International Tax Planning

Which Countries Win and Lose if the EU’s Digital Taxation Plans Are Adopted?

By Stan Veuger, Resident Scholar at the American Enterprise Institute and Editor of AEI Economic Perspectives (01/11/2018)

The European Commission recently released two proposed directives that relate to the taxation of the digital economy. Adoption of these directives requires consensus among the member states, which does not seem particularly likely in their current form. That said, the proposals are important indicators, both of where the Commission stands, and where some of the countries that have been supportive of the proposal, such as France, may choose to go by themselves. Both proposals would shift tax revenue from the United States to Europe – and would potentially invite retaliation – by taxing activities dominated by American firms where their customers are located. This shift toward destination-based taxation would also reduce the scope for tax competition, both within the European Union and between the European Union and countries outside it.

The first proposed directive  is meant to provide a definitive, permanent answer to the question of how to tax firms that operate online as opposed to only through traditional physical establishments. This question is an important one both within and across countries. In the United States, for example, the Supreme Court is in the midst of deciding whether South Dakota is allowed to collect sales tax from online retailers without a physical presence in the state, in South Dakota v. Wayfair, Inc. The disputed South Dakota law would subject online sellers with annual sales over US$100,000, or more than 200 transactions, to South Dakota’s sales tax regime and all the compliance and enforcement burdens that accompany it.

In this proposal, the Commission applies a similar criterion at the national level to determine whether firms are deemed to have a significant digital presence in a member state, in which case they are allowed to tax profits deemed to have been generated within their borders. A firm would be considered to have a significant digital presence – ‘a virtual nexus’ – in a member state if its annual revenue there exceeds €7 million (US$8,289,144), or if it has more than 100,000 users in the member state, or it has over 3,000 contracts for digital services with businesses in the member state.

The second proposed directive  is presented as a temporary solution that allows countries to collect taxes on certain digital activities while negotiations regarding the permanent fix take place. This interim tax – though what is temporary today can of course become permanent tomorrow – is more narrowly targeted. It would apply only to social media operations and online ad sales, and only to certain large companies – those with worldwide revenue of at least €750 million (US$886 million) and revenue within the European Union of at least €50 million (US$59 million). Those activities, if carried out by such firms, would be hit with a gross-proceeds tax of 3 per cent.

The central justification offered by the Commission for these two proposals is that digital activities escape traditional taxation. The implicit contrast here is with brick-and-mortar establishments that add value and sell products in a single location, which is also where its employees and consumers live. These various elements have of course come unbundled before, in all types of industries, and it is hard to believe that it was through purely deductive conceptual reasoning that the Commission arrived at these proposals. Instead, it is unlikely to be a coincidence that the economic activities at issue here – especially those affected by the interim proposal – are ones where the European Union is a net importer, not a net exporter. While the Commission argues, for example, that only about half of the firms that would owe the 3 per cent gross-proceeds tax are American, the share of actual payments owed would surely be larger. (Note that even a 50 per cent share is quite large, of course.)

But, back to the idea that digital activities escape traditional taxation in a unique manner. There are three different elements at work here. One is that, as discussed, non-European firms are dominant in this industry. Their intellectual property is often located outside the European Union, and most of the value added is created there as well. These companies’ income is therefore mostly not taxed in the European Union, but that certainly does not mean that they are not taxed, especially now that the United States has adopted what, for all intents and purposes, is a global minimum tax. The Commission responds to this by arguing that value in this industry is actually created through “user engagement”, and that the location of such engagement should determine where profits are taxed, which is not currently the case. Most economists would probably dispute that this is a unique feature of social media: the food I buy is also useless if I don’t eat it, where eating is a traditional form of user engagement.

This takes us to our second consideration. One can easily envision a system of corporate taxation that is destination-based, i.e. that taxes profits where consumers are located. In fact, Republicans in the US House of Representatives proposed precisely such a scheme just last year. What does not necessarily seem reasonable is to apply this type of system, as the Commission proposals do, only to industries where consumers are disproportionately domestic.

The third consideration, and one that has led to significant opposition to the Commission’s proposals within the European Union, is that a destination-based tax system, whether organised on the basis of ‘significant digital presence’ rules or not, automatically reduces tax competition. If companies owe taxes strictly based on where their consumers are, they can no longer choose to locate where the tax environment is friendliest unless they manage also to organise massive migration flows. This ought to be concerning to low-tax countries, which would lose some of their attractiveness. The specific criteria proposed to detect a significant digital presence are, in addition, absolute numbers that do not vary with country or population size. This reduces the taxation powers of small EU nations relative to larger ones, which should concern said small nations. (There are countries, of course, that are both small and of the low-tax variety!)

Perhaps then this debate is not solely about new challenges posed by new technology. Perhaps the allocation of resources and the power to extract them are, in fact, as controversial as they have always been.


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