Canada’s digital services tax: Detailed proposals raise concerns

This blog is for advisors working in practice or industry who provide tax services to large businesses with a global presence. We will be providing:

• a recap of where Canada currently stands with the DST
• a high-level overview of the proposed DST
• a summary of the issues we raised in our submission

In Budget 2021, the federal government confirmed its plan to introduce a federal Digital Services Tax (DST), as first announced in the Fall Economic Statement 2020. The budget also revealed some key features of the new DST and how it will be implemented, although draft legislation has not yet been released at the time of writing.

The DST is designed to tax proliferating business models that rely on digital technology to engage with online users in Canada, including intermediation and social media platforms. Unlike traditional businesses, these businesses often do not need a local physical presence to engage with users in Canada and they usually generate some or all of their profits from their users’ participation, data and content.

Although the Organisation of Economic Co-operation and Development (OECD) has been working to gain international consensus on a solution to deal with the tax challenges of the digitalized economy, an agreement has not yet been reached (as discussed further below). Budget 2021 says Canada’s proposed DST would apply as of January 1, 2022 until an acceptable multilateral approach takes effect.

In the budget, the federal government also invited feedback from stakeholders on the details of the proposed DST and implementation approach. In response, in our recent submission we highlighted some important concerns with some of the DST’s main elements.

Overview: Budget 2021’s DST proposals

While many questions remain in the absence of detailed legislation, the key features of the DST as set out in Budget 2021 are as follows:

Rate and base

The DST would apply to in-scope revenue at the rate of three per cent. This excludes any value-added tax or sales tax collected on the transaction.

In-scope revenue

The DST would generally apply to revenue from four types of online business models that rely on engaging with Canadian online users in order to generate income:

1. online marketplaces – including services provided through an online marketplace that helps match sellers of goods and services with potential buyers
2. social media – including services provided through an online interface to facilitate interaction between users or between users and user-generated data
3. online advertising – generally includes services aimed at the placing of targeted online advertising based on data gathered from users of an online interface
4. user data – generally, the sale of data gathered from users of an online interface

For online marketplaces, the DST would not generally apply to:

• tangible goods stored, sold and shipped through the marketplace
• goods and services sold by a seller through the marketplace on their own account (including the sale, licensing, or streaming of digital content such as audio, video, games, software, ebooks, newspapers and magazines)

Taxpayers

The DST would apply to large foreign and domestic entities (including corporations, trusts, and partnerships) or members of a group that meet both conditions:

• €750 million or more in global revenue from all sources in the previous calendar year, and
• in-scope revenue associated with Canadian users of $20 million (CAD) in that year

The €750 million threshold is the same threshold that triggers the OECD’s country-by-country reporting requirements.

If the two conditions are met, the DST would apply only to in-scope revenue associated with Canadian users that exceeds the $20 million threshold. The proposals indicate that the definition of groups in the DST legislation would follow the definition in the country-by-country reporting rules.

Source of revenue

When revenue flows from both in-scope and other business activities, the in-scope revenues would need to be reasonably allocated among the activities. Budget 2021 proposes two general approaches for determining an entity’s in-scope revenue related to Canadian users:

• when transactional information can be traced to Canadian users, that revenue amount would be in-scope
• when tracing is not possible, the in-scope amount would be allocated through a formula that varies depending on the revenue’s nature

Location of users

To source revenue related to digital service users in Canada, Budget 2021 suggests looking to the users’ ordinary location, although the user’s real-time location could be used for specific types of revenue. The digital service provider can determine a user’s location through data it already has, such as the user’s IP address, billing address, delivery address and telephone area code. Digital service providers would be expected to use a consistent approach for determining their users’ locations.

Income tax treatment

The DST would be deductible from an entity’s taxable income based on the usual Canadian income tax principles — that is, whether the entity incurred the expense in order to earn taxable Canadian income. DST liabilities would not be eligible for a Canadian income tax credit.

DST filings and payments

Businesses subject to DST would have to file an annual return after the end of the proposed calendar-year reporting period. One annual DST payment would be required after the end of the reporting period, and one designated entity would be allowed to file the DST return and pay the related liability for the entire group. However, the group would be jointly and severally liable for DST payable by any other group member.

Also coming soon: GST changes for ecommerce

With all the talk about new taxes on electronic transactions, it’s also important to keep in mind that GST changes for ecommerce will take effect on July 1, 2021. These GST rules will generally apply to a broader range of goods and services than the DST. For example, cross-border video streaming services will become subject to the GST but generally not the DST.

Key issues and what we recommend

With detailed legislation yet to come, many areas are still unclear, and more information is needed.

One fundamental question we raised in our submission is whether the Canadian DST is intended to be an indirect tax or, as we think more likely, a proxy for income tax. This distinction is important for ensuring that the tax’s features are consistently and logically designed. For example, if the DST is intended as a proxy for income tax, then double taxation becomes a more significant issue that should be addressed.

Some of the other issues we raised follow directly below.

Implementation and timing

In the June 5, 2021 communique from G7 finance ministers and central bank governors, the G7 countries committed to reach an equitable solution on the allocation of taxing rights associated with digital businesses and plan to reach an agreement at the G20 meeting in July. If so, we believe that implementing what would be a short-lived tax on January 1, 2022 would not be advisable given the costs that would arise for both taxpayers and the Canada Revenue Agency (CRA).

If a temporary DST does go forward, we believe the January 1, 2022, implementation date may not allow businesses enough time to understand and prepare for the DST, especially with the draft legislation still not published and so many outstanding questions. Businesses need time to understand the rules’ scope, analyze the impact and determine how to collect the information they need to calculate the tax.

DSTs may lead to double taxation

Generally, a tax on gross revenue may produce a higher tax burden than a net income tax. As costs are not deductible against the gross revenue, a three per cent Canadian DST could result in an effective overall tax rate that is higher than the proposed DST rate. The OECD has acknowledged this problem and warned that “. . . [e]conomic double taxation could also arise through cascading effects where a certain supply of e-services is made to a person that incorporates those services into an onward supply that is itself subject to the tax.”

Further, as countries around the world adopt their own DSTs with no consistency, businesses could become liable for DST in multiple jurisdictions on the same revenue. To avoid double taxation, we recommended that the government consider introducing a credit (similar to a foreign tax credit) or other mechanism to offset the DSTs that businesses pay to other jurisdictions.

The DST may impede the competitiveness of Canadian businesses

The DST is intended to ensure that Canadian tax is paid on revenue earned by large businesses, both foreign and domestic, by engaging with users in Canada. The proposals indicate that the DST would be not be creditable against Canadian income tax but could be deducted as an expense.

If the government intends the DST to be a proxy for income tax, this treatment would be inconsistent and therefore cause companies already paying Canadian corporate income tax to pay more tax on the same profit (assuming the underlying profit from revenue subject to the DST is taxed in Canada). This would disadvantage Canadian-based businesses compared to foreign operators because domestic businesses would pay Canadian income tax plus the additional three per cent DST.

We therefore recommended that Canadian-based businesses should be either excluded from the DST or allowed an income tax credit for their DST payable.

The DST’s scope should be more targeted

We are concerned that the DST might apply to a much broader group of companies than intended. All businesses with global revenues over €750M (whether or not in-scope revenue) would need to do a detailed analysis to determine if they have “in-scope revenue” that exceeds $20 million from associated Canadian users. We asked the government to consider a simpler mechanism for determining whether the DST would apply.

We also suggested to the federal government that it clarify which industries and businesses the DST is intended to apply to and ensure that the rules are targeted accordingly. A concern is whether businesses will recognize that they are carrying on activities subject to the tax. We recommended that the government consider including a purpose test in the proposed DST rules so that the tax only applies to business models that provide in-scope services as their “main purpose or one of the main purposes.”

We also asked the federal government to follow the lead of other countries by specifically listing the businesses that would be exempt from the DST.

Low-margin businesses

The DST may have the biggest impact on businesses with low margins or losses. Again, assuming that the DST is a proxy for income tax, we believe the government should consider allowing an alternative method of calculating the tax based on margins, as the United Kingdom has done. This rule would benefit groups with a loss or low domestic operating margin on their digital services activities.

Compliance issues

The proposals are vague when it comes to compliance matters, so we encouraged the government to provide the specifics as early as possible to give affected businesses time to prepare. We suggested that the government consider leveraging existing concepts and definitions, registration systems and reporting requirements to minimize the administrative burden of the DST. We also asked the government for guidance on supporting document requirements and examples of how the tax will apply.

Watch for more details

As you can see, many details remain to be provided and what we do know could change as the government reviews feedback from stakeholder consultations, including CPA Canada’s submission. As part of this, we also encouraged the government to evaluate the DST systems already in place in other countries. We will continue to discuss DST-related issues with the government and keep you updated through our tax blog or tax news page as things progress.

NOTE: The commentary function of this page has been temporarily closed. Unfortunately, because of the volume of feedback regarding recently announced COVID-19 tax measures, we do not have the capacity to respond to individual inquiries. We strongly encourage you to visit our Canadian Tax News and COVID-19 Updates page for information.