Not everyone’s cup of DST: five thoughts on the UK digital services tax consultation

by Julian Feiner, Dentons

Following its recent budget announcement, the UK government is consulting on its proposed digital services tax (DST), seeking views on the design, implementation, and administration, by 28 February.

The 8 November consultation paper considers the key elements and identifies 28 questions for discussion. Although the discussion is still speculative, there are five insights we can draw from the paper.

1. Purpose and design

The UK’s decision to introduce an interim revenue-based tax has been heavily criticised.

A pragmatic explanation is offered in the consultation paper. The UK “acknowledges the limitations and challenges of revenue-based taxes, and recognises the concerns expressed that such taxes do not represent a sustainable long-term solution,” while maintaining that “revenue-based taxation has a purpose, in demonstrating the importance that the government attaches to this issue”.

Reading between the lines, the DST may be understood as an attempt to advance the ‘painfully slow’ multilateral discussions on a permanent solution, from a position of strength, while seeking to ensure that it is sufficiently proportionate and delayed to deter any retaliatory measures.

2. Activities in scope

The government intends to define specific in-scope business activities and impose tax on the UK revenues generated from those activities. The in-scope businesses are social media platforms, search engines, and online marketplaces. The difficulty with this approach is to define them precisely.

For example, a social media platform will be a business that allows users to interact and share information, or join and create communities, as a ‘central part’ of the business offering.

This extends to blogging or discussion platforms and dating platforms and possibly also to some online gaming networks if they have ‘similar features’ to social media. There may be more difficult examples which are not examined in the paper.

Take, for example, a genealogy website, which offers a DNA testing service, charges subscription fees to access a searchable database, and enables some discrete information sharing and interaction among users. It is unclear whether the search engine or interaction features would be a ‘central part’ of the business offering to bring it within scope.  

3. Revenues in scope

The most challenging aspect of the tax is to delineate the UK revenues generated by the participation of a UK user. This would include, in theory, identifying the revenue from advertising that is ‘targeted at UK users or has involved a UK user action, e.g., a click’. Applying that in practice seems to impose an impossible compliance burden.

The most challenging aspect of the tax is to delineate the UK revenues generated by the participation of a UK user. This would include, in theory, identifying the revenue from advertising that is ‘targeted at UK users or has involved a UK user action, e.g., a click’. Applying that in practice seems to impose an impossible compliance burden.

The paper concedes that, in ‘more challenging cases’, the destination of advertising may be unclear and there may be contradictory evidence of user location or user identity (e.g., where an offshore company subscribes for use by UK employees). This casts doubt on the precision of the tax and is a key area of practical concern for businesses.

4. Safe harbour

The safe harbour mechanism will allow businesses with low profit margins to pay a reduced rate of DST on revenues (although still have a very high effective tax rate on profits, up to nearly 80%).

Calculating the ‘profit margin’ will be complicated. It must be adjusted to a ‘UK and business activity-specific’ level, which may not be readily discernible. It is unclear whether it would be based on past, or anticipated, profit. And how global or regional overheads might be allocated to UK revenues.

Moreover, the formula means that an election is only beneficial while the profit margin of the business is less than 2.5%. A business with a profit margin of 2.5% of UK revenues would pay a 2% tax on those revenues (less a £25 million allowance). That is an effective tax rate approaching 80% and may mean the activity is not economically viable. Even higher effective rates would apply if businesses are unable to disapply the safe harbour formula when their profit margin exceeds 2.5%.

5. Double taxation

The paper recognises the scope for double taxation if other countries implement a similar DST. This is because cross-border transactions, particularly those involving online marketplaces, may involve UK and non-UK user participation, and the UK considers that its double tax treaties will not apply.

The proposed solution is to negotiate ‘an appropriate division of taxing rights with the other countries which are also implementing a DST’. This could require complex negotiation with EU countries that impose digital taxes, such as Spain, and pending that negotiation, extremely high effective tax rates which make business activities in those countries economically unviable. 

Time will tell if the severity of those consequences will engender productive discussions on a multilateral solution, or if instead we will see an escalation of unilateral, reciprocal measures.