When Does E-Commerce Result in a Permanent Establishment? The OECD's Initial Response
The concept of a "Permanent Establishment" ("PE") is probably the single most important concept found in tax treaties since it serves to establish taxing jurisdiction by the source country (i.e., the country where the business activities are performed) over a foreigner's unincorporated business activities (including activities of a branch). The foreign enterprise's profits from business activities are taxable by the source country only if the enterprise has a PE located in the source country.
Traditionally, the concept of a PE required some physical presence in the country seeking to impose tax. Most U.S. tax treaties are based on the OECD Model Tax Convention. 1 Article 5 of the OECD Model Tax Convention provides that the "term 'permanent establishment' means a fixed place of business through which the business of an enterprise is wholly or partly carried on." (Emphasis added).
Today, however, technology is changing the way companies conduct business. It is no longer necessary to have a physical place of business in a country in order to sell products or services in that country. Internet sales are growing at a phenomenal rate and many companies are using the Internet as their sole sales mechanism.2As a result, the issue of whether the mere use of computer equipment (e.g., a computer server) located in a country through which e-commerce activities are carried on rises to the level of a PE in that country is of critical importance to both governments and businesses.3
The OECD Committee on Fiscal Affairs ("CFA") acts as a forum for the discussion of issues relating to the negotiation, application and interpretation of tax conventions, examines proposals for the modification of the OECD Model Tax Convention, and makes recommendations for dealing with these issues and for changes to the Model Tax Convention.4 Recently, OECD's CFA Working Party No. 1 issued a draft change to the Commentary to Article 5 of the Model Tax Convention which is intended to clarify how the concept of PE used in the OECD Model Tax Convention applies to e-commerce. This article discusses: (a) the development of the PE concept; (b) the current status of PE in the context of e-commerce; (c) the role of the OECD in the taxation of e-commerce; (d) the draft of the proposed changes to the OECD Commentary of Article 5; and (e) the propriety of the approach preliminarily taken by the OECD.
The Development of the PE Concept
The PE concept dates back to the second half of the 19th century in the German states. Its tax aspect emerged to prevent double taxation by Prussian municipalities.5 Prussian courts developed certain conditions which have become the core elements in the PE concept. A fixed physical location was required, and the enterprise had to intend to continue performing the business activity at that place.6
It was not until 1885 that the expression PE was actually used in Prussian tax statutes.7 The German Double Taxation Act of 1909 included a basic rule of PE which required: (1) existence of a place of business; (2) location of the business at a specific geographical spot; and (3) permanence of the business.8
In 1899, Austria-Hungary and Prussia entered into the first international tax treaty. It provided that business profits earned through a PE in one country were to be taxed there. The treaty relied heavily on the definition of PE taken from judicial practice in Prussia, particularly the requirement of a fixed place of business.9 Other treaties with similar PE definitions were concluded by Austria/Hungary with Liechtenstein, Bavaria, and Wu'rttemberg shortly thereafter, and between the German states and Swiss cantons.10 These early treaties also provided that a permanent agent could create a PE.
The League of Nations developed the first draft convention on double taxation in 1927 which included as examples of PE, the real centers of management, affiliated companies, branches, factories, agencies, warehouses, offices, and depots. For the first time, a distinction was made between dependent agents and independent agents, and dealings through a "bonafide agent of independent status" were held not to mean that the undertaking in question had a PE in that country.11 This draft also included affiliated companies (e.g., subsidiaries, parent companies) as examples of a PE.12 The reference to affiliated companies was omitted in later draft conventions.13The 1933 League of Nations draft convention established the primacy of residence-state taxation and provided specific criteria for the definition of an independent agent.14
Ten years later, in 1943, the League of Nations published the first model tax treaty for developing countries. This model favored source-state taxation of business activities without the requirement of a PE.15 However, in 1946, the full Fiscal Committee of the League of Nations revised the model tax treaty to include PE as a condition for source-taxation of business profits.16 The 1943 and 1946 model tax treaties both provide that an enterprise must have a fixed place of business, and this place of business must have a productive character (i.e., contribute to the business earnings). The commentaries to these treaties exclude "research laboratories, experimental plants, information bureaus, storehouses, purchasing offices, advertising displays and showrooms where no goods are sold." 17
The 1943 and 1946 model tax treaties also provided that a PE could be created as a result of an agency relationship based on four alternative criteria: (1) power of the local agent to bind the enterprise; (2) existence of a contract of employment with a local agent; (3) maintenance in the country of a stock of goods under the control of an agent for sales in that country; or (4) payment of rent of the premises used by the agent or his office expenses.18 Both model treaties provided that an independent agent does not constitute a PE, even if he has a warehouse.19
The 1943 and 1946 model treaties included certain novel provisions. First, construction work may constitute a PE if work at the building site "is destined" to last at least 12 months. In addition, the fact that a subsidiary is located in a country does not mean that the parent company has a PE in that country.20 However, many treaties completed during this period did not follow the League of Nations model treaty PE provisions.21
The OECD Model Treaties and PE, 1962-Present
The OECD (originally the OEEC) was founded after World War II and was composed of a body of "homogeneous developed countries." 22 The OEEC Fiscal Committee issued its first report in 1958, which included a definition of PE and led to the OECD Draft Double Taxation Convention on Income and Capital (1963).23 The OECD Fiscal Committee created the now generally accepted rule of PE; i.e., a "fixed place of business in which the business is wholly or partly carried on." 24 In addition, the Committee retained the list of positive examples of a PE from the 1943 and 1946 model treaties, but it replaced the "productivity test" included as part of the 1943 and 1946 model treaties with a list of exempted activities.25 The Committee also attempted to provide a general definition of a dependent agent, which basically looked to whether the agent had the authority to conclude contracts and whether the agent in fact habitually exercised this authority.26
In 1977, the OECD Committee on Fiscal Affairs issued the successor to the 1963 model tax treaty. Since the 1992 OECD Model Tax Convention (the "Treaty") definition of PE is unchanged from the 1977 OECD Model Tax Convention, our discussion is focused on this Treaty and its applicable Commentary.27Paragraph 1 of Article 5 provides the general rule of PE, i.e., a fixed place of business, through which the business of an enterprise is wholly or partly carried on. The current Commentary to paragraph 1 of Article 5 ("Commentary") provides that a PE requires the existence of three conditions: (1) a "place of business," i.e., a facility such as premises or, in certain instances, machinery and equipment; (2) this place of business must be "fixed," i.e., it must be established at a distinct place with a certain degree of permanence; and (3) the carrying on of the business of the enterprise through this fixed place of business.28
The Commentary addressing paragraph 1 of Article 5 states that the term "place of business" covers "any premises, facilities or installations used for carrying on the business of the enterprise, whether or not used exclusively for that purpose." 29 It is irrelevant whether the premises, facilities or installations are owned or rented, so long as the enterprise has the legal right to use the place of business.30 The place of business must be a "fixed" one which requires that there be a link between the place of business and a specific geographical point. With regard to equipment, the Commentary states that the equipment constituting the place of business need not be fixed to the site on which it stands, but it must remain on a particular site.31
In addition, since the place of business must be "fixed, "it cannot be of a temporary nature, but instead it must have a degree of permanence.32 Where the place of business was designed for a short temporary purpose, but is maintained for such a period that it can no longer be considered temporary, it retrospectively becomes a fixed place of business.33
Moreover, while the Commentary acknowledges that a PE results when the business of the enterprise is carried on by the enterprise's personnel (employees and dependent agents) at the fixed place of business, it also provides that a PE can exist where the business of the enterprise is carried on mainly through automatic equipment with the activities of the enterprise's personnel being restricted to setting up, operating, controlling and maintaining such equipment.34 As an example, the Commentary addresses gaming and vending equipment and provides that whether such machines constitute a PE depends on whether the enterprise carries on business activity besides the initial setting up of the machines.35 If the enterprise merely sets the machines up and then leases them to operators in the other State, then no PE results. However, if the enterprise also operates and maintains them for its own account, then a PE will result, and this result also follows if the machines are operated and maintained by the enterprise's dependent agent.36
Paragraph 4 of Article 5 of the Treaty lists various activities which do not result in a PE because they are, in general, preparatory or auxiliary activities. These include: (1) the acquisition of facilities for storing, displaying or delivering its own goods or merchandise; (2) the maintenance of a stock of merchandise solely for the purpose of storage, display or delivery; (3) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; (4) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information for the enterprise; 37 (5) the maintenance of a fixed place of business solely for the purpose of carrying on any other activity of a preparatory or auxiliary character; and (6) the maintenance of a fixed place of business solely for any combination of activities mentioned in items (1)-(5) above, provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.38
The Commentary provides that the determination of whether an activity is of a "preparatory or auxiliary character" depends on whether the activity of the fixed place of business in itself forms an essential and significant part of the activities of the enterprise as a whole. In the case of a fixed place of business whose general purpose is one which is identical to the general purpose of the enterprise as a whole, the activity is not of a preparatory or auxiliary nature. 39
The Treaty also deals with the issue of when the use of an agent can result in a PE. Paragraph 5 of Article 5 provides that despite of the general rule and specific examples, where a person (other than an agent of an independent status to whom paragraph 6 applies) is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a PE in that State on any activities which the person undertakes for the enterprise.40 Therefore, a PE results if a dependent agent has and habitually exercises authority to conclude contracts on behalf of the enterprise (other than contracts involving preparatory or auxiliary activities), whether in the enterprise's name or in the name of another, provided it binds the enterprise.41
In addition, Article 5, paragraph 6 of the Treaty provides that an enterprise shall not be deemed to have a PE in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business. The Commentary lists criteria to examine to determine if a person is independent vis-a'-vis the enterprise, such as whether the person's commercial activities are subject to detailed instructions or comprehensive control by the enterprise, and whether the person or the enterprise bears the entrepreneurial risk.42 If a commission agent acts outside the ordinary course of his own trade or business (e.g., concludes contracts on behalf of the enterprise), his presence could constitute a PE of the enterprise.43
Current Status of PE in the Context of E-Commerce
Due to the lack of consensus among the worldwide taxing authorities concerning what constitutes a PE in the context of e-commerce (and its exploding growth as a source of revenue for enterprises worldwide), countries are taking inconsistent positions on whether the location of a web site on a server in a country can constitute a PE, increasing the risk of double taxation.44 Some have argued that the mere maintenance of a web site on a server located in a taxing jurisdiction satisfies the requirements for a PE.45
The U.S. Treasury Department rejected this view in a discussion paper ("White Paper"), analogizing the server to ownership of a warehouse, which is a passive activity.46The Dutch Advisory Group on electronic commerce recommended to the Dutch Tax Authorities not to regard a mere electronic presence through a server as a PE in the Netherlands.47
The White Paper, however, distinguishes the situation where the server is integral to the realization of the nonresident's profits. For example, for a foreign telecommunications service provider, such equipment is integral to providing the service, and therefore the server may be deemed a PE. The server would not meet the "auxiliary or preparatory" exception to the general rule of Article 5 paragraph 1.
Others have argued that agreements and transactions with an Internet Service Provider ("ISP") create a dependent agency. Again, the Treasury White paper rejects this view because the activities or services performed by the ISP do not include contractual authority that is normally associated with a dependent agency.48
Some have argued that the activities a web site and associated server performs are actually more than the mere storage of information or processing of orders. The Commentary to Article 5, paragraph 1, discussed above, states that a PE may exist if the trade or business of the enterprise is carried on mainly through automatic equipment, the activities of the personnel being restricted to setting up, operating, controlling and maintaining such equipment. The Commentary then cites as examples gaming equipment and vending machines. However, unlike a gaming and vending machine where a user's entire transaction is conducted by interaction with the machine, the activities or functions performed at the site of a computer server are normally more limited.49
Servers are capable of performing tasks that do not require the intervention of others. For example, the server is able to process information such as the name and address of the user, payment, collection, and shipping information, and provide "artificial intelligence" interaction with the user. A German court decision, Bundesfinanzhof decision of October 30, 1996, arguably provides support that such automatic equipment should constitute a PE.50 The Second Chamber of the German Supreme Court held that an underground oil pipeline, located in Germany, but regulated by computer from the Netherlands constituted a PE in Germany for purposes of German business property tax. German law defines PE in the same manner for both its income tax and net worth tax. Clearly, the pipeline was integral to the taxpayer's business and there was a significant degree of permanence to the pipeline. The German tax authorities recently issued a pronouncement which provides that "for the time being" (i.e., pending the discussions at the OECD level), German authorities will take the position that a server does not create a PE pursuant to Article 5, paragraph 4 OECD Model Tax Treaty because the activities have to be classified as being of a preparatory nature, despite the view taken by the German Supreme Court in its so-called "Pipeline Decision." 51
Still another argument raised for finding a PE has been that a web site should be treated as the dependent agent of the non-resident under Article 5, paragraph 5 of the Treaty. The web site performs the tasks that the non-resident programmed it to do, similar to the tasks that an agent performs based on instructions from his principal. Sophisticated web sites can actually solicit customers by sending electronic mail to potential customers. Using artificial intelligence, it can refine the list of customers and actually target likely customers based on past responses. At least one country, Italy, has taken the position that where the server is loaded with "intelligent software" that can conclude simple contracts, the server's actions become similar to that of an agent, and thus may be sufficient to give a business a PE.52
This position, however, ignores the reference in Paragraph 5 of Article 5 to a "person" acting on behalf of the enterprise and the definition in Article 3 paragraph 1 of the Treaty of a person as "an individual or company or other body of persons." A web site or server is not a body or person, and therefore cannot be the dependent agent of an enterprise.
Role of the OECD in the Taxation of E-Commerce
The OECD has taken a leading role in developing a consensus on the various e-commerce tax issues. The significance of the OECD Commentaries to the model tax treaty on U.S. tax treaty issues is easily demonstrated by the National Westminster Bank 53decision where the court relied on the OECD Commentary to Article 7 in reaching its determination.54
In November 1997, the OECD conducted its first informal discussion of electronic commerce with the business community in Turku, Finland. At that meeting, the Committee on Fiscal Affairs identified issues for further discussion relating to electronic commerce and the PE concept. The first issue identified was whether paragraph 1 of Article 5 is satisfied by a web site on a server owned or used by a foreign enterprise, taking into account the possibility that the foreign enterprise may have no employees present in the source country. The CFA concluded that resolution of this issue requires a determination of whether: (1) a web site constitutes a "place of business,"(2) the server can be said to be "fixed" and (3) the automated business functions performed at the site (e.g., advertising, ordering, or payment) constitute the carrying on of a business through a fixed place of business. Difficulties identified in determining whether a "fixed place of business" exists included instances where a number of mirror web sites on different servers located in different countries would be used so that the customer could be directed to any site for any function depending on electronic traffic and where a single web site is electronically transferred in total to a new server in a different building, city or country every few months.55
The second issue the CFA identified was whether the activities carried on through a web site go beyond the types of preparatory and auxiliary activities which, under paragraph 4 of Article 5, would not result in a PE. The CFA believes that this determination requires an examination of the automated functions performed through a web site, including advertising, ordering, payment, storage and digital delivery, and the extent to which a database can be maintained solely for the purpose of storage, display or delivery if it also has a search and reporting facility (e.g., if a customer can select the contents of the database merely for viewing).56
The third issue identified was whether and to what extent an ISP may be considered the dependent agent of a foreign enterprise. The CFA suggested the need to examine what other activities are carried on through the server, (e.g., where the enterprise would lease excess capacity in its server to allow another to operate a web site).
The fourth issue raised by the CFA was how to deal with the mobility of an Internet business, especially considering the progress of cable and satellite technology. Soon it will be possible to locate most, if not all, of the functions of such a business in any country, including the country of residence or a low tax jurisdiction.57
The final issue raised by the CFA at the conference was the problem of determining the income attributable to a PE from e-commerce, assuming a PE exists. Because of the possibility of using linked servers located across many jurisdictions that switch signals from one server to another depending on traffic volume, it may be difficult to determine the transactions that should be attributed to the operations of the PE.58
The CFA held its next major conference regarding taxation issues of e-commerce in Ottawa, Canada in October, 1998. At that meeting, the CFA agreed to provide clarification in the Commentary on the Model Tax Convention as to how the current definition of PE applies where e-commerce transactions are conducted through a web site on a server located in a foreign country.59The CFA added that:
it may well be that the issue of whether a web site on a server can constitute a permanent establishment will have little impact on tax revenues. This is because technological developments in data transmission allow (or will very soon allow) most taxpayers to structure their electronic commerce operations so as to avoid the need to store their data or software on servers located in countries where these taxpayers do not want to risk having a permanent establishment.60
The CFA also addressed the concern that new tax rules are needed for e-commerce stating that e-commerce is in its infancy, and at this point, it would be difficult to determine whether and which countries would experience tax base erosion because of the shift from source-based to residence-based taxation resulting from e-commerce.61 It recognized that certain countries (i.e., countries that import more goods and services over the Internet than they export) are concerned that e-commerce will erode their tax base, and therefore, may institute unilateral measures if they feel nothing is being done on the international level to prevent such erosion.62 As a result, it promised to closely monitor how the existing international norms for taxing business profits will apply to e-commerce.63
Draft Commentary to Article 5 of the Model Tax Treaty Addressing E-Commerce
In late September 1999, CFA Working Party No. 1 issued draft commentary on Article 5 addressing certain e-commerce issues (the "Draft").64 The Draft is the result of a first discussion of the Working Party, and comments were requested before December 31, 1999. The Working Party intends to review and finalize its proposal at its February 2000 meeting.
The Draft first provides that:
[while] fixed automatic equipment operated by an enterprise and located in a country may constitute a PE in that country (see Para.10 [of the existing Commentary]), a distinction needs to be made between computer equipment, which could thus constitute a PE in these circumstances, and the data and software which is used by that equipment. For instance, an Internet web site may be seen as a combination of software and electronic data which is stored on and operated by a server. The web site itself does not involve any tangible property and therefore cannot constitute a "place of business" as there is "no facility such as premises or, in certain circumstances, machinery and equipment" (see para. 2 [of the existing Commentary]... .) as far as only the software and data constituting the web site is concerned. On the other hand, the server through which that web site is operated is a piece of equipment, which itself needs a physical location and may thus, if it is fixed within the meaning of paragraph 1, constitute a "fixed place of business" of the enterprise that operates it.65
Therefore, a web site alone is not sufficient to constitute a PE, while a server which is fixed in location and through which the business of the enterprise is carried on may constitute a PE.
The Draft goes on to state that unless the server itself may be said to be a fixed place of business of the foreign enterprise, e.g., where a server situated at a particular location is rented to the enterprise that carries on business through the web site, the mere operation of the web site of that enterprise from a server located in that country cannot constitute a PE for that enterprise. As an example, the Draft provides that where a web site through which an enterprise carries on business is hosted on the server of an ISP, the server and its location are not at the disposal of the enterprise, even if the enterprise has been able to decide that the web site should be hosted on that particular server, and therefore the enterprise has no physical presence at that place (a web site is not a tangible asset).66
The Draft then provides that it is irrelevant whether the equipment used for e-commerce is operated or maintained by personnel who are residents of that country or visit that country for that purpose. Totally automated equipment may constitute a PE.67
Next, the Draft states that computer equipment may constitute a PE only if it is "fixed." The possibility that the server may be moved is not relevant, but instead, what is relevant is whether, in fact, it is moved. Therefore, to constitute a fixed place of business, the Draft provides that a server needs to be located at a certain place for a sufficient period of time so as to become fixed within the meaning of paragraph 1.68
The Draft addresses the issue of whether an ISP can be deemed to be the dependent agent of the foreign enterprise so as to create a PE of that enterprise. The Draft provides that except in very unusual circumstances, paragraph 5 will generally not apply because the ISPs will not constitute agents of the foreign enterprise. Most ISPs will not have authority to conclude contracts in the name of the enterprise and will not regularly conclude such contracts, or, they will constitute independent agents acting in the ordinary course of their business because they host the web sites of many different enterprises. In addition, since a web site is not a person, paragraph 5 cannot apply to deem a PE, to exist by virtue of the web site being the agent of the enterprise.69
Finally, the Draft addresses the issue of whether particular activities performed through computer equipment meet the preparatory or auxiliary exception to PE. It provides that this determination needs to be done on a case-by-case basis focusing on the various functions performed by the enterprise through the software and electronic data stored or operated through that equipment. If the functions performed through the computer equipment include activities that form an essential and significant part of the commercial activity of the enterprise as a whole, these activities go beyond the activities provided for by paragraph 4 (preparatory and auxiliary). If the equipment constitutes a fixed place of business, the equipment would constitute a PE.70
Analysis of Draft Commentary on Article 5 Addressing E-Commerce
The CFA attempts, in the Draft, to apply the traditional rules of PE to e-commerce. Relying on the historical PE requirement of physical presence, the Draft concludes that the mere use of computer equipment will not create a PE unless the foreign enterprise either rents or owns a server fixed at a location in the source-country from which it carries on business.71A human presence is clearly not required. Moreover, a foreign enterprise's web site hosted on the server of an unrelated party (e.g., ISP) alone cannot constitute a PE because there is no physical presence by the foreign enterprise in the source-country.72
The Draft states that a PE will not be considered to exist for e-commerce operations carried on through computer equipment which are restricted to "preparatory or auxiliary" activities covered by paragraph 4 of the Model Treaty. The Draft provides for a case-by-case determination as to whether particular activities performed through computer equipment fall within the exceptions in paragraph 4.73
Treasury, in its White Paper, took the position that the use or lease of a computer server generally does not create a PE, by reason of paragraph 4, analogizing the server to facilities used for storage and display.74 Where a business sells information instead of goods, the White Paper provides that "a computer server might be considered the equivalent of a warehouse, which is excepted from the definition of PE." 75 Nevertheless, where the server is integral to the business (e.g., an ISP), the White Paper recognizes that the exception may no longer apply. The White Paper, however, does not analyze the multitude of functions a computer server and web site can perform, or the impact of these functions on the "preparatory or auxiliary" exception of paragraph 4.
The final Commentary needs to go much further in providing guidance. Examples of "preparatory or auxiliary" activities that relate to mainstream Internet activities should be provided to avoid disagreements, especially between countries that are net exporters of e-commerce and countries that are net importers of e-commerce. The CFA is requesting comments on possible examples in the Draft. Perhaps one example could include a computer server owned and operated by a seller of goods where purchasers can view the seller's goods from the web site's on-line catalog, order physical goods which are then delivered by traditional methods, and provide credit card information to pay for the goods. Paragraph 4(b) of Article 5 explicitly provides an exception to PE status for the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery (arguably this should include an on-line catalog as discussed below), and Paragraph 4(d) provides an exception to PE status for the maintenance of a fixed place of business solely for the purpose of collecting information for the enterprise.
Paragraph 4(f) of Article 5 provides an exception to PE status for the maintenance of a fixed place of business solely for a combination of activities in sub-paragraphs (a)-(e), provided the overall activity of the fixed place of business resulting from the combination is of a preparatory or auxiliary character. A customer's transmission of order and credit card information through the web site and server to the seller's main computer is arguably no different than the customer picking up the phone, calling a toll-free number and ordering through the seller's mail-order personnel. In this example, the server performs the same function as a telephone, communicating customer information to the seller.76 Hopefully, the OECD would agree that since the seller is not in the communication business, the use of the server for both product display and the collection and transmission of information is merely incidental to the seller's business, and therefore, no PE should result.
Correspondingly, the final Commentary should also provide an example involving the delivery of a digital product by electronic means (e.g., sale of software or music). Where the server and web site are designed to process customer orders, capture payment information, and store and deliver the digital product, it appears less likely that the functions performed by the server would be deemed to be of a "preparatory or auxiliary" character. Vendors of digital products require some guidance regarding the extent of activities that can be performed by their computer equipment without creating a PE in the country where the equipment is located.
Surprisingly, the Draft failed to address the question of whether a database containing a search and reporting facility may be deemed to constitute a "stock of goods" for purposes of the exception to PE provided in paragraph 4(b), although this issue was mentioned in the Turku discussion paper.77 For example, a web site containing only an on-line catalog would constitute a database with a search and reporting facility. This database would exist solely for the purpose of displaying the seller's products. Arguably such a database on a server should meet the requirements of paragraph 4(b), but confirmation from the OECD would be helpful. Obviously, if a web site is programmed to perform a broader range of activities (e.g., on-line catalog, accept product orders, and credit card payment), the exception under paragraph 4(b) may no longer apply.78
The Draft also fails to provide guidance on whether an enterprise has a PE where its business activities carried out through its web site on its server meet the paragraph 4 exception to PE, but it also leases excess capacity on its server to other businesses.79 Query: should the leasing of excess capacity result in a PE to the enterprise? Presumably, this aspect of its business is incidental or "auxiliary" to its primary business operations, but guidance is needed from the OECD.
The CFA also concludes in the Draft that except "in very unusual circumstances," an ISP cannot be the dependent agent of an enterprise for purposes of paragraph 5 of the Model Treaty. Query: what type of "unusual circumstances" can result in a PE for an enterprise using an ISP?
The Draft resolves the issue of whether a server loaded with "intelligent software" that can conclude contracts on behalf of an enterprise can be the dependent agent of the enterprise. At least one country, Italy, has taken the position that the server may give rise to a PE because the server's actions are similar to those of an agent. The Draft concludes that since a web site is not a person, as defined in Article 3, a web site can never be the dependent agent of an enterprise. Therefore, "artificial intelligence" software loaded on a server will not create a PE for an enterprise under Paragraph 5 of the Model Treaty.
Finally, as the CFA noted in its 1997 and 1998 discussion papers, the impact of its guidance may be minimal because technological developments in data transmission mean (or soon will mean) that an enterprise can locate its web site and server anywhere, thereby avoiding source-based taxation on its business profits derived from sales to residents of the source country. 80 Clearly, the impact of the Draft will be to reduce the role source-based principles of taxation play in taxing e-commerce since enterprises can easily arrange their activities so as to minimize the risk of PE status in a country. For example, an enterprise could avoid the PE rules simply by leasing space on the server of an ISP in a third country, since a web site does not involve tangible assets, thus, the enterprise would not have a place of business in the source country. Alternatively, the enterprise could locate its server in a low or no-tax jurisdiction. There may be situations, however, where several supporting activities (e.g., warranty work, marketing, and credit card processing) have to take place, for example, in the United States that may result in the enterprise being engaged in trade or business in the United States or having a PE in the United States.
While the role of residence-based taxation will likely grow as a result of e-commerce, resulting in some reallocation of tax revenues, it may be too early to contemplate abandoning the PE concept in the context of e-commerce, as suggested by some.81 To date, apparently there has not been a major shift of Internet businesses toward tax haven countries (possibly because facilities to support production or services may be limited), but a movement to tax haven countries may soon develop.82Therefore, the wait-and-see approach adopted by the CFA appears to be a rational response to the challenges created by e-commerce on the current system of international income taxation. The OECD Working Party is depending on its Technical Advisory Group (set up to monitor the application of existing treaty norms for the taxation of business profits in the context of e-commerce) to examine: (1) how the current treaty rules are working; and (2) the feasibility of alternative proposals. Ultimately, the Working Party will decide what changes to the Model Tax Convention are desirable and necessary.83
The draft Commentary to Article 5 of the 1992 OECD Model Tax Convention on Income and Capital issued by CFA's Working Party No. 1 retains the historical physical presence requirement for PE in the context of e-commerce and provides much needed guidance in determining when computer equipment creates a PE. The CFA failed, however, to address many important issues. Until they are resolved, they are likely to generate disputes among contracting parties and possibly result in double taxation. On the other hand, these uncertainties may present planning opportunities. The issues raised in this paper hopefully will be addressed in the final version of the Commentary, which should be issued by the CFA sometime this year.
On March 3, 2000, the OECD's CFA Working Party #1 issued a revised draft commentary to Article 5 of its Model Tax Convention and is requesting comments by June 15, 2000. The draft commentary is available at www.oecd.org/daf/fa/first en.htm.
Significantly, the revised draft commentary raises, without resolving, the issue of whether human intervention is necessary for automatic equipment to be considered to constitute a PE. Some countries are of the opinion that no human intervention is required since no personnel are in fact necessary to generate income. Others believe that some human intervention is necessary, but disagree on the extent of human intervention required. For example, does the human intervention have to take place in the country or can it be done from abroad? Does the human intervention need to be of employees of the enterprise or can an independent contractor's involvement meet the necessary standard? Finally, does the human intervention have to involve the operation of the equipment as opposed to its maintenance, and how does one distinguish between the operation and maintenance of the equipment (e.g., installation of software updates)?
There is also disagreement over whether the automatic equipment provision [paragraph 10] of the existing Commentary applies to computer equipment. Some countries distinguish between gaming and vending equipment, which are fixed in location and enter into completed transactions with customers, and computer servers whose location is irrelevant to the customer. These countries argue that the business of an e-tailer is carried on where its offices, warehouses, research facilities, and other brick and mortar operations are located, and therefore the server is not a "fixed place of business."
Finally, the revised draft includes examples of "preparatory or auxiliary" activities covered by paragraph 4 of Article 5. Included are (1) providing a communication link-much like a telephone line-between suppliers and customers; (2) advertising of goods and services; (3) relaying information through a mirror server for security and efficiency purposes; (4) gathering market data for the enterprise; and (5) supplying information. All countries agreed that where such functions form in themselves an essential and significant part of the commercial activity of the enterprise as a whole, or where other core activities of the enterprise are carried on through the computer equipment, the paragraph 4 exception would no longer apply.
There is disagreement, however, over what constitutes core functions of an enterprise. Some countries believe if any sales activities are conducted through computer equipment, the equipment is a "place of business " and perhaps a PE, regardless of whether the product is delivered on-line or by traditional methods. Other countries see the computer as a communication device, and believe the essential business activity is the selling of the product itself, not whether the transaction is concluded by mail-order, telephone, or through a server connecting the computer of the seller with the computer of the customer. Those countries would find a PE only where the server can conclude a contract, and handle payment and delivery of the goods.
The Working Party hopes to finalize the draft Commentary at its September 2000 meeting.
1 See Sher, "A Band-Aid or Surgery: It is Time to Evaluate the Health of the Permanent Establishment Concept," 28 Tax Mgmt Int'l J. 415 (July 9, 1999). The OECD is the Organization for Economic Co-operation and Development. The organization is composed of 29 member countries including the United States.
2 See Sher, fn. 1, above, at 419.
3 The issue with respect to foreign activities carried on by enterprises located in non-treaty countries is whether the enterprise is "engaged in trade or business in the United States." There is little authority for when e-commerce rises to a sufficient level so that a foreign enterprise resident in a non-treaty country would be considered engaged in trade or business in the United States.
4 Minutes of the 1st and 56th sessions of the Committee on Fiscal Affairs [CFA/M(71)1 and CFA/M(99)1] and document DAFFE/CFA(99)8.
5 Skaar, Permanent Establishment-Erosion of a Tax Treaty Principle 73 (Oslo/Deventer 1991).
7 Id. at 74.
8 Id. This permanence test seems to pertain to the business activity, not the place of business or to the use of such place like more modern OECD treaties.
9 Id. at 75.
10 Id. at 76.
11 Id. at 83.
14 Id. at 86-87.
15 Id. at 89.
16 Id. at 89-90.
17 Id. at 93, quoting League of Nations, London and Mexico Model Tax Conventions, Commentary and Text 14 (1946).
19 Id. at 94.
21 Id. at 95. It has been suggested that this was because of the non-homogenous body of countries represented by the League of Nations.
22 Id. at 96.
24 Id. (quoting OECD Comm. 1963, at 22).
25 Id. at 96.
26 Id. at 97.
27 The OECD 1992 Model Tax Convention was updated in 1994, 1995, and 1997 with changes to the Convention and applicable Commentary.
28 OECD Commentary 1992 Art. 5, no. 2.
29 Id., no. 4.
30 See Skaar, fn. 5, above, at 157.
31 OECD Commentary 1992 Art. 5, no. 5. See also Skaar, fn. 5, above, at 123 where Skaar concludes, based on present treaties, that machines, computers, ships, aircraft, and drilling rigs can be places of business, while light, portable equipment and machinery are not PE-constituting places of business.
32 See Skaar, fn. 5, above, at 226 where Skaar states that based on his research, a duration of 18-24 months will generally comply with the permanence test, while a duration of less than six months will not be sufficient to constitute a PE.
33 OECD Commentary 1992 Art. 5 no. 6.
34 Id. at no.10.
35 Id. Contrast gaming and vending machines, ATMs, and juke boxes, where a user's entire transaction is conducted by interaction with the machine, with the activities conducted or functions performed at the site of a computer server on the Internet, which are normally more limited.
37 The OECD Commentary to Article 5, no. 22, states that the reference to the "collection of information"is intended to include the case of a newspaper bureau which has no other purpose other than to act as one of the many "tentacles" of the parent body.
38 Examples provided in the OECD Commentary, Art. 5, no. 24, include a fixed place of business solely for the purpose of advertising, or for the supply of information, or for scientific research, or for the servicing of a patent or a know-how contract, if such activities have a preparatory or auxiliary character.
39 OECD Commentary 1992, Art. 5, no. 24.
40 However, the Treaty provides that a PE will not result where the activities of the person are limited to preparatory and auxiliary activities.
41 OECD Commentary 1992, Art. 5, no. 32.
42 OECD Commentary 1992 Art. 5, no. 38.
44 A server is defined as a special type of computer that can function as the primary site where information is stored, if part of a network, or as a gateway for incoming and outgoing information flowing to and from the Internet. A web site is a collection of web pages. Web pages are computer code which when interpreted by the computer, are converted into different formats understandable by the user, such as video, pictures, voice, etc. A web site cannot operate without a computer to which it is linked. See Sher, fn. 1, above, at 422 and 424.
45 See discussion, Levine and Weintraub, "The Importance of Treaties and the OECD in Electronic Commerce," Tax Planning International's e-commerce, No. 9, 9 (Sept. 1999). For example, the Income Tax Department of India recently set up a working group to examine the tax implications of e-commerce transactions. The group recommended that a computer terminal which is used to receive and send information across national boundaries and a website used in e-commerce should be regarded as a PE. In addition, the Australian Tax Office in its discussion paper stated that even a web site located on a server that is fixed in time and location, and through which business is carried on may constitute a PE.
46 "Selected Tax Policy Implications of Global Electronic Commerce," Department of the Treasury, Office of Tax Policy (Nov. 1996).
47 See Koch and Frey, "Taxation of Internet Transactions-A Swiss Perspective," Tax Planning International's e-commerce, No. 5, 16 (May 1999).
48 Switzerland appears to adopt the Treasury's view. See Hans Andre'e Koch and Martin Frey, fn. 47, above, at 13.
49 For example, while the order, payment, and shipping information for tangible goods can be processed by the computer, the computer cannot handle the actual production and delivery of the goods. This is not true for the delivery of goods that can be produced and delivered by digital means (e.g., a computer program). Also, see discussion Levine and Weintraub, fn. 45 above, at 9.
50 Budesfinanzhof Decision of Oct. 30, 1996 (IIR 12-92) published in Betriebs-Berater 1997 at p. 138.
51 See Hey, "German Tax Authorities Rule That Server Does Not Constitute PE," 19 Tax Notes Int'l 635 (1999). Also, see discussion Levine and Weintraub, fn. 45, above, at 10.
52 See Fairpo, "Electronic Commerce-U.K. Policy Document," 1 Tax Planning International's e-commerce, No. 5, 4 (May 1999). For a further discussion, see also Levine & Weintraub, fn. 45, above, at 10.
53 National Westminster Bank v. U.S., 99-2 USTC 50,964 (Fed. Cl. 1999) (where the U.S. branch of a U.K. bank has a PE, interest expense is computed as if the branch were a separate entity, rather than under the formulary approach of Regs. Search7RH1.882-5).
54 For a further discussion, see Levine & Weintraub, fn. 45, above, at 13.
55 OECD "Electronic Commerce: The Challenges to Tax Authorities and Taxpayers" at 24 (1997).
56 Id. at 25.
59 OECD, "Electronic Commerce: A Discussion Paper on Taxation Issues," at 24 (1998).
61 Id. at 25. The current PE rules will likely shift the taxation of business profits toward locations where physical production (e.g., where the enterprise maintains facilities through which its employees exercise their activities) takes place (i.e., the residence country).
64 OECD, "Proposed Clarifications of the Commentary on Article 5 of the OECD Model Tax Convention" (1999).
65 Id. at 3.
68 Id. at 3-4. See also fn. 32, above, where a duration of 18-24 months will generally comply with the permanence test, while a duration of less than six months will not be sufficient to constitute a PE.
69 Id. at 4.
71 Surprisingly, the Draft does not define the term "computer equipment," an omission which is likely to lead to confusion among tax practitioners.
72 Note that the position taken in the Draft appears to be in direct conflict with the positions taken to date by the Australian Tax Office and the Income Tax Department of India. The latter two apparently believe that a web site through which business is carried on is sufficient to constitute a PE.
73 See, fn. 70, above.
74 See fn. 46, above, para. 7.2.4.
75 Id. Art. 5, para. 4(a) excludes from the definition of PE the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise.
76 OECD Commentary 1992, Art. 5 no. 23 also provides that a fixed place of business solely for the supply of information is a preparatory or auxiliary activity. Although contributing to the profitability of the enterprise, the services performed are so remote from the allocation of profits that it is difficult to allocate any profits to the fixed place of business.
77 See fn. 55, above, at 25. Paragraph 4(b) of Article 5 provides an exception to PE for the "maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery."
78 It is possible that the exception in paragraph 4(f) may apply if the combination of activities performed on the web site mentioned in sub-paragraphs (a)-(e) of paragraph 4 is of a "preparatory or auxiliary" character.
79 The CFA raised this issue in its 1998 discussion paper, but did not discuss this issue in the Draft. See fn. 59, above.
80 Fn. 55, above, at 25 and fn. 59.
81 See, e.g., Avi-Yonah, "International Taxation of Electronic Commerce," 52 Tax L. Rev. 507, 532-541 (1997).
82 Bermuda and Anguilla, closely followed by Jersey and the Isle of Man, are taking steps to attract e-business (updating their facilities to provide available bandwidth, IT resilience facilities, contract and data protection legislation, and online company registration facilities). However, as one commentator notes, "one sees little in the way of concrete examples of new business" moving to tax havens. See Leuba, " The Taxing Business of Cyberspace Transactions," International Tax Report, Dec. 1999, at 1; See also, McIntosh, "Hope and Hype: Making Sense of E-Commerce Offshore," Offshore Finance USA, January/February 2000 at 30.
83 See fn. 64, above, at 2.