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Martin Beznoska / Tobias Hentze IW-Nachricht 6. März 2018

(Un-)Fair taxation of the digital economy

The EU would neglect its responsibility for the mismatch of tax policies among member states by implementing a taxation of the digital economy. It would translate into a tax increase for a specific group of companies, which would make the classification of digital companies alone highly controversial. This would further enlarge distortions instead of guaranteeing a level playing field. Instead of the taxation of the digital economy, the German Economic Institute suggests a two-step approach in order to avoid distortions and unfair taxation.

In general, the taxation of the digital economy faces the same challenges as the taxation of other sectors. However, the degree of misallocation of taxable profits appears to be higher in the digital economy. The main drawback of the current international tax scheme relates to the proper identification of the created added value in a global value chain of a Multinational Enterprise (MNE). The widely accepted arm’s length principle might lead to an inadequate allocation of profits within a digital MNE. It seems easier for digital MNE to manipulate taxable profits and to relocate them by sophisticated tax planning measures. Furthermore, preferential tax regimes by single countries distort the allocation of profits. Hence, it is rather a matter of allocating a digital company’s profits appropriately than determining the adequate (global) amount of taxable profits. This means that some member states would benefit from changing the rules of the game, others would not.

In the long run, the key to solving this imbalance is a smart tax policy on an international level. Any tax discounts, e.g. patent boxes, as well as individual tax deals should be prevented. This applies to jurisdictions outside but also inside the European Union. A further harmonization of international tax rules and a better cooperation between national tax authorities should therefore be enforced. The project against Base Erosion and Profit Shifting (BEPS) as well as the automatic exchange of information in tax matters between more than 100 countries reflect a substantial progress in this regard. However, further steps are needed.

A suitable approach in the long run is the CCCTB - even if the picture is ambiguous. The idea of the CCCTB would abolish the arm’s length principle as the main pillar of the current transfer pricing scheme and replace it by a different understanding of added value. From an economic point of view, it is questionable if any profit split methods (CCCTB) are more convincing than relying on (hypothetical) market prices (as in the current system). However, since the determination of (hypothetical) market prices lack sustainable results, a radical change might be reasonable. A profit split, e.g. by using revenues, number of employees and capital invested as the allocation key, could ensure that digital companies pay their fair share in each country they are active in. The destination country of goods and services would be strengthened, since, amongst others, sales numbers are considered. In this case, a taxation on the digital economy could be replaced by the CCCTB.

Yet, the identification of permanent establishments in the digital economy will still be an issue. If no permanent establishment of an MNE can be identified in an EU member state, there is no subject to taxation. In this case, even the CCCTB would not be a reasonable tool since there is no taxpayer to whom sales can be attributed. This might result in a non-taxation of a profitable operating business in the EU even if the sales numbers are significant. Therefore, the existence of a virtual permanent establishment should be clearly defined. Assuming sophisticated answers to these open issues, the implementation of the CCCTB (or a respective concept) would be a major step to remove the pitfalls resulting from the specific characteristics of the digital economy in the long run.

In the short run, two tax policy instruments should be evaluated by the EU. Firstly, the value-added tax (VAT) is an important instrument to guarantee at least a minimum of tax revenue. Thus, further harmonization can be recommended. Secondly, a small withholding tax on the European-wide revenue could be raised on this type of business if there is no way to access global profits and to apply the CCCTB rules accordingly.

Indeed, such a withholding tax should only be considered as a corporation tax credit and therefore work as a minimum taxation. Otherwise it could infringe WTO arrangements due to double taxation and would increase the tax burden for a specific group of companies resulting in augmenting distortions in the international markets. Additionally, if the company is not profitable, the risk of taxing the capital substance should be avoided. Private investments in the European Union would be at risk. In particular, this holds against the background of the current tax cut in the United States which significantly improves the attractiveness of the United States as a location for investments.

To sum up, the best solution in the long run will be a further harmonization of international tax rules. A radical shift towards profit split methods (CCCTB) on an international level might be a suitable approach. A separate taxation of the digital economy that enlarges mismatches of tax policy should be avoided. In the short run, however, two tax policy instruments should play a dominant role in the EU’s fight against unfair taxation: The value-added tax (VAT) promises at least a minimum of tax revenue. Thus, further harmonization of the VAT system is highly recommendable. And if there is no way to access global profits of digital Multinational Enterprises (MNE), a small withholding tax on the European-wide revenue could be raised on these businesses and thus work as a minimum taxation. In any case, the EU has to take into account potential side effects of any measures proposed.

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