By Akash Kalra

Much like in previous industrial revolutions, the world is once again grappling with how to join an old economic order to a new reality. As more and more economic activity happens in the digital realm, the tax structures of yesteryear have proven slow to adapt to the new reality.

Many Solutions, Little Consensus

Although the international community has yet to reach a comprehensive agreement on how to tax the corporations of the digital age, some bespoke solutions have emerged in the meantime.

Permanent Establishment: Closing Loopholes with Legalese

Under the tax regimes of many countries, foreign companies pay taxes when they have a fixed place of business there, rather than simply having customers in the country. The company may not have a legal entity in the country, but it has a location where it regularly conducts business and earns local revenue. For example, Ford’s assembly plants in Germany qualify as a permanent establishment in that country.

A fixed place of business in the country is a prerequisite for many taxes under the laws of most countries, and digital companies often can avoid establishing such a presence altogether. To illustrate, a digital music app doesn’t need an office in Bengaluru to keep Indians jamming on the app (or to enjoy revenue on their monthly subscriptions). However, the way we define a physical presence is changing with the times.

The Italian tax authorities recently set a new precedent in a landmark case against Netflix. While Netflix had no physical presence in the country, Italian authorities argued that its use of internet infrastructure in the country constituted such a presence, making it responsible for millions in taxes due to Italy.

As Bloomberg Tax explained, the Italian tax authorities argued “that the availability of a network of servers used exclusively to provide a streaming service to Italian customers qualified as a PE (Permanent Establishment) by creating a ‘fixed place of business.’”

This expanded definition of permanent establishment reflects an evolving tax landscape in Europe and beyond and could inspire other countries to adopt similar definitions of the concept to capture revenues from tech companies headquartered elsewhere.

While a bit of legal gymnastics won the Italian tax authorities over EUR 50 million from Netflix, some jurisdictions are adopting a blunter instrument to tax Big Tech: digital services taxes.

Digital Services Taxes

In the absence of an international arrangement, several countries and economic regions have taken a “wide net” approach. Across the developed world, some countries, including Belgium, Canada and Singapore, have enacted digital services taxes.

As the name implies, a digital services tax (DST), is levied on digital services, such as gaming, advertising and streaming. The tax applies to revenue earned within the taxing country, regardless of where the company is operating from. It is a top-line tax, which means it taxes gross revenue rather than income after expenses.

For example, the Austrian government’s 5% DST would take 5% of all Google Ads revenue earned in the country, regardless of whether Google has a physical presence in Austria and regardless of whether Google even made a profit on its Austrian ad service.

DSTs vary across countries, but they tend to target large companies with significant domestic business. For example, France levies a 3% DST on companies with at least EUR 750 million in total revenues and at least EUR 25 million in France. This focuses the tax on large multinational tech companies, which may otherwise escape paying significant taxes in France.

DSTs solve the problem of taxing digital economic activity, but they create a host of other issues. For one, they usually lead to double taxation, since a company like Netflix would have to pay a DST on revenue earned in each country, in addition to paying income taxes in countries it has legal entities and physical presence in.

DSTs also create trade tensions. The U.S., which hosts many of the companies targeted by DSTs, has in the past threatened to respond with punitive tariffs. The potential for an escalating trade conflict has motivated most countries to pursue a more comprehensive solution.

Ready Pillar One

The current system has obvious issues. The shifting definition of permanent establishment makes doing business abroad a riskier and more convoluted affair. DSTs shave revenue from companies, regardless of their profitability, and invite retaliatory trade measures.

The Organization for Economic Co-operation and Development (OECD) is trying to mitigate these problems through a shared set of rules for taxing multinational companies. The organization’s base erosion and profit shifting (BEPS) project, seeks to tax multinational entities (MNEs) in a more cohesive way across countries.

The BEPS project has two pillars. You may have heard of Pillar Two, which would set a global minimum corporate tax of 15% for the largest MNEs – those with annual revenues above 750 million euros. Pillar One seeks to address the sticky problem of taxation in the digital age.

Pillar One of the BEPS project would allocate taxable corporate income more objectively across the countries in which large MNEs earn revenue. The idea is to use a formulary approach, in conjunction with the existing transfer pricing guidelines, to share corporations’ income tax bill across the countries where they generate revenue, rather than just the countries where they have legal entities or permanent establishments in.

Pillar One is complex and has yet to be fully hammered out, but both OECD member countries and a large portion of the international community are inching closer to a resolution.

This system would address a persistent complaint from countries like Italy: that tech giants make billions off their citizens, using their network infrastructure, while avoiding paying taxes in their jurisdictions.

The Pillar One proposals would also be more amenable to the home jurisdictions of tech giants, most notably the U.S. The Pillar One approach is preferable to losing a slice of gross revenue in each country through DST’s or having to anticipate fluid and confusing definitions of physical presence.

A New Deal: Coming Soon?

While progress has been made on a global tax deal, including a provision to more consistently and objectively tax multinational tech firms, we are not there yet.

Several issues remain, such as which accounting standards to use in computing taxable net income, and how to ensure that developing countries are helped by the deal, in order to share in global development and achieve buy-in from as many countries as possible.

For now, we still live in a fragmented system of ever-changing local laws and potentially hefty DSTs. However, as in previous industrial revolutions, governments are working toward developing a better framework for the future.

The author is transfer pricing and international economics consulting expert

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