By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
This commentary reports on a remarkable decision from the Central Tax Court in Spain that a nonresident company may be subject to Spanish direct income tax on income derived from sales though a website hosted outside of Spain based on the theory of a "virtual" permanent establishment (PE). This theory, if upheld, would have dramatic implications for enterprises selling cross-border using internet-based channels. The taxpayer has appealed the case to the Audiencia Nacional (the first level of judicial court in the Spanish court system). The case was decided several months ago, but only now has been made public.1
The case involved sales into Spain by an Irish member of the Dell Computer group, Dell Products Limited (DPL). Readers may recall that DPL has had its share of international tax controversy lately, as it was the entity that the Norwegian tax authorities asserted had a PE in Norway under the Norway-Ireland Income Tax Treaty by virtue of the commissionaire relationship between DPL and its Norwegian affiliate. DPL eventually prevailed in that controversy, but it took appeals all the way to the Norwegian Supreme Court to achieve that result.2
In the Spanish case, the tax authorities argued, and the court accepted, that DPL had a Spanish PE on several different theories.3 The virtual PE theory, however, was the most extreme. The theory of the virtual PE was based on two factual elements. First, DPL sold goods into Spain through a website focused on the Spanish market. Second, DPL's Spanish affiliate Dell Espan˜a SA (DESA) employed persons who translated the web pages, reviewed content, and otherwise administered the site. The court also noted that DESA owned the .es domain name, although the case report is not clear as to how much significance the court placed on that point. On those facts, the court concluded that DPL had Spanish tax nexus under the Spain-Ireland Income Tax Treaty despite the absence of any other actual physical presence of DPL in the country.
In discussing the virtual PE issue, the court first cited the December 22, 2000 report of the Committee on Fiscal Affairs of the Organisation for Economic Co-operation and Development (OECD), entitled "Clarification on the Application of the Permanent Establishment Definition in E-Commerce: Changes to the Commentary on the Model Tax Convention on Article 5."4 This document released the final text of new Commentary dealing with e-commerce, contained in paragraphs 42.1-42.10 of the Article 5 Commentary.
This new e-commerce Commentary resolved several issues which had been debated by Working Party 1. The most vigorously debated issue at the time was the question of whether an enterprise that maintained computer equipment at a source state location could have a PE absent the presence of personnel at that location.
The new Commentary resolved that debate by stating that the presence in a State of computer equipment that is owned and operated by a nonresident can create a fixed place of business PE under Article 5(1), even if the nonresident does not have personnel physically located at that place of business. 5 More importantly, the Commentary also states unequivocally that a PE cannot be created by a website alone, as a website is not tangible property and thus cannot have a location that can constitute a fixed place of business.6 The Commentary also is clear that the mere presence of equipment alone is not sufficient to create a PE. The equipment may constitute a "fixed place of business," but for that fixed place to constitute a PE the business of the nonresident enterprise must be carried on through that fixed place. In general, that inquiry will boil down to whether the activities carried on through the computer equipment would be regarded as preparatory or auxiliary. The Commentary provides a list of representative activities which generally would be regarded as preparatory or auxiliary, including "providing a communications link" or "relaying information through a mirror server."7 In contrast, if the functions performed through the computer equipment "form an essential and significant part of the business activity of the enterprise as a whole, or where other core functions of the enterprise are carried on through the computer equipment," then the nonresident will be regarded as having a PE on the basis that it is engaged in business through the fixed place.8 The Commentary provides as an example the case of an "e-tailer" that performs typical functions related to a sale at that location.9
Under the facts of the case in front of the Central Tax Court, DPL had no actual physical presence in Spain. The computer equipment that hosted the Spanish-oriented site was located outside of Spain. DPL had no employees located in Spain. The Central Tax Court, nevertheless, found a "virtual PE" by reference to the e-commerce Commentary. Its interpretation of that Commentary, however, was gravely flawed.
The court started its analysis by stating that human intervention by the nonresident enterprise is not necessary to create a PE. For that proposition, it stated that it was guided by the new e-commerce Commentary. As noted above, however, the Commentary addressed the question whether human intervention, in addition to the presence of computer equipment in the source State, was a necessary prerequisite to finding a PE. Despite that context, the court referred to the Commentary to support the conclusion that "a permanent establishment may be fully automatic."10
Second, even though the court concluded that human intervention is not necessary to create a PE, the court endeavored to find some local contact on which to justify the PE. In DPL's case, the court concluded that the PE was based on the presence in Spain of staff of DESA dedicated to the Spanish website, in particular work involved in the maintenance of the website, and translation and review of content on the website. The court stated its conclusion as follows:Consequently, in accordance with the foregoing, the claimant enterprise has staff in Spain dedicated to the website for the Spanish market and this determines the existence of a permanent establishment, where there is no need for presence in Spain of a server operated directly by the company.
The court thus pointed to employees of DPL's Spanish affiliate as the justification for finding "virtual" PE of DPL.
The court then turned to paragraph 42.2 of the e-commerce Commentary which expressly notes that a website alone cannot create a PE, on the basis that a website is not tangible property and thus cannot constitute a "fixed place of business." The court acknowledged that the e-commerce Commentary limited PEs to cases where the nonresident enterprise operated in the source state the server on which the website is hosted. In response to that language, the court referred to observations which Spain had included in the 2003 and 2005 versions of the Commentary. In those two versions of the Commentary, Spain's observation in paragraph 45.6 read as follows:Spain and Portugal have expressed a number of reservations on the Report "Clarification of the permanent establishment definition in e-commerce." Greece, Spain and Portugal have some doubts concerning the opportunity of introducing paragraphs 42.1 to 42.10 of the Commentary in the Model at this time. Since the OECD continues the study of e-commerce taxation, these States will not necessarily take into consideration the aforementioned paragraphs until the OECD has come to a final conclusion.
This observation was not particularly clear as to which elements of the e-commerce Commentary Spain was not yet prepared to accept. A clearer statement appeared in the introductory text in the December 22, 2000, OECD document. There, the OECD reported that:… Spain and Portugal do not consider that physical presence is a requirement for a permanent establishment to exist in the context of e-commerce, and therefore, they also consider that, in some circumstances, an enterprise carrying on business in a State through a web site could be treated as having a permanent establishment in that State. That is the reason why Spain and Portugal look forward to the results of the work of the TAG on Monitoring the Application of Existing Treaty Norms for the Taxation of Business Profits in the Context of Electronic Commerce … as regards the issue of whether changes to the definition of permanent establishment should be made to deal with e-commerce.
The TAG issued its final report in June 2004. The TAG concluded that creating nexus for a nonresident enterprise without an actual physical presence in the State based on a "virtual PE" would require a fundamental modification of the existing PE standards, and should not be pursued by Working Party 1. Spain was one of the OECD member countries which participated in the TAG's deliberations.11
The court referred only to the observations in the 2003 and 2005 versions of the Commentary. In the 2010 version, Spain removed its observation. The court did not mention that fact, but apparently the withdrawal did not diminish the effect of the withdrawn 2003 and 2005 observation in the court's view.12
Once the PE was established, the next step to determine the actual tax liability is to attribute profit to the PE. On profit attribution, the court accepted the tax authority's argument that all revenue derived from the Spanish market from sales through the website should be attributable to DPL's deemed PE. The court then addressed which expenses of DPL could be allocable to that income. The effect of that approach to PE profit attribution is that all net income derived from the relevant market in the books of the principal would be allocable to the PE, assuming that 100% of the allocable expenses incurred by the principal were treated as deductible expenses of the PE. This approach clearly is not consistent with the authorized OECD approach of conceptualizing the PE as a separate and distinct enterprise from the head office, and determining the profits attributable to the PE by reference to deemed transactions between the PE and the head office.
As noted, the taxpayer has appealed this case to the Audiencia Nacional. The decision is remarkable on many fronts, but the most startling element of the decision is the adoption of the "virtual PE" theory based on a website focused on sales into Spain and local website administrators, and relying on a tortured interpretation of the Commentary.
It is easy to imagine the implications of this theory, should it not be overturned on appeal. Nonresident sellers into the Spanish market would be exposed to direct income taxation, if their business is supported by personnel of a Spanish affiliate who provide services for the management of the website. This would represent a huge extension of the power to tax nonresident enterprises that in fact do not maintain actual operations within the State. One can only hope that a higher court will reverse the Central Tax Court decision.
This commentary also will appear in the January 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, and Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties - U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶7130, Foreign Persons - Effectively Connected Income, and ¶7160, U.S. Income Tax Treaties.
1 Ruling of Mar. 15, 2012, R.G. 2107-07.
2 The lower court decision in that case was described in "Applying (and Misapplying) the OECD Commentary in Commissionaire PE Cases," 40 Tax Mgmt. Int'l J. 423 (7/8/11).
3 The court also concluded that a PE existed on fixed place of business and dependent agent theories, relying on various activities of employees of DPL's Spanish affiliate to support those theories.
5 Art. 5 Commentary, para 42.6.
6 Art. 5 Commentary, para 42.2.
7 Art. 5 Commentary, para 42.7.
8 Art. 5 Commentary, para 42.8.
9 Art. 5 Commentary, para 42.9.
10 All translations in this commentary are informal.
12 The court followed an inconsistent approach to the notion of an ambulatory Commentary in this case. In the discussion of the "fixed place of business" analysis in the section of the opinion not dealing with the virtual PE theory, the court embraced the ambulatory Commentary in order to refer to the most recent version of the Commentary. In contrast, in the case of the virtual PE, the court referred to older versions of the Commentary, which included the observation that subsequently was removed.