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By Paul Hannon 

LONDON -- The European Union's justification for a new tax on technology companies hinges on a novel view of how profits are generated that the U.K. Treasury presented in November.

Traditionally, the profits of a company operating internationally have been taxed where its major decisions are made and its most important assets are controlled. In practice, those taxes have often been levied in countries where the company also has a large number of customers. But the location of user of its product or service hasn't been decisive.

The European Commission, the EU's executive arm, on Wednesday proposed a tax set at 3% of revenues on some of the digital activities of a small cadre of tech superpowers, including Facebook Inc. and Alphabet Inc.'s Google.

European officials say that digital products rely increasingly on crunching millions' of users data to generate value -- for example, by targeting niche ads directly at users, or by combining millions of interactions to improve an app's voice-recognition capabilities. European officials say that means value is generated where users are located -- and the system should change so tax should be paid there, too.

That is a radical departure from the principles that have guided international business taxation to date, and incorporates a logic advanced in November by the U.K. Treasury. In a "position paper" setting out the potential arguments for a tax on digital companies, Treasury officials argued that "for many digital businesses that operate in markets through an online platform, the users of the platform...create material value for a business through their sustained engagement and active participation."

"That is a brand new principle," said Will Morris, deputy global tax policy leader at business services firm PwC.

The view that users do help create value under some business models isn't shared outside Europe. In a report that highlighted the lack of agreement between governments on how to tax digital businesses, the Organization for Economic Cooperation and Development Friday said there are "differences of opinion" on the question.

Instead, tax authorities such as those of the U.S. argue that digital businesses compensate users for the data they extract from them through the provision of services such as data hosting, email and entertainment. In other words, there is a digital barter economy, and the only things that should be taxed are the services provided to users, but as a form of income.

The difference of opinion over the role of users overlays a more fundamental split between Europe and the U.S. Europeans argue that some highly digitalized businesses are fundamentally different and should be targeted through special taxes. The U.S. is against taxes that single out digital businesses, and instead believes a broader overhaul of the international tax system is needed to respond to the digitization of business in general.

For now, the world's largest economies intend to try to work out their differences.

"The impacts of the digitalisation of the economy on the international tax system remain key outstanding issues," finance ministers from the Group of 20 largest economies said in a statement Tuesday. "We are committed to work together to seek a consensus-based solution by 2020, with an update in 2019."

But Mr. Mills, who helps represent the view of business in OECD deliberations on policy, said the Commission's adoption of a controversial new principle may make that more difficult to achieve.

"There is the danger that people who disagree with it will walk away," he said. "And for those countries that adopt these measures, it eases the political pressure to engage in a difficult conversation."

Write to Paul Hannon at paul.hannon@wsj.com

(END) Dow Jones Newswires

March 21, 2018 11:22 ET (15:22 GMT)

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