A digital tax is coming: what are the potential costs to Ireland?

By Jim Stewart, Trinity Business School, Trinity College, Dublin

The EU proposal to introduce a form of digital services tax (DST), that is, a tax on the sales revenues of firms whose main activities are in the digital sector, has attracted a lot of attention.

What has attracted less attention is that many countries both outside and within the EU have unilaterally either introduced or proposed to introduce some form of digital tax. This trend means that agreement at the EU level is of far less significance for countries opposing a digital tax, such as Ireland, and for digital firms.

Of greater significance than the proposed DST is an associated proposed  EU directive to change the definition of a permanent establishment for digital firms.

This note will first explain some key issues raised in relation to the introduction of a DST at European level. A discussion of the growth of unilateral measures follows, and the possible effect on Irish corporate tax revenues.  Finally, the key issue of the definition of the location of permanent establishment is discussed.

Irish DST opposition

The Irish government and other member states have consistently opposed a DST and other EU initiatives relating to corporate tax reform, such as the introduction of a common corporate tax base (CCTB). The DST proposal was discussed but no agreement was reached at an Ecofin meeting on 7 November.

Prior to this meeting, the Irish Minister for Finance stated he “would dig his heels in,“ according to a 3 November report in the Irish Times. Ireland remains opposed to a digital tax despite reported offers of compensating payments to Ireland.

This position is also supported by the main opposition party in Ireland, who have urged the government to use a “veto to stop this latest attempt by the Commission to undermine the sovereignty of individual member states over corporate tax.”

This is significant because the current Irish government depends on the support of the main opposition party via a “Confidence and Supply Agreement”.

At the same time, commentators within Ireland, such as Cliff Taylor, envision that change is coming. Brian Hayes (Fine Gael MEP) has stated: “the digital companies have to pay more but how they pay more is the question”.  Of greater significance is that, more recently, the Labour Party in Ireland has supported a digital services tax.

The Irish government position is that, while reform is needed, this must be done on a multilateral basis.  This was recently reaffirmed in Ireland’s  Department of Finance Corporation Tax Roadmap.

However, it is unlikely that the OECD will be in a position to agree on a digital tax. In the OECD’s interim report on the tax challenges of the digitalization, achieving a consensus by 2020 is regarded as “challenging”. 

The current US administration has stated they would not agree to any tax on digital companies. The US Secretary to the Treasury in October stated that the US government “firmly opposes proposals by any country to single out digital companies.”

Irish and other member states’ opposition is significant because any initiative at EU level may be blocked by one or more countries, including Ireland. This is because the Treaty on the Functioning of the European Union (TFEU) does not refer to direct taxation as being a competency of the Commission and changes to indirect taxation require a unanimous vote at the Council.

Unilateral measures

However, just as Ireland claims sovereignty in tax matters, so do other EU member states.

Several EU member states have unilaterally announced a specific digital tax. Recently the UK government joined Italy and Spain in proposing a specific digital tax but at 2% rather than 3% of revenues. Firms with global revenue of £500 million or more will be included, rather than the EU proposal of €750 million or more.  The UK proposal is in addition to a tax referred to as a ‘diverted profits tax,’ largely aimed at MNEs in the digital economy.

In the case of Spain, the proposed DST  would mirror the Commission’s outline digital tax proposals. 

There has also been widespread unilateral introduction of variations on a digital tax and other relevant changes, such as redefining permanent establishment to include digital activities.

These changes are well described in the OECD interim report on the tax challenges of the digitalization (see, section 4.1) and the European Commission impact assessment accompanying its proposals on digital presence and the digital services tax.

The Australian government is considering introducing a type of digital tax on the basis that “. . . a multilateral solution is likely to be several years away and there is no guarantee that international consensus will ultimately emerge.

What are the likely effects for Ireland?

Irish Revenue officials have stated that, assuming Commission estimates of total tax receipts of €5 billion and allocation across member states by population, a digital tax would cost Ireland €120 million to €160 million per annum because the tax would be deductible against profits that are currently taxable here. (Oireachtas Joint Committee on Finance, Public Expenditure and Reform, 3 May 2018).

That is, a DST paid outside Ireland may be offset against corporation tax due in Ireland. Ireland would, in return, receive approx. €45 million if the proposed tax was reallocated to EU member states by population.

In January 2018 earlier estimates were that a digital tax could cost up to €8 billion (Oireachtas Joint Committee on Finance, Public Expenditure and Reform 3 May 2018).

This estimate was based on internal revenue working papers and explained as follows:

“What we were looking at, therefore, was a possible reallocation of tax base away from Ireland, which is substantially different from the proposals that were ultimately published”.

Facebook announced in December 2017 this year that revenues from other countries would no longer be recorded in Ireland but rather in the countries where revenues accrued. The net effect is that revenues in other countries may rise, as will profits and tax payments. But more important, Facebook in these countries will have a significant digital presence.

The effect of imposing a DST in countries where Facebook operates would be to create an additional tax-deductible expense in those countries thus reducing profits in Ireland.

The introduction of a DST gives an incentive to Facebook to ensure profits and hence tax payments are high enough so that the DST charge is fully tax deductible. This could be achieved by reallocating profits from Ireland, thus reducing the Irish tax base and corporate tax receipts. The value of tax deductions is a function of the tax rate. The greater the differential between the Irish corporate tax rate and the tax rate in countries with a DST, the greater the incentive to switch profits from Ireland.

Unilateral action by governments in many EU and non-EU countries will cause a similar reallocation of revenues and profits away from Ireland.  Switching profits from Ireland is already occurring in cases of mutual agreement procedures and correlative adjustments.

 UK, Spain digital services tax

As noted above, the UK government has recently proposed a DST. Estimated revenues for 2020/2021 are Stg 275 million rising to Stg 440 million by 2023-2024. This digital tax will either appear as an expense in deriving Irish corporate tax revenues with a consequent reduction in tax yield.  An alternative is that it will appear as a deduction against UK corporate tax, because of Facebook-type reorganisation, or because of unilateral changes by tax authorities.

In this latter case, a maximum of Stg 1447 million or €1620 (assuming an exchange rate of 1.12) in profits could be shifted to the UK, and most likely from Ireland to generate sufficient tax to ensure the DST is fully tax deductible. This would result in a reduction of Irish corporate tax revenues of €202 million.

The digital tax proposals in Spain assume corporate tax revenues of €600 million in 2018 and €1.6 billion in 2019.

The Commission has assumed a DST yield of €5 billion. Using the same assumptions as above, and assuming an average corporate tax rate of 25%, this requires taxable profits of €20 billion to offset the DST. If half of these profits were diverted from Ireland, the loss in tax revenue would be €1.25 billion, substantially larger than revenue estimates of €100 million.

 Commission’s permanent establishment directive

Perhaps more important than the proposed DST are the likely effects of the associated EU directive defining a permanent establishment. This directive identifies a permanent establishment (and taxable presence) for digital companies as one where one of the following criteria is met:

• exceeds a threshold of €7 million in annual revenues in a member state;
• has more than 100,000 users in a member state in a taxable year;
• Over 3000 business contracts for digital services are created between the company and business users in a taxable year.

The EU has also published detailed recommendations on how double taxation treaties may be amended to extend the “concept of a permanent establishment to include so as to include a significant digital presence.” 

These initiatives, if implemented by the EU, will result in a large profit reallocation from Ireland with a consequent drop in Irish corporate tax revenues. Even if not accepted by the European Council, the same effects will follow, as in the absence of a multilateral agreement, these provisions become standards that other countries follow.

Many countries both within and outside the EU have unilaterally either introduced or announced a DST with associated changes to the definition of a permanent establishment.

A key policy issue for the Irish government is to decide which is more acceptable: proposed EU digital tax changes (with Irish government participation) or existing and proposed changes introduced on a unilateral basis.

A key policy issue for the Irish government is to decide which is more acceptable: proposed EU digital tax changes (with Irish government participation) or existing and proposed changes introduced on a unilateral basis.

Ireland and some other member states have argued that the Commission does not have competency in matters of direct taxation. The Commission argues that  the legal basis is for such action is article 113 of the TEFU which states:

 “ The Council shall, acting unanimously in accordance with a special legislative procedure and after consulting the European Parliament and the Economic and Social Committee, adopt provisions for the harmonisation of legislation concerning turnover taxes, excise duties and other forms of indirect taxation to the extent that such harmonisation is necessary to ensure the establishment and the functioning of the internal market and to avoid distortion of competition”.

This issue may only be resolved by a case taken to the European Court of Justice. It is unlikely that Ireland and other countries would follow the Apple precedent. Some argue that failure to agree on the Commission proposal at the European Council may lead to France adopting a ‘coordinating’ role in introducing a DST among like-minded EU countries.

What is more likely is that EU member states and non-EU member states will continue to introduce a form of DST and at the same time modify permanent establishment rules, along the proposals set out in the proposed directive relating to a significant digital presence.

In either event, the implications are that effective tax rates on the non-US profits of digital firms will rise and that Irish corporate tax receipts from digital firms will fall.