Rethinking the Taboo: Do DSTs Deserve Their Bad Rap?

Don’t let the cure be worse than the disease.

You’ve heard this remark in discussions of the COVID-19 pandemic. President Trump even tweeted it. The gist of the comment is that the widespread lockdowns across the country are inflicting an economic collapse that’s arguably worse than the virus we’re trying to avoid.

I offer no opinion as to whether that view reflects practical wisdom or crass foolishness. I do, however, hope to apply similar reasoning to the field of international tax policy — in particular, to the work of the OECD inclusive framework.

By now everyone should have had time to digest the basic contours of the OECD pillar 1 (nexus and profit allocation) and pillar 2 (global minimum tax) proposals. These reforms are bold and ambitious. If broadly adopted, they would alter the international consensus that has delineated national taxing rights for almost 100 years. But not everyone likes the two pillars. Many businesses are squirming at the thought of formulary apportionment concepts creeping into the mainstream, while practitioners are uneasy with increased complexity. As with our virus-induced lockdowns, we sometimes need to be reminded why we’re subjecting ourselves to the collective angst.

The justification for the latest round of the OECD base erosion and profit-shifting initiative (BEPS 2.0) is that without high-level coordination, a grievous calamity could occur. Our relatively harmonious tax environment could devolve into a melee as governments around the world enact unilateral countermeasures to backstop their corporate tax bases. We can’t allow that to occur; or can we?

The digital services tax has emerged as the convenient boogeyman that draws otherwise reluctant stakeholders into the inclusive framework process. The DST is a turnover tax; it’s based on gross receipts. That makes it a crude substitute for net income taxation. If someone were to task you with fixing the permanent establishment doctrine or arm’s-length transfer pricing, the DST would be an unlikely candidate. Yet that’s where we find ourselves. Thus far 14 countries have either enacted or plan to enact DSTs.¹ The count is likely to grow larger as the concept spreads. This amounts to patchwork self-help in lieu of a multilateral solution.

The trend is of heightened concern to the U.S. Treasury because (purposefully or not) DSTs target the U.S. tech sector, often excluding a country’s own tech companies. In the case of France, we need not speculate about who will be hit by its DST. The French secretary of state for digital affairs publicly acknowledged the country’s DST was structured so that no European business would pay it.² I guess that leaves Amazon, Facebook, and Google.

These factors seem like valid reasons to think poorly of the DST. But I have an awkward confession to make. Lately I’ve been wondering if DSTs have been unfairly maligned — and whether the disdain we hold for them should be balanced against the trajectory of BEPS 2.0. Before the global tax community signs up for pillars 1 and 2, it’s worth asking whether DSTs are all that bad.

This is especially the case after the U.K. government published final draft DST legislation in March in support of Finance Bill 2020.³ The draft includes provisions to mitigate double taxation, address hardships for low-margin businesses, and allocate digital revenues among multiple countries. The draft even includes an alternate charge that converts the relevant tax base from gross receipts to net receipts. Just maybe these DSTs aren’t so scary. If so, that could influence our appetite for the inclusive framework’s recommendations.

This article asks readers to think outside the box. Consider the following: What if the OECD presents the G-20 with a set of impressive deliverables at year’s end, but most governments opt out of the reforms because they’re considered too disruptive?

In other words, what if the cure (BEPS 2.0) turns out to be worse than the disease (DST)?

Fit to Be Taxed

The United Kingdom has been planning its DST since 2018. The tax was scheduled to take effect April 1, 2020. Technically, it would apply to accounting periods beginning between April 1 and March 31, 2021, and continue thereafter. That didn’t happen because Parliament was unable to finalize the finance bill before the effective date. The legislative session was suspended because of the COVID-19 pandemic.

Parliament reconvened on April 22 with most of its business taking place virtually — including floor debates, voting, and prime minister’s questions. Final approval of the finance bill should be among lawmakers’ first order of business. HM Treasury officials have indicated the government has no plans to delay the DST.⁴ In the meantime, some affected businesses have been left in limbo for a brief spell, not knowing whether to begin DST compliance on the basis of a bill that hasn’t yet become law. Prudence suggests they should.

The structure of the U.K. DST gives us plenty to think about. If other countries were flirting with a DST and seeking legislation to mimic, they could do much worse than the U.K. version. It applies to consolidated groups that offer digital services resulting in worldwide revenues of at least £500 million per year, and U.K. revenues of at least £25 million per year. The tax rate is 2 percent, applied to digital revenues attributable to U.K. users, and subject to a £25 million allowance. Taxable digital services are defined to include search engines, online marketplaces, and social media platforms. The definition excludes streaming services and online gambling, which seems like an odd omission. I imagine the scope of taxable digital services could expand over time, assuming the tax survives that long.

Draft guidance released in July 2019 assisted taxpayers in identifying U.K. users of digital services, and in distinguishing them from non-U.K. users. That can be challenging if a user accesses the taxpayer’s website through a virtual private network (VPN) as opposed to a conventional internet service provider (ISP). Use of an ISP allows tracing to the user’s geographic location, making identification relatively easy. Users with VPNs can only be traced back to where the server is, which has nothing to do with where the user is. A server and a VPN user can be hundreds of miles apart in different countries. The use of VPNs doesn’t mean taxpayers are off the hook for DST purposes; they must find other ways of determining where their users are.

Attributing digital revenues to users will be a tricky matter. It’s important because the same digital revenues could be subject to multiple digital tax charges (distinct from VAT or income taxes). The same online transaction could fall under both the U.K. and French DST regimes. Normally, all digital revenue related to a U.K. user would feed into the U.K. tax base, but an exception applies when a second DST jurisdiction is involved. For example, an online sale in which one user (the seller) is in London while the other user (the purchaser) is in Paris would result in only half the digital revenue being attributed to the U.K. DST. The remainder would be subject to the other country’s DST.⁵ The apportionment should prevent double taxation in relation to other DST regimes, which could be a problem as these taxes grow in number.

Note that the U.K. DST sidesteps the destination-versus-origin concepts commonly featured in VAT systems. VAT administration can get bogged down by trying to determine whether the place of sale is based on the buyer’s or seller’s location. That wouldn’t work for DSTs because transactional models don’t always fit digital activity. There is no buyer or seller when you utilize a search engine or post your vacation photos on a social media platform.

What about overlap with the income tax? U.K. DST payments are not creditable for purposes of U.K. corporate tax, but they are deductible. That’s partial relief from double taxation, assuming the DST payer has taxable income in the United Kingdom. A caveat applies to the income tax deduction; a multinational group cannot squeeze DST payments to other jurisdictions into its U.K. affiliate to inflate the income tax deduction. That could be a temptation when another group member has DST liability in a different jurisdiction that doesn’t permit a similar offset. Allocations of DST liability among group members must follow arm’s-length transfer pricing principles.

A common criticism of DSTs is that they’re based on turnover. That renders them a sloppy tool for taxing capital income.⁶ Early on, U.K. lawmakers recognized this could be problematic for loss companies. Many prominent players in the digital economy aren’t profitable yet, despite their size and influence. Netflix’s market capitalization exceeds that of Exxon Mobil Corp., but the streaming service still hasn’t turned a profit.

The U.K. DST compensates for this through an alternate charge. It permits a taxpayer to make an annual election that converts the DST from a gross to net basis for any of the three core digital activities (online marketplaces, social media platforms, and search engines). If the election is made, the tax is calculated as 80 percent of net revenue for the applicable digital activity, multiplied by the company’s operating margin for that activity. You arrive at net revenue by deducting costs of sales, administrative expenses, depreciation, and amortization. Interest expense and cost of goods sold are not allowed as deductions.

The alternate charge recognizes that margins vary within different segments of the digital economy, avoiding a blanket approach. Each taxpayer subject to the U.K. DST can calculate whether it’s better off under the standard gross-basis treatment or the elective net-basis treatment. One imagines that loss companies and others with low margins would be more likely to make the election. This type of flexibility goes a long way toward deflecting my initial knee-jerk DST opposition.

At a basic level, both the international consensus and the inclusive framework are attempting to apply net income taxes on foreign multinationals, though in very different ways. That chore is inherently challenging, as other commentators have noted. In a recent article, H. David Rosenbloom and Peter A. Barnes describe it as an “often intractable” problem.⁷ If such an approach is perpetually doomed, the pragmatic move would be to seek workable solutions outside of a net income tax structure. DSTs fit the bill. Again, Rosenbloom and Barnes:

The thing we like least about DSTs — gross basis taxation — could be the key to their suitability.

Unilateral and Proud of It

A separate criticism is that DSTs are unilateral in nature. Let’s dig deeper into that point. To begin with, what does “unilateral” mean for these purposes? Is the designation a matter of differing from commonly accepted practices, assuming such norms exist? Not really. Each country’s legal system contains scores of idiosyncratic taxing provisions. There are obvious commonalities, to be sure, but the details vary so greatly that it seems like a stretch to speak of clear universal standards.

One understanding of a unilateral tax is that it deviates from the goal of multilateral harmonization. But why should taxes be harmonized in the first place? There’s no obvious reason why the tax system of the United States should be harmonized with that of Canada, despite the two nations having one of the world’s largest bilateral trade relationships.

Harmonization is best suited for treaty-based pacts like the EU, in which governments agree to forfeit elements of their national sovereignty in exchange for membership in a collective enterprise. But even then, the EU framework generally regards the power of taxation as a sphere of national competency, as demonstrated by the limitations on qualified majority voting.

Which tax provisions could be labeled as unilateral measures? Brazil’s transfer pricing regime might be labeled as unilateral because it doesn’t carefully track what’s contained in the OECD transfer pricing guidelines. Japan’s VAT might be described as unilateral because it more closely resembles a subtraction-method approach than the traditional credit-invoice model used by almost every other country. In the United States, the Foreign Account Tax Compliance Act could be described as unilateral because it’s an outlier for automatic exchange of information. Nobody else has anything like FATCA, while more than 100 countries are abiding by the OECD’s common reporting standard.

You get the point. Unilateral taxes are directionally opposed to what most other nations are doing. But the provisions above are no less valid on account of the label. The lawmakers who voted for such measures have committed no foul; they owed no duty to the bodies responsible for setting international standards. Countries that adopt unilateral taxes have nothing to apologize for. The United States certainly isn’t apologizing for FATCA.

None of the above measures is a direct response to corporate profit shifting or the OECD’s BEPS initiative, the setting in which accusations of unilateralism are most frequently heard. Apart from DSTs, we have relatively few examples in this context.

India’s equalization levy comes to mind. Its logic flies in the face of the PE doctrine. The “equal” in equalization is a response to dissimilar outcomes, based on nexus status, among otherwise similarly situated taxpayers.⁹

The same can be said of the U.K. and Australian diverted profits tax. The point of that tax is to apply a higher corporate tax rate to firms that lack a PE, compared with the standard tax rate for firms with a PE. That flips the conventional wisdom that a local PE is best avoided for tax planning purposes. In some cases it’s having the desired effect on taxpayer behavior. Amazon started booking profits from U.K. sales in the United Kingdom once the diverted profits tax was announced; before that those profits were booked in Luxembourg.

It’s nearly impossible to reckon either of these taxes with the prevailing international consensus. If you believe our nexus and profit allocation standards are fit for purpose, there’s no way you’d want these laws on the books. Their existence implies a failure elsewhere in the tax code.

Recently the unilateral label has become a euphemism for instances in which a market country takes steps to tax profits in a way that implicates double taxation. It follows, then, that different groups will oppose unilateral taxes for one of two reasons. The OECD will object because opportunistic self-help runs counter to the quest for multilateral solutions — which is its raison d’être. Multinationals and their advocates will object to unilateral measures because of the risk of diminished after-tax profits. Readers can decide for themselves which grievance is more persuasive.

Either way, I’m not sure we’d be so focused on the perils of unilateral remedies if DST payments were eligible for foreign tax credits.

Here to Stay?

Like France, the U.K. government has promised its DST will be repealed once a new international consensus takes root. A spokesperson for HM Treasury has conceded that DSTs are “suboptimal.” An interesting admission, but hardly a guarantee of future behavior. Despite such statements, I remain skeptical about future repeal. It’s not as though such assurances are enforceable contracts. Rely on them at your own risk.

Also, few people are talking about what it means to change the international consensus. Just as some prominent countries (the United States and China) declined to sign the multilateral instrument that resulted from the BEPS final reports released in 2015, we can expect that some large countries will pass on signing the next MLI that effectuates the BEPS 2.0 reforms. In that case, we can question whether the international consensus has been replaced by a successor or supplemented with a rival.

The difference will matter to countries that promised to repeal their DSTs. It’s possible France and the United Kingdom could suspend their DSTs for companies headquartered in countries that sign the next MLI, while continuing to apply the DST in full force to multinationals parented in countries that don’t go along with the changes.¹⁰ Under those circumstances, France and the United Kingdom could continue applying their DSTs to the U.S. tech sector but few others. That’s hardly a change from where we are now.

Assuming DSTs prove to be cash cows, governments will be tempted to keep them around. Let’s not forget the politics. DSTs are the rarest of commodities — a tax that plays well with voters. DSTs are widely regarded as a means of exporting the local tax burden onto the backs for foreign companies and their shareholders. To the governments applying these taxes, the receipts will feel like free money.¹¹ Only a fool gives that up.

Don’t be surprised if DSTs have staying power. Depending on how you feel about pillar 1 and pillar 2, that outcome might not be so bad.