Taxation in the Digital Economy: Digital Services Taxes, Pillar One, and the Path Forward

Source: Joint Committee on Taxation

Note: Multiple taxes on digital multinational companies exist, contingent upon the extent of a company’s economic presence and the nature of operations they engage in (such as advertising, streaming, online marketplaces, etc.) and the collection and sale of user data. “DAT” refers to a Digital Advertising Tax; “DST” refers to a Digital Services Tax; “Digital PE” refers to a Digital Permanent Establishment or expanding the traditional definition of permanent establishment to include virtual or digital presence; “SEP” refers to a Significant Economic Presence, where companies are subject to either the country’s income tax or a tax on revenues; and “WHT” refers to a Withholding Tax.

DSTs have usually targeted only the largest companies in the digital economy. Typically, foreign taxes owed by U.S. companies can be offset by the foreign tax credit (FTC), protecting companies from double taxation while leading to a reduction in U.S. tax revenue. However, there has been uncertainty about whether companies subject to a DST should qualify for an FTC given that they do not adhere to traditional rules establishing “nexus,” a connection between a company and country that would give rise to taxing rights due to active and sustained participation in the country’s economy. Ultimately, if DSTs do not qualify for FTCs, U.S. companies will be even further burdened by these new taxes.

There is a real risk that the alternative to international consensus on DSTs is a global trade war. For example, as more countries proposed or implemented DSTs from 2017 through 2020, the U.S. retaliated to prevent double taxation for U.S. companies. In 2020, the U.S. proposed a 25% tariff against luxury French imports as a retaliatory measure for their 3% DST. Though the proposed tariffs have since been replaced, U.S. policymakers in both parties have been concerned about the disproportionate impacts of DSTs on U.S. companies.

Pillar One: A Consensus-Based Alternative?

While international negotiations over DSTs have increased in intensity and frequency over the past few years, the push for an international consensus has also increased. Pillar One of the Organisation for Economic Co-operation and Development’s (OECD) two-pillar global tax agreement is meant to replace multiple DSTs—each with different rules, rates, and reporting requirements for the companies subject to the tax—with a single global agreement to reallocate a portion of the global profits of high-revenue, highly profitable multinational companies to the countries in which those companies operate. The goals of Pillar One are to reform nexus rules, roll back current DSTs, and prevent future DSTs from being implemented. This pillar only applies to multinational enterprises with global revenue exceeding €20 billion ($21.6 billion) and profit margins exceeding 10%.

In October 2021, nearly 140 countries representing 90% of global GDP signed onto the deal, which also includes an agreement to tax large companies at a minimum of 15%, though the deal has not yet gone into effect. Most countries that have implemented DSTs can expect to earn similar or higher revenues from implementing Pillar One instead. U.S. critics of the agreement argue that the U.S. will continue to be disproportionately affected compared to the other countries involved. Under the current parameters, Pillar One will redistribute €91 billion ($98.3 billion) in profits from 68 companies. Nearly half of the affected companies (31 of 68, or 46%) are headquartered in the U.S., representing 58% of redistributed profits. Republicans are concerned that the deal will undermine U.S. competitiveness and give other countries new authority to tax American companies. However, Democrats—largely in line with the Biden administration and key U.S. negotiator Treasury Secretary Janet Yellen—maintain that U.S. participation in the agreement would “level the playing field” for multinational companies.

Risks and Challenges in the Years Ahead

Proponents of the agreement fear that without Pillar One implementation, U.S. companies might encounter renewed DSTs. We have seen this most recently with Canada’s 3% DST, a consequence of Pillar One’s delayed global adoption, potentially inviting retaliatory actions from the Biden administration.

As the agreement continues to trudge through political obstacles and practical challenges, more countries may look to DSTs as a viable solution to collect revenue from large technology companies or even to put pressure on negotiating countries to finish work on Pillar One. Many countries that currently have DSTs in effect have made repeal contingent on whether Pillar One is implemented.

There is a growing global interest in reforming and addressing nexus rules to account for changes in the economy. U.S. policymakers should seek to build consensus both among themselves and with global allies to avoid the significant negative consequences that stem from unilateral DSTs. Lawmakers must consider the economic and political ramifications of action (or inaction) on Pillar One, and prioritize policies that balance growth, equity, and efficiency with a rapidly changing digital economy.