Digital taxes have become a subject of significant debate in recent years. Following allegations that tech giants have paid very little tax anywhere in the world, some countries have moved to impose new taxes on profits derived from digital services provided by multinational enterprises on a jurisdiction-specific basis. For instance, France recently adopted a digital services tax of 3% per annum applicable to the portion of revenue that digital companies derive in France. Similarly, as of April 1, 2020, the UK imposed a 2% per annum tax on the revenue of search engines, social media services and online marketplaces that derive value from UK users. Such initiatives attempt to expand tax-collection powers beyond the countries in which digital companies are deemed to be tax residents and into market jurisdictions in which those multinational enterprises have significant consumer-facing activities.
The digitalization of the economy is raising novel questions about where economic activity is being generated and how taxes should be collected on a market jurisdiction basis to avoid the threat of double taxation. This question is especially important for companies interested in undergoing international mergers or acquisitions where tax-deferral benefits will be realized. In response to this challenge, the Organization for Economic Co-operation and Development (OECD) recently released a two-prong framework (the Framework), the Report on Pillar One Blueprint and Report on Pillar Two Blueprint, intended to address questions regarding the allocation of taxation rights in businesses that operate internationally. Some of the key propositions of the Framework include:
- The creation of a new taxing right for market jurisdictions over a share of the residual profits of multinational enterprises;
- A fixed return for certain baseline marketing and distribution activities taking place physically in a market jurisdiction;
- Processes to improve tax certainty through effective dispute prevention and resolution mechanisms; and
- The development of a series of interlocking rules that seek to (i) ensure minimum taxation while avoiding double taxation or taxation where there is no economic profit; (ii) cope with different tax system designs by jurisdictions as well as different operating models by businesses; (iii) ensure transparency and a level playing field; and (iv) minimize administrative and compliance costs.
Potential acquirers, particularly those that seek to acquire targets whose business is derived from digital assets, should give these developments adequate attention. Re-evaluation as to where a target may be taxed, and how, will need to be factored into the purchase agreements, particularly the purchase price. For example:
- The increased transparency intended by the OECD has given nations pursuing these tax initiatives greater access to information as a result of increasing reporting requirements. This information can be used to reevaluate where profits can be taxed, which creates uncertainty in deal valuation. An acquisition of a target or a target's assets that primarily involves consumer or user interaction with a platform could pose a unique challenge to an acquirer that is typically taxed in the country where the acquirer is deemed to be a tax resident if the acquisition is intended to assist with entry into new markets or to bolster its customer reach.
- The imposition of limitations on the amount of deductible interest on acquisition financing under the OECD's base erosion and profit shifting initiative may affect transaction structuring. Interest deduction limitations are intended to avoid debt-shifting by multinational enterprises to high-tax jurisdictions via intra-group financing arrangements. Restrictions on the ability to use leverage may present challenges to transaction financing for some acquirers.
As a matter of structuring the transaction, acquirers should consult tax counsel that has an international footprint in order to navigate the following:
- In a share purchase, how the new company or the acquirer, depending on the structure, will be taxed after the acquisition of a digital business; and
- In an asset purchase, how the operations of the combined assets may be taxed, which in some cases may be more beneficial than a share purchase.
These challenges will need to be mitigated during the negotiation of the purchase agreement in order to account for the possibility of reduced profits or difficulties in completing the transactions themselves. Sophisticated tax expertise at an international scale during the life of the transaction will become increasingly important as the effects from these new tax initiatives become clear.
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