What’s the Issue?
Traditional international tax rules make it difficult for governments to tax profits from foreign digital service providers. For more information on the reason for this, see
Pillar One – Summary, however, the key point is that domestic tax and tax treaties (which generally override domestic law) require a permanent establishment before a taxing right can exist in a market jurisdiction.
Given the growth of the internet, this has been a massive issue and has resulted in governments forgoing huge amounts of tax revenue.
In order to combat this, a number of governments took matters into their own hands and have introduced measures to tax this income. There are three main ways they have done this.
2. Secondly, other governments apply withholding taxes to revenue received from providing digital services. Examples include Malaysia (Under Section 109 of the
Income Tax Act) and Mexico (Article 113-A of the
Income Tax Law).
3. Thirdly, some countries deem there to be a permanent establishment (PE) in a jurisdiction when digital services are provided above certain thresholds. This often takes the volume of payments and the number of users located in a country.
This then allows the jurisdiction to tax the income attributed to that permanent establishment under its general corporate income tax regime, just as for any other PE income. Both Indonesia (
Regulation No. 1 of 2020) and India (Section 9 of the
Income Tax Act, 1961) have implemented some form of a deemed permanent establishment (referred to in their tax legislation as ‘significant economic presence’) as well as some of the other measures above.
The problem mainly lies with digital service taxes (ie the first method above). Not only do they distort the international tax system but they aren’t based on income but on revenue. This means there are few, if any, tax deductions allowed. A loss-making company could for instance still be subject to a DST in many jurisdictions. An effect of this is that this means the DST isn’t creditable for double tax relief purposes.
It’s also worthwhile noting that determining
DSTs internationally can be tricky, as they are not always referred to as DSTs and may be outside the usual tax legislation. For instance, in Poland Section 19(6a) of the
Cinematography Act provides for a 1.5% tax on the gross revenue from streaming services in Poland. This is a separate levy payable to the Polish Film Institute.
Pillar One
This is where the OECD steps in with
Pillar One. The aim was to find a way to allocate profits to market jurisdictions (ie where the revenue is sourced from). Initially, Pillar One applied to automated digital services and consumer-facing businesses (as it was targeted at solving the problems caused by countries unilaterally implementing DSTs). This is no longer the case, and it applies to all business models (subject to certain exceptions).
We have extensive information on the application of Pillar One, however, the end result is the
allocation of profits to market jurisdictions even where there is no permanent establishment there. This would therefore solve the issue of establishing a taxing right to tax digital services.
As such, a key part of Pillar One is the removal of DSTs and other unilateral measures. The recent
Progress Report on Amount A of Pillar One reiterates this and states that the multilateral convention on Amount A of Pillar One will include a requirement to withdraw all existing DSTs and relevant similar measures for all companies. Key points that flow from this include:
1. The requirement to withdraw DSTs applies to all companies. Currently, DSTs have a much lower threshold than Pillar One before they apply. This is because Amount A of Pillar One only applies where the revenue of the group is more than
20 billion euros and the pre-tax profit margin of the group is more than 10 per cent.
Therefore the scope of DSTs is wider than Pillar One. However, the OECD indicates that all DSTs for all companies will have to be removed.
2. No future DSTs. The Progress Report also states there will be a requirement not to enact DSTs (or relevant similar measures), where they impose taxation based on market-based criteria, are ring-fenced to foreign and foreign-owned businesses and are placed outside the income tax system (and therefore outside the scope of tax treaty obligations).
3. The definition of ‘relevant similar measures’. This has not been defined but the Progress Report states that it will not include value-added taxes, transaction taxes, withholding taxes treated as covered taxes under tax treaties, or rules addressing abuse of the existing tax standards. Therefore it is likely that of the three categories of digital tax provisions outlined above, only the first category (ie true DSTs) will be required to be withdrawn.
July 2023 Outcome Statement
In the OECD Outcome Statement issued on July 11, 2023, 138 countries and jurisdictions agreed to not impose any new DSTs (or relevant similar measures) on any company before December 31, 2024, or the entry into force of the MLC if earlier, provided the signature of the MLC has made sufficient progress by the end of the year.
Unilateral Measures Compromise with the USA
The USA had proposed trade sanctions against Austria, France, Italy, Spain, and the United Kingdom
which all have a digital service tax in place. On October 21, 2021, a statement was issued (the ‘Unilateral Measures Compromise‘) under which a transitional approach to these countries’ existing DSTs was agreed until Pillar One is implemented. Turkey also later signed the Unilateral Measures Compromise.
Under the Unilateral Measures Compromise with the USA, Austria, France, Italy, Spain, Turkey and the United Kingdom keep their existing DSTs in place until Pillar One is implemented.
However, to the extent that taxes that accrue to Austria, France, Italy, Spain, Turkey and the United Kingdom under their DSTs between January 1, 2022, and December 31, 2023, exceeds the amount of deemed tax under Pillar One for that period, the excess is creditable against the corporate income tax liability on Amount A under Pillar One.
In exchange for this, the USA agreed to terminate the proposed trade sanctions with these countries.
On February 15, 2024, the Unilateral Measures Compromise was
extended until June 30, 2024. This reflects the latest Pillar One timeline from the OECD which suggests the finalization of the text of the Pillar One multilateral convention by the end of March 2024 with a view to holding a signing ceremony by the end of June 2024.
