Taxing the Digital Economy: Challenges and Solutions in the Age of Intangibles and Innovation

 

Abstract:

The digitalisation of the economy presents novel challenges for the international tax framework, largely around nexus rules and profit allocation. Traditional tax concepts, premised on physical presence and tangible assets, are increasingly outpaced by digital business models. This article explores these issues and evaluates leading global policy responses, including unilateral Digital Services Taxes (DSTs), digital Permanent Establishments (PEs), and the OECD’s two-pillar solution, with a focus on balancing fairness, efficiency, and global cooperation.

Key words: digitalisation, international taxation, profit allocation, nexus rules, OECD.

 

Seen in a certain light, the current architecture of international taxation resembles Hermann Hesse’s masterpiece Glass Bead Game: an intricate intellectual network in which old and new rules intertwine within an abstract yet deeply influential system governing the invisible flows of global economic value. Just as in Hesse’s game, where each combination of beads represents a synthesis of knowledge, in digital taxation every legislative decision reflects a carefully calibrated balance between sovereignty, fairness, and cooperation. The question remains: who holds the right to move the next bead, and in which direction will the game unfold?

The digitalisation of the economy is a global, contemporary phenomenon, which creates issues in terms of international taxation, which exceed the question of how to stop base erosion and profit shifting (BEPS). The essential character of the main tasks that firms perform nowadays in order to make profits has not been fundamentally altered as a result of the digital revolution. However, digitalisation has modified how organisations function, especially with regard to digital business models, utilised by firms such as Facebook, Instagram, Booking.com etc.[1] The landscape of tax issues brought up by digitalisation, mostly pertains to the issue of how states should allocate the taxing rights on the money derived from cross-border operations under the new digital business model.[2] Another important issue is the growing reliance on intangibles, whose pricing is very challenging because they have singular characteristics, and comparability – required under the arm’s length principle – is not possible. This difficulty extends to taxing transactions involving intangibles.[3]

In other words, the main problems created by the economic digitalisation exist in relation to nexus rules (the linkage company-jurisdiction for tax purposes) and to profit allocation, and the guiding question is whether markets create value that could be taxed.

Concerning nexus rules, the increasing use of digital technologies, the fact that many companies no longer require an actual physical presence to conduct business, and the growing significance of network effects brought about by customer interactions raise the uncertainty whether the current rules and principles regarding the establishment of nexus with a jurisdiction for tax purposes are still appropriate and effective.[4] How can a nexus be determined between the company and a particular state, considering that no physical connection exists with the country and everything takes place in cyberspace?

With regard to profit allocation, it can be said that, due to the development and sophistication of information technologies and the high reliance on intangibles, there is now a growing number of businesses which are able to collect and use information internationally extensively. This raises the questions of how to characterise for tax purposes a person or entity’s supply of data in a transaction, and how to attribute the value created from the production of data through digital products and services. Additionally, user-generated value provides even more difficulties because the contributions increase the platform’s value, without it being attributed directly to the company itself.[5]

Since states have discovered these problems, they searched for acceptable solutions to grapple with the issues explained above. There are three main solutions that can be adopted by a government: amending double tax treaties (DTCs) so that they include the concept of digital permanent establishment (PE), imposing a unilateral Digital Services Tax (DST) or following the multilateral, consensus-based solution of the OECD/BEPS Inclusive Framework/G20 structured in two pillars.

• The concept of a digital PE would be an expansion of the current notion which conditions the existing of a PE on the existence of an actual physical presence in a state (a fixed place of business or a dependent agent), so that a PE could be deemed existent even based on digital presence on the market of a certain jurisdiction. The implementation of such a solution can take place only by modifying DTCs between countries, particularly the articles regarding PEs (corresponding to Article 5 OECD MTC[6]). There are proposals discussed in international forums about the details, but the general characteristics of such a virtual PE can be summarised as follows: a digital PE would be established when a firm has significant digital presence in a jurisdiction, based on factors like revenue, active user accounts, digital content, or electronic contracts, and once a company is deemed having such a PE, the profits of that PE will be attributed to that state and taxed accordingly.[7] The digital PE concept is easy to implement and easy to administer, after modifying the existing double taxation treaties, considering that the “physical” PE already exists and there are rules and procedures which guide the allocation of profits and the taxation of companies based on their PE established abroad, without having the disadvantage of double taxation of corporate profits.

 

• The DST is a unilateral solution, which has been in practice adopted by certain countries over the past years (for instance, France or Hungary), frequently called the “Google Tax”. It is a tax levied on digital businesses that meet specific sales thresholds in a jurisdiction, having a flat tax rate (usually, around 3-4%), targeting companies generating revenue from digital services and applicable once a firm falls within the scope of the tax, e. surpasses a defined level of sales in that country. A similar withholding tax on gross profits exists currently in the United Nations Model Tax Convention (UN MTC), in Article 12 B[8], but it is limited to Automated Digital Services, which are for example: online advertising services, online search engines, social media platforms, online gaming, cloud computing etc.[9] The DST is easy to administer and to implement by countries in their national tax laws and regulations, but it has a very important drawback residing in the fact that it allows for double juridical taxation because the tax is also levied on the profits of a company, even though the company is already taxed in its home jurisdiction based on its worldwide income.

 

• The OECD solution comprises of Pillar One and Pillar Two, a joint solution developed by the OECD based on consensus so that digital giants could be taxed in market jurisdictions, but eliminating the risk of double taxation as much as possible.

Pillar One has two prompts. Amount A uses a residual profit split calculated with the help of formulas to give market jurisdictions the authority to tax profits over specific thresholds earned by multinational enterprises (MNEs) that operate in their territories. On the other hand, the purpose of Amount B is to standardize the compensation for related party distributors who carry out basic distribution and marketing tasks. “Notably, the rationale of Pillar One is in opposition to long-standing standards on the allocation of taxing rights of business profits such as the requirement of physical presence to allow source taxation or the arm’s length standard as a profit allocation mechanism.”[10] Pillar One targets MNEs with global turnover above €20 billion and profitability above 10%. It eliminates DSTs, by allocating to market jurisdictions the possibility to tax 25% of residual profit (profit in excess of 10% of revenue), if those MNEs make at least €1 million in revenue from that jurisdiction (€250.000, if the country’s GDP is below 40 billion).

Pillar Two (GloBE) seeks to impose a worldwide minimum top-up tax on MNEs, irrespective of the tax rates enforceable in the countries in which they conduct business. The main objective of the floor tax (set at 15%), is to cease base erosion and profit shifting (BEPS), which happens when MNEs choose lower tax jurisdictions to minimize their worldwide tax burden. Pillar Two effectively deters the use of tax havens and detrimental tax practices, while the possibility of tax arbitrage will be drastically diminished if global coordination regarding the minimum tax is accomplished. “Two basic mechanisms are foreseen for the collection of this top-up tax: an income inclusion rule (IIR) if a parent company is liable to pay top-up tax, or an undertaxed payments rule (UTPR) if the tax is collected from a company making intra-group payments.”[11]

In conclusion, the digitalisation of the economy has posed complex challenges to international taxation so far, particularly regarding nexus rules and profit allocation. Whereas each solution has its advantages and disadvantages, a coordinated global approach, as proposed by the OECD, appears to be the most efficient and fair way forward to tackle with the issues presented above while minimising double taxation.

 

[1] Chapter 5: Adapting the international tax system to the digitalisation of the economy. In: Tax Challenges Arising from Digitalisation – Interim Report (OECD, 2018), 167.

[2] ibid, 166.

[3] ibid.

[4] ibid, 169.

[5] ibid, 169-170.

[6] Organization for Economic Co-operation and Development (OECD) Model Tax Convention (2017), Article 5.

[7] Tereza Homa, ‘The Future of the Digital Permanent Establishment Concept: Challenges and Obstacles’ (2024), 34(2) Financial Law Review, 23-36.

[8] United Nations Model Double Taxation Convention (2021), Article 12B.

[9] United Nations Model Double Taxation Convention (2021), Commentary on Article 12B, 434-475.

[10] A. Navarro, ‘The Allocation of Taxing Rights under Pillar One of the OECD Proposal’ (March 31, 2021). OUP Handbook of International Tax Law (F. Haase, G. Kofler eds., Oxford University Press 2021 Forthcoming).

[11] J. Englisch, ‘International Effective Minimum Taxation – analysis of GloBE (Pillar Two)’, (April 18, 2021), OUP Handbook of International Tax Law (F. Haase, G. Kofler eds., Oxford University Press 2021 Forthcoming).