In Search of Tax Solutions for the Digital Economy

By Dmitri Jegorov, Undersecretary for Tax and Customs Policy, Finance Ministry, Estonia and Chair of the High-level Working Party on Taxes, EU Council (01/03/2018)

Recent European and transatlantic debates on issues related to taxing digital economy multinationals may have gotten off on the wrong foot if all blame goes to businesses with no regard for the problems’ actual causes. Of course, that is not true for companies that capitalize on or even abuse mismatches between tax systems in different countries – there the blame is legitimate. However there are companies who respect the letter and the spirit of the law and of the internationally agreed principles. If these companies still end up with large discrepancies between the places where value is created or extracted and where they pay their taxes, then the blame should go to outdated international taxation rules that are the root of the problem and it is up to governments to fix them.

With cross-border operations, it is inevitable that questions arise about where exactly profits are made and where they must be taxed. For traditional cross-border businesses, taxation of profits in different markets relies more or less on being physically present there. This is where a permanent establishment – a fiction of a foreign subsidiary – kicks in as a taxpayer. The rule takes its origins as far back in time as mid-19th century Germany when there was no digital economy whatsoever.

That economy is now far past its dawn stage and most of it is actually a profit-earning algorithm in bits and bytes that have no physical shape and know no borders. Globalization has made it easier than ever to expand business to another country. The EU Single Market has gone further by making it possible for everybody to do business in another member state. Ten years ago, one out of five organizations with the biggest market value was digital, today one out of five is non-digital.

When it comes to the taxation of cross-border businesses, there is a decades old international agreement that every country should have the right to tax the profit that was created in its territory. Therefore, it was also agreed that countries have the right to tax profit, only if the business is physically present: a mine, a factory, a construction site, a shop, etc. Governments, tax authorities, and courts, therefore, find themselves in a paradoxical situation trying to apply rules implying physical presence to something that was never physical from the start. The most recent such case was Google’s battle against a US$1.3 billion French tax bill in July of this year. The Paris court concluded that Google didn’t illegally sidestep French taxes by routing sales in the country out of Ireland.

As a result, we witness a whopping chasm between taxes on profits paid by the old and new economy companies operating in the same fields and exhibiting equal economic presence in a market. But to avoid market distortions, it is important that corporate income tax is as neutral as possible. It should impact businesses in the same way, independent of whether they are small or big, local or foreign, selling vinyl albums or producing military aircraft. This gives our society certainty that all businesses are paying their fair share of taxes and the businesses know that none of their competitors have any unfair advantages. But today we are in a situation where the fastest growing part of the economy is not subject to paying its fair share of taxes in the right jurisdiction.The result is a degree of ambiguity over the tax contribution of the digital economy.

The solution to the problem may lack appeal for some, but alternatives are scarce. With many modern business models, physical properties are no longer relevant for assigning taxing rights to jurisdictions and, instead, looking at significant economic presence gains popularity. Reliance on physical qualities of a digital business must therefore be dropped.

As tempting as it may seem for some to view the issue at hand as yet another EU vs US transatlantic tax woe, the problem is truly global. With the speedy rise of Asia–US and Asia–EU trade, the same questions are now being asked all over the world. India’s equalization levy and Australia’s diverted profit tax demonstrate the global nature of the problems associated with taxing digital economy. Notwithstanding, the issue is quite intra-European as well. There are member states that host digital businesses’ European headquarters and, if any profit tax is paid in Europe at all, it is paid in those countries regardless of where in the EU the underlying value is earned. And some EU members already engage in counteractions by adopting unilateral solutions similar to the ones mentioned above.

The trouble with unilateral solutions is that, contrary to decades-long attempts to curb double taxation, they may instead create it and, one fears, at an unprecedented scale. This is because these solutions tend to be alternative levies and taxes and in that case countries usually deny the application of tax treaty provisions and benefits. According to tax treaties, one country’s profit tax can only be offset against another country’s profit tax. For the European Union as a single market, a set of 28 disharmonized unilateral solutions would make Europe a horrible place in which to do digital business and would greatly undermine the region’s global competitiveness. Imagine a business trying to comply with 28 different solutions to addressing the same problem!

With this in mind, amending the international permanent establishment regulations looks much more promising. The digital economy is as a virtual entity, intangible, and therefore the test of physical presence is irrelevant and must in future be confined to the traditional economy. For the digital economy, the definition of a permanent establishment must be amended to allow a new concept of a virtual permanent establishment to emerge. Detailed requirements for concluding that a virtual taxpayer exists (and must pay real taxes) are of course a matter of a separate agreement. But for those familiar with international tax treaties, it is well known that this will not be a precedent because such agreements exist now, for construction sites, as an example. So, when a digital business engages in active operations in a given market, exceeds the agreed thresholds for the number of customers and / or the volume of trade, and exhibits the continuous nature of its activities, it is then significantly present in that market and must pay taxes on profits earned there. The appeal of this solution, as opposed to unilateral quick fixes, is that the rest of the internationally agreed tax principles can remain intact. If it takes time to reach such an agreement on a global or even a European scale, then quick fixes can be a useful alternative in the interim, but one hopes not for too long, for there is nothing more permanent than temporary.

Holding the Presidency of the EU Council, Estonia is putting solving the digital economy taxation problem high on its agenda. The Estonian Presidency believes that it is possible to fix the international tax rules so that a level playing field between businesses can be restored – countries would re-establish their right to tax profits and society would regain the faith that all the businesses are paying their fair share of taxes.


The OECD, as the world’s academic leader in tax matters has previously tried to come up with a global solution for the profit tax issue but these attempts came under harsh criticism for achieving nothing, but stating the obvious – that a problem existed and it needed to be solved. Some would view the failure to stem from the divergent views of OECD member states who cannot agree on issues such as whether tax should be paid where the digital business originates (is registered) which then conflicts with where (in which member state) this same business has significant presence and earns its income. Hopefully the discussion Estonia started in the EU will be a fruitful one and an acceptable solution will be agreed. The EU solution, not being a global one, can nevertheless feed into the work of the OECD, where results are expected in spring 2018.