Germany: 251. Lower Court Sees Server as Permanent Establishment

Alexander Loh, KPMG Frankfurt

The first German tax court to address the much discussed issue of whether a computer server can constitute a permanent establishment has decided this question in the affirmative (Schleswig-Holstein Tax Court judgement of 6 September 2001, II 1224/97 – EFG 2001, 1535 = SWI 2002, 17). In a case involving a German corporation with a server in Switzerland, the court held that the server was a permanent establishment to which apparently substantial amounts of income should be attributed. Such income was exempt from German tax under the German-Swiss tax treaty. The tax authorities contended that the taxpayer had no permanent establishment in Switzerland, hence that its entire income was taxable in Germany. The lower court's judgement has been appealed to the Federal Tax Court (docket no. I R 86/01).

Germany's December 1999 regulations on the taxation of permanent establishments (see KPMG German News no. 1/2002 p. 2 = article no. 214) are silent on the issue of when permanent establishments exist in connection with e-commerce. A directive issued by the Karlsruhe Regional Tax Office dated 11 November 1998 takes the position that computer servers are fixed places of business, but generally do not create permanent establishments because their installation represents an activity of a preparatory or auxiliary character. This was the stance taken by the tax authorities in the instant case.

The server in question was owned by the taxpayer and installed on leased premises. It operated automatically, that is, without on-site personnel. The server was connected with Germany by a dedicated line owned by an affiliated company. Informational content was fed into the server via the dedicated line and distributed to Swiss customers, who retrieved it for a fee using their television sets. While the statement of facts is not entirely clear, it seems that the affiliate company, not the taxpayer, was responsible for generating the content. Hence, the taxpayer's only economic function was to distribute the content via its fully automatic server. The sums paid by Swiss customers were collected by Swiss Telecom and forwarded to the taxpayer, less a collection charge. The taxpayer in turn deducted a charge for its services and forwarded the balance to its affiliate. Unfortunately, the reported decision contains no figures, so it is not possible to determine the relative shares of gross proceeds earned by the taxpayer and its affiliate.

Citing the Federal Tax Court's 1996 underground oil pipeline decision (30 October 1996 – BStBl II 1997, 12), the court had little difficulty finding that the presence of personnel was not a necessary requirement for a permanent establishment.

Most of the decision deals with whether the server was part of a preparatory or auxiliary activity. Activities of a preparatory or auxiliary nature do not constitute permanent establishments under the German-Swiss tax treaty (cf. Article 5 (4) of the OECD model income tax treaty). The court refused to analogise the server, in which information was stored until retrieved by customers, to a facility "used solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise" (cf. Article 5 (4)(a) of the OECD model treaty). The court's rather technical reasoning was that information was not comparable to merchandise because information could not be capitalised on the taxpayer's balance sheet.

The court also considered whether the server was part of a non-enumerated "other activity of a preparatory or auxiliary character" (cf. Article 5 (4)(e) of the OECD model treaty). The court's reasoning on this point turns on its analysis of the overall activities of the enterprise. The court found that transmitting information from the server was the taxpayer's sole business activity, hence that there was no other activity to which such transmission could be preparatory or auxiliary. The factual part of the judgement does not clearly support this conclusion.

The court cited the official OECD commentary on permanent establishments in e-commerce (new paragraphs 41.1 - 42.10 on Article 5 of the model treaty, released in December 2000). Whether computer equipment is part of an activity of a preparatory or auxiliary nature is decided "on a case-by-case" basis under the OECD approach (new paragraph 42.7).

Information is disappointingly sparse in the decision on the profits attributable to the permanent establishment, whose existence the court affirms. The court claims that the tax authorities did not contest the taxpayer's profit calculations and states that it likewise has "no concerns" regarding their accuracy. Numerous commentators have argued that, even if a server constitutes a permanent establishment, the profits attributable to it should be low because of its generally minimal relative contribution to value added. Indeed, the new OECD commentary on Article 5 is based on this assumption (see sec. 7 of the introduction to the new commentary).

As noted, the case is now before the Federal Tax Court. Affirmation of the lower court decision is not a foregone conclusion. Reversal is possible both on the issue of whether a permanent establishment exists and on the issue of the profits allocable to it.

This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. KPMG Germany in particular insists that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note that the article is current only through its editorial cut-off date shown immediately above (not to be confused with the later date as of which the article was placed online – the date appearing at the article's outset). Related developments subsequent to the editorial cut-off are not necessarily reported on in later articles. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While KPMG Germany's articles are carefully reviewed, it can accept no responsibility in the event of any inaccuracy or omission. Any claims nevertheless raised against KPMG Germany on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Germany (KPMG Deutsche Treuhand-Gesellschaft AG). No use of or quotation from the article is permitted without full attribution to KPMG Germany and the article's stated author(s), if any. Distribution to third persons is prohibited without the express written consent of KPMG Germany in advance.