Questions facing businesses as the UK’s Digital Services Tax enters into force

As announced by Rishi Sunak, Chancellor of the Exchequer, on 11 March 2020, the UK Digital Services Tax (“DST”) has now entered into force as of 1 April 2020. The UK’s DST comes into force despite progress being made by the OECD on a unified approach (as discussed here). The DST will be chargeable at a rate of 2% on revenues generated from digital activities that are attributable to UK users. The UK government has published proposed legislation for the DST in Finance Bill 2020 (here) and HMRC have also published more detailed guidance on the DST (here).

Businesses within the scope of the DST may be required to make their first DST payments as early as 31 January 2021 (where a business’s accounting period ends on 30 April 2020) and submit their first DST returns as early as 30 April 2021. We recommend that businesses now review their DST position and set up any systems necessary for tracking any in-scope revenues to ensure that they are fully compliant by the time they are required to make any DST payments and submit any DST returns. Below we discuss some questions that should help businesses with this DST preparation work.

Does your business carry out “digital services activities?”

The DST is targeting large businesses that:

1. provide social media services, operate internet search engines or provide an online marketplace. Each of these is a “digital services activity” for DST; and
2. meet the two annual revenue thresholds of (a) generating £500million of worldwide revenue from “digital services activities” and (b) of which £25million of revenues are attributable to UK users.

The definition of “digital services activity” goes further than businesses might think. For example, revenues arising in connection with an online marketplace that are generated from the provision of accommodation or the sale of an estate, interest or right in land in the UK will be within scope for the purposes of the DST.

DST only applies to revenues from “online services”. We query whether services that are only partially provided electronically will be within scope. HMRC’s DST guidance suggests in these circumstances it needs to be considered whether a particular service is “substantially provided offline”. If so, these types of services “will not be online services for the purposes of DST unless the online element of the service is substantive enough to qualify as an individual service in its own right”. This of course will immediately turn taxpayers’ attention to considering the ever-evolving area of VAT law regarding single vs multiple supplies, which will also be relevant for DST compliance.

For example, are the revenues for services of an estate agent within the scope of DST where the agent advertises property for sale online (meaning there is an online marketplace digital services activity) but also carries on most of its business away from its website? Presumably services of this nature would be deemed as a single service, albeit with certain new business models providing an ever-reducing element of the service offline.

The only businesses specifically excluded from the scope of the DST are those that fall within the exclusion for online financial marketplaces. These are businesses where more than half of the revenues arising to the business in an accounting period are connected with the business’s facilitation of the trading of financial instruments, commodities or foreign exchange.

HMRC’s guidance on this issue is non-exhaustive. If a business does not fall under the online financial marketplaces exclusion and has any sort of digital activity, it should seek to understand or take advice on whether or not it is carrying on a “digital services activity” for DST purposes and if relevant track quantum of revenues for considering the relevant thresholds.

Is the “digital services activity” attributable to a “UK user?”

Revenues generated from “digital services activities” are only within the scope of the UK DST where they are attributable to “UK users”. The definition of “UK user” is broad and this means that revenues may be caught by the UK DST in a wide variety of circumstances. Let us take the example of a business that operates an online marketplace (from a country other than the UK) that enables goods or services to be sold cross-border between UK users and users from another country (“Country A”). The following transactions of this online marketplace business would be regarded as generating in-scope revenues for UK DST:

Regardless of where a business is located and regardless of where money is transferred, an online marketplace operator will be regarded as generating in-scope revenues for UK DST where there is any “UK user” involvement. Businesses will need to be vigilant in monitoring “UK user” interactions to ensure that all digital services revenues are correctly apportioned.

This matter is further complicated where Country A is a country that operates its own DST (for example, France or Italy). The UK’s DST legislation provides for a reduction of digital services revenues within the charge to UK DST by up to 50% where all or part of the digital services revenues arising are subject to a foreign DST charge. No such relief exists, however, where Country A is not a country that operates its own DST, despite the involvement of non-UK users. Although revenues may be attributable to users in non-UK countries, businesses need to be aware that where the country of those non-UK users does not operate its own DST, no cross-border relief will be available.

Businesses will therefore not only need to monitor their activities as to whether any of those are in-scope for UK DST across all business lines and countries, but also trace any revenues that may be within the charge to any overseas DST from time to time to claim appropriate relief from UK DST.

What are the areas of concern when a business is trying to calculate its DST liability?

The UK’s DST will be calculated by reference to the revenues of a group rather than on a company-by-company basis. The legislation defines “group” broadly in accordance with international accounting principles and expressly states that both UK resident and non-resident entities are members of the group for DST purposes. Therefore, regardless of how groups are structured or where revenues arise, businesses will be assessed on revenues in-scope for UK DST arising to any member of the group and each company in the group will be responsible for its share of the group’s UK DST liability unless the alternative basis for charge (discussed below) applies.

Businesses will also face challenges in deciding whether revenues do arise from “digital services activities” where separate digital and non-digital supplies are carried out in furtherance of the same business. HMRC’s guidance acknowledges that some revenue streams may be received in connection with both an in-scope activity and another activity and that the proportion of the revenue that is within the charge to UK DST should be determined on a “just and reasonable” basis. There is no guidance, however, for determining a revenue split in complex cases where there may be no readily available metrics to determine how the revenues should be split. Businesses will need to work out what their DST liabilities might be and prepare justifications for the apportionment of revenues to digital services activities and non-digital services activities.

How should my business protect itself when acquiring a business within the scope of the DST?

Where a business is looking to acquire another business with any sort of online or digital activity, we would recommend that warranties and indemnities be requested, and diligence be undertaken, in respect of that business’s historic DST compliance and the potential future cost (including compliance cost) of DST. In addition to usual records and information warranties, businesses should look to establish:

• where a business carries out digital services activities and non-digital services activities, what steps have been taken to identify and trace in-scope activities and apportion the revenues of the target business on a “just and reasonable” basis; and
• where an acquisition is of part of a group of companies, whether the member of the group responsible for DST compliance is a member of the target group or the retained business? Where the “responsible member” is a member of the target business, we would recommend seeking confirmation that the “responsible member” will be changed to a member of the retained business.

The penalties for non-compliance with the DST regime can be as much as 20% of any unpaid tax and so all buyers will need to make sure that they are sufficiently protected when entering into acquisition transactions.

Would your business benefit from using the “alternative basis of charge”?

As announced previously, a ‘safe harbour’ provision has been included in the legislation introduced in the Finance Bill 2020. This enables a business to calculate its DST liability by reference to its operating margin for its UK activities rather than by reference to global digital services revenues that are attributable to UK users. The alternative basis of charge essentially replaces the standard rate of DST (2%) with a rate equal to 80% of the profit margin of the digital services activity that generates UK digital services revenues. Therefore, where the profit margin of the digital services activity is less than 2.5% of the UK digital services revenues, this alternative basis of charge may generate a UK DST charge which is less than the DST charge that would be produced using the standard 2% rate. Businesses should carefully consider whether they are eligible to make an election to use the alternative basis of charge and potentially reduce their liability under the DST.

Next Steps

The UK’s DST adds another layer of complexity to the tax affairs of businesses in the UK. We recommend that businesses take action now to speak to their advisers and prepare quickly if they consider any of the above are relevant to your business.