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The French Digital Fig Leaf

Posted on Sep. 23, 2019

Last month, U.S. and French officials announced that they’ve reached an agreement to at least temporarily resolve the potential for trade conflict created by France’s enactment of a digital tax that mostly affects U.S. tech companies. (Prior coverage: Tax Notes Federal, Sept. 2, 2019, p. 1629.)

France has said that once the OECD reaches a multilateral consensus, it will refund U.S. companies the amounts paid under the digital tax if the amounts owed its treasury under the OECD deal are less than the digital tax already paid. It’s unclear what the United States has promised in return, although presidential tweets threatening tariffs on French wines have ceased for now. The U.S. trade office’s investigation into whether the French tax is a discriminatory violation of trade obligations under section 301 of the Trade Act of 1974 apparently remains ongoing.

If the U.S. commitments are unclear, the French promise — while succinctly stated — borders on the absurd. Refunding a tax assessed on gross revenues in one year based on a true-up calculated in a subsequent agreement over how to allocate multinationals’ net income across jurisdictions requires a calculation that there’s no reasonable basis for performing. But the alternatives — such as an escalating trade war — aren’t attractive either. Plus, the fight over a gross revenue tax that’s difficult to calculate and hard to assess obscures the larger problem: the reluctance of U.S. tech companies to recognize that society wants more in return for the large profits and economic dominance they’ve managed to achieve. And not just in taxes, but by also acknowledging greater responsibility as corporate citizens in areas such as privacy; preserving the nature of countries’ democratic institutions; and addressing larger concerns over concentrations of wealth, globalization, and inequality.

At the International Fiscal Association’s annual congress in London this month, Lafayette G. “Chip” Harter III, Treasury deputy assistant secretary (international), referred to the OECD’s pillar 1 proposals as a tax on excess profits. His comments hint that the OECD work could be heading toward an eventual agreement on a base amount of multinationals’ profits to be allocated to each country. A tax on excess profits means that someone somewhere must decide what the right of amount of profits is for each jurisdiction. A French-U.S. agreement — even a temporary one — over France’s digital tax might set a baseline of expectations for the results under that kind of formula.

The Not-So-Grand Bargain

The principle behind the U.S.-French bargain rests on the assumption that countries ultimately will agree to a multilateral plan for taxing the digitalized economy under OECD auspices. The United States has apparently committed to ensuring that its companies will pay the French digital tax in 2019 and 2020. That raises more questions, such as whether the agreement also includes a tacit commitment that Treasury will allow U.S. companies a foreign tax credit for the digital tax paid.

On its face, a digital tax imposed on gross revenues wouldn’t meet the requirements for a creditable tax under section 901 (but see reg. section 1.901-2(b)(4)(i)(B)). However, Treasury has managed to look the other way in enforcing those requirements when larger political considerations are at stake (see the Puerto Rican excise tax). Treating the French digital tax as a de facto tax on net income is the only way to make sense of the refund deal. Otherwise, the gross revenue tax — which could retroactively morph into a net income tax — is lost as a credit for U.S. companies if imposed on income such as that under the global intangible low-taxed income regime.

Not everyone’s thrilled with the deal the administration has struck. Last month, Senate Finance Committee ranking member Ron Wyden, D-Ore. — generally a strong advocate for ensuring that multinationals pay more taxes — issued a statement emphasizing that the administration shouldn’t agree to an arrangement that would allow France and other countries to impose “discriminatory taxes on U.S. technology companies in exchange for vague promises down the line.” Wyden said giving France a pass will result in “open season for foreign governments to go after major American employers.”

That season has already begun (see U.K. draft legislation for a digital services tax, which is supposed to come into effect in April 2020).

Making Sense of the French Digital Tax

The French digital services tax is a 3 percent tax on gross revenues, limited to companies with €750 million in global digital sales and more than €25 million of sales in France. It applies (retroactively to January 2019) to two main categories of revenue: that from online ads generated by sales of data — that is, revenue from advertisers that place targeted advertising on a digital interface based on user data — and fees generated from intermediary services linking users to online sales platforms. Revenue is calculated net of VAT, and a deduction is allowed for French corporate income tax payments. The first installment is due soon, with companies required to make an estimated tax payment by October 31.

The new law raises many questions, including, as a threshold matter, how to calculate the amount of sales in France for determining whether the tax applies. There’s one set of rules for determining the revenue threshold for intermediary services (for which gross receipts is defined to mean all sums paid by interface users), and another for advertising services (defined to include receipts from advertisers generated by the posting of ads).

Taxpayers also must be able to determine when services are supplied in France. For digital interfaces, a service is considered supplied in France when a transaction is undertaken by a user located there, or when a user has an account opened from France that allows it to access the platform’s services. Targeted advertising is supplied in France when an ad is placed on a digital interface consulted by a user located in France or when data sold is derived from the consultation of one of those interfaces by a user located in France. Whether a user is located in France is determined using its IP address. (See KMPG, “France: Digital Services Tax (3%) Is Enacted” (July 25, 2019).)

The tax is assessed based on the percentage of sales representing the portion of French-related taxable services after the application of a French digital presence ratio to the corresponding worldwide receipts. That ratio is determined by multiplying the number of transactions involving a French user by total receipts, then dividing by the total number of transactions.

As the large (U.S.) tech companies that are the primary targets of the tax have pointed out, data systems aren’t set up to collect, aggregate, and dissect information into the formulas required to calculate the tax owed. And although the calculation on its face is technical and not overtly discriminatory, its effect clearly is. A tax on revenues generated from fees from online marketplaces obviously targets the largest players in the field: Airbnb, Amazon, and Uber. A tax based on data-driven advertising revenue clearly has U.S. giants Google and Facebook in its crosshairs. At the same time, the DST doesn’t apply to other types of digital services in which French companies have a larger presence; revenues from supply of digital content, communication services, and qualifying payment services are all excluded.

It’s not just highly profitable U.S. companies with tax-efficient structures that are upset about a tax based on gross revenues. German company Bertelsmann, which has a large digital media presence, has suggested that the tax likely will be more harmful for European companies, because they generally operate at lower margins than U.S. companies. The flawed design also means the tax could disproportionately affect businesses such as online intermediaries that operate at very low margins but with large amounts of revenue. There’s a reason the world has historically relied on the concept of net income, rather than gross receipts, in trying to tax businesses — it’s a better measure of a company’s profitability and ability to pay.

The Section 301 Investigation

Aside from presidential insinuations about possible tariffs on French wine, the U.S. response to the French DST has consisted of launching an investigation into whether the tax violates U.S. trade agreements and unfairly restricts trade under sections 301-310 of the Trade Act of 1974. Those procedures apply to foreign acts, policies, and practices that the U.S. trade representative (USTR) determines violate, or are inconsistent with, a trade agreement; are unjustifiable; or burden or restrict U.S. commerce. An act is considered unreasonable if, while not necessarily in violation of, or inconsistent with, the international legal rights of the United States, it is otherwise unfair and inequitable.

The Trade Act provides procedures and timetables for taking action. The USTR is supposed to seek a negotiated settlement (generally within 12 to 18 months) with the foreign country once a section 301 investigation has begun, or pursue a formal WTO dispute proceeding. If a negotiated resolution can’t be reached, the USTR may decide to retaliate in a manner proportional to the U.S. companies’ economic losses. Section 301 investigations generally have been little used since the United States joined the WTO in 1995, but the current administration has revived them.

The USTR initiated a section 301 investigation into the French DST in July and held a hearing for affected parties in August. It said it will focus on concerns that the tax amounts to de facto discrimination against U.S. companies (the revenue thresholds affect larger companies, which tend to be U.S. companies, while exempting smaller companies, particularly those that operate only in France). The USTR is also concerned with the tax’s retroactive nature, which it said brings its fairness into question. Finally, the USTR is looking into whether the tax constitutes unreasonable tax policy because it diverges from international tax norms in several respects.

At the August hearing, tech companies and trade organizations voiced their grievances with the French tax and mostly supported the USTR investigation. For example, Facebook argued that the tax is based on false assumptions about the amount of taxes it pays and emphasized the harmful nature of the tax both to it and to the digital economy. It also said the tax’s design and structure pose difficulties for its business model and will hinder growth and innovation.

Facebook noted that applying the tax to a base focused on user location is problematic because revenue is generated from advertisers, not users. It said that as a result, it expects to incur additional tax, compliance, audit, engineering, and maintenance costs, and that its systems must be reengineered to capture the necessary data. The U.S. Chamber of Commerce raised similar concerns, estimating that compliance costs for U.S. companies would probably be in the millions. It recommended initiating WTO dispute settlement proceedings, rather than applying tariffs to French goods under section 301, which it said would add to the potential for an escalating trade war.

The Information Technology Industry Council said the narrow focus on a subset of digital companies appears to be designed to single out just a few companies, adding that there doesn’t appear to be a legitimate, principled basis for drawing those distinctions. Amazon pointed out that the French tax would harm not just large tech companies, but also the small and midsize businesses that use its services to reach French customers. It also noted that its consumer business outside North America operates at a loss, and that the French tax would result in a substantial expense that it would be unable to absorb if it was to continue investing in infrastructure. In response to the French tax, Amazon has announced that it will pass on the cost to its online sellers, increasing fees by 3 percent for sales made on Amazon.fr.

An Alternative?

Section 891, a provision that’s never been applied despite having been part of the code since the 1930s, might offer an alternative for addressing the types of concerns raised by the French tax. It provides that if the president finds that U.S. citizens or corporations are being subjected to discriminatory or extraterritorial taxes under the laws of any foreign country, tax rates on citizens of that country are doubled (including both ordinary rates on personal and business income and withholding rates).

In 2016 Senate testimony, professor Itai Grinberg of Georgetown University Law Center suggested that the threat of a penalty imposed by section 891 could be a possible remedy for the de facto discriminatory cases being brought against U.S. companies by the European Commission under the EU state aid doctrine. Grinberg argued that section 891 could present “a less drastic and more pragmatic U.S. response” to the EU state aid challenges and constituted a “plausible source of leverage in connection with the state aid cases.” He argued that the threat of section 891 “could be a means to encourage European institutions to conclude the EU state aid cases in a sensible manner.” (Prior analysis: Tax Notes Int’l, Jan. 11, 2016, p. 167.)

Grinberg’s arguments don’t necessarily hold sway in the current context. It’s unclear whether the section 891 option would be a less drastic response than that available under the Trade Act. Given the heightened trade tensions, imposing penalties under section 891 could mean an even greater escalation of a trade war than tariffs on a limited set of goods — but lawmakers have seized on the possibilities that blunt instrument could provide. In an unusual bipartisan move, Wyden and Finance Committee Chair Chuck Grassley, R-Iowa, in June signed a letter suggesting that Treasury invoke section 891, encouraging the government “to take all the steps necessary to convince the French government to abandon its unilateral DST provision.” Treasury said in July it was considering taking that route.

The Status of the OECD’s Work

Amid all the furor over the French digital tax, the OECD work on devising a multilateral solution to seemingly intractable problems continues. Speaking at the IFA conference, Harter emphasized the ongoing work to develop a way to allocate a greater share of residual or excess profits to market jurisdictions (more detail is supposed to be released next month). But it’s easiest to achieve consensus on high-level plans that lack detail, because that would allow each country to interpret the agreement as it sees best. At this point, while the OECD agreement could allow countries to save face and retreat from draconian positions, it’s difficult to see how it will address the concerns supposedly motivating the French tax.

Fig Leaf for Broader Concerns

Even if tech companies have legitimate cause for complaint against the French digital tax, there’s a risk that their views ignore the larger concerns. And the U.S. government, in supporting their positions, runs that risk as well. Some of the motivations for the French digital tax lie in nationalist angst over the rise of U.S. economic strength and market dominance. But those concerns are also congruent with a bigger debate about the need to reform capitalism and ensure greater corporate social responsibility. That debate is also playing out in questions regarding corporate purpose, and whether companies have obligations aside from maximizing shareholder returns. That the corporation exists primarily to maximize value for its shareholders is the guiding principle behind the corporate tax department’s drive to reduce taxes. A rethinking of the larger purpose could necessitate a rethinking of the role of the corporate tax department as well.

Last month, the Business Roundtable, the leading organization of CEOs, issued a restatement of the purpose of a corporation, which it called a “modern standard for corporate responsibility.” It said its companies share a fundamental commitment to all their stakeholders — not just shareholders, but also employees, suppliers, and communities. In a departure from the emphasis on shareholders as the only real stakeholders, the Business Roundtable called each of its stakeholders “essential” and committed to delivering value to them all. Its letter follows a series of annual shareholder letters written by Larry Fink, CEO of BlackRock, who has highlighted the importance of a company’s purpose, which he referred to as “a company’s fundamental reason for being.” According to Fink, “purpose is not the sole pursuit of profits but the animating force for achieving them.” He called for “a new model of shareholder engagement.”

The debates over corporate social responsibility and reforming capitalism are echoed in policy debates regarding taxing wealth. Those kinds of ideas include a 2 percent annual wealth tax that Democratic presidential candidate Sen. Elizabeth Warren of Massachusetts has proposed to apply to individuals with more than $50 million in net worth, increasing to 3 percent on those worth more than $1 billion. Wyden has unveiled his own proposal, which would apply mark-to-market taxation on tradable assets for high-income individuals and a passive-foreign-investment-company-type lookback charge on non-publicly traded assets. Professors Gabriel Zucman and Emmanuel Saez have also offered ideas for progressive wealth taxation.

There’s lots of skepticism about whether wealth taxes are effective, as well as whether they will raise the promised amounts of revenue. But the rhetoric used by their advocates is eerily reminiscent of the language used by nongovernmental organizations in their campaigns for fairer corporate taxes. Wealth taxes might not make an appearance in the next administration, but the debate over the need for them doesn’t appear to be going away. And even Democratic proposals that seem radical at first can be co-opted by Republicans eager to push a different or related agenda. (Prior analysis: Tax Notes Federal, Sept. 9, 2019, p. 1695.)

Conclusion

Pressures on U.S. tech companies are growing, and not just in the form of digital taxes. The larger agenda is highlighted by the increased portfolio given to Margrethe Vestager, who proved so effective at using nontax tools to address concerns over corporate tax payments, in the recent revamp of the European Commission. Vestager continues in her role as director of the competition agency while also taking on responsibility for the digital economy generally. (Prior coverage: Tax Notes Int’l, Sept. 16, 2019, p. 1176.) Specifically included in Vestager’s portfolio is coordination of “work on digital taxation to find a consensus at [the] international level by the end of 2020 or to propose a fair European tax.” Vestager’s mission letter puts her in charge of a European agenda that will strive for digital leadership and “making markets work better for consumers, business and society.”

The larger debates over the need to reform capitalism, questions about corporate purpose, and concerns over inequality suggest that the motivating forces behind digital taxes aren’t going away, and that if the system doesn’t leave room for accommodation, pressure will continue to build.

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, of counsel at Ivins, Phillips & Barker Chtd., and a contributor to Tax Notes International.

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