INSIGHT: U.K. Digital Services Tax—How Will it Work in Practice?

The U.K. government announced at Budget 2018 that it will introduce a digital services tax on the revenues of businesses resulting from certain digital activities in the U.K.

As we commented earlier this year, HM Treasury published an updated position paper in March 2018 (the “U.K. Updated Position Paper”) following consultation, which explored a number of options for a U.K. digital services tax (the “U.K. DST”). The government has now published a further consultation paper, and it intends to apply the U.K. DST from April 2020.

A Note of Caution

The U.K. is in a state of political flux at present. Brexit is due to occur on March 29, 2019. Given the current uncertainty, it is not clear whether the U.K. will even have the same government on March 29, 2019 as it does at the time of writing, let alone having the same government by April 2020 when the DST is due to come into force. Therefore, as political priorities may change, the scope of the DST (and even whether it is enacted) may change. For businesses potentially in scope of the DST, it is key to monitor developments.

U.K. DST

The government’s proposals are brief at this stage, and supporting draft legislation has not been published at the time of writing. However, the government has stated that the U.K. DST will apply as follows:

• The U.K. DST is a charge to tax of 2 percent on the revenues of specific digital business models, where those revenues are linked to the participation of U.K. users. The business models that will be within scope of the U.K. DST are:
  • search engines;
  • social media platforms; and
  • online marketplaces.
• However, the U.K. DST is not a tax on the online sales of goods. The focus of the U.K. DST will be instead on the revenues resulting from the intermediation of such online sales—rather than the online sale itself.
• The government has also confirmed that the U.K. DST is not a tax on online advertising or the collection of data per se; rather, the tax will be charged on the revenues derived from those services to the extent that the business operates one of the business models above.

Who is in Scope of the U.K. DST?

Businesses in scope of the U.K. DST must operate one of the business models identified above, and generate revenues of at least 500 million pounds (approximately $635 million) globally. However, the first 25 million pounds of such revenues in the U.K. is not taxable. The government provides the working examples below, which clarify to some extent the in-scope business models and revenues that are to be targeted by the U.K. DST, which must be linked to U.K. users (whether individuals or companies):

• if a social media platform generates revenues from targeting adverts at U.K. users, the government will apply a 2 percent tax to those revenues;
• if a marketplace generates commission by facilitating a transaction between U.K. users, the government will apply a 2 percent tax to those revenues; and
• if a search engine generates revenue from displaying advertising against the result of key search terms inputted by U.K. users, the government will apply a 2 percent tax to those revenues.

The government anticipates that small businesses will therefore be out of scope due to the double threshold, with the Chancellor stating at Budget 2018 that: "[the UK DST] will be carefully designed to ensure it is established tech giants—rather than our tech start-ups—that shoulder the burden of this new tax.”

The government proposes a safe harbor to allow businesses generating very low profit margins to calculate the charge on a different basis. The government’s initial Budget 2018 proposal intended to exclude from scope completely loss-making businesses, though that commitment is not referenced explicitly in the consultation paper.

Initial Issues

Revenues v Profits

The government’s proposals address to some extent a key criticism of the discussion under the U.K.'s Updated Position Paper: that because the U.K. DST is a tax on revenues, rather than profits, those businesses that are either loss-making or generating low profits will be affected disproportionately. Whilst the government’s aims to shield such businesses are laudable, the issue still remains that many businesses will fall within the ambit of the tax that are not considered to be “tech giants.” The government will need to take care in the drafting of the legislation to ensure that businesses are not burdened too heavily.

As regards the safe harbor referenced above for loss-making and low profit margin businesses, in its consultation the government has proposed that such businesses should be able to elect to calculate their DST liability by reference to an alternative formula: (profit margin) x (in scope revenues (less allowance)) x (A).

The government has stated that it intends to set A at a level where the safe harbor is only of benefit to businesses with very low profit margins, and has initially proposed 0.8.

The government intends that the profit margin should be U.K.-specific and business activity specific. It appears therefore that the key issue will be the profit margin in the U.K.—being loss-making globally will not necessarily prevent a DST charge from arising, and being profitable globally will not necessarily mean a DST charge arises. What is clear however is that the safe harbor, as initially proposed, could still lead to a very high effective tax rate for some businesses.

As ever, the devil will be in the detail of the final legislation.

Double Taxation

As well as being faced with an additional tax burden in the U.K., some businesses that are liable to U.K. corporation tax will pay that as well as the U.K. DST. Businesses need to review carefully whether they may be faced with a liability to double taxation in other jurisdictions implementing similar charges to the U.K. DST.

Identification of U.K. Users and Associated Revenues

The government has stated that “for the purposes of the [UK] DST, what matters is the location of the user, not the business.” Briefly, revenues in-scope will be those derived from advertising that is targeted at/displayed to U.K. users or that has involved a U.K. user action, such as a click. Where the revenue is based on commission, subscription, etc. payments, the payment must either come from a U.K. user or relate to a transaction involving a U.K. user.

However, identification of U.K. users may prove challenging—especially where internet protocols are re-routed, or perhaps even manipulated, to place the user outside of the U.K.

It is unclear at this stage how the proposals will operate on the broader stage currently occupied by data privacy and geo-location concerns: any obligations on businesses—the burden being on businesses to apportion U.K. user-derived revenues on a just and reasonable basis—to track and monitor the revenues generated specifically from U.K. user inputs may prove burdensome and problematic.

What About a Global Solution?

The government has emphasized its commitment to reaching a global solution to the taxation of digital businesses and will delay the application of the U.K. DST, bringing forward legislation from April 2020 unless an international solution is agreed in the interim.

The government has emphasized therefore that the U.K. DST “is intended to be narrowly-targeted, proportionate and ultimately temporary, pending a global solution.” Additionally, a formal review of the legislation in 2025 will assess whether the U.K. DST is still required in light of international developments, with further commitment to dis-apply the U.K. DST prior to 2025 if an international solution is agreed.

However, the prospect of international agreement at this stage seems unlikely, even at EU level. The EU’s proposed tax is itself another interim solution—pending approval of a proposed long-term solution to tax profits derived from a “significant digital presence” in the EU—which demonstrates the difficulties of achieving any form of multilateral solution. The Organization for Economic Cooperation and Development (“OECD”), for example, published a detailed interim report on the Tax Challenges Arising from Digitalisation in March 2018 which offers no consensus on the merits or need for interim measures in this area (p. 20, paragraph 27). For further detail on the EU’s joint-proposals, please see our previous article, “U.K./EU Approaches to Taxing the Digital Economy.”

Conclusion

The Chancellor noted in his Budget 2018 speech that:

"[t]here is one stand-out example of where the rules of the game must evolve now if they are to keep up with the emerging Digital Economy […]. The rules have simply not kept pace with changing business models. And it’s clearly not sustainable, or fair, that digital platform businesses can generate substantial value in the UK without paying tax here in respect of that business.”

The U.K. is clearly willing to implement the U.K. DST and such unilateral action will either prompt steps towards a uniform international solution, or result in a patchwork of taxes at different rates and with different scopes. Whilst the EU’s proposals have yet to achieve consensus, other member states, e.g. France, appear willing to follow the U.K.'s lead in the implementation of a unilateral solution.

Planning Points

• Businesses should prepare for the charge of the U.K. DST from 2020, and monitor the developments of other countries in this area, particularly in the EU member states.
• The government is consulting on the design of the U.K. DST, closing February 28, 2019. Businesses operating the in-scope business models should therefore be prepared to engage with the consultation, and monitor developments.

James Hill is a Partner and James Harrison is an Associate at Mayer Brown International LLP.

This article provides information and comment on legal issues and developments. The article is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek legal advice before taking any action with respect to the matters discussed herein.