Navigating taxation in a digital world
Read time: 8 mins
As technology continues its relentless rate of acceleration, with the growing digitalisation of the global economy and some arguing that value creation is increasingly uncoupled from physical location, the international tax landscape is evolving too. How can your fast-growth tech business best navigate this complex, ever-shifting terrain?
- Ross Robertson: International tax partner working with large international businesses, often in the tech industry, with an area of focus on helping them to develop their IP strategy.
- Dan Pietkiewicz: Senior corporate tax manager working in the tech and media space with a focus on providing international support to fast-growing corporate clients.
- Julia McCullagh: International tax partner specialising in international business operating models.
Some commentators argue that the growth of the virtual, networked economy has played into the hands of a handful of larger multinationals, notably those in the tech space, by allowing them to deliver services remotely from low-tax jurisdictions and so pay little tax on profits in the territory where the end customer is based.
In response to this development, countries have been debating at an international level – notably under the auspices of the OECD – how best to combat such practices. In the short term, however, many countries have also pushed ahead with their own unilateral – and often globally inconsistent -- measures aimed at compelling digital businesses to pay their ‘fair share’ of tax.
The changing paradigm, coupled with the proliferation and variance of local regimes, poses a complex challenge to fast-growing tech businesses looking to expand into new markets. Our experts look at how you can best keep pace with developments, and respond to the evolving situation in a way that’s compliant across all your territories without increasing your overall tax burden unnecessarily…
A new tax paradigm for a new normal
The tax paradigm is shifting. The incumbent framework for international taxation – based on principles which date back over 100 years – is predominantly built upon the premise of ‘taxation by physical presence’. It’s an obvious approach for a pre-digital world, but less suited to today’s new and evolving commercial models, through which it’s possible for a business to sell its products or services internationally with minimal or even zero presence in a country, often via digital means. The OECD are keen to address this issue on a multi-lateral and consistent basis. However political discussions are proving complex, and a global solution still looks to be a way of.
A classic example is a social media platform whose users in different geographic territories create communities which in turn attract other users to those communities by virtue of the content that they share, which activity the business is then able to monetise through advertising or other means to drive its own commercial value. True, the business has created the platform in location A, but the platform in itself has very little intrinsic value without its users in locations B, C and D being willing to use it in a way that creates communities and content that can then be monetised. And so it’s that focus on those contributions that the users of the tech service are making to the business itself – simplistically speaking, a recognition of taxable value in jurisdictions B, C and D, as well as A – which forms the basis of this paradigm shift.
Examples such as the one outlined above mean that countries are seeking to assess whether there is more taxable value that is being created within their borders than is currently being recognised – or recovered. Whereas in the past fixed presence and physical assets were key indicators to help tax authorities compete over who gets which share of the pie, we now see tax authorities arguing over users and remote / digital value-creating activities to try and get their hands on what they think is their fair share of taxable profits.
To address this challenge, member countries of the OECD have been working since 2015 on a series of initiatives aimed at overhauling the existing international tax system. In recent years the continued escalation of tech success, now accelerated by the fiscal constraints imposed by the pandemic, provide a catalyst for individual governments to find quick new ways to shore up their fiscal position at home, and many tax authorities are opting to implement their own measures to bolster tax bases locally. These measures take a range of forms and, even where they align in concept – for example, around a ‘digital services tax’ – the base for taxation can differ significantly, as illustrated by our international tax tool.
Although the majority of these new rules may be thought of as targeting the tech giants of the world, don’t forget that many countries are actively considering and implementing measures with much lower thresholds and broader scope that simply tax remote activity. These measures are likely to affect a huge range of businesses operating across different borders. For example, India's equalisation levy only requires a turnover of around USD260,000 (INR 20 million) from Indian customers before its rules apply, as compared to the UK's much higher Digital Services Tax thresholds (i.e. more than £25m in revenues from UK users and over £500m of revenues worldwide).
"These measures are likely to affect a huge range of businesses operating across different borders."
So with each country taking a different approach to these issues, fast-growing tech businesses need to be aware of the tax rules locally to ensure that they remain compliant both at home and when entering new markets.
Managing unilateral activity
The issue of unilateral activity and local variance across different tax geographies presents a couple of key challenges for businesses. On the one hand, it could well mean an extra compliance burden at a time when the finance function in the business is already severely resource constrained. And on the other, there’s the challenge the labyrinth of local tax rules that may require collection and reporting of new types of data. What’s to be done?
As a starting point for a fast-growing tech businesses in this position, the best first step will often be to first map out where the business currently sits, and to understand what further steps may need to be taken to comply with existing tax laws. This is not always straightforward, and is an area where businesses can benefit by working closely with a tax adviser.
Next, once the business has taken steps to become compliant, the focus can switch to optimising the business model, and getting ahead of the curve tax-wise, whilst retaining a sufficient degree of flexibility. The key here, as in all these issues touching on international taxation, to look proactively at the tax situation ahead of any major new development such as a move into a new territory, rather than leave the tax dimension till after the event and try to fix things retrospectively.
Getting ahead of the tax curve
There are many areas which tech businesses need to think about in this matter, but three key points to address early on are determining the location of value creation, establishing a systematic approach for entering new markets, and planning for maximising free cash flow.
(i) Value creation
Tax rules generally seek to assert taxing rights over where the value is. But, as we have seen, in an increasingly digitised marketplace the question of where becomes more complex. And with much of a tech business’ value being tied up in intellectual property or, potentially, its user base and associated data flows, understanding these value drivers becomes critically important as the business scales.
Commercial objectives need to be developed in parallel with the business’ tax strategy to ensure that the two are aligned right along the value chain. Finance and tax teams should be actively involved in this decision-making process, because factoring tax consequences into commercial decisions from the outset will help ensure that you are able to navigate prevailing tax rules and comply with relevant laws in the most effective and efficient way possible.
(ii) Entering new markets
Tech businesses are often able to capitalise on opportunities to sell to multiple customers in a range of different jurisdictions. However the model for entry into new markets can have a significant impact on the tax profile of the business because each territory will assert different indirect and direct taxing rights on sales made to customers in their country, and these rights may vary based on the extent of local establishment and the form of the sale itself. It’s vital that tech businesses strategise the optimal model for new market entry; here again, expert advice can be a valuable support.
(iii) Free cash flow
The performance of a tech business is often assessed on the basis of free cash flow: a positive value here can impact significantly on a firm’s ability grow and/or attract investment. For this reason, it’s essential that the impact of VAT, customs/duties and withholding taxes on your business is fully understood and factored into sales and purchases, and consequential cashflow forecasts. Where applicable, businesses should seek to maximise cash tax reliefs too such as R&D and other intellectual property / innovation incentive regimes, and access to these reliefs can vary significantly depending upon the business model adopted; early consideration is key.
With the above said, the primary driver of success in a tech business is usually access to quality talent, so a successful tech business will usually look to structure itself around where it can secure access to the right talent as a first priority, closely followed by where it can access to capital to fund its growth. This is, of course, why we see tech businesses clustering around international hubs like the West Coast of the US, London, Israel, Singapore and elsewhere. Whilst tax considerations are important, the tax strategy should not wag the tail of the dog. The tax strategy should be developed in tandem with the business strategy – an optimised tax strategy can make a significant difference in free cash-flow for a scale up business, but a business which lets the tax strategy rule its growth plans is far less likely to ultimately succeed. Where there is tension between the business strategy and the tax strategy, the business strategy will invariably overrule the tax strategy, and this can have a value eroding effect through the creation of tax risk or cost if not sufficiently built into the strategy.
"Whilst tax considerations are important, the tax strategy should not wag the tail of the dog."
New tax challenges in the New Normal
The recent increase in demand for online services internationally, and the need for businesses to adopt remote working practices during the pandemic, has also thrown up a number of interesting tax issues, especially where teams being required to work virtually and not being able to travel overseas.
From a corporate perspective, there are potential issues surrounding permanent establishments and maintaining tax residence. With teams working more from home and remotely, businesses need to be mindful of how tax authorities may view and seek to tax such arrangements, particularly where short-term fixes are made more permanent.
There are personal issues for employees too. With employees working remotely effectively becoming part of a remote workforce, many employers have had to intervene on a range of issues which they might not have had to consider otherwise, such as visa issues, supporting employees with personal tax issues surrounding residence, addressing extra expenses associated with working from home, and the processing of government furlough schemes.
Working remotely is not an entirely new concept, of course, but what is new is the scale we are now seeing and accompanying shifts in policy and strategy. In time, these changes may become more permanent, and could result in some businesses re-evaluating who they employ. Rather than hiring someone based on physical proximity to the office, the prospect of either hiring the best talent for the role from a much wider geography – or outsourcing work to individuals in places where the cost base is lower – could become a more attractive proposition.
This diffusion of value creating activity across borders adds an additional layer of complexity in the context international tax system not fully accustomed to the notion of operating a virtual workforce at scale. Businesses seeking to hire the best talent need to therefore be cognisant of the associated costs and risks, and accordingly factor these into hiring decisions. Those not managing such risks carefully, may be faced with an increased level of tax risk, and extra costs.
Rethinking the present – and the value of advice
Proactive tax considerations can help optimise the planned design and delivery of new products and services. Whether you deliver an offering on a software-as-a-service (SaaS) basis or via a more traditional delivery model will impact in many jurisdictions upon the end tax outcome. So if you haven't talked to a tax advisor in the course of designing your product about how you're going to deliver it to your customers, you may be missing out on opportunities to optimise what your post-tax cash flows look like, or you may be carrying unknown risks.
For all the efforts at global standardisation, the fast-moving nature of tech means that local tax rules targeted at digital businesses continue to proliferate and diversify as countries scramble to recover revenues and keep apace of industry developments. All this adds up to a complex, moving target to aim at as a tech business tries to juggle sometimes very different regimes across its different markets.
By their very nature, tech businesses pride themselves on being fast-moving, fast-growing innovators, so the real challenge for the finance and tax function supporting them is to ensure that they are working with the commercial team in real time. Too often there is still an assumption that tax is about compliance and so follows along behind, whereas now more than ever it needs to be part of the forward-looking strategic conversation that informs a business’s future direction of travel. Many fast-growth businesses don’t have dedicated in-house resource to address these issues, so they will often look to an agile and trusted external partner for the support they need.
Try our tool: Navigating the global tax landscape
While the OECD is working towards a solution to a fair tax system in a global digital economy, many countries have already announced their own measures. These measures take a range of forms and, even where they align in concept – for example, a digital services tax – the base for taxation can differ significantly. This lack of consistency creates additional complexity for tech businesses seeking to operate compliantly but efficiently in multiple territories.
Use our tool to help you navigate this emerging landscape.
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