Finding Canadian Online Users

As I’ve noted before, in many ways formulary or unitary taxation (apportioning taxable income proportionately based on set factors like sales or workforce, rather than the current “arms-length” system of valuing internal assets on market prices) is seeping into the global tax system in barely noticed ways. We’re approaching the point where it could be called a hybrid of the two frameworks–maybe we’re already there.

Another recent way that formulary aspects have been introduced was revealed last month, when Canada announced it was moving ahead with its plan for a digital services tax, despite an Organization for Economic Cooperation and Development agreement with 138 countries to hold off on DSTs for another year. The OECD hopes to finalize its consensus-based alternative by then, but the Canadians were apparently done waiting.

Maybe it’s kind of obvious that a DST–which is based on revenue from select online activities, rather than income–is a formulaic tax. It’s really a consumption, destination-based tax. But there’s an interesting wrinkle in how the Canada tax approaches one of the trickier issues in digital taxation: how to capture business-to-business transactions involving an online user who isn’t actually a paying customer.

This comprises a huge portion of the online tech world's business–think of Facebook or Google, which both offer services for free so they can harvest user data and deliver viewers to advertisers. As the phrase goes, if you’re not paying for a service you’re not really the customer, you’re the product.

There’s not necessarily a reason to include the user in the tax system at all. Most consumption taxes don’t, they just charge the final customer whether they’re an online consumer or a business. But as a political matter, the countries with these online user bases feel they’re creating the real value here, and they deserve a cut of the revenue that they're not getting now. (Which does make some sense if you’re working from the “user = product” paradigm.)

The OECD recognized this in its “Pillar One” project, the proposed alternative to DSTs. The OECD project began as countries were considering enacting digital taxes in Europe and throughout the world, in response to public anger over the perceived non-taxation of digital transactions and tech companies. The OECD’s goal was to satisfy these political impulses without targeting digital activities in particular, which the U.S. considers to be discriminatory towards Silicon Valley. The OECD's solution was to create a new tax system for a slim portion of all sales, whether or not they’re digital and whether or not they’re accompanied by a physical presence of the taxpayer in the jurisdiction.

That may make sense–but what about the Facebook and Google users? For them, the proposal included a “proxy” system, where end-users are considered the final customer for certain transactions, for the purpose of sourcing the revenue. That may seem complicated, but OECD officials always maintained that this would be relatively simple, at least compared to the complexity of the rest of the project.

I always wondered if that was a bit Pollyannish. In theory it’s simple enough to track the advertising revenue to the viewer. (And to be honest, most of the time the advertiser and the viewer will be in the same jurisdiction anyways.) But the online world is a strange, complex dimension, and think of all of the data harvesting and exploitation which social media and online search engines engage in. What about products that are based on global analyses of user trends and data–will it really be so easy to track them down to whichever jurisdictions?

That’s not even getting into the technical questions of how to track users, especially those who use VPNs and other means to hide their locations. (Although, given the recent controversies about online user privacy, it is a high bar for the tech giants to convince governments that they don’t already have this information at their fingertips.)

The OECD’s Progress Report on Pillar One, released last summer, confirms that advertising revenue and revenue from user data will both be sourced to the jurisdiction of the viewer or user, and lays out a series of options for the taxpayer to determine that. The report doesn’t mention social media specifically, but presumably that would be covered by those–or by some of the other nebulous “Other” or “Non-Customer Revenue” categories.

Canada’s new DST–which includes advertising, user data collection and social media as three separate categories–uses a similar system, but with a twist. It acknowledges that in some situations, singling out that data may be impossible. So, for social media revenue, the draft proposal would claim as taxable revenue a slice of the taxpayer’s total global revenue, proportionate to its percentage of overall users who are based in Canada.

For user data and online advertising services, the formula is more complicated, taking into account users who can be identified as being based in Canada as well as the same percentage-based calculation as above.

The Information Technology Industry Council, a U.S.-based trade association of tech companies, claimed that the proposal’s definition of Canadian user is “unworkable,” in a recent comment to the Canadian government. The letter included a longer submission from last year, where the ITI criticized the whole percentage-based concept. (They also argued that social media revenue should only include revenue from paying customers.)

“We recommend an approach to revenue sourcing based on a company’s existing records as opposed to the currently envisioned approach of applying a ratio to global revenue, which distorts the true income earned by a company for views in each jurisdiction,” the ITI wrote. “Revenue sourcing should be based on the existing data that companies already have, rather than requiring companies to collect new data solely for the purposes of compliance with the DST.”

That, to me, is the key formulary aspect–requiring a company to submit global data and then working from there to determine the local amount. Maybe it’s a stretch to call it a formulary system. But even though most DSTs look, walk and quack like consumption taxes, technically they’re supposed to be “temporary” patches to the income tax system. So in that sense, the Canadian DST is an income tax that’s apportioned by global formula in some situations.

Since it looks like DSTs will be with us for a while (whether or not they're considered temporary), we may need to consider more carefully how they tackle this online user concept. Especially because we may be entering an era where online users and Internet use in general will comprise a bigger and bigger portion of the entire economy.

Are user percentages the right way to approach online revenue? Are all users created equal? Or will the tax system eventually demand a more extensive analysis of online dynamics? And can the arm's-length standard survive in this global environment?

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• While I was enjoying a lovely (but hot) week in the Outer Banks, House Republicans had their own, presumably less relaxing trip to Europe over Labor Day weekend to protest the OECD’s global minimum tax. According to the House Ways and Means Committee’s latest release, the delegation met with OECD Secretary-General Mathias Cormann and German Finance Minister Christian Lindner, but not Bruno Le Maire, France’s finance minister. These well-publicized meetings are thought to be part of the efforts of Ways and Means Chairman Jason Smith, R-Mo., to raise the profile of this issue outside his committee. Despite the white-hot partisan rhetoric from Ways and Means Republican members, the OECD agreement hasn’t found a ton of notice in the broader debates.
• It’s not all partisan discord on the Hill, though. Today the Senate Finance Committee unanimously approved legislation to create a double taxation agreement with Taiwan, in lieu of a formal treaty. Both parties pitched the pact as a way to protect Taiwan’s crucial semiconductor industry from Chinese encroachment. According to Sen. Mike Crapo, R-Idaho, Taiwan is the largest U.S. trading partner without a tax treaty, and this kind of workaround only applies to this “very unique situation.” (In other words, don't start thinking you can use this as a precedent to avoid the Senate ratification requirement for other treaties, or pacts like the OECD's multilateral convention for Pillar One.) See the Joint Committee on Taxation's summaries of the legislation here and here.
• The OECD is continuing its foray into climate change and carbon tax policy with a new report on carbon pricing metrics. As I’ve written, this issue could eventually eclipse base erosion as the key challenge in future global tax policy, so this is definitely worth a look.

You may have noticed some new features in this newsletter. I'm excited to announce that Things of Caesar has entered into an exclusive sponsorship arrangement with Exactera, a provider of AI-based tax solutions. I've had a relationship with Exactera going back several years–I've been on their podcast many times–and they're a perfect fit for this publication.

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PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Commando Ranger, appearing first in Rangers Comics #13 in 1943. A scientist, boxer, pilot, mountain climber and philosopher who mastered "the secret of mind's dominion over matter" studying for the Great Lama in Tibet, Commando Ranger fights Nazis on a secret mission from FDR and Churchill. His signature weapon is a winged dagger, which is apparently all he needs to kick some Axis butt.

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