New Zealand: E-Tax Uncertainty Reigns In Cyberspace?

Last Updated: 31 January 2001
Article by Rob G Macnab

This article summarizes the recent issue by the OECD of final rules regarding article 5 ("permanent establishment") of the OECD Model Tax Treaty and how it applies with respect to electronic commerce. Another report is due out from the OECD soon that will address whether the PE definition should be modified or abandoned in light of the challenges posed by Internet technologies and global e-business. The writer concludes that it is too soon to rely on the findings of the OECD regarding e-commerce and PE’s.

Cyberspace - the final tax frontier? Can international tax advisers continue to seek out new tax structures and opportunities and to boldly go where no one has gone before? Can international tax systems keep up with the challenges presented by Internet technologies and global e-business? Will international revenue authorities also boldly go where no one has gone before? Can traditional tax treaty concepts such as the "permanent establishment", created in the "industrial age", survive into the "digital age"?

The "permanent establishment" concept ("PE" to tax geeks) was originally designed in the later half of the 19th century to prevent double taxation of trade between Prussian municipalities. In 1899, the concept was included in the first international tax treaty between Austria-Hungary and Prussia. Obviously, this tax concept (based on fixed place of business) was created eons before electronic commerce (based on-line trade) was ever thought of.

The PE concept settles whether a tax treaty country has the right to tax profits of a business operating in that country. Such a country can only tax that business if it has a PE in its country and derives profits from sources from within that country. Now that it is no longer necessary to have a physical presence in countries in order to trade internationally, it is questionable whether the PE concept should continue to apply, in light of the pace of change and innovation associated with Internet technologies and on-line trade.

The OECD has recently issued final e-commerce tax guidelines based on the current definition of a PE in its Model Tax Treaty. It should be noted that the guidelines do not amend the PE definition, but rather seek to fit the proverbial "square peg" (viz. e-commerce) into the proverbial "round hole" (viz. the PE definition). The guidelines merely determine whether an entity conducts its business through a PE in a particular OECD member country based on the current PE definition. Another OECD technical advisory group report will hopefully be issued before the end of this year determining whether this existing PE definition should be modified or abandoned because of the challenges brought about by electronic trade.

Under the current PE definition a non-resident entity has a PE in a treaty country if it has both a physical presence and carries out essential business activities in the treaty country from which PE profits are sourced. Fortunately, for those involved in electronic trading, the guidelines conclude that a web site of itself will never constitute a PE. This is because a web site is merely intangible software and data, and cannot be classed as a place of business as there are no "premises or, … machinery or equipment". Also, a web site hosting arrangement will usually not create a PE. Lastly, an ISP will usually not be a dependent agent of a non-resident entity, which would create a PE in the relevant country. The OECD concludes that a web server may sometimes be a PE in a country (e.g. when it is owned or leased by the non-resident and carries out essential business activities). But where the server does no more than carry information that will be processed elsewhere, it cannot be considered to be a PE.

It is questionable why there should be such a distinction between owning or leasing computer equipment and ISP web site hosting arrangements. The only reason that there is a distinction is because of the unique nature of Internet on-line trading that makes this possible. Traditional businesses cannot avoid taxable presence as premises, machinery, or equipment must either be owned or leased, and cannot be "hosted" like web sites can. A German court decision, known as the "pipeline decision" [the 1996 Bundesfinanzhof decision], arguably supports the principle that automated equipment can constitute a PE. The German Supreme Court held that an underground oil pipeline, located in Germany and controlled by computer from the Netherlands constituted a PE in Germany for German tax purposes. This was because the pipeline was essential to the taxpayer's business and there was a significant degree of permanence to it.

Even if you fall foul of the OECD PE rules, income tax can be minimised between OECD countries in a number of ways, by such strategies as: changing ownership or leasing arrangements of computer equipment; ensuring the equipment is portable; restricting activities taking place on the equipment to being solely of a "preparatory" or "auxiliary" nature (e.g. for market research, advertising, warehousing, procurement, etc, as opposed to concluding of contracts); relocation of the computer equipment to a nearby tax haven; using "mirror", parallel or linked web servers; minimising the amount of profits that will be attributed to the PE … (an OECD report is to be released on how to calculate e-commerce PE profits)

Note that there is still a lack of consensus among the OECD taxing authorities concerning what constitutes a PE. 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. Others argue that a web server alone can never be a PE regardless whether it is owned or leased by a non-resident.

The final guidelines issued by the OECD on the current Model Tax Treaty definition of a PE in light of e-commerce seeks to fit the e-commerce concepts into the existing historical physical presence / essential business requirements for a PE. The guidelines do not address whether the traditional definition of a PE is adequate to address the challenges presented by Internet technologies and global e-business, or whether the PE concept should be abandoned altogether in preference to a better international tax concept for the Digital Age.

The current guidelines provide some clarity in determining when computer equipment may create a PE under the current definition. However the expected report, on whether the PE definition should be amended or abandoned, may override the current guidelines. It is arguable that it may have been more prudent for the OECD to report all its findings on the PE and e-commerce issue at the same time.

So the final word is not yet out and income tax uncertainty continues to reign in cyberspace, providing risks of double taxation, but also opportunities for those who dare to plan ahead.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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