The worldwide corporate tax system has traditionally worked on the basis of where a corporate entity is physically located and where it puts its employees and the tools of its business. These have been the primary driving factors in where it is taxed. So, if you are a U.S. tech corporation, for example, and you have UK customers, you would not be subject to UK direct taxes, unless you have a subsidiary or branch trading in the UK.

This is about to change.

The problem tax authorities around the world are facing is that the existing tax rules were never designed to cater for the digital economy. Companies in several sectors are increasingly virtual, or they have little or no physical presence in the countries where their users are based. They are seen, at least in the eyes of revenue authorities, to make large profits from consumers while paying insufficient tax where those consumers are located.

The Organisation for Economic Co-operation and Development, which coordinates global tax policy, has been considering how to reform the international tax system and is trying to establish an agreed approach by 2020. It is, however, struggling to make headway in the face of differing views among its member countries.

To confuse matters further, the European Commission is proposing its own version of a digital tax for the EU. This is currently mired within the EU political system as different members argue about its terms.

The UK, France and Italy have all been pushing for quicker action, and the UK is going first in introducing unilateral measures. On October 29, the UK government announced that they will go ahead with plans for a UK digital services tax (DST), to be introduced in April 2020.

What Is Proposed?

The exact design of the tax is subject to further development, but what we know so far is that it will charge UK tax at a rate of 2 percent on any revenues that can be linked to UK user participation, regardless of where the corporate owner of those revenues is located and irrespective of the physical presence that the corporate has in the UK.

Note that that 2 percent—which sounds like a low rate—is applicable to revenue not profit. If you are an entity with high turnover but relatively low profit because you are cost-heavy, that does not necessarily get you out of the regime.

A big problem here—for the UK fiscal authority and corporates—is how to link revenue to user participation. There is no clear guidance on that as yet, and many in the market (the author included) have questioned how as a practical matter it is to be judged.

Who Is Caught?

The original proposals were widely drawn, and many feared they would be inadvertently caught, especially given that few sectors these days have no online sales presence.

The final scope, however, applies the DST to businesses engaged in only three key areas—search engines, social media platforms and online marketplaces.

It is explicitly not a tax on the following:

• Online sales of goods, though it will hit revenues from intermediating such sales
• Online advertising
• Data collection
• Financial and payment services
• Provision of online content
• Sales of software/hardware
• Television/broadcasting services

There is scope for further exemptions to emerge as the public consultation on the proposals continues.

The UK’s digital services tax may be with us for some time, and the UK government has left itself room to decide what they consider appropriate.

To be caught, a business must generate revenues from those key areas of at least 500 million pounds ($650 million) globally, and the first 25 million pounds of relevant UK revenues are exempt.

This means that smaller businesses will not be caught by the tax. Rapidly growing businesses, however, will fall within it as soon as they pass that 500 million pound threshold. This has triggered complaints of anti-competition in the market, given that a global giant can more easily absorb the cost of the DST than a smaller player trying to compete with them. There will also be some sort of alternative calculation, so that those with losses but high revenues will be exempt, and those with very low profit margins pay at a reduced rate. The details of this are not known yet.

It May Well Be Permanent

The DST is intended to be an interim measure until the OECD can come up with an approach that enough countries worldwide can agree on.

The UK government has committed to a formal review in 2025 to see whether the DST is still required once further international discussions have occurred and to suspend the DST if an “appropriate international solution” is in place prior to that date.

However, given the difficulties faced by the OECD in trying to reach an international solution, the DST may be with us for some time yet, and the UK government has left itself room to maneuver in what they do or do not consider appropriate.

Social Media In the Crosshairs

Although the final details will change, absent a complete government U-turn, the broad ambit is unlikely to be altered at this stage, and the DST will become law on schedule with effect from 2020.

The likely impact of the rules will depend on which business you are in and how much of it is digital.

Although few examples are given of the type of income caught, there are some obvious ones in the areas targeted:

• Revenue generated by a social media platform from targeting adverts at UK users
• Commissions generated by digital marketplaces for facilitating transactions between UK users
• Income generated from display advertising shown to UK users when they input search terms into search engines

It is no accident that search engines, social media platforms and online marketplaces were the key areas chosen. The UK revenue authorities have had established tech giants (read Google, Amazon and Facebook) in their crosshairs for some time, and this is just the latest in a line of new rules aimed at them.

That is because the UK government considers that their business models derive significant value from the participation of UK users, which goes largely untaxed (in their view).

Obviously, anyone whose core business is in these three areas will have to consider how much of their revenue is UK user-generated (whatever that comes to mean). Unfortunately, it looks like anyone else with significant revenues generated from those three areas could have to apply the rules, even if it is not their core business. It is as yet unclear exactly how the revenues from the target areas are to be split out from other income.