Another Digital Services Tax in Sight

Canada is planning to join the club of countries that, in the past 3 years, introduced a digital services tax (DST) despite U.S. opposition and concerns expressed by Canadian businesses.

The country first announced plans for a digital services tax in the 2021 budget, before putting it on pause to see how the OECD global tax deal turned out. However, at the beginning of August, the Canadian Department of Finance renewed its push by publishing a revised draft of the DST on which it’s currently seeking feedback. The Canadian digital services tax would levy a 3 percent tax on revenues from online marketplaces, social media platforms, sale and licensing of user data, and online ads, by tech companies with at least €750 million (US $818 million) in total annual worldwide revenues and Canadian revenues of CAD $20 million (US$14.8 million).

The tax would be calculated on Canadian in-scope revenues for any calendar year that exceeds CAD $20 million. The Canadian digital services tax is expected to be enacted January 1, 2024, and be applied retroactively through January 1, 2022.

The Problem with Digital Services Taxes

Unlike corporate income taxes, digital services taxes are levied on revenues rather than profits, not taking into account profitability. Seemingly low tax rates of such turnover taxes can translate into high effective tax burdens. For example, if a company earns $15 in profits on $100 in revenue and a 3 percent DST is applied to that revenue, the company would owe $3 in tax (3 percent of $100 in revenue). In other words, for this company, a 3 percent tax on revenue equates to a 20 percent tax on profits (3 percent of $15). As you can see, this would lead to a disproportionate tax burden being placed on companies with lower profit margins—the less profitable a company is, the higher their effective tax rate becomes.

In addition, DSTs are discriminatory in terms of firm size. The domestic and worldwide revenue thresholds result in the tax being solely applied to large multinationals. While this can ease the overall administrative burden, it also provides a relative advantage for businesses below the threshold and creates an incentive for businesses operating near the threshold to alter their behavior. Similarly, digital businesses are at a relative disadvantage to non-digital businesses operating in a similar field like online and traditional advertising.

Apart from these design issues, the introduction of a digital services tax raised concerns for Canadian businesses.  Alex Gray, from the Canadian Chamber of Commerce, warned that while “digital commerce underpins global economic growth” the proposed DST “would burden Canadian businesses while stoking tensions with our closest ally,” the U.S. Additionally, a new DST would “contravene Canada’s obligations under both the Canada-U.S.-Mexico Agreement (CUSMA) and the World Trade Organization (WTO).”

International Solution

The ongoing international tax negotiations, first at the Organisation for Economic Co-operation and Development (OECD) level, and potentially also at the United Nations level, were partially motivated to provide alternative solutions to countries proposing or implementing their own DSTs on international companies. Since DSTs largely affected US-based digital companies, they are viewed as de facto tariffs on U.S. companies. That’s why countries involved in the international negotiations agreed in 2021 not to enact a new DST before the end of 2023, by which point Pillar One was to be implemented.

Pillar One, part of the OECD inclusive framework on base erosion and profit shifting,  gives countries a taxing right, Amount A, over a portion of the profits that the largest multinational companies make in their jurisdictions, regardless of physical presence. In exchange, it was the hope that countries would agree to withdraw existing DSTs and refrain from introducing new ones.

In July 2023, 138 countries agreed to extend the DST moratorium for one more year in order to move forward with Pillar One. However, while Canada still backs Pillar One, the country did not join other nations in their agreement to extend the DST freeze, as doing so “would place it at a disadvantage compared to countries that implemented DSTs before the moratorium”.

Although technical concerns about how multinational companies’ profits will be reallocated are expected to be resolved by this fall, currently, there is no actual deadline for Pillar One to take effect. In order to take effect, a “critical mass” of countries will be needed to ratify the treaty, which, according to the OECD, would be at least 30 jurisdictions accounting for at least 60 percent of in-scope multinational companies. Therefore, this process will need to include the U.S., where many companies that fall within the scope of Pillar One are based. However, U.S. ratification, which requires two-thirds of the Senate to vote in favor, is highly unlikely.

Additionally, there are serious concerns that unilateral digital services taxes like the one Canada plans to implement won’t be removed immediately, even if Amount A comes into force. The incentive to remove a DST will depend on whether a country sees a better tax revenue outcome from Amount A. In turn, those revenue numbers will depend on how the rest of Amount A gets negotiated.

Nevertheless, a multilateral solution to digital taxation would be preferable over the proposed digital service taxes and possible retaliatory trade measures. Digital services taxes are distortionary taxes that can act as trade barriers while retaliatory tariffs from the U.S. would negatively impact both economies.