Pandemic Vexes Debate On Digital Taxes, Unprofitable Cos.

By Alex M. Parker
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Law360 (April 24, 2020, 9:58 PM EDT) -- Discussions about how to tax online commerce were complicated enough during the economic expansion of the past 10 years, when the internet behemoths were assumed to be hugely profitable.

A man wearing a mask walked past a wall mural in east London Thursday. The economic fallout from the novel coronavirus pandemic will turn the current debate over taxation of digital services on its head. (AP)

The chaotic economic fallout from the novel coronavirus pandemic will turn that debate on its head, and it will force governments to accept that to raise revenue from digital activities, they'll also need to account for economic losses when those activities become unprofitable.

Despite questions about whether governments can focus energy amid the crisis, the Organization for Economic Cooperation and Development remains committed to forging an agreement among nations on the issue by the end of this year. The pressure on countries to reach a deal, even as the task seems to grow more difficult by the day, has only increased as countries go deep into debt to fight the disease — and look to digital taxes as a way to climb out.

Anger about perceived tax avoidance and nonpayment by tech and digital companies has simmered for years in both the U.S. and Europe, especially since the economic crisis of 2008 and 2009. The OECD's 2015 Action Plan on Base Erosion and Profit Shifting reworked some of the global taxing rules and created new recommendations to prevent income-shifting to low-tax jurisdictions, but failed to quell the rage. Both the U.K. and France have enacted digital services taxes on revenue from online activities, and many countries outside Europe have passed or looked at similar measures.

While the OECD has worked toward an agreement on digital taxation — what has become known as BEPS 2.0 — tensions have flared over the issue between the U.S. and Europe, with President Donald Trump's administration pursuing possible tariffs against French products in retaliation.

These debates took place in the context of a decadelong economic expansion and the rise of Silicon Valley behemoths that have become ubiquitous aspects of nearly everyone's daily life. The global spread of the coronavirus, which causes the respiratory disease COVID-19, has halted the economy in its tracks, and it will likely create an unpredictable new environment for digital and nondigital companies alike. This could call into question some of the assumptions behind the policies that governments have pursued.

In the past, U.S. officials have blasted the digital services taxes as discriminatory, but the new climate could heighten those criticisms.

"Applying a DST in this context could have even more inequitable results than it would normally, because countries imagined that with a DST they were effectively taxing some average profit margin that companies tended to realize, and those profit margins may have vanished," said Brian Jenn, a partner with McDermott Will & Emery LLP and a former official with the U.S. Treasury Department.

The OECD's proposed solution, which countries have not yet agreed to, would create a new taxing system on top of current taxing norms. One key provision, the so-called first pillar of a two-pillar approach, would allocate some of the income of global multinational corporations to market jurisdictions — where their sales or users are located. This tax would apply regardless of whether the company has a physical presence in the country, a major shift from the rules in current tax treaties. Under this system, countries could tax some of a company's excess profits, based on a formula that has yet to be determined.

Even before, the issue of how to account for losses in this new system was a difficult one. Would companies be entitled to refunds or deductions in unprofitable years in these countries, and if so, how would that be determined? While the OECD was working toward potential solutions, those questions have become much more pertinent and less theoretical in the current environment.

"Losses are not being taken into consideration as much as they should be," said Catherine Schultz, vice president for tax policy at the National Foreign Trade Council.

Countries have been eager to grab more in revenue from online activities that use their markets or citizens, but are resistant to proposals that would leave them worse off in revenue when those companies take a loss. The OECD has looked to potential loss accounts, offsetting future tax payments under the new system, as a way to address the issue.

The issue could smooth out some of the discussion by forcing countries to look only at the most profitable corporations.

"That could be a feature rather than a bug, in the sense that if this new system is going to be implemented, they're really going to need to start small," Jenn said. "This is a natural way that could play out. Under the scoping criteria that they had in mind, there will just be fewer companies that will be subject to reallocation."

But with a smaller pool of cash, more countries could lose out, complicating the political dynamics. The OECD has said it will not move forward with the proposal without the approval of every member of of the 137-jurisdiction inclusive framework, an advisory coalition.

"A tax on rents is designed to be a kind of painless tax, if there is such a thing," said Stephen Shay, a tax professor at Harvard Law School. "The notion is that it taxes excess profits, which make them sound like they are not needed by the taxpayer. They increase the government's share when things are going well — and they go away when things are going badly."

Steep drops in revenue pose a larger threat to poorer countries and could make this new system less attractive to them, Shay said.

"The countercyclical feature is great for rich countries that can borrow to cover fiscal deficits," he said. "The feature for rich countries is a problem for poor countries that have no access to global capital markets and only can borrow from the World Bank and [International Monetary Fund]."

The political discussion is being driven forward by the perception among many that digital companies are likely to come out of the pandemic in a relatively strong position. These are the websites that people around the world have turned to for work, entertainment and the delivery of food and supplies as they are forced inside by the pandemic.

But the reality could be much more complicated and dynamic. Advertising has plummeted as businesses close. Other companies are pressed to the breaking point to deliver the services that consumers demand.

"We should assume every company is less profitable unless we have strong reason to doubt it," said Shane Greenstein, an economist and professor at Harvard Business School. "All but a small number of firms in tech got hit with the double whammy that hit firms outside of tech: Revenue declined and production costs increased due to shelter at home."

Existing problems with digital companies, already more chaotic than brick-and-mortar industries, will be aggravated by the crisis, Greenstein said. Many online services are ultimately tied to offline activities that have been decimated by the worldwide lockdown. The pandemic has created a one-time surge in traffic that won't likely be sustainable and may not make up for other costs that have skyrocketed.

Providers of server space and cloud computing will likely have a strong advantage, he noted, but otherwise the result is likely to be unpredictable.

"All in all, it will be hard to find profitable firms other than producers of hand sanitizer," Greenstein said.

--Additional reporting by Matt Thompson and Todd Buell. Editing by John Oudens and Robert Rudinger.

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