Firm Offers Input on Defining Digital Services Taxes

February 16, 2022

Mr. Itai Grinberg
Deputy Assistant Secretary (Multilateral Negotiations)
U.S. Department of the Treasury, Office of Tax Policy

Defining "Digital Services Taxes" and "Relevant Similar Measures"

Dear Mr. Grinberg,

We are writing to you on behalf of the Digital Economy Group (the “DEG”), which is an informal coalition of leading U.S. and non-U.S. companies that provide digital goods and services to global customers. DEG member companies have followed with interest the work being conducted through the OECD/G20 Inclusive Framework to stabilize the international tax system through the adoption of the two-Pillar proposal. The DEG appreciates the resources that the Treasury has devoted to this important work.

In particular, we applaud the Treasury's work to include in any Pillar 1 consensus a “standstill and rollback” agreement relating to Digital Services Taxes and other taxes that have destabilized the international tax framework. As part of that agreement, parties to any eventual multilateral convention will need to define “Digital Services Taxes” and “Relevant Similar Measures”. We would like to offer our thoughts on this definition.

Introductory Notes

We believe that an appropriate definition ensures that the agreed standstill and rollback of Digital Services Taxes and Relevant Similar Measures will apply to those recent unilateral measures that have contributed to the destabilization of the international tax framework and that impose tax on remote suppliers of digital services in a way that conflicts with the two-Pillar compromise approach.

Amount A will grant to market states taxing rights over a portion of the profits of the largest and most profitable multinationals, but on a basis that is neutral as to sector. Unilateral measures that impose special taxation on digital services thus are inconsistent with the sector-neutral design of Amount A.

It is self-evident that this definition will include those Digital Services Taxes now imposed by certain countries, in particular but not exclusively in Europe. Those taxes, however, are not the only unilateral measures that have either undermined the stability of the international tax system or imposed discriminatory taxes on digital services. Therefore, a narrow definition based only on an analogy to those Digital Services Taxes in form would not sufficiently address the policy purpose of the standstill and rollback agreement.

We propose a “hallmarks” approach to identify Digital Services Taxes and Relevant Similar Measures. These hallmarks identify the specific features of tested measures that would destabilize the international tax framework. The hallmarks are based on those points previously presented by Treasury to the Inclusive Framework Steering Group, as we believe that those hallmarks remain the best indicators of a Relevant Similar Measure. Each of the four hallmarks indicates a feature that could cause the tested tax to fall within the scope of “Digital Services Tax or Relevant Similar Measure.” The features of the taxes should be considered in their entirety, and the hallmarks do not need to be applied with equal weight in all cases. The hallmarks relate to the nature and scope of the financial contribution rather than its label. In this context, the definition of “tax” needs to be broad enough to capture measures that may not be labeled as a “tax,” but nonetheless function as one.

To illustrate the application of these hallmarks, we have prepared the attached Schedule A setting forth those taxes, levies or other impositions that should be withdrawn because they satisfy one or more of the hallmarks. The schedule also notes which hallmarks each measure satisfies. We suggest that the Multilateral Convention or supporting documents should include such a schedule as interpretive guidance for the hallmarks. Any tax proposed to be introduced in the future would be a Relevant Similar Measure if its features are substantially similar to any of the taxes listed on the schedule.

Below, we provide a proposed definition of a Digital Services Tax or other Relevant Similar Measure for inclusion in the Multilateral Convention implementing Pillar 1, text of proposed Commentary for the Multilateral Convention, and some further comments on what taxes should be in scope.

Proposed Definition

Each Party agrees to withdraw upon this Convention coming into force with respect to that Party any Digital Services Tax and other Relevant Similar Measure then in effect that is imposed on behalf of that Party or its political subdivisions or local authorities. Each Party also agrees that neither it nor its political subdivisions or local authorities shall introduce, enact, or impose any Digital Services Tax or other Relevant Similar Measure after the entry into force of this Convention with respect to that Party.

For purposes of this [Article], a “tax” is defined as any mandatory financial contribution imposed by law which is due to a governmental entity, including a political subdivision or local authority, for public purposes and not in return for a specific benefit, regardless of whether denominated a “tax”, “levy”, “contribution”, or any other form of financial obligation.

For purposes of this [Article], “digital services” means any service provided on the Internet or another electronic network, in either case requiring minimal human involvement from the service provider. “Digital services” include online advertising services; sale or other alienation of user data; online search engines; social media platforms; online intermediation platforms; digital content services; online gaming; standardized online teaching services; and cloud computing services. “Digital services” shall not include customized professional services; customized online teaching services; online sale of physical goods, irrespective of the physical good's connectivity to the Internet (i.e. “Internet of things”); online sale of services other than those digital services described above; and the service of providing access to the Internet or another electronic network.

“Digital Services Tax” or “Relevant Similar Measure” shall mean any tax whose effect is to impose a tax on the gross or net income of the taxpayer and that contains at least one of the hallmarks below.

Proposed Commentary

The purpose of Pillar 1 is to stabilize the international tax framework. In recent years, the introduction of unilateral measures principally designed to impose tax on the revenue or profits of nonresident suppliers has undermined the stability of the international tax system by introducing taxes inconsistent with prevailing international norms of nexus and source. In many cases, the defined scope for these taxes has been sector-specific, applying exclusively or principally to digital services suppliers. These unilateral measures undermine the purpose of bilateral and multilateral tax agreements to provide certainty, facilitate international trade, and avoid double taxation. These taxes impede trade, slow development, create risks of double taxation, create trade tensions, and impose undue administrative costs on taxpayers.

In this Convention, the Parties agree to withdraw those measures that represent unilateral responses to the tax challenges arising from the digitalization of the economy, in favor of Amount A, which grants a new taxing right to market jurisdictions. Specifically, market jurisdictions will be authorized to impose tax on the Amount A allocated to their jurisdiction, irrespective of the existence of a physical taxable nexus of the taxpayer in that country. Amount A, as part of the multilateral, two-Pillar approach, is intended both to address the tax challenges arising from the digitalization of the economy and to stabilize the international tax framework by promoting tax certainty and relieving trade tensions. In furtherance of these goals, the Parties have agreed to a modification of existing nexus and profit attribution rules for certain multinational enterprises meeting the turnover and profitability thresholds established for purposes of Amount A.

The continued existence of Digital Services Taxes and other Relevant Similar Measures is inconsistent with the agreed modification to the nexus and source rules as implemented through Pillar 1. The continued existence of these taxes would continue to destabilize the international tax system.

A Digital Services Tax or Relevant Similar Measure can be identified through comparing the tested tax against hallmarks representing the key destabilizing features of unilateral measures that recently have been introduced to address the tax challenges of the digitalized economy. The features of the taxes should be considered in their entirety, and the hallmarks do not need to be applied with equal weight in all cases.

Hallmark 1 reflects the Parties' agreement to define the new taxing right created over Amount A based on objective measures of revenue and profitability, rather than to ring-fence particular industries. For example, the design and effect of Digital Services Taxes is to impose the tax only on certain taxpayers based on their business model features.

Hallmark 1 recognizes that the scope or threshold definitions in certain measures may not apply solely to digital services business models, but in effect may have a disproportionate impact on non-resident digital services providers. Hallmark 1 also describes express extensions of existing tax regimes to non-resident digital services suppliers. For example, if a general withholding regime that previously applied to services was amended to specifically include digital service providers by reference to a business model feature, that extension would be described by Hallmark 1.

Hallmark 2 identifies a feature of unilateral measures that creates substantial instability in the international tax system. This hallmark exists when a taxing state asserts that a tested tax generally is regarded as outside the scope of the Covered Taxes articles of its bilateral tax treaties, and is not clearly a VAT or similar indirect tax whose cost is borne by consumers. Cases where the taxing state asserts that the tested tax is not covered by its generally prevailing bilateral tax treaties and is not designed as a VAT or similar indirect tax strongly indicate that the tax may create instability in the international tax system. Designing tax legislation to fall outside the scope of tax treaties erodes the certainty that bilateral tax agreements provide to taxpayers and undermines confidence in multinational agreements.

Hallmark 3 identifies unilateral measures that create an alternative nexus standard that deviates from nexus principles expressed in the OECD Model Tax Convention on Income and on Capital (2017), particularly Article 5. Measures exhibiting this hallmark may subject the nonresident taxpayer to taxation on an amount of net income allocated to the taxing state or an amount of gross income determined in lieu of net income. Measures that deviate from these agreed nexus principles create uncertainty and destabilize the international tax framework by undermining the Pillar 1 consensus agreement that the creation of taxing rights in market states over Amount A is the only agreed change to generally prevailing nexus rules to address the tax challenges of the digitalized economy. To successfully stabilize the international tax framework, the modification to existing nexus principles under Pillar 1 must apply to the exclusion of any unilateral measures directed towards taxation of the income of nonresident digital services providers based on nexus measures that take into account as a significant factor the location of customers, users, or any other similar destination-based criterion.

Hallmark 4 is a corollary to Hallmark 3. Hallmark 4 addresses measures that establish (or extend existing) gross-basis taxes to items of income recognized by non-residents not subject to net-based taxation in the taxing state, and that expressly reference digital services business transactions or items of income derived from the provision of digital services. This hallmark includes taxes that define the scope of taxable income in a manner specifically to include payments for digital services, regardless of whether the tax is collected by means of withholding or is payable directly by the nonresident.

Hallmark 4 acknowledges that many recently enacted unilateral measures apply to digital service providers on the theory that such providers are engaged in business activity in the market state, but the tax is imposed on a gross basis without allowing recovery of costs and expenses attributable to such receipts. This contrasts with and is inconsistent with the net income taxation right allowed under Amount A. This feature destabilizes the international tax framework because it implements a theory of non-resident taxation based on economic presence in the jurisdiction, but does not impose the tax on actual net income derived from the jurisdiction.

Whether a tax is a Relevant Similar Measure is to be determined by reference to these hallmarks, and not solely by a comparison to the specific features of Digital Services Taxes. The fact that a tax may be labeled as something other than a Digital Services Tax has no bearing on how and whether the Hallmarks indicate that the tax is a Relevant Similar Measure.

The attached Schedule A sets forth those taxes, levies, or other impositions now in effect that shall be withdrawn no later than the date this Convention comes into effect with respect to the Party imposing such tax. Each of the taxes on Schedule A constitutes a Digital Service Tax or a Relevant Similar Measure based on the hallmarks described above. Any tax proposed to be imposed in the future by a Party would be a Relevant Similar Measure if its scope and nexus definitions are substantially similar to any of the taxes listed on Schedule A.

Other Points:

1.1 Inclusion of subnational taxes. We believe that the standstill and rollback agreement should apply to measures enacted by political subdivisions. We note that questions have been raised whether the U.S. federal government can bind the U.S. States when negotiating and ratifying tax treaties. United States tax treaties already bind the States in at least one respect. For example, for several decades prior to its most recent revision in 2016, Article 24 of the U.S. Model Income Tax Convention included language indicating that the Article's non-discrimination rules “shall, notwithstanding the provisions of Article 2 (Taxes Covered), apply to taxes of every kind and description imposed by a Contracting State or a political subdivision or local authority thereof.” This language has appeared in dozens of U.S. bilateral tax treaties.

Further, the federal government already preempts state and local tax laws in the digital economy through the Internet Tax Freedom Act¹ (“ITFA”), which preempts state and local taxes that would interfere with the free flow of interstate commerce over the internet. Specifically, ITFA preempts state and local taxes on digital activity that are not generally imposed or not imposed at the same rate on similarly situated transactions accomplished through non-digital means.

We also note that in Japan Line v. County of Los Angeles et al., the Supreme Court held that, under the foreign commerce clause, the states cannot impose tax where doing so would prevent the nation from “speaking with one voice” when regulating commercial relations with foreign governments.² We acknowledge that courts in some cases have declined to strike down state taxes by reason of this element of the holding in Japan Line where the federal government either has not established an international practice or policy,³ or where the state's method of taxation would not be inconsistent with tax treaties.⁴ By participating in the Pillar One agreement, the U.S. federal government will have established a clear position on the taxation of digital services. We believe that this would constitute a material element of the foundation for applying the Japan Line standard to a federal preclusion of state-level DSTs and relevant similar measures.

Marketing and Distribution Safe Harbor. Questions have been raised whether a well-designed marketing and distribution safe harbor (“MDSH”) provision under Amount A could address the unilateral measures particularly described by Hallmark 3, such as significant economic presence nexus rules. We do not believe that the two issues are connected. First, Amount A, and thus the MDSH, only applies to select entities meeting the turnover thresholds. Taxes identified by Hallmark 3 would continue to exist for all taxpayers not subject to Amount A if those taxes were not covered by the standstill and rollback agreement. Second, given that the mechanics of the MDSH are not now known, we do not think that the scope of the standstill and rollback requirement should be limited in favor of a speculative possibility that the MDSH could provide some relief. We believe that Hallmark 3 should be retained, as that is a simpler and more comprehensive solution, especially for taxpayers not falling within the scope of Amount A.

Other taxes. We respectfully recommend that the negotiators not overlook the impact of disguised forms of taxes, such as the content levies imposed as a result of EU Directives (e.g. the Audiovisual Media Services Directive (“AMSD”)).⁵ These levies may create instances of double taxation and in some cases primarily target non-resident service providers. For example, levies imposed under the AMSD are imposed on gross revenue, which causes that levy to have the same financial impact as a DST. We believe that such a measure should not be disregarded merely because it is labeled as a “cultural levy”. While we have not included such taxes on Schedule A, these taxes also create barriers to cross-border trade, and many of them are explicitly imposed on forms of digital content delivery.

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We appreciate any consideration you can give to the points made in this letter, and we would be happy to provide any clarification you might find useful.

Sincerely,

Gary Sprague
Baker & McKenzie LLP
Palo Alto, CA

Mary Bennett
Baker & McKenzie LLP
Palo Alto, CA

Kathryn Rimpfel
Baker & McKenzie LLP
Palo Alto, CA