Press Room

6 Mar 2020

Netflix’s UK Tax issue – Miles Dean

Miles Dean, Head of International Tax at Andersen Tax takes a closer look at Netflix’s UK Tax issue.

Miles’ article was published in Law360, 05 March 2020, and can be found here.

Netflix is the latest US tech company to find its tax affairs under media and political scrutiny, even being accused of “superhighway robbery” in the House of Commons. This is nothing more than scaremongering – Netflix quite properly structures its affairs in a tax efficient way so as to increase its profits and keep its service competitive. It is certainly not doing anything that UK law does not envisage,

Yet when the media covers the tax affairs of large US tech companies like Netflix, Amazon, Airbnb or Google, it often conflates revenue and profit. Much of the coverage typically also fails to distinguish between where the actual business activities take place and where services are received by consumers.

In reality, Netflix does not operate unduly complex tax structures. It is a US business, with headquarters near San Francisco and it’s listed on the NASDAQ. It sells UK customers its services via a Dutch subsidiary. Doing so doesn’t require any business premises in the UK. Instead, Netflix’s UK customers contract with its Dutch subsidiary, Netflix BV, which has servers based in the UK to efficiently provide its streaming service. Having local servers is commercially very important as they enable quicker response times for streaming services.

The OECD guidance actually allows such servers to be taxed as if they were a business premises selling physical goods in a country. However, interestingly, the UK intentionally opted out of this system. It has therefore in effect unilaterally decided not to tax the UK profits of Netflix BV. This fact undermines the increasingly strident arguments being made that Netflix isn’t paying its “fair share” of tax.

During the OECD’s lengthy BEPS negotiations, agreement could simply not be found as to how the digital economy should be taxed. This means that, in the absence of any international consensus, the activities of internet-based companies like Netflix are being taxed by domestic laws. For example, France introduced a 3% digital services tax effective from 1 January 2019, that is imposed on the gross revenues derived from digital activities involving French consumers. The law is wide in its application and affects digital companies  and digital business models.

Italy has also chosen to tax the profits which Netflix BV makes from its Italian customers.  The UK also now proposes to introduce its own digital services tax of 2%, in the face of stern opposition from the US, which has even threatened a retaliatory tariff on British cars if the digital services tax goes ahead.

The UK’s lenient tax treatment of businesses such as Netflix to date makes sense when you consider the UK’s wider incentives for the film and television industry. Indeed, Netflix is now a significant part of that industry, having committed to spending £232mn on Shepperton Studios.

Take with the other hand

Thanks to the ongoing lack of consensus on how to tax the digital economy, individual countries are increasingly pursuing their own agenda, as the UK did with its Diverted Profits Tax in 2015. This “go it alone” attitude is understandable, but it’s also potentially counterproductive and it threatens the harmony of the international tax system. The US, for example, is unsurprisingly not best pleased with many such measures, since it is mainly US companies that are in their crosshairs.

In an attempt to stem the tide, the OECD entered into the fray on 9 October 2019. It floated an idea that would allow countries where customers are based to tax some of the profits earned by the business, no matter where they “arise”, according to the current system. What is interesting about this idea is that it overturns decades of the OECD insisting that the “arm’s length principle” is the only way to tax international transactions between group companies and, indeed, it is being quite snippy about the methodology it now proposes to use.

In the absence of transfer pricing rules, related parties in a commercial group can set the terms on which they transact to suit themselves – often ensuring that the profit goes to the company with the lowest tax rate. However, under the arm’s length principle, which is a cornerstone of transfer pricing legislation, the transaction takes place as if each party was independent – each gets the best price it can.

This approach is said to ensure that the profit arises in the right place and is theoretically simple to implement. However, while this may once have been the case, nowadays the OECD’s own guidance runs to over 600 pages and multinational groups are increasingly complex. Indeed, being able to benchmark specific transactions, that are often unique to the group in question, is now more of an art than a science. It should be noted that despite transfer pricing being undertaken by all multinationals, and the amounts at stake being very large, the UK has only ever had one dispute reach court, and that was over a relatively simple question relating to extended warranties.

The alternative to the arm’s length principle is known as formulary apportionment. This method is used by some US states to raise their corporation taxes. It works by dividing the profit, or income and expenses of a business, between the various locations where it carries on a business. However, the OECD has always dismissed this method, and it has always made clear in its guidance that it is not as good as the arm’s length standard because it is too difficult to agree on the formula to be used to divide the profits.

Well, times change, and the OECD is now prepared to use this method – but only as part of the answer. The OECD’s new proposal, published on 9 October 2019 entitled Proposal for a “Unified Approach” under Pillar One sets out a unified approach to the nexus and profit allocation challenges arising from digitalization. This includes a new nexus for taxpayers that is largely based on sales (as opposed to physical presence) and could be tailored to include country specific sales thresholds so that smaller economies can also benefit.

On 21-22 November last year, the OECD hosted a meeting in Paris to discuss the Unified Approach. Most US multinational corporations appear to accept that that there will be a shift in approach with Netflix in particular stating “We support in particular increased taxing rights for market countries through the creation of a new nexus.”

However, any changes to the established system of taxation will undoubtedly take time to settle down and teething problems are inevitable. The country where the customers reside will, as now, be rewarded for any marketing and distributions activities that are carried on there. This is a low level of profit, often based upon the “cost plus” methodology. Put simply, if a company spends 100 on marketing at cost plus 10, its income is 110, less the 100 costs, leaving a profit of 10.

However, the mark up and the actual deductions are often different. The costs to be marked up may be 100, but the company may also have other costs of, say, 8. On this basis the company’s income is the 110, but its costs are the 100 used in the mark-up, plus the extra 8 to leave a profit of 2. It pays tax on the 2 and the press howls that it is unfair.

To address this “unfairness”, the OECD is now proposing that along with the “routine functions” mentioned above, the country where the customers are to be found will also be granted part of the “residual profits” of the business. This looks to set up a whole new series of bun fights as countries and companies squabble over what is and what is not part of the residual profits.

First, the routine functions of the business will need to be rewarded, administration, head office costs etc, leaving the residual profit to be allocated between the “customers” and, as now, intellectual property or the capital that was put at risk.

How to allocate the residual profit between all of these areas cannot be done using the usual transfer pricing methodologies, so the OECD is holding its nose and suggesting that the profit be allocated by a formula, possibly one formula per industry. For example, a company such as Netflix which distributes its product digitally will have a very different cost base in each jurisdiction to Amazon, which distributes much of its product physically, which involves warehouses, staff and couriers.

Finally, the OECD proposes that companies and countries can argue that they are different to the rest and they should be awarded more/less of the profit figure.

This means that multinationals will now have to apply the arm’s length standard for marketing and distribution, then formulary apportionment – referred to by the OECD as a “formula based approach” – for the residual profits, and finally consider whether they want to make a case that they are exceptional, and should have a further adjustment – and then be prepared to argue about it. It’s the best, or worst, of both worlds depending on whose viewpoint you take. It is though, undoubtedly, a recipe for even more disputes!

I used to be undecided, but now I’m not so sure

The debate around the taxation of international companies has been driven by the media for a number of years and governments, especially the UK, are in a quandary as to how to respond. On the one hand, they want to appear to be tough and in line with their electorate, no matter how ill-informed, and tax the businesses till the pips squeak.

On the other, they recognise that these businesses have a choice as to where they place their operations and provide tax breaks, such as the two given to Netflix, as they bring much needed foreign direct investment into the country, plus give us some brilliant films and boxsets to watch!

However, the proposed cure to this particular problem, may well turn out to be worse than the current disease.

Miles Dean

Miles Dean

Miles is Head of International Tax at Andersen Tax in the United Kingdom. He advises privately held multinational companies, entrepreneurs and high net worth individuals on a wide range of cross border tax issues.

Email: Miles Dean