The UK's Digital Services Tax update

The UK’s digital services tax (DST), introduced with effect from April 2020, is intended as a temporary remedy to the tax challenges posed by the digital economy. The problem it seeks to address is that the international tax framework, designed in a pre-digital age, permits highly digitalised businesses to generate substantial profits in a jurisdiction without having any physical presence there - which in turn means that that jurisdiction cannot tax those profits. In other words, a business can create value from UK users, without paying UK tax.

The UK government has been clear that it believes the taxation of the digital economy is a global problem requiring a globally coordinated response. But it also noted that a global solution is necessarily slow. As a result, the UK (along with a number of other jurisdictions, including Austria, France, Italy, Spain, Turkey and others) decided to adopt a unilateral solution, pending consensus on the multilateral approach.

That unilateral solution took the form of the DST.

The UK’s digital services tax

The DST’s scope does not cover all digital services but focuses only on three digital activities – social media services, internet search engines, and online marketplaces (plus associated online advertising services). It affects only large businesses, specifically those whose annual revenue from digital services activities exceeds GBP500 million , of which GBP25 million is attributable to UK users (known as UK digital services revenue). The first GBP25 million of UK digital services revenue is not taxed. Once that allowance is exceeded, the DST applies to such revenue at a rate of 2%.

The DST is an unusual tax in that it is applied to revenue, as opposed to profit. This approach gave rise to criticism that large businesses with substantial revenue but low profit margins (or which are loss-making) could be unfairly affected. In acknowledgement of this, the DST permits businesses to elect to calculate their liability using an alternative basis of charge, which involves replacing the 2% rate with a rate equal to 80% of the profit margin of the digital services activity that generated the UK digital services revenues.

The National Audit Office’s report on the DST

The UK’s independent public spending watchdog, the National Audit Office, has published a report on the DST’s first year in operation. The report records that in 2020-21, the DST generated GBP358 million - around 30% more than the DST’s forecast revenues of GBP275 million - with many in-scope businesses paying more in DST than they do in corporation tax. Around 90% of the DST’s take was generated by just five businesses. Interestingly, the businesses liable to DST paid roughly the same total amount of DST as they paid in corporation tax.

HMRC has suggested two reasons for the unexpectedly high revenue. The first was that in-scope businesses did not, as had been expected, change their behaviour to minimise their liability under the DST. The second was that, of the 18 businesses which paid DST, 14 of them had paid more than was predicted, partly due to higher-than-expected revenues.

The fact that HMRC has not observed businesses seeking to minimise their DST charges may, however, have less to do with the fact that they are content to pay it, and more to do with the fact that those businesses may simply have passed on their DST charges to customers and other parties – in other words, the intended taxpayer may not be bearing the tax costs. A number of businesses had previously announced their intention to do this.

The report also noted that the DST’s impact in 2021-22 was affected by the COVID-19 pandemic, with certain in-scope businesses having paid significantly more than expected due to increased use of online marketplaces and social media as a result of government COVID restrictions, while others paid less than expected, or nothing, due to decreased revenue (for example, in the travel industry).

The OECD’s Pillar One

Pillar One is the OECD’s proposed global solution to the tax challenges posed by digitalisation, and the UK has committed to the repeal of the DST on the implementation of Pillar One. Its application and effect will, however, be different from that of the DST.

In certain aspects, Pillar One is much broader than the DST. It involves the creation of a new nexus between the largest multinational enterprises (MNE) and the jurisdictions which contain their markets, even where the MNE has no physical presence there, which will permit those jurisdictions to tax some of the profits of the MNE. This is in contrast with the DST, which taxes revenues rather than profits. Pillar One is not aimed at a narrow range of services like the DST but, rather, a broad range of activities (with certain exclusions, including regulated financial activities).

However, in other aspects Pillar One’s effect will be narrower. It will not catch MNEs unless they have (i) a global turnover of more than EUR20 billion and (ii) a pre-tax profit margin of more than 10% (though the global turnover threshold is anticipated to fall to EUR10 billion once the proposal has been successfully implemented). These in-scope MNEs will be subject to the new taxing right in respect of 25% of their pre-tax profits in excess of 10% of their revenue.

A joint agreement relating to the transition from unilateral digital services taxes to Pillar One has been established between the US, UK, and a number of other European jurisdictions. The agreement provides that, while the UK and other European jurisdictions will not withdraw their unilateral digital services taxes until Pillar One takes effect, there will be an offset mechanism under which, broadly, amounts paid under the DST in 2022 and 2023 which exceeded the tax which would have been payable had Pillar One been in effect will be creditable against the portion of the corporation tax liability computed under Pillar One.

Given how few businesses paid the DST in 2020-21, and the planned introduction of Pillar One, does this mean businesses can largely ignore the DST?

Unfortunately – no.

With Pillar One due to take effect in the UK by 2024, the DST will remain in play for at least one more year (and potentially longer if Pillar One’s implementation were to be delayed). Meanwhile, HMRC has found an increase in the number of businesses potentially within the scope of the DST – having initially identified 31 such groups, it went on to carry out pre-return risk assessments with 101 groups (for the 2020-21 tax year). HMRC has also significantly increased its estimated revenue from the DST, with forecasts showing revenue growing year on year, and with the total estimated revenue over the DST’s lifespan than doubling (from GBP1.5 billion in 2019 to over GBP3 billion in 2022). The DST is therefore alive and well despite its limited duration, and remains a subject of focus for HMRC.

Potentially in-scope businesses should also bear in mind that, although any excess of their DST liability over their hypothetical Pillar One liability during 2022 – 2023 may be capable of offset against corporation tax in future, there may well be groups which fall within the DST’s scope but will not fall within that of Pillar One – such that no offset is available.

Given HMRC’s continued active approach to applying the DST and its unexpectedly high revenues, any potentially in-scope business should carefully consider the DST’s application, despite its short remaining life.

If you would like more information on the scope or application of the DST or Pillar One, please don’t hesitate to get in touch.