U.S. Taxpayers Subject to Foreign Digital Economy Taxes without Physical Footprint

March 1, 2021

Historically, certain types of foreign taxes in a foreign country may not have applied to U.S. taxpayers unless they were considered to have a physical footprint in the respective country.  A taxable presence in a foreign country typically has depended on whether the U.S. taxpayer has a physical connection to the country at issue. In a country that has a U.S. income tax treaty in effect, a U.S. company must be considered to have a taxable presence through a permanent establishment before the U.S. company will be subject to foreign income tax on its business activity in the foreign country. A U.S. individual could be subject to foreign individual income tax if the person also has resident status in the foreign country. The rules in each country are different.  There are different requirements and thresholds in each country for determining whether a U.S. taxpayer is considered to have a taxable presence in the foreign country for income tax, value-added tax, payroll tax, and other types of foreign taxes. Many countries have required activity in an actual physical location within the country as the basis to impose taxing jurisdiction on U.S. taxpayers that earn revenue or income from the foreign country.

With the advancement of e-commerce including cross-border online internet business such as software as a service (SaaS) and online retail, the OECD launched an initiative in the year 2020 to address the “Digitalization of the Economy”. This initiative has included certain pillars and a blueprint for countries to follow to adopt tax policy and changes in tax legislation to address the taxation of the digital economy. Within these guidelines, there is a call for a new Digital Services Tax (DST) including new rules for a digital permanent establishment and nexus, i.e., taxable presence concept without a physical presence in the country. Additionally, the OECD guidelines advance new nexus, source, and profit allocation rules based on sales to consumers within a country instead of physical presence.

Some countries have already made an effort to develop and implement new rules to advance the OECD’s initiative to impose tax on the digital economy. For example, Canada implemented new legislation in November 2020 that will impose the Canadian GST/HST, i.e., an indirect tax like value-added tax, on sales by nonresident businesses to consumers within Canada.  The Canadian tax will apply to nonresident businesses that sell goods or services in Canada even when the nonresident business does not have a physical footprint in Canada. Based on the new rules, the threshold for the Canadian GST/HST tax is 30,000 CAD from sales of goods and services to consumers in Canada by a non-resident business.  To be effective as of July 1, 2021, the Canadian GST/HST law will eliminate the former requirement that a nonresident business must have a physical footprint in Canada. The new Canadian tax rules for the GST/HST target services and products that are supplied through a digital format or media.

Similarly, the EU has advanced new value-added tax rules that will address the sale of goods online to consumers in the EU. The EU rules will also take effect in July 2021.  The purpose of the new EU VAT rules is to address loss of tax revenue and competitive disadvantage to businesses within the EU.

Going forward, it is important for U.S. taxpayers with business activities in foreign countries to plan in advance for the implementation of the new tax rules in different countries.  Certain types of e-commerce and online business activities that did not create a taxable presence for foreign tax purposes in the past may now be subject to the jurisdiction of a foreign tax authority.  It is possible that other countries could move forward to advance the OECD initiative to tax the digitalization of the economy.

The United States generally has not implemented OECD international tax guidelines except for Country-by-Country reporting. However, there are some State taxing jurisdictions in the United States, such as the State of Maryland, that are beginning to consider taxing e-commerce and the digital economy. In the past year, Maryland has moved forward to implement a tax on digital advertising that is intended to be effective for the year 2021.

Overall, the OECD initiative on digital economy taxation, now advanced by certain countries including Canada and EU countries, may gain some momentum going forward.  It will be important to watch these developments closely to ensure compliance with the new rules as they are implemented. It will also be interesting to follow whether the State of Maryland digital advertising tax can withstand certain legal and constitutional challenges in the United States.  These digital economy taxes could apply to certain types of U.S. businesses, particularly technology businesses. U.S. taxpayers potentially subject to foreign digital economy taxes are those that engage in cross-border business activity with the online sale and delivery of services, goods, subscriptions, software, and other technology that reaches consumers within a foreign country.

For more information on the U.S. and foreign digital economy taxation developments, please contact Alison Dougherty at ADougherty@aronsonllc.com or 301.222.8262.