Article by Adrian Rudd, PricewaterhouseCoopers, summarising the Institute’s representations on two discussion papers issued in February 2001 by the Technical Advisory Groups (TAGs), which had been set up by the OECD to consider international tax issues arising from electronic commence.
Published in the August 2001 issue of Tax Adviser. Attribution of profit to a permanent establishment involved in electronic commerce transactions
The Business Profits TAG had been asked to prepare a discussion paper based on the assumption that a computer server based in a particular territory, with no human involvement in that territory, could amount to a permanent establishment within art. 7(2) of the OECD Model Treaty. The paper did not question this assumption, but considered how, if the assumption was correct, profit should be attributed to a permanent establishment involved in electronic commerce transactions. The paper concluded that it would be very rare for there to be any case for attributing more than an insignificant level of profit to such a permanent establishment.
The Institute commented that this conclusion demonstrates that to treat a computer server as a permanent establishment in the first place shows a high degree of artificiality. The Institute was unsure whether the discussion paper intentionally tried to demonstrate this, or whether it was unintentional.
The Institute pointed out that most double taxation agreements provide that the term ‘permanent establishment’ should be deemed not to include:
• the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
• the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
• the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
• the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise;
• the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;
• the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs (a) to (e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.
The Institute commented that the display of information relating to products on a website clearly falls within ‘display’.
The Institute believes that the taking of orders and the transmission of that information to the home base for decisions is merely collecting information, even (or indeed especially) when done by a computer rather than by a person. The discussion paper assumes that a computer can create contractual arrangements between an enterprise and a customer, in the same way as an agent can. This assumption is highly contentious.
Examples illustrating the artificiality required in treating a computer server as a permanent establishment can be found in the discussion of whether to attribute assumption of credit risk to the server (para. 55); the possible attribution of inventory to the server in para. 63; the question as to whether a server could ever increase the value of marketing intangible provided by the head office (para. 80); the irrelevance of the question of transfer of hardware or the use of hardware as between head office and permanent establishment when the permanent establishment itself consists of the hardware and has no personnel to which any such transfer could even notionally be made (para. 89).
The Institute agreed with the conclusion that little value should be attributed to the automated functions of a server. However, the examples in the paper simply apply the traditional functional analysis, and do not attempt to clarify the particular problems associated with e-commerce and transfer pricing as identified at the Ottawa conference in 1998.
In the circumstances, the Institute strongly recommended that further debate on this matter should be deferred until the general rules about attribution of profits to permanent establishments have reached a more advanced stage and the transfer pricing issues involved in e-commerce are addressed.
The impact of the communications revolution on the application of ‘place of effective management’ as a tie-breaker rule
The Business Profits TAG of the OECD also issued a discussion paper looking at the application of tie-breakers in double tax agreements. Where a company is resident in two countries under the respective tax law of each country, the traditional tie-breaker has been the place of effective management concept, which is included in art. 4 of the OECD Model Treaty. A traditional business is conducted through management usually located in one country, often physically in the same building. Where management is located in different countries, board meetings are usually held in the same location each time, generally where the headquarters is located.
However, the advent of fast train and air travel, improved telephone and video-conferencing facilities and e-mail have changed the way business is conducted. While the traditional concept of place of effective management necessitates there being only one place of effective management at any one time, the modern way of doing business means that there could be:
• a changing place of effective management – board meetings could be held in a different jurisdiction each time;
• a mobile place of effective management – board meetings or key decisions could be made in a moving train or plane which is crossing international borders;
• numerous simultaneous places of effective management – for example when board members are conducting meetings by tele-conference or video-conference;
• place of effective management in a third country.
The possible solutions
The Business Profits TAG examined possible replacements to the place of effective management test. The suggestions included:
• place of incorporation – this is simple to administer, but might be too arbitrary and liable to be changed without changing the substance;
• place where the directors or shareholders reside – this was believed not to give a clear result;
• where the economic nexus was the greatest – the rationale for this basis is that where a company uses the legal infrastructure and facilities of a jurisdiction, it should contribute to that jurisdiction. The TAG recognised that the concept of economic nexus was linked more closely with source-based taxation, in its view this did not prevent
it being used as a tie-breaker.
The Institute commented that the essence of the tie-breaker test is that it must provide a solution to the question of the place of residence of a company based upon a real and substantive connection with the centre from which profits are generated, and not upon formal or legalistic concepts. This means that the place of effective management test remains the best primary test which should only be displaced if that place cannot itself be determined, either because effective management is spread over more than one country or never stays in one country with any degree of permanence. Accordingly, the Institute would not like to see this primary test replaced.
The Institute suggested that in the absence of a clear place of effective management the ‘fall-back’ test should be (by analogy with the test for individuals of ‘centre of vital interests’) the place where the economic nexus is strongest. The place of incorporation and the place where the directors/shareholders reside are both inappropriate, for the reasons given by the TAG. The place where the economic nexus is strongest may not always be easy to decide but, except in extremely rare cases, it will always produce a single answer, based on real and substantive criteria.
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August 2001 by