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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
One of the most frequently asked tax questions by companies engaged in providing goods or services through e-commerce is whether they will have a permanent establishment (PE) at a location where they establish a data center. Companies particularly nervous about the issue in some countries may even wonder whether they might have a "PE" if they install applications or allow data to be stored on a server owned and operated by an unrelated party. In a recently published ruling (Document No. 2012-0432141R3), the Canada Revenue Agency (CRA) has provided some very useful guidance which describes circumstances under which a data center owned and operated by a Canadian affiliate of a U.S. group will not constitute a PE of the U.S. parent or another group member company.1 The conclusion is consistent with Organisation for Economic Co-operation and Development (OECD) commentary guidance in the area, and hopefully will prove to be a useful precedent not only in Canada but in other jurisdictions where the tax administration may be considering the issue.
The ruling states the relevant facts as follows. The taxpayer, the U.S. parent, operated a business in which users accessed the group's website through web browsers or mobile applications. It appears from the facts as stated in the ruling that the taxpayer monetized its site through sales of advertising shown to the site's users. Advertising content was stored on the servers. Canadian advertisers purchased ads from the U.S. parent. The taxpayer also monetized its site by facilitating the sale of digital content to users, for which it charged the developers of such content a fee. Transaction processing for purchases of both content and advertising was handled through the taxpayer's website hosted in its data center. Another member of the group, a non-U.S. company, also operated in the same manner.
The group operated multiple data centers in various jurisdictions. In general, all software and data were contained in each of the group's data centers. Whether a user would access one or another of the data centers would depend on the user location, current loads in the various data centers, and other factors that the taxpayer used to manage traffic to its various centers.
In the ruling, the U.S. parent proposed forming a new Canadian affiliate (Canco) to acquire land and build the data center. Canco would own the data center building, and own or lease all of the servers and other equipment contained therein. Canco's employees would operate and maintain the physical assets of teh data center. The servers in the data center would host the webpages containing advertising content, and the applications that allow access to and provision of the group's service to users.
The most critical statements of fact relate to what activities with respect to the data center and the website and data hosted in the center were to be performed by Canco employees in Canada, and by employees of the U.S. parent or other group entities outside of Canada.
According to the ruling, Canco employees or contractors would be principally responsible for the installation, operation, maintenance, and repair of the equipment located in the data center. Access to the data center, and other secured areas within the data center, would be restricted to Canco employees. In accordance with the group's protocol in place at each of the group's data centers, employees of the U.S. parent would not have unrestricted access to the Canco data center, but must show identification and will be escorted upon visiting the data center. A small group of site operations employees of the U.S. parent would be authorized by Canco to visit the data center from time-to-time for the purpose of inspection, maintenance, or similar purposes. Canco intended to enter into a contract with the U.S. parent and another member of the group whereby Canco will provide website and data hosting capacity to the U.S. parent and the other member in return for an arm's-length fee.
As is the case with any data center, the website activities could be managed remotely. The ruling notes the following in particular:Applications and data hosted in the Data Centre will be managed remotely by employees of [other group companies] located outside of Canada. Such persons will have the ability to monitor performance of the hardware and software located in the Data Centre, install and uninstall applications, perform maintenance on the hosted applications, and otherwise manage the software and data resident in the Data Centre by remote access.
On the basis of these facts, the CRA concluded that the U.S. parent and the other group company did not have a PE in Canada under Article V of the U.S.-Canada Income Tax Treaty, and the corresponding treaty with the other affiliate's country of residence. The ruling itself does not present a technical discussion of the issue or support for the conclusion. The conclusion, however, is consistent with a proper interpretation of the OECD commentary on e-commerce. The reason this ruling is significant is that some have suggested that the commentary is not entirely clear on the point of whether remote management of data and applications can cause a server to be "at the disposal" of the remote person for purposes of determining a PE. This ruling hopefully will put some of those concerns to rest.
In 2003, the OECD added several paragraphs to the commentary on Article 5 of the OECD Model, which paragraphs deal with e-commerce transactions. The purpose of the new commentary was to answer the question: Does a server constitute a PE? The commentary concludes that equipment, standing alone, could constitute a "fixed place of business." In describing the complete analysis of whether such a place of business could constitute a PE, the commentary expresses several important principles.
First, the commentary distinguishes between the physical items of computer equipment and the nonphysical elements of software and data. Para. 42.2 of the Article 5 commentary states as follows:2Whilst a location where automated equipment is operated by an enterprise may constitute a permanent establishment in the country where it is situated …, a distinction needs to be made between computer equipment, which may be set up at a location so as to constitute a permanent establishment under certain circumstances, and the data and software which is used by, or stored on, that equipment. For instance, an Internet web site, which is a combination of software and electronic data, does not in itself constitute tangible property. It therefore does not have a location that can constitute a "place of business" as there is no "facility such as premises or, in certain instances, machinery or equipment" … as far as the software and data constituting that web site is concerned. On the other hand, the server on which the web site is stored and through which it is accessible is a piece of equipment having a physical location and such location may thus constitute a "fixed place of business" of the enterprise that operates that server.
Second, the commentary notes that some uses of the equipment might constitute preparatory or auxiliary activities. If the only use of the computer equipment is to conduct such preparatory or auxiliary activities, then the computer equipment, while it still may constitute a fixed place of business, does not create a PE on the basis that the business of the enterprise is not carried on through that place. In elaboration of these activities, para. 42.7 of the commentary lists the following activities as representative of preparatory or auxiliary activities:
Finally, the most important point the commentary addresses is when an item of computer equipment might constitute a place of business of the enterprise in the first place. The general rule is stated in para. 4 of the commentary, as follows:
The term "place of business" covers any premises, facilities or installations used for carrying on the business of the enterprise whether or not they are used exclusively for that purpose. A place of business may also exist where no premises are available or required for carrying on the business of the enterprise and it simply has a certain amount of space at its disposal.
As applied to computer equipment, the commentary first notes that when an enterprise uses the services of an internet services provider (ISP) to host the enterprise's site, the enterprise is not likely to have a PE at the ISP location, on the grounds that the enterprise does not have the ISP's equipment and location at the enterprise's disposal. The commentary then goes on to note that a different result may occur when the enterprise is using its own equipment:
However, if the enterprise carrying on business through a web site has the server at its own disposal, for example it owns (or leases) and operates the server on which the web site is stored and used, the place where that server is located could constitute a permanent establishment of the enterprise if the other requirements of the Article are met.
In practice, some have expressed concern that an enterprise that can manage the applications and data on a server from a remote location might have that server "at its disposal," even if the enterprise itself does not own or lease the server. While the literal text of the commentary would appear to require that the enterprise "own or lease" the equipment, as well as "operate" the server, in order to have a place of business at the server location, it has been argued that this text in the commentary is expressed as an example, and thus the fact of remote management of the site might cause a data center to constitute a PE if the nonresident is allowed to exercise sufficient control over the applications and data hosted on the equipment, even in cases where the nonresident entity does not own or operate the equipment. Finally, with respect to the commentary reference to "ISPs" as generally not creating a PE of their customers, it has been argued that the term ISP normally would apply to unrelated parties, not affiliates in a corporate group whose business activity is to host a site that is a core activity of the group. Accordingly, these concerns that remote management might give rise to a PE have been expressed principally in the context of data centers owned by related entities. This is the factual case addressed in the Canadian ruling.
These arguments, however, are not proper interpretations of the commentary. The PE concept is based on a physical location of a place of business in the source state. An enterprise that does not own or lease the data center premises or equipment itself or otherwise have the physical premises at its own disposal, such a fixed place, even if it is able to manipulate from a remote location the applications and data hosted on the server.
The Canadian ruling comes to this conclusion, albeit without expressing the technical discussion in the text of the ruling itself. Nevertheless, this ruling may provide guidance to other tax authorities around the world on how to apply the commentary to similar cases. Despite the significance of this issue in modern commerce, to date there has been little administrative guidance on the point. Rulings or other guidance have been published in New Zealand3 and Australia,4 but those cases either involved an unrelated ISP or in-country equipment that was in fact owned by the nonresident enterprise. A private (unpublished) ruling was given by the Japanese NTA to the Tokyo Stock Exchange (TSE), which was later made public by the TSE, to the effect that equipment owned by a third party located at the TSE premises and used by nonresident traders to effect trades on the TSE would not create PEs of the nonresidents.5 Finally, the U.K.6 and Hong Kong7 tax authorities have indicated as a general principle that they do not treat automated computer equipment, without more, as creating a fixed place of business of the owner.
Putting aside the U.K. and H.K. positions, none of the other rulings dealt with the common situation of a related party formed to hold the data center assets. The Canadian ruling neatly fills that gap, at least in Canada.
The U.S.-Canada treaty now contains a "services PE" provision, which applies in certain circumstances in the absence of a "fixed place of business," where a U.S. company provides services to a Canadian customer generally for 183 or more days in a 12-month rolling period. By issuing the favorable ruling, the CRA accepted the fact that the U.S. parent would not be providing services to Canadian customers that would create a deemed PE under this provision.
While this is an important ruling which should provide clear guidance to groups that need to establish geographically dispersed data centers, there are many other similar situations where more concrete guidance would be useful. For example, many taxpayers would benefit from guidance applying the preparatory or auxiliary interpretation of para. 42.7 of the commentary to edge servers, servers which cache selected content temporarily in order to reduce access times, and similar situations. In those cases, the in-country equipment normally should not constitute a PE, even if the equipment is owned or leased by the nonresident enterprise.
This commentary also will appear in the May 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.
3 Location of web and server sites has few tax implications, Policy Advice Division, Inland Revenue, New Zealand (1/25/01), http://taxpolicy.ird.govt.nz/news/2001-01-25-location-web-and-server-sites-has-few-tax-implications.
4 Ruling 79967 (online subscription service): PE resulted where taxpayer owned and operated servers, but no employees physically present; TD 2005/2 (merchandise sold to Australian customers through an unrelated ISP): no PE.
6 Paragraph 45.5 of the Article 5 commentary contains the following observation: "In relation to paragraphs 42.1 to 42.10, the United Kingdom takes the view that a server used by an e-tailer, either alone or together with web sites, could not as such constitute a permanent establishment"; see also http://www.hmrc.gov.uk/manuals/intmanual/intm266100.htm.
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