Paul L. Caron

Friday, July 5, 2019

Weekly SSRN Tax Article Review And Roundup: Kim Reviews Schön's How To Tax The Digitalized Economy

This week, Young Ran (Christine) Kim (Utah) reviews a new work by Wolfgang Schön (Max Planck), One Answer to Why and How to Tax the Digitalized Economy (June 2019).

KimTaxation of the digitalized economy is without a doubt the most important topic of international taxation in 2019. The G20 and the OECD have already released three documents this year—a Policy Note in January, a Public Consultation Document in February, and a Programme of Work to Develop a Consensus Solution in May—to follow up on the Action 1 of the BEPS Project (Addressing the Tax Challenges of the Digital Economy) released in 2015 and the interim report published in 2018. The February 2019 Public Consultation Document outlines three proposals under its consideration: 1) the User Participation Proposal, 2) the Marketing Intangibles Proposal, and 3) the Significant Economic Presence Proposal. The subsequent May 2010 Programme of Work categorized important differences in the prior three proposals into new nexus rules and new profit allocation rules. In consideration of the new profit allocation rules, the Programme of Work addressed several options under a number of different labels, including the modified residual profit split method, fractional apportionment method, distribution-based approaches, and so on.

Wolfgang Schön’s new work, One Answer to Why and How to Tax the Digitalized Economy, assesses the merits of the recent proposals based on the benchmarks of revenue, fairness, and efficiency. Note that the paper’s analysis focuses on the three proposals offered in the February 2019 Public Consultation Document, rather than the options addressed in the May 2019 Programme of Work document. It offers an important contribution by providing many profound theories on taxation of the digital economy, which this review will briefly mention along with the paper’s evaluation of current policy options.

To illustrate his evaluation, let us examine the Destination-Based Cash Flow Tax (“DBCFT”) proposal. The DBCFT is an extreme solution which allocates the right to tax business profits exclusively to the country where the business’s clients are located. Under this proposal, there will be a huge revenue shift from production countries to market countries, making it difficult to achieve a political consensus. With regards to fairness based on the benefit principle, market countries’ claims for greater taxing rights partly makes sense because the countries offer public goods—in other words, benefits—to foreign firms selling goods and services to their market. However, production countries can raise an offsetting claim based on their own provision of “benefits” to the same firms during the production stage. On the other hand, the DBCFT’s focus on the customer is highly efficient as the customer base is largely immobile. 

Although Schön consistently applies these three criteria—revenue, fairness based on the benefit principle, and efficiency—to the remaining proposals, the analysis puts more emphasis on efficiency. Such emphasis is understandable considering that revenue allocation and fairness among countries are not dependent on a preempted rule, but rather ultimately depend on a political compromise. So, it is not surprising that Schön's own proposal, introduced later in this review, is efficiency oriented. Furthermore, it is interesting that Schön rigorously distinguishes the private sector (e.g., market) from the public sector (e.g., government or benefits from public goods). This distinction is particularly noticeable in his discussion of the user participation proposal, of which Schön is critical. With respect to the fairness prong, Schön challenges the theory of user value creation, arguing that a user’s contribution is not an activity performed by the taxpayer. Rather, the user seems to be a special category of supplier in this business model. Furthermore, Schön argues that it is hard to impute the value contributed by users to the local government or the state in order to justify the taxation based on the benefit theory. Finally, efficiency is argued to be in favor of allocating the taxing rights to market jurisdictions under the user participation proposal, as with the case of all proposals allocating more taxing rights to market jurisdictions. To push back on this efficiency-based justification, however, Schön again indicates that the contribution of the users is not part of the firm's profits.

The paper moves on to proposals that put more emphasis on a digital firm’s investment or assets as compared to an emphasis on users. Schön finds this approach particularly persuasive on the ground that the corporate income tax is a tax on the return on capital investment. In this regard, the marketing intangible approach supported by the United States is easy to reconcile with the traditional concept of the corporate income tax as a tax on capital income. A digital firm makes specific investment in marketing intangibles to enter and penetrate a given market, so it makes sense, especially from an efficiency perspective, to enable the market country to participate in the rent deriving from this investment. Nonetheless, the marketing intangible approach builds on three different elements that are difficult to reconcile: (i) the anti-avoidance element derived from the BEPS project; (ii) the residual profit allocation theory, which is not fully consistent with the marketing intangible theory when it comes to the allocation of profits; and (iii) the corporate tax theory as a return on a specific investment in a given country.

To overcome such incoherence in the marketing intangible approach, Schön sets the digital investment in a specific market (“digital investment”) as a starting point and proposes to allocate the taxing rights based on the extent of the digital investment. The highly digitalized business model invests a great amount of money to create and maintain a user base in a given market that gives rise to specific network effects and externalities. Thus, it would be efficient for the market country to tax the rents deriving from such digital investment. Schön argues that the use of the digital investment as a tax base goes along with the corporate tax theory better than user participation as a tax base. Furthermore, taxation in the market country should be limited to such a highly digitalized business model where rents are derived from the unique products, dominant market position, and low marginal costs.

While admitting that it is not easy to identify the specific investment that can give rise to the taxing rights of market jurisdictions, Schön offers a general idea of what constitutes country-specific digital investment as opposed to the general expenditure targeted at the overall profits of the firm. The expenditure related to the initial creation of algorithms and hardware is the general expenditure that should be allocated to a country where the firm is resident, whereas the expenditure to attract users from a specific market, marketing campaigns aimed at the market, and regulatory compliance costs are examples of country-specific digital investments where market countries may exercise taxing rights. 

The merits of Schön's proposal, as he explains, is that it does not require a fundamentally different approach to profit allocation. While the user participation approach and the marketing intangible approach both reject the traditional profit allocation rules built on arm’s length pricing and instead plead for residual profit allocation, the concept of digital investment is in line with the arm’s length standard. However, even Schön rejects the traditional notion that any profit allocation to a given country requires the significant physical presence.

It is not certain whether Schön's proposal based on "digital investment" would be considered by the G20/OECD task force. However, the proposal deserves a closer look for one who wants to understand more theoretical issues of digital taxation or for another pursuing a policy option that is deeply rooted in a traditional view of the corporate income tax and international taxation.

Here’s the rest of this week’s SSRN Tax Roundup:

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