Tax and the digital economy

An overview of the challenges raised by the digital economy – from tax issues to reputation risks – and what companies should be doing to safeguard their business. 

Technological advancements and digital capabilities are transforming the global economy; the government estimates that the global digital services market will be worth as much as the entire UK economy by 2020. However, the ability of governments around the world to tax companies in this new online marketplace has not kept pace. As a result, some companies, despite legally complying with the law, have fallen foul of both the authorities and the general public.

What can companies do to ensure they operate within the letter and spirit of the law while also meeting public expectations and protecting their reputation?

The digital economy has snowballed over the past two decades, largely led by improving access to broadband and the increasing prevalence of smartphones. Recent research by Oxford Economics and Virgin Media Business shows that digital capabilities generated £123 billion in business revenues, equivalent to 3.4% of GDP. What’s more, this same research reveals that the UK economy could receive a £92 billion boost if firms fully develop their digital potential.

Tax challenges of digital economy

Given the digital economy’s rapid and substantial growth, the accompanying tax regime is now no longer fit for purpose, especially for those businesses with an international presence. As a result, there have been several high-profile examples of companies that have become embroiled in tax issues that have significantly affected their reputation.

In this new economic environment, we have seen a trend towards tax authorities around the world moving away from direct taxes (such as corporation tax) to indirect taxes (such as VAT). Ultimately, to catch digital transactions and ensure governments’ collect their ‘dues’, authorities are moving towards a system where the consumer bears the cost. The argument often given is that this increases money into government coffers and boosts competitiveness as reducing direct taxes reduces the costs of doing business, creating a more attractive environment for growth. In the UK for example, by 2020 corporation tax will be 18%, which, by historical standards, is very low. To compensate for reductions in direct taxes however, VAT has increased from 17.5% to 20%.

But, as the international tax environment continues to evolve, how should a company navigate its tax affairs and the accompanying risks?

Managing international tax affairs under BEPS

The biggest change to the international tax regime is the Base Erosion and Profit Shifting (or BEPS) project led by the Organisation for Economic Cooperation and Development (OECD) and the G20 group of industrialised nations. The changes recommended under BEPS aim to align taxing rights with relevant value-adding activity, improve transparency and curb avoidance. It will fundamentally alter international tax rules.

The first action (one of 15 in total) addresses the digital economy, recommending a new approach to indirect taxes. This report indicates that best practice is for VAT to be collected where a business’s customers (be they consumers or organisations) are based, and not where the supplier is based – similar to the changes put in place across the EU earlier this year.

This creates plenty of challenges for businesses operating in the digital space, of which complying with VAT regulations around the globe is only one issue. For example, how do you establish where a customer is located, and how can you keep a record of this for the statutory 10 years without falling foul of data protection laws? How should you price a digital download, now that the VAT rate will be different for each customer?

Secondly, in addition to the indirect tax aspects, companies will no longer be able to claim ‘auxiliary or preparatory’ exemptions from having a direct tax presence in a country if such activities or assets are central to the company’s operations. For example, a company such as Amazon will not be able to claim a tax exemption for warehouses in the UK, as they are crucial to the business's ability to deliver its products in the UK. BEPS also puts an end to organisations claiming exemptions if contracts were not concluded in that country. This rule enabled multinationals to escape local taxability tax even if their people, headquarters and consumers were based in country, provided that contracts were concluded elsewhere. Now, if companies go 99% along the road of agreeing a deal, they will be taxable.

Thirdly, BEPS brings in a multilateral instrument which once agreed should ensure that all tax treaties are amended in the same way. This is an important development as, without this overarching agreement and political will, amending individual treaties would simply take too long. What’s more, in October 2015, the latest recommendations were endorsed by G20 finance ministers, renewing their commitment for swift, extensive and consistent implementation of the new rules.

There will be follow-up work and monitoring until 2020, at which point further tax changes for digital businesses may follow. In the meantime, the OECD and G20 recognise that some countries may wish to go further and bring in unilateral measures. These could include seeking to tax a digital ‘nexus’ (taxable presence) locally, a digital withholding tax or some sort of  ‘equalisation levy’. This is seen by many in business as unhelpful, and a stronger steer against measures like a digital transactions tax had been hoped for.

Unilateral measures add to tax uncertainty

While BEPS seeks to establish a common, global framework, companies should remain aware of local developments in their operating countries.

The effect of some countries bringing in their own provisions could be a period of uncertainty, additional cross-border tax disputes and double taxation. For example, in April last year, the UK government implemented a diverted profits or ‘Google tax’ for companies that move their profits overseas to avoid tax. Under the new regime, companies with an annual turnover of £10 million will have to tell HMRC if they think their company structure could make them liable for diverted profit tax. Once HMRC has assessed the structures, and decided how much profit has been artificially diverted from the UK, multinationals have 30 days to object or be subject to a 25% tax on these profits.

Tax strategy and reputation risk

The tax landscape has changed dramatically in recent years, and the reputational risk is high for those companies that don’t keep up. Employees, customers and the general public now expect more from businesses. While tax is a cost of doing business, multinationals are expected to pay their ‘fair share’. This is a subjective area, and the complexity of the tax rules means that it is difficult to judge what is too little and what is too much.

It is important for groups to review and model the impact of the new rules on digital sales, given the amplified the risks of ‘getting it wrong’ and the potential detrimental impact on reputation. Company boards need to be aware of tax in a way they never had to before.

What should companies do now?

The digital economy is redefining the UK and global marketplace, and governments (and their tax systems) have often struggled to keep up.

Companies should be proactive in understanding the new tax regime, and ensure they operate both within the spirit and letter of the law. Crucially, they must consider public opinion and the associated impact on reputation.

For further information on this topic, contact Karen Robb or Wendy Nicholls.