When does e-commerce create a PE?

The growth of electronic commerce faces an increasing risk of double taxation, unless steps are taken to develop a uniform approach as to whether an enterprise's Website is a taxable presence for that enterprise. The Organization for Economic Cooperation and Development (OECD) is working to reduce the risk by seeking to clarify how the permanent establishment (PE) concept should be applied to e-commerce. In September 1999, a subgroup of the Committee on Fiscal Affairs (which is responsible for updating the OECD Model Tax Convention) issued a draft commentary (the Proposal) addressing these concerns; see OECD, "The Application of the PE Definition in the Context of Electronic Commerce: Proposed Clarification of the Commentary on Article 5 of the OECD Model Tax Convention." The subgroup was scheduled to issue its final changes to the commentary in February 2000.

To place the Proposal in perspective, a short history of the PE concept is in order. First, if the source of an item of income can be determined, the right of a country to levy tax on business income usually depends, under income tax treaties, on whether a nonresident business has a PE in the source country (i.e., place where business activity occurs). (Only businesses not incorporated in the source country are of interest, because businesses incorporated in the source country are treated as residents of that country for tax purposes.) Absent a PE, the source country has no right to tax business income of a nonresident (even though the income has its source in that country).

Traditionally, tax systems in Europe and North America base the right to tax on physical presence. In the U.S., a state's right to tax generally requires nexus (a concept closely tied to physical presence). Thus, states have been unsuccessful in forcing out-of-state sellers to collect sales tax, unless the seller has physical presence in the state in which the buyer is located. Tax treaties, such as the OECD Model Tax Convention, and U.S. treaties (most of which are now based on the OECD model) have incorporated the physical presence test in the definition of a PE. Implicit in this concept is that some physical presence of the nonresident is required, whether personally or through an agent operating in the country. Absent a PE, the source of the income becomes irrelevant, and the income is effectively taxed only in the country of residence. Exceptions are made for ancillary functions that include physical presence (such as information gathering and maintaining a stock of goods for filling orders), in an effort to facilitate international business.

That physical presence is a prerequisite for jurisdiction to tax continues even in today's business world, in which increasing numbers of business transactions are conducted in cyberspace. The problem for tax authorities (and the benefit for businesses and consumers) is that e-commerce enables a foreign person to engage in extensive transactions with customers in another country without physically entering that country. For the Internet, the search for a PE (i.e., a physical presence) has led to a focus on the physical location of the server on which the provider or seller maintains its Website. However, given the user's indifference to the server's location, should the server's physical location be sufficient to create a PE of the seller or provider? Courts and tax authorities have taken apparently contradictory positions on this point.

In October 1996, a decision of the German Supreme Tax Court held that merely owning tangible personal property (an oil pipeline) in Germany gives rise to a PE, despite the absence of employees in the country. The German court focused on the physical presence of equipment that served the taxpayer's business, of which the taxpayer had more than just temporary dominion and control. A seemingly contrary position was taken by the German tax authorities last year, when they held that a Website on a server owned by a German resident in another country did not create a PE, because it merely served an ancillary or preparatory purpose. This technical distinction, using one of the treaty exceptions even though there was actual physical presence, was further limited in that the position applies only as long as the OECD does not take a contrary position.

The U.K. recently focused on the issue of physical presence and PE in a lengthy paper issued late last year, titled "Electronic Commerce: The U.K.'s Taxation Agenda." The U.K. recognized the doubts as to what constitutes a PE in the context of e-commerce. In particular, it questioned whether and under what circumstances a Website on a server is a fixed place through which business is carried on and, hence, a PE: "It seems clear, however, that some activities (such as advertising) on a web site will not of themselves constitute a PE, because they will fall into the category of preparatory or auxiliary activities." The paper continued, "the possibility has also been raised that a web site could be deemed a PE on the grounds that it acts as an agent concluding contracts." Without taking a position on either issue, the paper points out that a practical outcome is needed that will keep down compliance costs for business and be easily enforceable by tax authorities. Finally, while stating that, as e-commerce grows, the PE concept may become less appropriate, the paper also notes that it is unclear whether a local and fixed place of business is the right threshold for taxation in the long term, despite the long history and wide support that the concept enjoys.

The most recent OECD proposal merely addresses the issue of when e-commerce creates a PE and not the "broader and ultimately more important issue of ... whether the PE concept should be abandoned." It represents the OECD'S latest thoughts on how and when e-commerce conducted within a country rises to the level of a PE. The Proposal is structured as seven new paragraphs to the OECD's commentary on PEs. First, it draws a distinction between the computer equipment (the server) and the data and software used by that equipment (the Website). Both are required to conduct e-commerce; each is useless without the other. The server requires a physical location and may (within the meaning of Article 5, paragraph 1) constitute a "fixed place of business" of the enterprise that operates it. A Website alone, however, cannot be a "place of business," as there is "no facility such as premises or, in certain circumstances, machinery and equipment." (In other words, there is no physical presence.)

The Proposal recognizes that an enterprise operating a Website is different from the enterprise running a server that hosts a site. It is common for a Website owner to contract with an Internet service provider (ISP) to host a site on a server run by the ISP. A Website enterprise generally has no control over where an ISP locates its servers. Consequently, the mere fact that a Website is on a server located in a particular country will not necessarily constitute a PE for the enterprise operating the Website.

Conversely, a fixed place of business will be found when a Website rents or operates a particular server located in a country. It is not relevant whether or not individuals maintain equipment. It is merely required that the equipment be "fixed" for a sufficient amount of time in order for presence to constitute a PE. The fact that equipment is not actually moved is more important than the possibility that it is capable of being moved. Although not stated in the Proposal, "sufficient amount of time" for purposes of Article 5 probably means a period of six months or more.

The Proposal discusses whether a PE could be established via a dependent relationship with an agency, created by a server or a Website or both. It concludes that an ISP will not create a PE for an enterprise running a Website via a dependent relationship with an agency; ordinarily, the ISP is not given any authority to conclude contracts in the name of the enterprise that owns the Website, nor does it regularly conclude such contracts. Instead, an ISP should be viewed as an independent agent acting in the ordinary course of its business, as it contracts with many enterprises to host Websites on its servers.

The Proposal addresses Websites last. It is somewhat unclear when it states, "It is also clear that since the web site ... is not itself a `person' as defined in Article 3," paragraph 5 "cannot apply to deem a PE to exist by virtue of the web site being an agent of the enterprise." (Emphasis added.) Although the OECD Model Treaty defines a "dependent agent" to be a "person" (paragraph 5, Article 5), the definition of "person" contained in Article 3 is inclusive and not limited to individuals, companies, bodies or other persons. Presumably, the OECD intended the term "person" to be broadly interpreted. Consequently, it is not entirely clear that a Website would not constitute a "person" for purposes of applying the dependent agency test.

If that hurdle is passed, the other elements of dependent agency appear to be met. First, it does not really matter for purposes of determining the existence of dependent agency status whether the enterprise owns (rather than rents) the server on which its Website runs. In any event, the enterprise (and not the ISP) controls the operation of the server (if not its location) through the programming of a Website. Current technology allows Websites to interact with a user, process detailed information about each customer, send e-mail to targeted potential customers and perform other functions required (and programmed) by the enterprise. In addition, Websites are interactive. For example, contracts are often concluded on behalf of an enterprise in real-time, on-line, not concluded at some future time back at the enterprise's headquarters. In sum, the duties of the traditional dependent agent are performed by the Website. Therefore, it is arguable that a Website alone, operating within a country, could be deemed a dependent agent of an enterprise. Consequently, the dependent agent issue should be more fully developed by the OECD.

Finally, the Proposal provides exceptions when e-commerce operations are restricted to preparatory or auxiliary functions. This will be tested on a case-by-case basis to determine whether those activities are in fact an essential and significant part of an enterprise's commercial activity.

Although the Proposal is a step in the right direction, it fails to adequately address (if at all) a number of important issues:

* The dependent agent status created by certain activities performed by servers and Websites;

* Delivery of a product electronically (e.g., software, music, video, etc.) rather than by traditional means;

* Whether enterprises conveniently locate their servers (owned or leased) in tax-haven countries, to evade Article 5's reach;

* The methodology of calculating the amount of income attributable to a PE; and

* The continuing relevance of applying the PE concept to the new way of conducting commerce.

Until these issues are resolved, there will still be the risk of double taxation arising from countries taking inconsistent positions on whether a Website on a server constitutes a PE. While foreign tax credits may reduce or eliminate the double income tax bite, compliance with other countries' commercial and other tax laws will continue to be burdensome. For example, other tax issues (such as ad valorem, value-added and sales/use taxes) still need to be dealt with, as many tax treaties do not address them.

FROM LEONARD D. LEVIN, J.D., LL.M., AND ROBERT C. PEDERSEN, CPA, J.D., LL.M., NEW YORK, NY