Taxing the Digital Economy: A Critical Look at EC Proposals

Although the European Union’s (EU) digital service tax has been on hold since March, the European Commission (EC) continues to compel its case for a digital services tax. Last year, the EC could not reach an agreement on implementing a digital services tax, and deferred it until the release of the OECD's report on digital taxation, originally due by mid-2020. However, on Oct. 9, the OECD released its “Unified Approach” under Pillar One as part of its continuing work of the Inclusive Framework on BEPS. Nevertheless, it is important to examine the EU-EC proposal. As a potential EU solution, should the “Unified Approach” not be ratified by the bloc? But again, how sound are its arguments?

Not very, according to Gary D. Sprague, partner in the Palo Alto office of law firm Baker & McKenzie LLP. Sprague takes aim at the EC’s underlying rationale in a Bloomberg Tax reprint from the Tax Management International Journal titled “A Critical Look at the European Commission Staff Impact Assessment Relating to the Proposed EU Directives on Taxation of the Digital Economy.” This short, densely argued 2018 article remains a must-read for tax leaders with an interest in the future of taxation in the era of global digitization. (Take a close look at the discussion on page six under the “The Interim and Comprehensive Proposals” subheading.)

Sprague takes issue with the EC’s definition of the perceived problem that it’s seeking to address, as well as the objectives of the proposed changes, as laid out in the Commission’s Impact Assessment. For example, the EC argues that much of the value of a business is created where users are based, as well as where data is collected and processed. But Sprague points out that “the aggregation, structuring, processing and analysis of data does not occur at the user’s location; it happens at the location of the enterprise through the enterprise’s personnel, employing the enterprise’s hardware and software assets.” In my estimation, the significant factor remains the “Value Creation” assessment and the proper allocation of risk, cost and profit distribution in proportion to the appropriate jurisdiction. Therefore, two questions must be asked:

1. What is the value creation?
2. How is value creation measured and determined for the purposes of digital services tax?

One by one, Sprague tackles the EC’s positions on why digital enterprises deserve special tax treatment: their supposed tax avoidance advantages, “scale without mass,” “winner-takes-most” dynamics, and so on.

Perhaps the most compelling analysis comes in the closing section, where Sprague looks at how the proposed tax would alter the distribution of the tax base among the countries where digital services are created and the countries where users are located. The proposed 3% tax would be levied on gross revenue from certain digital services. Sprague finds that the new tax would result in 87% of the taxable profits being allocated to the user location country, and just 13% to the country where the service provider is located. This disproportionate allocation of profits is significant, as it would further create deadweight loss and market distortions.

What’s more, the OECD is already exploring potential solutions to this question of source and residence taxation through its Inclusive Framework, with a final report expected in 2020. Sprague expresses the hope that EU countries will regard their own digital taxation proposals as “contributions to the debate, but then let the OECD perform its normal role of setting global standards for international tax.”