In Brief
Understanding Digital Services Taxes & the OECD
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How have the OECD and governments responded to tax challenges?
The digital economy has grown two and a half times faster than the global GDP over the last fifteen years, fundamentally changing how businesses operate in foreign markets. International tax codes have not kept pace with its rapid expansion until recently.
Many multinational corporations do not have a physical presence in the countries where they conduct business. Consequently, some companies have avoided paying taxes through base erosion and profit sharing (BEPS) strategies, which exploit gaps and mismatches in tax rules. BEPS practices are harmful for countries, especially developing countries, that rely on corporate income tax.
The Organisation for Economic Co-Operation and Development (OECD) has been working with governments, policy makers, and citizens across the globe on international tax standardization via the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting.
The OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting seeks to address tax challenges that have arisen from the digitalization of the economy through its Pillar One and Pillar Two proposals.
Pillar One establishes new nexus and profit allocation rules for large multinational enterprises that meet certain revenue and profitability thresholds. In addition, the Pillar broadens countries’ ability to tax activity occurring within its borders regardless of a company’s physical presence or market jurisdiction.
Pillar Two establishes mechanisms to ensure large multinationals pay a 15% minimum level of tax regardless of where they are headquartered or the jurisdictions in which they operate.
Since 2013, the OECD has worked to implement these changes but has experienced difficulties. 137 member jurisdictions agreed to the Two-Pillar Solution as of November 4, 2021. However, not all Inclusive Framework members joined as of November 2022, which has pushed the Two-Pillar implementation date from 2023 to 2024.
What are digital service taxes, and what are countries doing about them?
Because the OECD has faced difficulties reaching a global consensus, numerous nations have implemented unilateral measures to protect their tax base and tax income derived from certain digital activities carried out within their jurisdiction. One such measure is digital services taxes (DSTs).
Directed toward large U.S. multinational companies, DSTs are a tax on gross revenue derived from a variety of digital services. They are a mix of gross receipts taxes and transaction taxes that apply on receipts from the sale of advertising space, provision of digital intermediary services such as the operation of online marketplaces, and the sale of data collected from users.
Countries can levy DSTs differently. Austria, for example, only applies a DST to digital advertising, whereas Poland only assesses a DST on streaming services. Multinational companies can face double taxation if one government imposes DSTs on a company’s revenue and then another government imposes DSTs on the same revenue.
How does Pillar One impact DSTs, and how do DSTs relate to the Unilateral Measures Compromise?
To implement Pillar One of OECD/G20 Inclusive Framework on Base Erosion and Profit Sharing, the Multilateral Convention (MLC) will require the removal of DSTs and other relevant similar measures for all companies.
The OECD/G20 Inclusive Framework issued a statement mentioning that no newly enacted DSTs or other relevant similar measures are to be imposed from October 8, 2021, until the earlier of December 31, 2023, or the coming into force of the multilateral convention to give effect to Pillar One. However, this statement did not address the treatment of existing DSTs.
A number of countries have reached an agreement with the United States as to the treatment of their existing DSTs, pending the implementation of Pillar One. This is known as the Unilateral Measures Compromise. This compromise – agreed upon by the U.S. and Austria, France, Italy, Spain, the United Kingdom, Turkey, and India – covers the interim period between January 2022 (April 2022 for India) and the earlier of the date Pillar One formally takes effect or December 31, 2023 (March 2024 for India).
Under the compromise, these countries can keep their existing DSTs in place until the implementation of Pillar One of the OECD agreement. However, corporations that are subject to DSTs may receive a tax credit against future tax liabilities.
In return, the U.S. agreed to terminate proposed punitive trade actions under Section 301 of Trade Act of 1974 and to refrain from imposing further trade actions against these countries.
That said, DSTs and other similar measures for other countries may exist outside of this compromise. So, companies should continue to track progress on this topic as the framework continues to unfold.
What are the differences between DSTs and VAT?
Digitalization of the economy creates challenges from an indirect tax perspective, and some countries have expanded Value Added Tax (VAT) to digital sales. But DSTs are distinct from income taxes and online sales taxes, and they are not a VAT.
To date, the OECD also has delivered guidance on how to collect VAT on cross-border sales, beginning with the International VAT Guidelines, released in 2015 and updated in 2017. These guidelines set nonbinding international standards for the treatment of international trade in services and intangibles. Their aim is to simplify the administration of the VAT regime, increase tax certainty for compliant businesses, and reduce double taxation and opportunities for VAT fraud.
The OECD recommends that foreign B2C service providers register and account for VAT in the jurisdiction where the customer is located, generally via a simplified registration process.