INSIGHT: Digital Permanent Establishment: Where Are We Now? (Part 1)

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By Annabelle Bailleul-Mirabaud and Céline Pasquier

The traditional concept of “permanent establishment” was born in the era of brick and mortar companies and relied on their physical presence in a given state to trigger the taxation of their activities performed there.

As pointed out by the Organization for Economic Co-operation and Development (“OECD”) (OECD report “Addressing Base Erosion and Profit Shifting” published February 12, 2013), the digitalization of the economy puts pressure on this concept, as nonresident taxpayers can derive substantial profits from transactions with customers located in another country without having a substantial physical presence or a dependent agent in such country—thus without having a taxable presence there.

In addition, the digitalized economy relies to a certain extent on users to contribute to value creation, and also relies heavily on intangible assets and on data collection, processing and use.

Initiatives to Address Digital Permanent Establishment

As a result, initiatives emerged at both domestic and multilateral (OECD and European Union, “EU”) levels to capture the digital economy business models through the broadening of the traditional permanent establishment (“PE”) concept, resulting in the emerging concept of “virtual PE,” or “digital PE.”

Country Level Initiatives

Some countries unilaterally implemented legislation addressing the concept of digital PE. The most advanced countries are Israel, India and the Slovak Republic.

Israel is a way ahead of India and the Slovak Republic, as it introduced a circular in 2016 on “significant economic presence” which is in force and applies to digital products and services.

Building on the same concept, India introduced the “significant economic presence” in its law. This should become applicable as from April 1, 2019.

In the Slovak Republic, an expanded definition of the fixed place of business was introduced to address facilitation of conclusion of contracts through an online platform (for services of transportation and accommodation).

Other initiatives were adopted in various countries consisting in either a diverted profit tax (U.K., Australia) or equalization taxes (India and Italy).

Considering that all these initiatives are domestic, they should only apply with non-tax treaty jurisdictions. For this reason, a multilateral solution is being looked for: the digital PE concept is under discussion and is a work in progress for both the OECD and EU.

OECD: Where does it Stand?

The OECD dedicated the first action of its anti-Base Erosion and Profit Shifting (“BEPS”) Action Plan to the tax challenges arising from digitalization. In its Final Report dated October 5, 2015, the OECD identified several routes to address the taxation issues raised by the digital economy business models, including a new “nexus” definition relying on significant economic presence.

However, no recommendation was issued in this respect.

Building on its 2015 Final Report, the OECD released its Interim Report on Action 1 on March 16, 2018. The Interim Report points out that (other) OECD BEPS Actions have led enterprises to modify their business structures “to improve alignment with their real economic activity.”

However, the BEPS package may not be sufficient, and the international tax system will need to be further adapted. The Interim Report analyzes the coverage of the BEPS package, the digital business models implemented, and contemplates a better understanding of the value contribution of certain aspects of digitalization.

The OECD would carry out further work on the amendment of the “nexus” criteria for the characterization of a PE and on profit allocation rules applicable to the digital economy, in order to recommend a long-term multilateral solution.

A new Report should be released in 2020 and a first update should be provided in 2019.

On March 16, 2018, more than 110 countries confirmed their support for this initiative in the context of the Inclusive Framework on BEPS. The aim is to build a consensus-based solution.

Tax Challenges Indirectly Addressed through BEPS Actions

To date, the tax challenges raised by the digitalization of the economy have indirectly been partly addressed by the OECD through other Actions of the BEPS package in relation to transfer pricing and to the broadening of the general PE definition (i.e., not specifically focused on the digital economy, but with an effect on it).

On the transfer pricing side, reference to the “development, enhancement, maintenance, protection or exploitation” (“DEMPE”) of intangibles has been included in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Transfer Pricing Guidelines”) in order to determine which entity is entitled to the profit derived from intangible ownership (Actions 8 to 10 on Aligning Transfer Pricing Outcome with Value Creation and Action 13 on Transfer Pricing Documentation).

On the PE side, the OECD Final Report on Action 7 “Preventing the Artificial Avoidance of Permanent Establishment Status” dated October 5, 2015, recommended amendments to the PE definition in double tax conventions which are intended to be implemented further to the signature of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (the “MLI”) on July 6, 2017.

Amendments to the traditional PE definition notably include the introduction of an anti-fragmentation rule to allow characterizing a PE in case of exercise of several preparatory and auxiliary activities (which on a single basis do not allow characterizing a PE) that are part of a cohesive business operation in a same country.

As a result, in the context of the digital economy, this means that where an online platform has warehousing delivery, merchandising and information collection activities allocated among two sites in a same country, it would have a PE where the warehouse and office business activities of the company would constitute complementary functions that are part of a cohesive business operation.

In addition, in order to address the artificial avoidance of PE status through commissionaire arrangements, the dependent agent PE notion is broadened so that a PE shall be characterized not only in case of conclusion of contracts in the name of a foreign enterprises, but in all cases where

“[a] person habitually concludes, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise and these contracts are in the name of the enterprise, or for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or for the provision of services by that enterprise […]”.

This may enable the tax authorities to tackle, for example, online advertising pre-sales structures where such structure would habitually play the principal role leading to the routine conclusion of sales by the foreign company to customers in the other country without material modification of the terms and conditions on which the customers offer to purchase the advertising space (OECD Additional Guidance on the Attribution of Profits to a Permanent Establishment dated March 22, 2018).

The signature of the MLI is to lead to the implementation of PE amended clauses in all covered tax treaties, but it is subject to reservations made by countries, notably on the implementation of PE clauses. For instance, Ireland and Luxembourg reserved the right not to apply the entirety of the commissionaire and anti-fragmentation clauses in their covered tax treaties.

Still, the MLI PE amended rule may be implemented at a later stage in the context of the renegotiation of an existing tax treaty. While Luxembourg had reserved its application of the commissionaire amended clause and the anti-fragmentation rule, the double tax treaty renegotiated between France and Luxembourg has overcome this restriction and the two rules have now been introduced in the revised double tax treaty signed by France and Luxembourg on March 20, 2018.

In parallel to the negotiation of the MLI and potential reservations that could be made by the various states on the implementation of PE clauses which could have an impact on the digital economy, the OECD pursued its study of the digital economy and of the digital PE. As mentioned above, this should lead to new recommendations from the OECD by 2020.

Reinforced by the work of the OECD, but with the willingness to move at a quicker pace, the EU is now one step ahead; its approach will be discussed in detail in part 2 of this series.

Annabelle Bailleul-Mirabaud is a Partner and Celine Pasquier is an Associate with CMS Bureau Francis Lefebvre Avocats, France

They may be contacted at:;

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