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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
In a commentary written three years ago,1 I reported on a ruling released by the Canada Revenue Agency (CRA) dealing with the permanent establishment (PE) analysis of a data center owned and operated by a related party in the context of an OECD-based treaty. As noted in my prior commentary, the ruling was notable in that it was the first publicly available ruling to conclude that hosting services provided by a related entity did not create a PE for the nonresident affiliate supplying digital services into the jurisdiction where the data center was located. As is normally the case with CRA rulings, however, the text of the ruling did not contain a detailed technical discussion of the issue to support the conclusion.
SKAT, the Danish tax authority, has now issued a ruling2 on the same issue and reaching the same conclusion, but the SKAT ruling contains a more complete technical discussion of the relevant authorities. This ruling now is the most complete expression in the public domain of the technical reasons why a separate entity that owns and operates data center assets, and provides hosting services to an affiliated nonresident entity that supplies the digital goods or services to the market, does not constitute a PE of the nonresident entity.
The facts describe a common situation in multinational groups, both those supplying digital goods and services, and those that use internet communications to support deliveries of other goods and services. In this case, the nonresident entity supplied digital services into Denmark and other countries from a regional base. In order to reduce latency for Danish and other users, the group proposed to establish a data center in Denmark. The data center assets were purchased (or leased) by a Danish affiliate established to own (or lease) and operate the equipment. That affiliate employed personnel and engaged independent contractors as necessary to provide local operational control over the assets. Those personnel were responsible for day-to-day management, including installation, operation, maintenance, and repair of the equipment located in the data center, janitorial services, and security.
As is always the case with multinational groups that operate networked equipment across the globe, network operations personnel outside of Denmark could access the data center remotely for purposes of managing the website, applications, content, and data hosted in the data center. Network operations personnel had the ability through remote access to monitor performance of the hardware and software located in the data center, install and uninstall applications, perform maintenance on the hosted applications, and otherwise manage the software and data resident in the data center. In case of a malfunction or other required maintenance of a server, remote engineers could power down the server and redirect data traffic to other servers. The taxpayer represented that this sort of remote access is a feature of data center architecture generally, and was not unique to the Danish center.
As in the Canadian ruling, the taxpayer made representations regarding physical access of the nonresident's employees who may visit the data center premises. Employees would not visit the Danish data center premises on other than an occasional and temporary basis, would have limited physical access to the data center premises, and would be escorted when visiting the data center.
In supporting the conclusion that these arrangements do not give rise to a PE of the nonresident digital services supplier, the SKAT ruling provides a detailed technical discussion grounded on the OECD Model Tax Convention (OECD Model) and its Commentary.
The SKAT ruling commenced the technical analysis by referencing important principles that are too often ignored by some tax authorities today, namely, that a PE analysis proceeds on a strict separate legal entity basis, so that the question of the existence of a PE under OECD Model Art. 5(1) of a particular nonresident entity must be based on whether that entity, and not an affiliate, has a fixed place of business in the jurisdiction. The ruling referenced Art. 5 Commentary which states that even the fact that the trade or business of a subsidiary is managed by the parent company does not entail that the subsidiary constitutes a PE of the parent.3 The ruling then referenced further Commentary which notes that, as a general rule, an affiliate rendering services to the nonresident does not create a PE of the nonresident, even if the affiliate's activities provide an economic benefit to the nonresident.4
Setting the groundwork by referencing the general principles in the Commentary makes an important connection between those general principles and the more specific guidance in the Commentary describing data center activities. The Commentary guidance which is specific to data center activity is thus seen in context as a logical application of the general principles. The SKAT ruling quotes in full the Commentary passages specific to data centers, in particular the Commentary that notes that data, software, or a website itself cannot constitute a fixed place of business,5 as well as the following passage dealing with data center assets:The distinction between a web site and the server on which the web site is stored and used is important since the enterprise that operates the server may be different from the enterprise that carries on business through the web site. For example, it is common for the web site through which an enterprise carries on its business to be hosted on the server of an Internet Service Provider (ISP). Although the fees paid to the ISP under such arrangements may be based on the amount of disk space used to store the software and data required by the web site, these contracts typically do not result in the server and its location being at the disposal of the enterprise (see paragraph 4 above), even if the enterprise has been able to determine that its web site should be hosted on a particular server at a particular location. In such a case, the enterprise does not even have a physical presence at that location since the web site is not tangible. In these cases, the enterprise cannot be considered to have acquired a place of business by virtue of that hosting arrangement. 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.6
Finally, SKAT reviewed other rulings that have been issued by various tax authorities germane to the question of when a nonresident might have data center premises at its disposal. That review included references to prior SKAT rulings, guidelines from the United Kingdom that a server cannot as such constitute a PE, the Canadian ruling discussed in my prior commentary, and a Swedish private ruling. While the text of the SKAT ruling simply described those other authorities without comment, it seems fair to assume that SKAT considered that those other authorities supported its conclusion in the ruling at hand.7
Turning to its reasoning, SKAT stated in the ruling that the nonresident could have a fixed place of business only if the nonresident exercised control over the servers as if the nonresident "de facto owned or operated the servers" in the data center. The ruling concluded that the nonresident did not exercise such control, on the basis that the nonresident did not issue day-to-day instructions to the Danish employees nor supervised their work, and that the nonresident entity employees did not have unrestricted physical access to the data center premises. Further, SKAT concluded that the nonresident did not exercise control in a way that the nonresident could be considered as "operating" the servers.8
The Commentary guidance in ¶42.3 notes that a PE of the nonresident could arise when the nonresident has equipment "at its own disposal," giving as an example when the nonresident "owns (or leases) and operates the server." It usually is fairly easy to determine which legal entity owns the equipment. The concept of "operating" the equipment is a much more ambiguous term. It is important to note, therefore, that the SKAT ruling concluded that this case where the nonresident's network operations personnel had remote access to the data centers did not constitute the "operation" of the data center assets by the nonresident. SKAT came to this conclusion even after noting that only employees of the nonresident could access the servers, who therefore enjoyed exclusive (remote) access to the data center equipment.
SKAT thus addressed directly the key issue in this scenario: whether the remote access by network operations personnel of the nonresident could cause the data center equipment or premises owned by an affiliate to be regarded as "at the disposal" of the nonresident.
This ruling represents the most complete examination to date of the issue of whether a related entity providing data hosting services to an affiliate creates a PE under OECD Commentary principles. The ruling connects the general guidance in the Commentary regarding related-party service functions to the specific guidance dealing with servers, and includes a survey of relevant guidance from other tax authorities. Given the current international tax environment for internet-enabled enterprises, it can be expected that many groups will seek the certainty of advance rulings on this issue. One can hope that other tax authorities will consider SKAT's comprehensive technical analysis on this point as persuasive.
This commentary also appears in the July 2016 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, Nauheim and Scott, 938 T.M., U.S. Income Tax Treaties — Income Not Attributable to a Permanent Establishment, Emmeluth, 959 T.M., Business Operations in Denmark, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively-Connected Income, ¶7160, U.S. Income Tax Treaties.
4 Art. 5 Commentary, ¶42. The SKAT ruling notes that the taxpayer in its technical submission also referred to an OECD Discussion Draft dealing with the "at the disposal" issue produced as part of a recent project to update the OECD Model Art. 5 Commentary. This project did not result in amendments to the Art. 5 Commentary, as the project was put on hold as the BEPS project consumed the full attention of Working Party 1. Examples in that Discussion Draft, however, are also consistent with the general principles cited in the ruling. See 2012 Discussion Draft available at http://www.oecd.org/ctp/treaties/PermanentEstablishment.pdf, pp. 6-7.
7 For the U.K. guidance, see INTM266100. The Swedish ruling kicked off a complex administrative appeal process, which ended up with Sweden's Supreme Administrative Court annulling the ruling based on insufficient facts being described in the ruling.
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