Policymakers across the world are currently enamored by taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policies that target digital companies, and there are many policy efforts projects that are currently running in parallel. First, the OECD has been working on an approach that we learned last week is expected to wrap up by mid-2021. Second, many countries have been moving unilaterally to adopt digital services taxes, equalization levies, and other policies that would change tax rules for digital companies. Third, the UN is working to change tax treaty language with special provisions for digital companies.
In each case, policymakers are relying on an assumption that digital companies should be subject to special rules. However, a special approach to digital businesses is likely to introduce new distortions into an already complex system of cross-border tax rules.
This week, the UN Tax Committee is having virtual informal meetings on international tax issues, and digital taxation is on the agenda for Friday. The committee will be considering a change to the UN’s model tax treaty. The changes, if adopted and implemented by countries, could result in digital companies paying more taxes in countries where their customers are located even if those companies do not have physical locations there.
Countries regularly enter bilateral tax treaties to minimize the likelihood that income is taxed in two jurisdictions. When two countries adopt a tax treaty, they are essentially agreeing to share taxing rights over income flows between the jurisdictions. In some cases, taxing rights are attributed to the residence location of an individual or business. In other cases, taxing rights are shared more evenly between jurisdictions.
Individual tax treaties are often built off a model tax treaty like the OECD model or the UN model. The UN model is generally more generous (relative to the OECD model) in providing taxing rights to countries where products are sold or that are receiving investment flows.
On digital taxes, the UN is considering new language in its model tax treaty that would give more taxing rights to countries where customers of digital platforms are located.
If, for instance, a social media company based in Country A sells digital advertisements to customers in Country B, but the company has no other activities in Country B, the proposed UN model tax treaty language would give Country B the opportunity to tax the company’s income based on the location of the sales.
That tax could take one of two forms under the proposal. First, Country A and Country B could agree on a gross-based withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. tax rate that Country B could apply to payments for digital services from customers in Country B to companies providing those services from Country A. Because gross-based withholding taxes do not take net income into account, companies subject to such a tax could be taxed in excess of their profit margin.
This is why the proposed treaty language provides an alternative mechanism for taxing cross-border digital services. The company in Country A could choose to pay based on net income that is deemed to be associated with sales in Country B. The company would take its gross sales to Country B, multiply it by its global profit ratio, and multiply again by 30 percent to arrive at its tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. in Country B.
The UN proposal only matters to the extent that countries might adopt the provisions. In the example, Country A and Country B would need to agree to the treaty language that lets Country B tax the profits of a company that only has a connection to Country B through sales. So it would need to be in Country A’s interest to share taxing rights over the digital company with Country B.
If multiple countries adopt the new language into their bilateral tax treaties digital companies could end up paying tax on 30 percent of their profits using the new UN approach.
The UN treaty discussions are not occurring in a vacuum and it is worth considering the potential impact of a new treaty provision in the current environment. If some countries are fully engaged in the OECD process and see that forum as the path to cross-border tax reform on digitalization, then those countries will be unlikely to want to change their tax treaties to reflect the UN proposal. It is possible that this proposal could have a longer-term impact, however.
Research on the influence of changes in model tax treaties has been done by law professors Elliott Ash and Omri Marian. Their work finds that changes to the UN model tax treaty have historically been less influential on bilateral tax treaty provisions than changes to the OECD model. However, over the longer run, countries have tended to adopt bilateral tax treaty language that more closely follows the UN approach in some areas.
Other research by Martin Hearson, a research fellow at the International Centre for Tax and Development, points to the potential for a change at the UN to influence tax treaty language agreed to between non-OECD countries. Such a result would likely leave many digital companies that are headquartered in OECD countries beyond the scope of the UN approach.
The drafting group that developed the UN proposal includes several non-OECD country members of the UN Tax Committee. The group includes committee members from India, Argentina, Ghana, Nigeria, Brazil, Ecuador, Djibouti, Liberia, Zambia, Thailand, Kenya, Vietnam, and Jamaica. The prospects of the proposed treaty language will depend on it gaining sufficient support beyond this drafting group.
Whether the UN approach, the OECD approach, or the ongoing uncoordinated approach to taxing digital companies is to prevail, the trend toward targeting digital firms looks likely to continue. Given this, it seems that digital companies, however defined, will be subject to special tax rules that other companies may not face. By designing taxes with a single industry in mind, policymakers are choosing to fragment international rules while moving away from a neutral approach to taxation.
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