A Tax Playbook for the Digitalised Economy (Part 1)

In a series of articles aimed at promoting debate on the evolution of international tax regimes, Michael Lennard, Chief of International Tax Cooperation and Trade in the Financing for Development Office (FfDO) of the United Nations, discusses the tax-related challenges governments, professionals and practitioners face. In the first of this two-part article, Mr Lennard expresses a range of views on taxation and the digitalised economy from a personal perspective.

As professionals working in the field of international company tax, dealing with different entities, governments and tax regimes is a necessary, but complex task. For many years now, the international tax community has grappled with the possibility of developing a global tax system that takes into account business innovation and the digitalised economy, yet is fair to all stakeholders. While there are no quick-fix solutions to modernising existing frameworks, devising a playbook that focuses on a range of achievable challenges addressed positively can help visualise a pathway to help kickstart the transformation of the global tax system that takes digitalisation into account. 

1. Devise a set of principles as basic building blocks

One of the critical challenges of modernising tax systems so that they are consistent and fair is that stakeholder starting points will always be different depending on the depth and range of the business mix, as well as the current economic challenges an individual country faces. Conflicting government and company agendas will always mean that even getting beyond the drafting stage is difficult. One way to get beyond this point is to, as a foundation, develop a set of principles that convey the spirit of what governments are looking to achieve from a modern tax system and what the consequences are for companies. While such principles would not be prescriptive tax measures, they would aim to embody the essence of a taxation system that applies whether you are a developing country, a developed super-power; a big tech giant or a family business. This has the virtue of helping establish whether there is enough agreement to form the basis of a grand consensus or whether a more piecemeal approach to improving the system is required.

2. Revisit the Permanent Establishment rule

With companies continuing to embrace the digitalised economy, taking a fresh look at Permanent Establishment (PE) rules is a crucial challenge. The principle of companies having a physical connection to a country as a test of economic engagement is not only outdated but also penalises ‘bricks and mortar’ business models unfairly. Initially designed to allow companies to put a physical toe in the economic waters of a country to test whether they wanted to be there over the longer term has been superseded by the rise in ‘business without borders’ as technology has become more advanced. So we have to rethink what constitutes economic engagement in a country today, the different ways it can be achieved and how tax regimes deal with such variations fairly. Such an approach does not necessarily always mean rewriting the tax rules as we already have some precedents to fall back on. In 2018 in the US, for example, Justice Kennedy’s opinion for the Supreme Court majority in Wayfair helped to usher in a sales tax collection method that is more suited to an internet-based economy, The UN Model Tax Convention has an Article on taxing Fees for Technical Services that does away with the PE concept, and there is no principle of international economic law that requires a PE for taxation, it is a more a creaky historical allocation rule to avoid double taxation under treaties than any general principle of taxation. So it’s more a question of achieving global consistency on what now constitutes economic engagement in the light of technology-enabled business models than starting from the PE premise. It’s about looking at what’s in our tax toolbox that can be applied or adapted to ensure that the beneficiaries of the digitalised economy pay a fair amount of tax that does not rely on having a physical presence. Fairness to other businesses and the wider citizenry demands that.

3. Take a fresh look at tax treaties – rights and allocation rules

Often when we discuss the digitalised economy and the taxing rights of countries, we hear the reference to ‘new taxing rights’. However, as I have noted, international economic law already gives comprehensive taxing rights and the ability to tax companies based on their digital commercial presence in a country in various ways. Yet, tax treaties currently in place between states to prevent double taxation problems have had the effect of limiting a country’s taxing rights. This is because tax treaties have the impact of countries yielding otherwise legitimate taxing rights on an entity resident of a treaty-partner country unless the entity has reached the PE threshold. This seems to be more of an allocation issue rather than new taxing rights – countries have that right at domestic law, and any “gift” is partial preservation of domestic law taxing rights through new allocation rules rather than a new taxing right.  

4. Aim to achieve balance and flexibility

It’s not surprising that tax-related issues are high on a country’s political agenda. Yet, it’s difficult to achieve anything at the political level unless you get the technical element of tax norms right. This technical input is not only important in achieving a country’s wider political demands, but also in fulfilling international tax community needs. So a key challenge as we head towards a more digitalised business model is getting the right balance of technical involvement so that political tax requirements are achieved, and loopholes closed. This balance should be based on a shared language and understanding of tax rules that are fair to both digital and bricks and mortar business models. At the same time, there’s the need for flexibility to cope with situations such as COVID-19. Having mechanisms that enable countries to quickly implement temporary emergency tax measures that support all businesses in times of high economic stress will be a key and ongoing challenge in the future. Recognising the disruptions to business caused by the pandemic is also important.  For international companies, tax measures taken unilaterally are less effective. Of course, we seek consensus multilateral solutions as the ideal, but their slowness to yield revenue is not lost on countries, and if proposals put forward do not yield expected benefits, we have to understand why – in an imperfect world – some might prefer good unilateral action to what they see as deficient consensus proposals, just as in parliaments, the consensus is often sought, but there is a unilateral backup when it does not yield expected benefits. I will look at multilateralism more closely in the second part of this article.

Challenges faced by the Financial Services industry

“Many of our clients in the FS industry are well aware of the global push to transform international tax regimes. However, they face challenges as often the new principles and situations cannot be projected easily on FS business models.

While they are in an industry that is heavily regulated including an enormous focus on de-risking operations, they will clearly face situations where the tax risk is more apparent without immediate answers to control such risk. Here it is where all responsible stakeholders involved should seek more alignment and understanding of each other’s challenges.”

Erik Stroeve, Mazars Financial Services Tax Leader

We are all aware that the transformation of international tax regimes is vital to the health of global businesses as they evolve to a more digitalised economy. Identifying some of the key challenges we face in achieving this will not only help to map out the next steps to take but do so in a more positive, collaborative and fairway, consistent with the part we all can play in achieving the sustainable development goals and lifting people up.

The second part of Michael Lennard’s article will address some of the barriers members of the international tax community face in transforming to a digitalised economy.