Most taxation is concerned with raising revenue for government expenditure in the short term (typically within a year or so of the taxable event). A well-designed modern tax will also typically involve a withholding mechanism: think, for example, of payroll withholding on wages or the charge / input tax credit system in a typical VAT, such as Canada's GST. The Digital Services Tax as set out in the December 14, 2021 Notice of Ways and Means Motion1 (the "DST"), departs from these principles in interesting ways. This briefing note sets out some observations on the DST and touches on who will bear the economic cost of that tax if it is ultimately implemented.
Basics of the DST
The DST is proposed to be 3% of a taxpayer's digital services revenue, which is itself made up of four categories: online marketplace services revenue, online advertising services revenue, social media services revenue, and user data revenue. There are two relevant thresholds: to be in-scope, a taxpayer must meet two revenue thresholds: group revenue in excess of EUR750m, and Canadian digital services revenue of more than CAD 20,000,000 in a year. The tax is proposed to apply both to domestic and foreign enterprises, provided they have Canadian users.
The DST is not proposed to apply until January 1, 2024. If it does come into force on that date, then tax is payable for the period of January 1, 2022 to the date on which it comes into force, i.e. there is effectively a catch up tax charge. The rationale for this is that Canada has committed to the OECD process to reach a multilateral solution to taxing digital businesses, i.e. Pillar One (or perhaps Pillar Two).2 Indeed, in its press release, the Federal government notes that it has a "strong preference for a multilateral approach" and that the DST will only be imposed if a deal is not reached on Pillar One.3
The purpose of the DST, then, is not to raise revenue in the short-term. Indeed, if Canada is successful in its stated aim of pursuing a multilateral solution, then it may never raise any revenue via the DST. Why, then, release draft legislation? Other commentators, more attuned than this writer to the negotiations between the U.S. and Canada on trade matters, have suggested that the DST announcement should be seen in the context of an ongoing trade discussion between those nations.4
As noted above, the DST is proposed to apply to both foreign and domestic enterprises. But there is no obvious mechanism in the draft legislation for Canada to enforce payment from a non-Canadian business which is subject to the DST. Because the DST is an entirely separate tax to Part I tax under the Income Tax Act, the proposed DST legislation includes enforcement and collection provisions, but none go directly to the matter of how to enforce a tax against a non-Canadian enterprise. The Income Tax Act has various mechanisms, such as section 116 withholding on the sale of Canadian real property (with the obligation being imposed on the purchaser, rather than the non-resident vendor, to ensure ease of collection). But there does not seem to be a similar approach taken with the DST.
It may be that Canada assumes that the sorts of taxpayers who will be subject to the DST will be compliant as a matter of good corporate governance, or to avoid enforcement action in their jurisdiction of residence (perhaps under the mutual assistance provision of an applicable bilateral tax treaty). Or it may be that Canada assumes that the burden of the DST will be borne by end-users of digital services.
Effective Incidence: Who Will Pay the DST?
France introduced a digital services tax in 2019, also at a rate of 3% on a tax base of digital services revenue.5 Netflix raised its prices in France in 2019. This points to a truism of all taxation for which a corporation is the formal taxpayer: the effective burden cannot be borne by the corporation and is shared (in some proportion) between shareholders, employees, and customers.
The additional difficulty with digital businesses is that they are broadly indifferent as to the location of their next customer: having established a platform and content, Netflix probably doesn't care whether its next new customer is French or German. So, if France introduces a digital services tax, the logical thing for Netflix to do is to pass it on immediately to its French customers, to equalize the after-tax return to its shareholders from the acquisition of that customer (compared with a German viewer). This all depends, of course, on the elasticity of demand for streaming services in France (and elsewhere), but in a time of pandemic and reduced in-person socializing, many digital businesses are thriving.
The DST is an odd tax. Canada hopes that it will be unnecessary, doesn't want to collect any tax revenue until 2024 at the earliest (but may then look back to 2022 and 2023), and doesn't have a clear means of collecting it from foreign businesses. If imposed, it is quite likely to be borne entirely by Canadian users of digital services. The Federal government should focus on the additional GST from digital sales in Canada,6 which is a better tax: it has begun to generate revenue (from July 2021) and has a more straightforward collection mechanism.
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