UPDATE (July 12, 2019): On July 11, the UK released draft legislation for its digital services tax. The proposal is expected to be adopted by the government this fall as part of the annual finance legislation, and the new 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. would be effective beginning in April 2020. In addition to the policy elements outlined below, the draft legislation provides for a 50 percent reduction in the tax in certain circumstances if revenues that would otherwise be taxed are connected to a user that is located in a country with a similar tax. The purpose of this is to limit double taxation of revenues that are covered by digital services taxes in other countries.
When Chancellor Philip Hammond of the United Kingdom introduced his 2018 budget in October, he included a proposal for a digital services tax (DST). As part of his remarks on the DST, Mr. Hammond said, “This will be a narrowly-targeted tax on the UK-generated revenues of specific digital platform business models.” He went on to clarify that the tax would fall only on profitable companies and not on goods ordered over the internet.
These comments seem to suggest that this tax will not be a serious burden, and that this is a surgical policy approach to taxing the revenue of digital firms. Unfortunately, though, the details of the proposal reveal what is likely to become a significant compliance and administrative burden.
The UK is not alone in pursuing a special tax on digital companies; however, it is taking a unique approach. The proposed DST will be a 2 percent tax on revenues of search engines, social media platforms, and online marketplaces. The tax will apply to companies with global revenues of at least £500 million (US $638 million), although the first £25 million (US $31.9 million) of UK revenues would be exempt.
The proposal also suggests that the calculation of the tax will ensure that loss-making businesses will not have to pay the tax and that businesses with low profit margins will be able to pay a lower rate. For some companies, the tax expense from the DST will be deductible against their UK corporate taxes.
This design makes the DST an excise tax on certain revenues that also allows for a profitability calculation.
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The various thresholds and definitions create challenges for firms that are expecting to face the tax. In addition to complying with current corporate tax rules, companies will have to determine whether they meet the applicable revenue thresholds for the specific activities targeted by the tax. In many cases, this will require businesses to untangle their revenue streams to verify whether they even have to comply with the DST.
Firms will not only have to calculate the amount of revenue associated with the targeted lines of business, but they will also need to determine how much of that revenue is associated with UK users. Companies have no control over their users and will need to monitor the location of those users and evaluate how much each user contributes to the company’s revenue. This will be a complex process that is likely to result in disputes about how much value a generic user generates.
In its consultation for the DST proposal, the Treasury laid out an example that reveals not only the burden of the tax, but also the challenges associated with calculating it.
For simplification, the Treasury describes a firm that is only a social media platform and has revenues associated with that business. Let’s say that business has £600 million in global revenues, £100 million in revenues associated with UK users, and a profit margin of 1 percent. The standard calculation would result in this company having a DST liability of £1.5 million, even though its profits associated with UK users are just £1 million.
However, because of the safe harbor for businesses with low profit margins, the company could choose an alternative calculation that accounts for a safe harbor parameter. The consultation paper stipulates that this parameter should be 0.8 at a minimum. Under the alternative calculation, the social media platform would have a DST liability of £0.6 million. Assuming the profit margin is applicable to the UK operations of the social media platform, this is a tax rate of 60 percent on profits from its business with UK users.
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Source: HM Treasury and HM Revenues and Customs, author calculations |
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Global Revenues |
600 million |
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Global Costs |
594 million |
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Global Profits |
6 million |
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Revenues linked to UK users |
100 million |
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UK Costs |
99 million |
|
UK Profits |
1 million |
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Revenues linked to UK users |
100 million |
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Allowance for UK revenues |
– 25 million |
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DST Tax Base |
75 million |
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Standard DST Liability (2 percent * Base) |
1.5 million |
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Profit Margin |
1 percent |
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Safe Harbor Parameter |
0.8 |
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DST Tax Base |
75 million |
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Safe Harbor DST Liability (Profit Margin * Parameter * Base) |
0.6 million |
Each of these calculations represents various incentives for business to structure their companies to minimize the compliance costs and tax liability associated with the proposal. Additionally, growing companies could find themselves suddenly subject to the tax and realize that they need to begin calculating several new metrics to gauge how much tax they will owe under this regime.
And all of this is for a proposal that is supposed to be temporary. The UK government is planning for the tax to apply beginning in 2020, but it could be done away with in 2025 after a review or if a broader international approach takes its place.
Digitalization has certainly created new challenges for policymakers, but this should be an opportunity to think about how principles of sound tax policy can apply. The UK has instead opted for a distortionary system that is both complex and temporary.
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