are not domiciled in an EU Member State. Swiss entities could, therefore, become subject to the DST if their turnover exceeds EUR 750 million worldwide and EUR 50 million within the EU. Although not fully clear yet, we would expect that such expenses are considered as tax deductible expenses in Switzerland.
The proposals of the Commission need unanimous acceptance by the EU Member States. This will be challenging since the intended reform would reallocate taxing rights between EU Member States and the ones that are currently hosting many head offices will likely oppose to these changes. Nevertheless, the Commission and the supportive EU Member States aim for a fast approval process and implementation in domestic law already by 31 December 2019, so that the new rules would become effective as of 1 January 2020.
The content of this newsletter does not constitute legal or tax advice and may not be used as such. If you need advice with regard to personal circumstances, please reach out to your contact person at Reichlin Hess AG or to the authors of this newsletter.
Our tax advisors would be happy to support with any further questions you may have regarding this topic.