What’s wrong with the UK’s Digital Services Tax?

November 2019  |  SPECIAL REPORT: CORPORATE TAX

Financier Worldwide Magazine

November 2019 Issue

The UK’s proposed Digital Services Tax (DST) is an odd and problematic beast. The UK’s direct tax code could broadly be described as ‘follow the accounts unless you are doing something questionable or unusual’. The tax statutes in Tolley’s Yellow Tax ‘Handbook’ deal mostly with this quite simple concept.

The draft DST legislation, published in July, introduces a completely new tax, twice, in 37 pages. The core is only seven pages long. The new tax is written twice because the basic rate is 2 percent of revenue, but there is an optional, and astonishingly disproportionate, 80 percent rate on profits, which is calculated completely differently and potentially requiring complicated segmentation and transfer pricing allocations. As a result, a lot of potential taxpayers will have to calculate or at least estimate it in two ways, knowing that at least one of those exercises will be a waste of time.

Digital businesses are characterised by unknowable and potentially spectacular exponential growth. Her Majesty’s Revenue and Customs’ (HMRC’s) view of the DST seems to be that the thresholds should avoid most digital businesses having to worry about it. The tax is presented as temporary, but it is only likely to be repealed to make way for an Organisation for Economic Co-operation and Development (OECD)-led replacement covering the same tax base. Even if the OECD arrives at an international consensus solution by the end of the year, as it committed to, realistically it will take a few years to implement, at least. As a result, the only digital businesses which need to worry about the DST are the ones which aspire to be huge at some point within the next few years.

Income taxes are disliked but at least the concept is generally recognised as fair. People and companies which earn more pay more tax. Inheritance tax is one of the most disliked taxes even though only a small number of people pay it and all of them are at least relatively rich. The Office of Tax Simplification’s review of Inheritance Tax, published in November 2018, pointed out that while over 275,000 people annually complete returns, less than 10 percent of those pay the tax. The DST could be like inheritance tax in the sense that a lot more companies will have to worry about it, and perhaps even spend time on systems and compliance relating to it, than will actually end up paying any tax.

So, if the thresholds are not the answer, maybe the scope will help most online businesses tick the box which says they do not have to worry about the DST? For example, it should be obvious that a business is not an ‘internet search engine’. Unfortunately, the way the scope has been defined is unhelpful in this exercise. The DST only applies to companies that are a ‘social media platform’, ‘an internet search engine’ or ‘an online marketplace’. It is ‘if’ you are, rather than ‘to the extent you are’ because there is a defect in the drafting which makes all of the activities of a platform which is mostly, for example, an online marketplace into taxable ‘digital services activity’. So, if 49 percent of a company’s revenue comes from selling its own products or services and 51 percent from third-party sales, 100 percent of that revenue is ‘digital services activity’. This, along with other defects, has been pointed out to HMRC.

‘Social media platform’ and ‘online marketplace’ are further defined, whereas ‘internet search engine’ is not defined and neither are the other key terms such as ‘online’, ‘platform’ and ‘user’. It seems the excuse that the tax is intended to be temporary is being used to justify woolier than usual statutory drafting, with key definitions being left to guidance. There are all sorts of problems with that, not least that guidance is not law and we are unlikely to see what the courts decide the law really is before the DST hits its sell-by date. So HMRC can basically say whatever it likes in the guidance and businesses will have little choice in practice but to go along with it.

Some of the terms which are defined make it clear that the tax can only be calculated using data which the taxpayers will almost certainly not have. A ‘UK user’ is not defined as a UK tax resident, but in the case of individuals it means “any person who it is reasonable to assume is normally in the United Kingdom” which probably amounts to much the same thing. The DST, therefore, excludes tourists to the UK but includes Brits who are on holiday abroad. Similarly, advertising revenues are attributable to UK users so far as the advertising is “intended to be viewed by UK users”. The guidance suggests that what is meant here is really “not intended not to be viewed by UK users”, advertising which is not targeted at any particular geography is supposed to be included. This is one of many areas where a lawyer may conclude that a court would come to a different conclusion than the HMRC guidance. But in practice, in the exercise of estimating when, based on the projections in their business plan, they might breach the thresholds, businesses will have to err on the side of caution and make estimates based on the data they do have.

The conceptual justification for DST is that users in the UK are adding value to online businesses which are profiting from that value without being taxed in the UK, and that the magnitude of this value is determined, in part, by UK standards of living and what fosters this. The only place where user value comes into the calculation of the tax, however, is in the scope – the business models targeted and the level at which the thresholds have been set. It is easy to see how certain social media platforms derive profit from user value. But distinguishing on the grounds of user value between selling your own goods online, which is supposed to be out of scope, and enabling third-party sales, which is supposed to be in scope, seems less defensible. There is a gap between the justification and the draft law. In the justification, a ‘user’ is a consumer, either an individual or a small company. In the law, a ‘user’ can be any person, even the largest company in the world. The guidance, although not the draft law, even suggests a user does not even have to be a person.

With only six full months left before the DST is scheduled to come into force, now is the time digital businesses need to grapple with all these issues.

 

Philip Harle is a partner and Graham Poole is a senior director Economics and Transfer Pricing at Hogan Lovells International LLP. Mr Harle can be contacted on +44 (0)20 7296 5783 or by email: philip.harle@​hoganlovells.com. Mr Poole can be contacted on +44 (0)20 7296 2014 or by email: graham.poole@​hoganlovells.com.

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BY

Philip Harle and Graham Poole

Hogan Lovells International LLP

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