“In a digital world, we don’t just tax profits in the country where a business has a physical presence.”

Most international businesses pay taxes via local offices (permanent establishments) on profits they realize in other countries. But in today’s digital economy there is often no such thing as a permanent establishment, despite the fact that products and services are sold in several countries, and customers create information that is valuable. Should the country where the customers are located therefore not also be able to tax part of the profits? Michael van Gijlswijk, partner at KPMG Meijburg & Co, explains these developments in more detail.

How do you actually tax the profits of a digital business? And what has to change in order to achieve this? The contours of a solution already exist and require the following steps to be taken:

1. Determine which businesses would be subject to a new tax regime
2. Define a way of determining which countries may levy taxes
3. Create an allocation formula to determine which part of the profit the ‘customer countries’ are allowed to tax

Step 1: Determine which businesses are subject to the new regime

In order to tax the profits of a ‘digital’ business, the first step is to determine which businesses belong to the digital economy. But how do you do that? In the case of Apple, Google, Amazon and Facebook that is beyond dispute. But cars also contain software and generate data on driving behavior and consumption. They thus generate value. Just like apps, smart lighting and TVs.

Specifying which businesses are part of the digital economy, and thus which businesses should be taxed differently, is harder than it looks. A reference point for the new tax thus becomes a problem.

The easiest way to solve this is to have it apply to all businesses, which means ring-fencing issues are avoided.

Step 2: Define a way to determine which countries may tax part of the profits

Under current international tax law, the profit of a business is the starting point for corporate income tax. And that is also the right yardstick. More than turnover, profit better represents the ‘capacity’ of a business to contribute to society in the form of taxes.

In principle, tax is paid where the business is physically located. If a company has a permanent establishment in another country, it pays tax in that country on the profits earned there. When is there a permanent establishment? Physical presence is the deciding factor here. In order to allocate profits to this permanent establishment, it is simply assumed that it is an independent entity. In the digital economy, little, if any, physical presence is needed in order to do business in a country.

So we need to find a way to define the digital variant of the old-fashioned ‘permanent establishment’. Only if this is the case is a country eligible to tax part of the profits generated in that country.

What criteria can be used to define a digital presence in a country? That is debatable. A relatively easy to use criterion could be the turnover generated in a country that exceeds a certain amount.

Step 3: Create an allocation formula to distribute profits among the countries 

So far so good: we’ve established the digital permanent establishment in a country. What now needs to be determined is which part of the total profit can be allocated to the digital permanent establishments (and the digital activities). The amount of this allocation constitutes the amount on which tax is levied.

As is currently the case, the allocation would be determined on the basis of various functions and the extent to which they contribute to profit. The value added by customers should also be explicitly included.

This allocation will vary from case to case since every business is different. The downside of this is that it can cause a lot of debate, which in turn creates legal uncertainty. As it often does in matters that prove divisive, the OECD (Organisation for Economic Development and Cooperation) could develop rules to provide some guidance. An alternative could be to create a fixed allocation formula. That won’t be easy, because different countries means different vested interests. For example, large countries with a large sales market will be more enthusiastic about a profit distribution linked to customers than countries with a smaller sales market.

A solution in ten years

The contours of a solution already exist. However, its actual interpretation is still complicated. Doing nothing is not an option either. On May 31, 2019, the OECD indicated in its report Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising from the Digitalisation of the Economy that it intends to deliver a final report by the end of 2020. That gives us hope.

Information

Would you like to know more about the consequences of the above developments for your business? Please feel free to contact Michael van Gijlswijk or your designated contact at KPMG Meijburg & Co.