Executive summary
Introduction: The challenge of taxing digital services
The digital economy has presented complex challenges in the allocation of taxation rights between countries. Large multinational corporations, without establishing a physical presence or tax base in Canada, have been generating substantial revenues through digital services within the country. These activities include selling digital services, collecting and monetizing user data, providing social media services and delivering digital advertisements to Canadian users. Under the current multilateral tax frameworks, these digital service revenues remain largely exempt from taxation in Canada unless allocated to a physical presence. This challenge is compounded by the exponential growth of the digital economy, which now accounts for nearly 20% of the global economy.
The future of digital taxation in Canada: A comparative analysis
The Digital Services Tax Act (DSTA): A Stop-Gap Solution
The DSTA, slated to take effect on or after Jan. 1st, 2024, introduces a new tax regime for the taxation of digital services within Canada. It is a unilateral measure designed to address two critical issues:
- Taxation of revenues generated by large corporations from digital services within Canada.
- The absence of a multilateral instrument to effectively regulate the taxation of digital services revenue across multiple jurisdictions.
The DSTA will impose a three percent tax on in-scope revenues exceeding $20 million in a calendar year, generated by corporations with global annual revenues surpassing €750 million. The DSTA's application will be retroactive to Jan. 1, 2022, for corporations meeting the specified threshold.
The OECD's Pillar One: An evolving multilateral solution
The Organization for Economic Cooperation and Development (OECD) proposed an initiative under the Base Erosion and Profit Shifting (BEPS) project, known as Pillar One, which aims to address the taxation of digital services. The current draft of Pillar One is composed of two primary elements: "Amount A" and "Amount B", having since dropped an originally proposed “Amount C”.
Amount A: Under Pillar One, a market jurisdiction–determined by sourcing rules such as where customers and users are located–gains the authority to tax the income of foreign multinational corporations even in the absence of a physical presence. Adjusted global profits before tax are calculated and utilized to reallocate a portion of profits to the respective market jurisdiction for taxation. Multinational corporations with global revenues of €20 billion or more and profits exceeding 10% fall within the scope of Pillar One Amount A’s application. The amount of an MNEs global profits subject to reallocation to a market jurisdiction is 25% of the total profit amounts exceeding the 10 profit threshold.
The proposals also include a marketing and distribution profits safe harbor mechanism to avoid conflicts with existing profit allocation rules and prevent double taxation.
Amount B: This element simplifies transfer pricing rules for marketing and distribution activities by standardizing pricing and streamlining the process. The final framework for Amount B, encompassing scope, pricing methodology, documentation requirements, and tax certainty considerations, is still under development by the OECD.
Comparing DSTA and Pillar One Framework
While both the DSTA and Pillar One address the taxation of revenues from digital services in Canada, they differ significantly in two key aspects.
Thresholds: The DSTA applies to corporations with global revenues above Euro 750 million, whereas Pillar One sets a substantially higher threshold of Euro 20 billion. This variation in thresholds significantly impacts the potential tax base.
Taxable Base: Pillar One reallocates profits exceeding 10 percent across market jurisdictions, with only the profit amount above this threshold subject to reallocation. In contrast, the DSTA imposes a 3% tax on revenues exceeding $20 million CAD, representing a tax on gross revenues rather than net profits.
The decision ahead: DSTA and the future of Pillar One
The OECD has released the multilateral convention (MLC) to implement Amount A of Pillar One on Oct. 18, 2023. The crucial question arising from recent developments is whether Canada will sign onto the multilateral Pillar One framework as presently constituted and repeal the DSTA, which is designed as a proxy to Pillar One. The decision hinges on several factors:
- Amount B's significance: Amount B's finalization is crucial for efficient tax base determination under Pillar One. Without clear guidance on related party transaction valuation, MNEs may exploit existing transfer pricing rules and reduce taxable profits under Pillar One or evade its application entirely.
- Revenue projection: The DSTA's projected revenue may surpass that of the Pillar One Framework, mainly due to lower thresholds (i.e., DSTA scope test being purely revenue-based vs. Amount A scope test being partly profit-based).
- Negotiation complexity: Negotiating and finalizing multilateral agreements for Pillar One is expected to be a protracted process, unlikely to conclude within 12 weeks.
- Ratification process: Once Canada agrees to the Pillar One framework, the DSTA must be repealed. The details of the MLC will need to be reviewed and approved by the Canadian government. In addition to these steps, new domestic legislation will be required to implement the Pillar One framework into domestic law or applicable existing tax legislation (i.e., the Income Tax Act), will need to be amended.
Conclusion
In conclusion, while both the DSTA and Pillar One aim to address the taxation of digital services in Canada, the differences in thresholds, taxable base and negotiation timelines may lead to the DSTA remaining in effect for the foreseeable future. The decision to sign onto the multilateral framework and repeal the DSTA hinges on several complex factors, and a definitive resolution is not expected in the near term. The DSTA serves as a practical stop-gap solution until the multilateral framework becomes operational.
