The UK's proposed Digital Services Tax

As with the other jurisdictions taking unilateral action, the UK's decision to introduce a digital services tax was initially prompted by frustration at the slow pace of progress by the OECD and EC in this area.  As noted elsewhere in this publication, the OECD has criticised this as potentially "undermining the relevance and sustainability of the international framework for taxation of cross-border business activities". In addition, this "proliferation of uncoordinated" actions, which includes domestic measures proposed by Spain, France, Italy, Australia and Mexico, and legislation already enacted by India introducing a concept of "substantial economic presence" - all of which operate in different ways, on different bases and at different rates – creates enormous scope for confusion, double taxation and disproportionate administrative burdens.

Despite calls to wait for coordinated international action, a strong domestic political impetus for ensuring global tech giants operating in the UK are "paying their fair share" of tax means that the government has nonetheless forged ahead. Draft legislation and guidance, explanatory notes, a policy paper and an outcome to last November's consultation) were published over the summer, with comments sought by 5 September 2019.

Perhaps unsurprisingly, given the UK's proposed DST's similarity to the French DST, US representatives have also been putting pressure on the UK to drop its plans in this area. Prior to the G7 Summit, the Prime Minister Boris Johnson reportedly expressed a willingness to consider redrafting these DST rules as part of a broader post-Brexit US-UK free trade deal with the US, but apparently no such deal has yet been reached.

Key features

The key features of this new tax are as follows:

• the DST will be a 2% tax on the UK gross revenues of certain digital businesses. Importantly this is thus a tax on revenues rather than on profits;
• the business activities in scope are social media platforms, search engines and online market places (other than market places provided by financial services providers in connection with the trading or creation of financial assets), together with any associated online advertising business deriving significant benefit from its connection with the in-scope activity;
• the tax will apply only to revenues linked to the participation of a UK user base

• a business will only become taxable if the global group of which it is a part generates:

• more than £500m in global annual revenues from in-scope business activities; and
• more than £25m in annual revenues from in-scope business activities linked to the participation of UK users;

• businesses will not have to pay tax on their first £25m of UK taxable revenues;
• in order to avoid prejudicing low profit margin businesses, an election for an alternative tax base will be available;
• DST payable may potentially be deducted from profits subject to corporation tax but DST will not be creditable against the corporation tax actually due (nor, as a tax on revenues, will it be creditable under the UK's double tax treaties);
• companies will be required to self-assess liability to the DST and pay any DST due annually. Other companies within the group may be made jointly and severally liable for the tax;
• the tax will be reviewed in 2025, alongside a consideration of progress in international discussions, to determine whether it remains necessary. However, the consultation response notes that "an international solution would need to address the specific policy concern that has been identified by the UK, and lead to a greater allocation of profit of highly digitalised businesses to the countries in which their users are located"; the implication here being that, if the OECD solution doesn't reflect this approach, the DST will be retained indefinitely and alongside the global tax changes in this area.

Remaining issues

Despite changes following on from the consultation, which are intended to focus the proposal more closely on the policy objectives and improve the administration of it, a number of issues, both conceptual and mechanical, remain.

Definitions of in-scope businesses and revenues

The UK's approach is to define objectively a limited number of business activities that derive most value from user participation and to tax all UK revenue streams from these activities; it is therefore not relevant how the business monetises its digital engagement. This approach has echoes of the OECD's proposals to re-allocate taxing rights to the so-called "market jurisdiction" (i.e. that in which the user or consumer is located) although, in the OECD's case, taxing marketing intangibles is also still being considered as an option, as is the concept of "significant economic presence" in determining the appropriate nexus for taxing rights.

The OECD's latest policy papers are currently focused on exploring what methods might be appropriate for determining how much profit should be allocated to market jurisdictions under its various proposals, rather than choosing any one at this stage. The UK, by contrast, has jumped straight to three specific targets, being the type of digital businesses it considers to be most obviously benefiting from user participation.

While this might be seen as a more simplistic approach to defining the scope of the rules (albeit one which is likely to be anything but simple to operate in practice), it is fair to note that the DST is intended to be in place only until international measures are agreed and implemented and the UK has committed to engaging with the OECD process.

The three targets of the DST, (i) social media platforms, (ii) search engines and (iii) online market places, have been defined in the draft legislation or otherwise delineated in the draft guidance, broadly as follows:

• "social media platforms" are those which enable content to be shared and where there is a main purpose of promoting interaction with other users and the content provided by those users. This would be shown by factors such as growth and engagement of the user base being a key performance indicator which might be expected to be monitored by external investors and whether the ability to interact with other users is an important driver in attracting further users to the platform. The government anticipates that this would include social networks, microblogging sites, video or image sharing platforms, review platforms and online dating sites. The scope of this "social media platform" head is perhaps the one that is least immediately obvious and may surprise some;
• "internet search engines" are not defined as it is expected to be clear under the normal understanding of the term when a business is providing this activity. Essentially, it will extend to engines that allow a user to view webpages beyond those provided by the platform itself and would therefore not include search functions to find pages or content within a site;
• "online market places" are platforms with a main purpose of facilitating the sale or hire of (by allowing users to advertise, list or sell) goods and services to other users, whether or not the transaction concludes on the market place or away from it. 

Notably, and following responses to the November consultation, online financial market places have been specifically excluded from this definition, largely on the basis that the financial services industry is highly regulated and therefore are required to bear specific financial risks rather than relying on users to bear those risks. This regulated nature also means that their activity is likely to be localised, meaning that the underlying rationale about profit attribution may be less relevant. Online financial market places are those provided by a financial services provider and where more than half of the relevant revenues arise in connection with the provider's facilitation of the trading or creation of financial assets, including insurance contracts.

The draft guidance indicates activities that are specifically not intended to be caught by the DST, such as the provision of online content and the sale of own goods online, and provides some guidance on borderline scenarios. However, given the scale and continued rise of innovative digital products available now and the fact that they evolve rapidly, determining where any given activity sits will not always be easy. Already it is acknowledged that online games share similar features to social media and online market place models and will need further consideration. No doubt there are many more such examples.

The revenues subject to DST include all third-party revenues generated from in-scope businesses where linked to the participation of UK users. The identity and tax residence of the recipient of the revenues within the worldwide group is not relevant. The revenues are obviously not limited to payments by the particular UK user; on the contrary they are expansively defined and would include all payments for online advertising, subscription fees, sales of data, click-through commissions etc. About the only useful exception is that intra-group payments are not caught, although this is because third party revenue (wherever earned in the group structure) which relates to the participation of UK users will be in-scope.

Multinational enterprises with a mixture of in scope and out of scope activities will need to attribute revenues on a "just and reasonable basis". This may or may not be a straightforward task, depending on the degree of separation of the business activities, but is likely to be a concern regardless and the method used may need to be the subject of a pre-clearance from HMRC.

UK user participation

The policy behind the DST is to ensure that multinationals with a significant presence in the UK pay an acceptable level of tax here on the basis that value is generated by UK users of the platform. Unhelpfully, a "UK user" is defined in the draft legislation simply as a person who it is reasonable to assume is normally in or established in the UK. Draft guidance indicates that this may be based on any available evidence, such as payment details, delivery addresses, IP addresses or the intended destination of advertising based on contractual evidence.

Following the determination of where the user is located (which may not be straightforward), there is then the question of where and how value is generated by user activity, and on what basis it should be calculated - one of the main sticking points preventing progress by the OECD and EC.

The OECD, for example, advances a modified residual profit split method, a fractional apportionment method and distribution-based approaches as possibilities. These all involve reconsidering the current transfer pricing rules and many unanswered questions remain; for example appropriate allocation keys or proxies for allocating profits, what adjustments might be required to accounting rules, and the interaction between the existing framework and the new rules. The possible use of simplifications to minimise compliance costs and disputes will also be central to the shape of the new rules.

Even assuming it can be shown that value is generated, it will not always be easy to determine to which market jurisdiction it should be linked. The UK draft rules provide simply that, save in specified circumstances, where revenues arise in connection with UK users and others, the revenues are to be treated as attributable to UK users to such extent as is "just and reasonable". The specified circumstances are online marketplace revenues arising in connection with interests in land or provision of accommodation in the UK, which will be treated as attributable to UK users regardless of the location of the parties to the transaction, and online advertising revenues will fall within the DST where the advertising is intended to be viewed by UK users.

The draft guidance amplifies the "just and reasonable" apportionment requirement to some degree. Subscription fees, payments to access content or a premium service will all be UK relevant revenues where paid by a UK user. Where the revenue or user activity is not so easily tracked, businesses are given little assistance but can perhaps extrapolate from the guidance given in respect of apportioning advertising revenues. This lists a number of potentially relevant factors such as the relative volume of users, the relative engagement of users and the size and maturity of the platform in each jurisdiction.

Helpfully, the UK's proposal to treat all of the commission earned on a transaction as UK revenue provided either one (or both) of buyer and seller is UK based has been amended. Recognising the potential for double taxation here, the taxable amount is halved where the other user is normally located in a country with a similar tax to DST.

While the OECD's work on allocations as between market jurisdictions is still at an early stage, it is clear that having a globally agreed allocation key, for example revenues, would sidestep many issues.

Alternative calculation election

The DST, in common with certain other unilateral proposals, is based on gross revenues and would therefore result in punitive effective tax rates for those with low profit margins. This "safe harbour" election moves the calculation of the DST from a turnover-based test to one which takes into account the profit margin of the company or group in question. The proposed calculation, as confirmed in the draft legislation, is:

Profit margin * in-scope gross revenues in excess of £25m * 0.8

This would have the effect of capping the rate of DST at 80% of the business's profits over the £25m allowance. While this would be of benefit to any business with a profit margin of less than 2.5% (including, of course, loss making companies), it is still potentially an extremely high rate of tax and demonstrates how disproportionate the effects of a tax on gross revenues rather than profits can be.  Moreover, there is a whole raft of issues around how to define and calculate the "profit margin" for these purposes and the timing and revocability of such elections.

In particular, although most normal operating costs will be allowable in calculating the margin (provided these have been determined in accordance with GAAP), certain costs will not be allowable; notably interest expenses, expenditure on acquisitions and any exceptional costs.

Deductibility of DST

The DST will be calculated and reported at the group (rather than entity) level, including any thresholds. However, the DST liability and expense will sit with the entities generating the underlying revenues on which that DST is payable.

Businesses subject to UK corporation tax will be able to deduct the DST expense for UK tax purposes if and only if it is deductible as a business expense under the normal UK corporation tax rules. This means that, in order to be deductible as a cost against profits for CT purposes, it needs to have been incurred wholly and exclusively for the purposes of the trade in the entity which incurs the DST, i.e. that which receives the taxable revenues. It is expected that this will normally be the case as the DST expense is directly related to the earning of its revenues and is a legal obligation of performing that trade.

However, that is not any help to non-UK tax resident businesses. Again, this is recognised in the consultation document, but the only solution would appear to be restructuring group arrangements and intra-group payments where possible to mitigate against the tax charge being in a non-UK taxpaying company.

The consultation document was clear that the tax is not intended to be creditable under double tax treaties, again raising the spectre of double taxation, and this position has not changed.

Further Thoughts

In addition to the other points here, there are some less obvious but potentially important points that we think are worth flagging:

(a) the group aspects. The UK has not historically had many taxes payable on a group basis. The main exceptions being VAT groups and the way in which the corporate interest restriction was adopted. Based on the issues we see in those contexts, we can believe that this aspect may have some major impacts for joint ventures and lenders into sub-groups. The impact on securitisations will also need to be considered.

(b) "revenue" – this follows an accounting definition. If a particular transaction could either be accounted for as either: (i) gross revenue of 2 and nil expense; or (ii) gross revenue of 100 and gross expense of 98; the tax burden is drastically reduced if the first method is appropriate.

Way Forward

The intended targets of the DST are clear; it is easy to think of a number of household names which fall into the categories of social media platform, search engine or online market place, and given the size of the thresholds, there will be few others caught. However, the scope of the DST is widely drawn in places and, given the continued uptick in strategic acquisitions, market consolidation and collaboration in the UK digital economy, as means to maintain competitive innovation, many more businesses may be drawn into the scope of the regime. Businesses that do find themselves on the wrong side of the line face what could be complicated attributions of revenues and, for those with low profit margins, potentially eye-watering effective tax rates above the £25m threshold.

The UK government has reached for its usual solution to broadly-drafted legislation i.e. issuing guidance to "clarify" the precise application of the rules. However, rapid change and innovation is in the very nature of the digital economy and such generalised guidance as is found in the current draft will not be of much assistance at the (crucial) margins. Of more use is the government's commitment to provide a non-statutory clearance mechanism for taxpayers; a sensible and prompt approach to queries will be invaluable.