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International Tax and Public Finance

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02-01-2021

Profit-splitting rules and the taxation of multinational digital platforms

Authors: Francis Bloch, Gabrielle Demange

Published in: International Tax and Public Finance | Issue 4/2021

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Abstract

This paper analyzes the strategy of a monopolistic digital platform serving users from two jurisdictions with different corporate tax rates. We consider two profit-splitting rules, Separate Accounting and Formula Apportionment based on the number of users in the two jurisdictions. We show that, even in the absence of transfer pricing, the platform shifts profit from the high-tax to the low-tax jurisdiction exploiting network externalities under Separate Accounting and manipulating the apportionment key under Formula Apportionment. In order to shift profit, the platform distorts prices and quantities. Under Separate Accounting, the direction of the distortions depends on the sign of the externalities. We use a numerical simulation to show that the ranking of fiscal revenues under the two regimes differs in the two jurisdictions: The high-tax jurisdiction prefers Separate Accounting to Formula Apportionment, whereas the low-tax jurisdiction prefers Formula Apportionment to Separate Accounting.

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See the proposal in OECD (2019)

This is the case with France, which passed a law in July 2019 imposing a tax of 3% on the revenues based on intermediation and targeted advertising of 27 large digital platforms. Austria has passed a similar law in October 2019 imposing a tax of 5% on online advertising. Other countries, such as Turkey, UK, Belgium, Spain and the UK, have also declared their intention to introduce taxes on digital services (ranging from 2% in the UK to 7.5% in Turkey) in 2020. See “Why digital taxes are the new trade war flashpoint,” The Washington Post, December 10, 2019. However, to the best of our knowledge, none of the proposed taxes has actually been implemented yet.

In January 2016, Google and HM Treasury reached an agreement on the tax liability of Google in the UK. See “Google agrees to pay British authorities £130 m in back taxes,” The Guardian, January 23, 2016. In 2016, Facebook decided to stop declaring all its non-US profits in Ireland and agreed to submit profit declarations in all countries in which it operates a sales office.

We note that this manipulation under FA can happen even in the absence of network externalities across jurisdictions.

For the high-tax jurisdiction, the effect is ambiguous as the tax base is reduced when the gap increases, and the total effect depends on the elasticity of the tax base with respect to the tax rate.

The intuition underlying this result is easy to grasp: In order to shift profit assuming the number of users in the other jurisdiction fixed, when externalities are positive, the platform has an incentive to increase rather than decrease the number of users in the high-tax jurisdiction, as this increases demand in the low-tax jurisdiction. A similar reasoning shows that the number of users is reduced in the low-tax jurisdiction with positive externalities.

As we show in the paper, the direct and indirect effects may have opposite signs, making the total effect of an increase in the gap between the two corporate tax rates ambiguous. However, there are some simple cases—such as symmetric markets, or markets with one-sided externalities where the total effect can easily be signed.

See “Supreme Court Widens Reach of Sales Taxes for online Retailers,” The New York Times, June 21, 2018.

See Bibler et al. (2018) for a study of tax compliance by AirBnB hosts in cities with and without tax collection agreements.

See Weyl (2010) for a general argument, showing equivalence between price and user strategies for monopolistic platforms. This equivalence does not hold for competitive platforms where competition in prices (Bertrand) leads to different results than competition in quantities (Cournot). See Belleflamme and Toulemonde (2018) for a study of two platforms competing in prices.

In online appendix, we show how prices can be derived from a micro-founded model based on heterogeneous users in the two jurisdictions.

Gordon and Wilson (1986) were the first to note that FA generates distortions in the choice of the platform, albeit in a different model where firms are competitive whereas we consider a monopolistic firm.

As shown in online appendix, this number is perfectly correlated with user surplus, so that the number of users is also a measure of user welfare in the two jurisdictions.

In online appendix, we present the detailed computations in the linear model and numerical simulations with asymmetric jurisdictions and asymmetric externalities.

In online appendix, we compute the equilibrium tax rate in a symmetric model under SA. This tax rate is equal to \(t^* = 1 - (\frac{\alpha }{\sigma -\alpha })^2\), a level which is very high when externalities are small.

The finding that the low-tax country prefers FA and the high-tax country prefers SA holds true whenever externalities across jurisdictions are positive. If externalities from one jurisdiction are positive and from the other negative, as seen in online Appendix, the ranking between the two regimes may be different. It remains true, however, that the two countries always disagree on the optimal profit-splitting regime: If one gets higher tax revenues under SA, the other one gets higher tax revenues under FA.

The price functions are akin to inverse demand functions, with one caveat: Due to coordination issues, a given couple of prices \((p_A,p_B)\) could lead to different demands. In that case, we select the largest demands.

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Belleflamme, P., & Toulemonde, E. (2018). Tax incidence on competing two-sided platforms. Journal of Public Economic Theory, 20(1), 9–21.CrossRef

Bibler, A. J., Teltser, K. F., & Tremblay, M. J. (2018). Inferring tax compliance from pass-through: Evidence from Airbnb tax enforcement agreements. Review of Economics and Statistics, forthcoming.

Bourreau, M., Caillaud, B., & De Nijs, R. (2018). Taxation of a digital monopoly platform. Journal of Public Economic Theory, 20(1), 40–51.CrossRef

Gordon, R., & Wilson, J. D. (1986). An examination of multijurisdictional corporate income taxation under formula apportionment. Econometrica, 54(6), 1357–1373.CrossRef

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Title: Profit-splitting rules and the taxation of multinational digital platforms
Authors: Francis Bloch
Gabrielle Demange
Publication date: 02-01-2021
Publisher: Springer US
Published in: International Tax and Public Finance / Issue 4/2021
Print ISSN: 0927-5940
Electronic ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-020-09643-0

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