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The UK digital services tax: ashes to ashes, DST to dust?

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The UK government has published draft legislation to establish a new 2% digital services tax in the UK. The UK DST will be a charge on the revenues large multinational enterprises derive from certain highly digitalised activities (search engines online marketplaces (with an exemption for financial and payment service providers) social media platforms and any associated online advertising business). The new tax will be payable annually where the worldwide group’s total digital services revenues exceed £500m and its total UK digital services revenues exceed £25m. There are draft rules providing for an alternative ‘safe harbour’ mechanism for calculating DST liability; targeted anti-avoidance; the interaction with other taxes; and administrative requirements. The draft provisions are scheduled for inclusion in the next Finance Bill and are due to take effect from 1 April 2020. However in the current political environment it is conceivable that the tax may not...

On 11 July 2019, the UK government published draft legislation to establish a digital services tax (DST) in the UK. Originally announced at Budget 2018, the UK DST is a 2% tax on the revenues (not profits) of large multinational enterprises (MNEs) conducting highly digitalised business activities deriving value from UK users.

The draft legislation (and guidance) is subject to technical consultation until 5 September 2019. Assuming everything proceeds normally, the UK DST will be included in the next draft Finance Bill (which should become Finance Act 2020) and enter into force from 1 April 2020.

This article provides a technical summary of the draft legislation. It then considers how the US administration in Washington views the unilateral action of various countries, including France, to introduce a DST and how it might respond should the UK implement one. Finally, we consider what the implications for the UK DST might be following Boris Johnson becoming UK prime minister.

The UK digital services tax

Groups and revenues

The calculation of UK DST liability relies on identifying the digital services revenues of a large, global, group during an accounting period.

A group is comprised of any ultimate parent company (or any other listed, widely held, entity) and all of its subsidiaries (if any) consolidated in accordance with international accounting standards (IAS), UK generally accepted accounting practice (GAAP) or US GAAP.

The charge to UK DST follows the accounts, i.e. the regime relies on accounting principles to calculate the liability. Revenues arising to, and expenses incurred by, members of the groups, in relation to in scope digital services activities, are the amounts recognised in the income statement in the group’s GAAP compliant accounts.

Digital services activities and digital services revenues

‘Digital services revenues’ are the group’s total revenues arising in connection with any digital services activity (i.e. substantive business services provided for a commercial purpose) carried on by any group member.

A ‘digital services activity’ is:

  • a social media platform, i.e. an online platform that promotes interaction between users and enables the sharing of content between users. The definition covers social networking sites, video or image sharing platforms and online dating websites but not email or messaging apps;
  • an internet search engine. The legislation does not specifically define what an internet search engine is and so the term should take its ordinary meaning. It will not cover intranet or single webpage search functions; or
  • an online marketplace, i.e. an online platform that facilitates the sale (including hire) of any services, goods or other property by its users. Online marketplaces provided by authorised financial services providers, recognised investment exchanges and payment services providers, are excluded from scope, and so exempt from the UK DST, if more than half of the relevant revenues arise from the facilitation of the trading or creation of financial assets.

A UK DST liability will also arise on revenues from any online advertising business (i.e. a business operated on an online platform providing or facilitating online advertising) associated with providing a digital services activity and derives a significant benefit from its connection with it. An online advertising business is not a digital services activity in its own right.

UK users and UK digital services revenues

‘UK digital services revenues’ are the proportion of a group’s total digital services revenues that are attributable to UK users.

A user is any person that uses a digital services activity. A ‘UK user’ is widely defined as (based on the available evidence) any:

  • individual normally located in the UK; and
  • legal or non-natural person established in the UK.

In most cases, digital services revenues will be attributable to UK users to the extent they arise in connection with UK users using the digital services activity. There are two exceptions to this general rule:

  • Revenues arising from an online advertising business will be attributable to UK users to the extent UK users are the intended audience for the advertising. The test sets a low threshold. It is the intention that matters, irrespective of actual UK user views or engagement.
  • All revenues arising from any (in scope) online marketplace business transactions will be attributable to UK users if:
    • a UK user is a party to a transaction; or
    • the revenues arise in connection with the sale, hire or provision, of UK land, premises or accommodation.

Respondents to the government’s UK DST consultation expressed concern that the introduction of a DST by another country would risk double taxation on cross-border transactions. Consequently, the second exception is subject to a special rule that provides relief to the extent that a member of the group is party to a relevant cross-border transaction.

A ‘relevant cross-border transaction’ is:

  • an online marketplace transaction;
  • involving a UK user and a non-UK user; and
  • where some or all of the revenues arising from the transaction are (or would be) subject to a foreign DST charge (i.e. a non-UK tax charge which is substantially comparable to the UK DST).

In such cases, the calculation disregards 50% of the UK digital services revenues arising to the member of the group (and, under the alternative basis of charge, 50% of the relevant allowable operating expenses) in respect of the transaction. In effect, the regime halves UK DST liability on revenues attributable to such transactions.

Liability: the principal basis of charge

There is no liability to UK DST unless the worldwide group meets two financial threshold conditions in any accounting period. The two thresholds are:

  • total digital services revenues exceeding £500m; and
  • total UK digital services revenues exceeding £25m.

The rules restrict the maximum length of any accounting period to 12 months. This means long accounting periods will be split into a 12 month period with another ending on the next accounting reference date (or after a further 12 months if earlier). Where the relevant accounting period is shorter than one year, the rules reduce the threshold amounts proportionately.

When the thresholds are met, a group’s liability to UK DST is 2% of the total amount of UK digital services revenues arising in the period in excess of £25m, i.e. there is an annual allowance for the first £25m of group-wide UK digital services revenues. As for the thresholds, the £25m exemption is pro-rated for periods of less than one year.

Where the group has a UK DST liability, each member of the group (a relevant person), wherever it is resident for tax purposes and irrespective of whether it has a taxable nexus in the UK, will be separately liable to UK DST. The relevant person’s liability will be its share of the group’s UK DST liability that reflects the proportion of the group’s total UK digital services revenues attributable to that person.

Liability: the alternative basis of charge

The legislation allows a group to claim an alternative, ‘safe harbour’, mechanism for calculating its DST liability for any accounting period. The safe harbour will only be of interest to groups with very low (or negative) UK operating margins.

However, applied in appropriate cases, a valid safe harbour claim should ensure:

  • a reduced effective rate of UK DST (or, where the group operating margin for its UK digital activities is nil or loss-making, eliminate liability altogether); and
  • a UK DST liability cannot create a loss for the group.

A group elects to use the alternative basis of charge by making a claim in the group’s DST return for the relevant accounting period.

A valid claim eliminates the two financial threshold conditions. It can apply to group revenues arising in connection with any, or all, of the in scope digital services activities. Consequently, a group can make a maximum of three elections (one for each type of activity) in respect of any one accounting period.

In essence, the alternative basis of charge:

  • Apportions the £25m annual allowance (as reduced in a short accounting period) between the in scope digital services activities in proportion to each activity’s contribution to the group’s total UK digital services revenues in the relevant period. This produces the group’s total net revenues for each category of activity in the relevant accounting period.
  • For each digital activity (as specified in the claim), multiples the net revenue figure by a factor equal to 0.8 of the group’s operating margin (calculated in accordance with accounting principles) for the specified activity in the relevant period.
  • The calculation deducts certain operating expenses (incurred in earning the UK digital services revenues from the specified activity) from the group’s total net revenues for that activity in that period.
  • Interest expenses, acquisition costs, expenses incurred outside the normal course of business, any taxes and any cost resulting from a change in asset valuation, are all unallowable expenses for these purposes. In addition, groups cannot carry forward losses from earlier periods.
  • The product is the group’s total UK DST liability in relation to the specified digital services activity for that period.
  • Determines the group’s UK DST liability in relation to any other (i.e. unspecified) digital services activity as 2% of the net revenues for that category of activity in that period.

The draft guidance published alongside the legislation includes some basic example that illustrate how to carry out the calculation in practice.

Adding the group’s UK DST liability in relation to specified digital services activities to the group’s UK DST liability in relation to its unspecified digital services activities, results in the group’s total UK DST liability. As under the principal basis of charge, each group member is separately liable to UK DST in proportion to the share of the group’s total UK digital services revenues attributable to it.

Anti-avoidance and interaction with other taxes and administration

The regime includes a targeted anti-avoidance rule (TAAR). The TAAR counteracts any DST advantage (broadly, any avoidance, reduction or deferral, or any repayment, increased repayment or accelerated repayment of DST) obtained from avoidance arrangements where:

  • obtaining the DST advantage was the main, or one of the main purposes of entering those arrangements; and
  • entering them was contrary to the policy objectives of the DST.

A UK DST liability is deductible as a normal expense of business (provided it is incurred wholly and exclusively for the purposes of a trade) but it cannot be credited against a UK corporation tax (or any other tax) liability. The UK government recognises UK DST could result in double taxation, creating ‘challenging outcomes for businesses which already recognize significant taxable profit in the UK’. It has refused to introduce a credit system on the basis that it would not be ‘simple’ and could jeopardise the ‘non-discriminatory’ design of the tax.

Finally, the legislation sets out comprehensive rules covering the administration of the tax including group registration, self-assessment and the submission of returns, penalties and far-reaching powers for HMRC.

The view from Washington

The US is opposed to digital services taxes, which it views as revenue grabs targeting primarily US companies. According to press reports, the Trump administration has already threatened to walk away from discussions of a new US/UK free trade agreement (FTA) if the UK does not drop its plan to implement the UK DST.

After France enacted a digital services tax in July this year, the Office of the US Trade Representative (USTR) announced an investigation under s 301 of the Trade Act of 1974 into whether the new French tax merited retaliatory measures by the US. Such measures could include tariffs on imports from France into the US. Section 301 allows retaliatory measures to be taken (at the president’s discretion) on where a foreign country’s action is discriminatory or unreasonable and burdens or restricts US commerce.

Both Republican and Democratic leaders of the tax-writing committees in the US Congress praised the USTR’s announcement. In a joint statement, Senators Chuck Grassley and Ron Wyden, the top Republican and Democratic members of the Senate Finance Committee, said, ‘the US would not need to pursue this path (of potential retaliatory measures) if other countries would abandon these unilateral actions and focus their energies on the multilateral process that is underway at the OECD.’

The UK and France are both participating in that multilateral process as members of the Inclusive Framework on Base Erosion and Profit Shifting (‘the Inclusive Framework’), which has undertaken a programme of work, blessed by the G20 leadership, to address the tax challenges of the digitalisation of the economy.

The senators also suggested that the Treasury department consider using a different tool in response to the French DST (and other unilateral DSTs), namely s 891 of the US Internal Revenue Code. This little-known provision (that has never been used) permits the US to impose taxes on the nationals of a foreign country in response to the imposition of a discriminatory tax by that country on US nationals. It is not at all clear that the French DST (or the UK DST) would actually provide a basis for action under s 891, given that they apply to all companies that come within their scope, rather than to US companies only.

Whether or not the s 301 investigation of the French DST leads to tariffs on French goods or to other retaliatory measures, it seems clear that the US is determined to take an active approach to opposing the enactment of digital services taxes that would apply disproportionately to US companies. As the UK is likely to be in a weak bargaining position vis-à-vis the US in the wake of a UK exit from the EU later this year, it can be expected that the US will press its advantage in an effort to persuade the UK to abandon the UK DST.

London calling

The policy justification for the UK DST is that globalisation has facilitated a misalignment between the place of economic activity (i.e. value creation) and the place of taxation of profits arising from that activity. Digitalisation exacerbates the problem.

The UK government insists it supports international cooperation in tax matters and is leading the effort to find a global, consensus-based, solution to the tax challenges of digitalisation. However, signalling the UK’s willingness to act unilaterally, former Chancellor of the Exchequer Philip Hammond described progress as painfully slow. By announcing ‘a targeted, proportionate, and temporary tax’, the UK hoped to pressurise the Inclusive Framework to accelerate efforts to find a consensus.

There is debate over how targeted and proportionate it is but, if implemented, it is also far from clear the UK DST will be temporary.

The passage of the UK DST is well advanced. It has progressed in accordance with the normal Budget timetable and tax policy-making process. In normal circumstances, it would be certain that the UK DST would enter into force from 1 April 2020.

Once in force, it could be set to stay. There is no ‘sunset’ provision in the draft legislation. HM Treasury is merely obliged to, ‘conduct a review … and prepare a report’ before the end of 2025. The only stated metric for that review is, ‘whether [the UK DST] is meeting its policy objectives’. It is not at all certain that the review will initiate the withdrawal of the tax, even if the Inclusive Framework has reached an agreement on a consensus solution.

However, politically and economically, current circumstances are anything but normal.

Politically, Brexit dominates. Although the governing party has not changed, the UK has a new government, led by a radically different prime minister, Boris Johnson, at the head of an unrecognisable Cabinet. It also has a new, less austere, chancellor of the exchequer, Sajid Javid. The priority for the new government is to ensure the UK leaves the European Union. Prime Minister Johnson has promised to deliver Brexit, ‘do or die’, on 31 October 2019.

Economic reality is largely unchanged. The need to find new sources of tax revenue, and to ensure MNEs contribute a ‘fair share’, will remain a priority. However, economic policy is about to experience a transformation. ‘Boosterism’ under Johnson and Javid will replace the ‘austerity’ of (former PM) Theresa May and Hammond. Alongside numerous pledges to cut taxes and increase spending, the new government heralds Brexit as an opportunity to remake the UK economic model. UK policy is likely to pivot away from Europe towards a new globalism (and the US in particular). The theory is that (given time) incentivising economic growth reaps higher tax receipts. It is an argument that echoes justifications for the Tax Cuts and Jobs Act in the US in 2017.

The importance of securing a comprehensive new FTA with the US is central to the success of this strategy. Putting to one side the (im)possibility of securing Congressional approval, and irrespective of the scale of the US administration’s retaliation against the introduction of a French DST, the implementation of the UK DST will be an obstacle to a UK/US FTA.

The combined effect of the imperatives to secure Brexit (‘come what may’), reboot the UK economy and align UK interests more closely with those of the US, it is conceivable the UK DST will become a small bargaining chip in larger, trade-related, negotiations. If, during the course of this autumn:

  • the UK leaves the EU without a deal on 31 October (and conducts an emergency Budget primarily focused on addressing the economic shock that follows);
  • politically, the UK decides to swing firmly behind the US stance on the digitalisation of the global economy (i.e. that the tax challenges must only be resolved by global consensus), and
  • as is expected, the Inclusive Framework publishes an agreement on the framework for that consensus to be implemented by the end of 2020,

the Johnson government could decide that implementing the UK DST for what would be a very short period, for a very small amount of revenue, at the risk of angering Washington and jeopardising progress on a UK/US FTA, is simply not worthwhile.

Very quietly, it might decide to bury the UK DST. Ashes to ashes, DST to dust.