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Digital tax must be solved outside arm’s-length principle, says UK Treasury official

Taxing the digital economy will mean going beyond the arm’s-length principle (ALP), one UK Treasury official has confirmed. This could spell trouble for taxpayers.


As the world scrambles to find a solution to taxing technology companies, the UK has reiterated its commitment to the controversial plan to such companies by user data in the face of US opposition. The G7 agreement could defuse this situation, but there are no guarantees of an international consensus taking shape by January 2020.


“If we threw our tax policies up in the air and decided to start again from scratch, businesses would not know what to do,” said Mike Williams, director of business and international tax at the UK Treasury. “The solution has to be outside the ALP, but the question is how far outside it.”

“You need to look at the group as a whole and we have to look at non-routine profits,” he stressed. “You do need to maintain a link with the existing arm’s-length rules.”

The UK government issued its draft guidance for a digital sales tax (DST) earlier in July and shows little sign of backing down, even after the US warned it will not sign a free trade deal if the levy becomes policy. The DST is set to come into force in April 2020, several months after the UK is officially scheduled to leave the EU.

“The UK has always sought to lead in finding an international solution to taxing the digital economy,” said Jesse Norman, paymaster general in the UK Treasury.

“This targeted and proportionate digital services tax is designed to keep our tax system in this area both fair and competitive, pending a longer term international settlement,” he added.

Everything hinges on the OECD and the G20 fleshing out the idea of a global minimum tax rate and making it viable for all signatory states. If no solution is reached, countries such as France, Italy, Spain and the UK, which have all announced unilateral measures, can fall back on special tax regimes for the tech industry.

Moving against the tech giants

The UK government confirmed on July 11 that it will go ahead with the DST, but key details have been revised to “limit the revenue from a marketplace transaction” charged to the DST in certain cases, i.e. where users are located in a country that also has such a tax in place.

Williams stressed that the international tax system has coped with change in the past. Those days might have ended with the birth of the internet, though.

“The key issue for the UK is the strain on international tax rules by high-tech business models,” Williams said.

“There have always been lossmaking companies and businesses that offer things for free, at least for a little while,” Williams continued. “Now there are free services that last forever because, in using those services, you provide your data to be harvested and monetised. A free service in perpetuity is not something that we’ve seen before.”

“You have social media websites where users generate content and nothing except what the users put out there in their interactions creates the value,” he added.

“My iPhone is a high-value physical good, but in terms of value creation the branding of Apple is in California and the parts are assembled in China,” Williams explained. “The iPhone is a reflection of the modern economy.”

“How much of that activity should be taxed in the UK because the goods are purchased online in the UK?” he asked. “We’re still keen to find some principle in all of this.”

The UK’s plan has no shortage of critics. Many online businesses would argue the problem is that the amount of user data is hard to determine the real contribution by individuals to a company’s margins.

“If we’re going to impose a threshold, you have to be able to measure it,” said one tax director at a UK software company. “If you’re going to come up with tax policies just for tech, you need to ground them in reality if you want them to be practical.”

Taxing companies like Facebook and Google by user data is just one consideration. The UK Treasury is eager to find a reform to the nexus and profit allocation rules that would not alienate businesses. However, politicians are much happier to talk about the issues around nexus, even though profit allocation is far more important.

Many businesses favour an approach to residual profits that would leave the arm’s-length principle in place for routine profits and the rest of the supply chain. However, the details will determine whether this proposal will lead to a modest reallocation or a dramatic redistribution.

Splitting the difference

There are alternatives on the table. The IMF is considering whether the best solution would be a residual profit allocation (RPA) by income. The OECD is paying close attention to the debate on this particular proposal because it may be a way of balancing opposing interests.

“The OECD can deliver certainty for business. Of course, the opposite is also true and more uncertainty would be very unwelcome,” said Janine Juggins, senior VP of global tax at Unilever.

US businesses are less worried about a reallocation of residual profits because they stand to lose out less than foreign multinationals. According to the IMF, the US accounts for 30% of global residual profits compared to just 12% in China, 8% in the UK, 6% in Japan and 4% in Germany.

Meanwhile, the rest of the world accounts for 40% of residual profits. So, the tax revenue impact of a destination-based RPA system would be dramatic. Most countries would see their tax revenue either increase or fall under this system.

“The RPA system would encourage investment in countries with comparably higher taxes on residual profits than the weighted averages of such rates, while it would discourse investment in lower-tax countries,” said Li Liu, economist at the IMF.

Developing countries like Rwanda and Uganda would stand to gain the most revenue, whereas low-tax jurisdictions like Ireland and the Netherlands would have the most to lose. For example, Cyprus could lose 80% of its tax revenue.

Of course, there is more than one way to divide routine and residual profits and it is possible to shore up existing TP rules through residual profit splits. This is where some US companies and some OECD countries might find their interests align.

“The isolation of residual profits for our purposes reflects the wish to have the least possible impact on transfer pricing,” said Richard Collier, senior tax advisor to the OECD. “It’s the least complex approach.”

“I’ve worked on residual profit splits for more than 20 years,” he continued, adding that “residual profit splits are rarely used in most industries, but they tend to work well in the financial sector where they are used a lot.”

This is why it is clear the digital tax debate is not just about the online economy. It is about how the international tax system works for all companies.

“The tech industry is like any other trade and the whole of the global economy is going online,” said one TP director at a UK cybersecurity firm. “It’s not the case that you can ring-fence the so-called digital economy from everything else.”

“So we need something new and it needs to work for the whole economy,” the director said.

As international organisations try to find a consensus, the tax world watches as a growing number of countries take action on their own. Even if global agreement is reached soon, the outcome may still be more fractured than united.



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