India: Concept of Permanent Establishment and Electronic Commerce

Gurram Ramachandra Rao

Today, tax administrations throughout the world face the formidable task of protecting their revenue bases without hindering the development of new technologies. The challenges posed to tax systems worldwide by Electronic Commerce (EC) are real. Numerous governments and fiscal organizations and institutions (e.g. the OECD) are focusing on how to address them in a spirit of collective co-operation. The allocation of taxing rights must be based on mutually agreed principles and a common understanding of how these principles should be applied. In addition to the need for consensus between governments, a need for co-operation between governments and business has also been identified.ⁱ

Changes in business practice due to the advent of EC will affect taxation in the following ways: (i) Lack of any user control as to the location of activity: As the physical location of an activity becomes less important, it becomes more difficult to determine where an activity is carried out, and hence the source of income. (ii) No means of identification of users: In general, proof of identity requirements for internet use is very weak. The pieces of an internet address (or "domain-name") only indicate who is responsible for maintaining that name. It has no relationship to the computer or user corresponding to that address or even where the machine is located. (iii) Reduced use of information reporting and withholding institutions: Traditionally taxing statutes have imposed reporting and withholding requirements on financial institutions, which are easy to identify. In contrast, one of the great commercial advantages of EC is that it often eliminates the need for intermediary institutions. The potential loss of these intermediary functions poses a problem for the tax administration.ⁱⁱ

The principle that a country has the right to tax the business profits of a resident of another country only if that person has a permanent establishment in that country is one of the primary legal principles in international tax law and is a vital provision in international tax treaties. The concept of permanent establishment is essentially a trade-off between source state and residence state jurisdiction to tax. It determines whether an enterprise carried on in more than one country is subject to tax on its business profits only in the country of residence; or if that enterprise is also subject to tax on the same business profits in one or more of the countries in which the business is carried on.

A taxpayer is generally taxed on its worldwide income in the country of its residence (‘residence based taxation’).ⁱⁱⁱ In the case of a company, this is usually the place where the company is incorporated, registered, or has its place of central management and control. A company may also be taxed in another country if it has a recognized source of income there (‘source based taxation’). Generally tax treaties^iv restrict the use of domestic source rules by requiring a certain minimum nexus to allow taxation in that jurisdiction. Thus, taxation of business income on the basis of the source rule requires the presence, in the country of source, of a Permanent Establishment of the enterprise sought to be taxed.

But when it come EC there are lot questioned that are raised. For instance, whether international trading by an enterprise through EC will result in the enterprise creating a taxable Permanent Establishment (PE) in the other countries in which customers are located. The most important aspect here will typically be whether the existence of a web site and server in a country where no employees are located is sufficient to create a taxable PE. A related question would be whether an Internet service provider can be considered to be a dependent agent? Similarly, if an enterprise provides excess server capacity to another business to operate a web site, is equipment (the webserver) considered to have been leased? If it is determined that an enterprise does have a PE in another country, another important issue then arises: How to attribute profits to the PE? Secondly, EC gives rise to new issues concerning the characterization of payments under double tax treaties. It is often difficult to distinguish whether payments for activities such as searching a computer database and downloading a document represent payment for the sale or lease of property, payment for the provision of services, or royalty payments. If double tax treaties strictly follow the OECD model tax convention, the distinction may have little importance as taxing rights will be allocated to the country of residence of the enterprise unless it has a PE in the other country.^v

The concept of permanent establishment was originally developed under Prussian domestic legislation and developed a narrower meaning as the necessity of prevention of double taxation grew among German States^vi Between 1927 and 1946, a number of draft tax treaties, which included variations of the permanent establishment principle, were introduced by the League of Nations but no commonly accepted definition of permanent establishment was established. In 1958, the Fiscal Committee of the Organisation for Economic Co-operation and Development (the "OECD") published its first report with a draft definition of permanent establishment. This draft definition formed the basis for Article 5 of the OECD Model Convention and, with some modification, was also used for Article 5 of the UN Model Convention of 1980.^vii

There are generally three circumstances in which a "permanent establishment" will be found to exist for treaty purposes. The primary rule provides that a permanent establishment exists if there is a fixed place of business through which the business of the enterprise is wholly or partly carried. There are a number of implied conditions that must be satisfied in order to constitute a permanent establishment. If one of those conditions is not met, there is no permanent establishment under the primary rule. Where the conditions of the primary rule are not met, a permanent establishment may be deemed to exist under either a "construction clause" or the "agency clause" in the relevant bilateral tax treaty.

The first question to ask is "What is the difference between the taxation of an Internet-based international transaction and a conventional transaction?" The answer should provide tax administrators with reason for optimism: where a sale results in the physical delivery of goods, there is generally no difference. Shipments must still go through customs, are subject to import duties, and may be subject to income or consumption taxes based on rules that have been around for decades.^viii

The growth of international electronic commerce will undoubtedly pose real—though often exaggerated—difficulties for the administration of national tax systems as they are currently structured. The list of possible issues is a lengthy one, but at least four have been the focus of much recent concern and analysis:

1. Should Internet content be subject to customs duties or new taxes?
2. Is the concept of "permanent establishment" valid in cyberspace and, if so, is the existing definition adequate to ensure that different jurisdictions do not tax the same income?
3. Will electronic commerce increase the incidence of non-compliance with or avoidance of consumption taxes? How will the characterization of intangible products and services affect that trend?
4. Will the ease of conducting business electronically lead to "harmful" tax competition among countries?

But for the purposes of this article we are concerned is with the aspect of permanent establishment.

Tax treaties have created the concept of a "permanent establishment" in order to establish a nexus for local country taxation. The OECD Model Treaty defines a permanent establishment in Article 5 as "a fixed place of business through which the business of an enterprise is wholly or partly carried on." There is a clear attempt to distinguish substantive economic activity, which creates a taxable presence, from mere "preparatory or ancillary" activity; the latter, although conducted through a "fixed place of business," does not create a taxable permanent establishment. Although not free from doubt, the permanent establishment concept, with its requirement of a fixed place of business, tends to lend some certainty to the circumstances in which a foreign person will be subject to tax in a host country. Moreover, as described in the business profits article, Article 7, of the OECD Model Treaty, the income that is sought to be taxed by the host country must be "attributable to" the economic activity of the permanent establishment.

Article 5 of the OECD Model Tax Treaty also distinguishes when, and under what circumstances, the activity within the host country of an agent of the foreign person will establish the requisite nexus to permit direct taxation of the foreign person’s business activities by the host country where there is no "fixed place of business." A foreign person will not have a taxable presence solely by reason of using an agent, regardless of the type of activity carried out on behalf of the foreign principal. Rather, the agent must be "dependent," that is, dependent both legally and economically, on the foreign person. Beyond that, the agent must be able to enter into contracts in the name of the foreign person, which, at least, means that the agent must be able to bind the foreign person to a contract as a matter of local law. If these indicia are not present, the OECD Model Treaty takes the view that the agent is one of independent status and the principal cannot be taxed by reason of using the agent. In such a case, the host country, in effect, is conceding that the taxation of the agent’s income is an appropriate amount of taxing jurisdiction for it to have in the context of the overall transaction.

As noted, no "fixed place" of business is required if the foreign person is using a dependent agent. By requiring that the agent be dependent and conclude contracts in the name of the foreign principle, the dependent agency concept is trying to link taxing jurisdiction to the notion of significant economic activity occurring in the host country in relation to the transaction under scrutiny. Because of its insistence on a "fixed place" of business, the permanent establishment rule should not create taxation for those taxpayers planning electronic commerce transactions with customers in countries where they have no other business activity. For example, selling widgets over the Internet should not, in and of itself, result in a United States company having a permanent establishment in another country; the economic functions creating the income simply would not have occurred in that country.

Nevertheless, there can be no assurance that contemporary international taxation principles lead, inevitably, to such a result. As a practical matter, it can be expected that taxing authorities of net consumers of products and services marketed through Cyberspace will seek out ways in which to tax these transactions. In view of the fact that prior to electronic commerce, most of such transactions would have been readily taxable by the purchaser’s country, at least to some extent, under traditional principles, because the seller would need to have distributors within the country to market and sell its products or services there.^x Reaching for such a position, taxing authorities will seek to develop analogies and analyses that relate electronic commerce transaction flows to fixed places of business that can be found "in-country." In this regard, attention needs to be drawn to two potential "hooks" upon which a finding of permanent establishment existence could be supported. First, there is the issue of whether the geographic presence of a server with the relevant Web site is adequate to create a permanent establishment. Second, there is the issue of whether the ISP creates a dependent agency permanent establishment for the foreign merchant.

The Commentary to the permanent establishment article of the OECD Model Treaty has something arguably applicable. Paragraph 10 of the Commentary on Article 5 contains a discussion of the circumstances under which activities conducted through automatic equipment such as "gaming and vending machines and the like" may constitute a permanent establishment. In these cases, a permanent establishment may exist if "the business of the enterprise is carried on mainly through automatic equipment, the activities of the personnel being restricted to setting up, operating, controlling, and maintaining such equipment."^xi

The key factor, according to the Commentary, is "whether or not the enterprise carries on a business activity other than the initial setting up of the machines." The Commentary suggests a "facts and circumstances" approach:

A permanent establishment does not exist if the enterprise merely sets up the machines and then leases the machines to other enterprises. A permanent establishment may exist, however, if the enterprise which sets up the machines also operates and maintains them for its own account. This also applies if the machines are operated and maintained by an agent dependent on the enterprise.^xii

Clearly, as the nation most likely to be selling to foreign customers through servers based abroad, India should maximize its taxing jurisdiction by adopting a policy that a server geographically present in a country does not create a permanent establishment. It is also possible to see how other countries, whose tax revenues may be perceived to be threatened, could look to the OECD Commentary for some support, at least by analogy. Nevertheless, as mentioned earlier, ultimately an attempt to treat a server as a taxable permanent establishment must fail, in the face of the ease with which the server with the Web site can be relocated offshore.^xiii

In late 1999, the OECD’s Working Party No. 1 on Tax Conventions and Related Questions released a discussion draft of comments ("OECD Draft") that would clarify the definition of permanent establishment in Article 5 of the OECD Model Treaty. In that document, the authors distinguish between a Web site, which consists of computer programs and data, and computer equipment on which the Web site is hosted. The OECD Draft proposes that a Web site, without more, cannot create a permanent establishment because it has no "fixed place." However, if the Web site owner owns or leases the server on which the Web site resides, the combination of the two can create a "fixed place of business" for purposes of Article 5.^xiv

Under the OECD Draft, the fact that the Web site is hosted on a server owned and operated by an ISP is not enough to analyze the situation as combining the Web site and the server. Moreover, the OECD Draft notes that even in the case where the server is owned/leased by the Web site provider, the server must remain in one place long enough to become "fixed" for purposes of Article 5.^xv Finally, the OECD Draft states that even where a "fixed place of business" exists, a permanent establishment will not exist if the activity conducted through the computer equipment is "preparatory or auxiliary." Unfortunately, the OECD Draft offers only vague guidance on this point, directing the reader to a "facts and circumstances" analysis.^xvi

Moreover, there is the issue of whether the ISP providing a server creates a "dependent agent." Where the Web site accepts orders after, in effect, establishing all the terms of the sales or services contract with the customer through interactive, but pre-programmed, decision software, and then, again automatically, directs the shipment of the goods or the provision of the services, a basis may exist for analogizing the ISP’s server to an agent of the nonresident seller. Arguably, however, the ISP should be an "independent agent." In the typical case, the ISP will be analogous to an independent broker with myriads of "principals" with respect to any one of whom it is not dependent either legally or economically. Beyond that, the computer programs that operate to engage in the transaction probably have been created and installed on the Web site (and thus the server) by the foreign merchant, itself, and not by the ISP; accordingly, it cannot be said that it is the ISP that is entering into contracts in the name of the foreign merchant, although it may provide the equipment--the server--that enables this to occur.

The OECD Draft essentially agrees that a typical ISP cannot provide a "dependent agency" permanent establishment with respect to the provider of the Web site. More importantly, the OECD Draft is conclusive that the Web site itself cannot be a dependent agent. This is because a dependent agent must be a "person," according to the OECD Model Treaty, and a computer program, no matter how sophisticated, is not a "person."

ISPs providing online or database services in their own right may themselves be treated as having a permanent establishment where they actively provide such services, e.g., America OnLine’s extensive organization of electronic information and provision of "front end" entry into the Internet, particularly if those activities are classified as "services" for tax purposes. By contrast, if the activities are treated as the sale of property, the ISP can argue that it does not have a permanent establishment, but merely a facility used "solely for the purpose of storage, display or delivery of goods."^xvii

As the OECD Draft concludes, a Web site, alone, should not qualify as a "fixed place of business." As noted, it is, by its nature, ephemeral, a collection of electrons organized into bits of data. It can be moved from one server to another with great ease. Thus, it does not have the "permanence" envisioned by the concept of a "fixed place of business." One is tempted to apply the analogy of the tax treatment of sales through a mail-order catalog to electronic commerce transactions through a Web site. At first blush, this seems an extremely apt analogy; some Web sites don’t arise to much more than a listing of products coupled with an order form. In those cases, the Web site isn’t much more than an electronic catalog, advertising products and soliciting sales. However, as electronic commerce becomes more interactive, customers will, in effect, be inquiring about specific products and terms of sale, and the transaction looks less and less like a purchase from a mail order catalog. As one commentary has put it:

Computers and telecommunications equipment at present, and in the future, may do more than routinely execute commands. This equipment may perform credit checks, enter into purchase and sales agreements and perform other functions that, if performed by individuals located in the United States, would be found to comprise a U.S. trade or business and permanent establishment.^xviii

Clearly, the technology and the marketplace that takes advantage of it are going to present challenges to the simple adaptation of traditional permanent establishment concepts to the world of electronic commerce. The OECD Draft has already been criticized for not addressing a number of the issues surrounding its general principles.^xix

The shift in business models to incorporate electronic commerce, as well as the constant use of Internet as a means of business attracted the attention of both private sector tax professionals and government tax authorities. Corporate tax executives recognized several years ago that e-commerce would create both compliance challenges and planning opportunities while tax authorities became concerned that the freewheeling, jurisdiction-blind nature of e-commerce would erode their tax bases. The current general consensus among business tax professionals is that existing tax rules can accommodate e-commerce transactions and therefore the compliance challenges will be resolved and planning opportunities will be pursued in the normal course of business. While tax authorities also tend to agree that existing tax rules can be applied to e-commerce, they are not yet convinced that they have identified all of the potential chinks in their armor and quantified the related potential loss of tax revenue. This uncertainty continues to fuel a significant policy debate on the taxation of e-commerce at the international, national and sub-national levels. ^xx

Electronic commerce may pose problems for the definition of permanent establishment that existing tax treaties do not address. The most obvious question concerns the ability to access a Web site from within a particular taxing jurisdiction. Does the fact that consumers can place orders through a foreign firm’s Web site subject that firm to income taxes in the country where the customer lives? The answer to that question is almost certainly "no." A Web site has no physical presence, and thus cannot be considered as a permanent establishment in any meaningful sense. To say that the ability to access a Web site, without some other more substantial contact, is sufficient to create permanent establishment is to say that online businesses are liable for income taxes in every country where their customers happen to reside. Such a broad definition would be virtually useless. If anything, the ability to access a foreign Web site is a lesser degree of contact than is the solicitation of orders via catalog or telephone. Under existing tax principles, mere solicitation does not create a permanent establishment. That principle should not be abandoned—and indeed should be clarified—with regard to electronic commerce.

A second, more complex question concerns the location of computer file servers: should the mere presence of a server in a particular taxing jurisdiction be considered sufficient contact to create permanent establishment? Again, the best answer to that question is "no." In most cases, the existence of a foreign-owned server does not require employees to be present in the host country—traditionally a prerequisite for permanent establishment. But even when a business maintains its own server through its own employees, the level of contact with the host country would rarely rise above the "storage, display, or delivery of goods" standard that exists in the OECD Model Tax Convention. Following the OECD’s guidelines, most tax treaties do not consider facilities that are used in that manner as a permanent establishment. A computer file server is essentially used for exactly the same purpose.

There are additional reasons why an in-country file server should not be defined as a permanent establishment, not the least of which is Article 5 of the Model Treaty. Article 5 has generally been interpreted to exclude mail-order activities as insufficient to create permanent establishment. Functionally speaking, a Web site that displays product information and takes orders from customers is the equivalent of an electronic catalog and should thus receive the same tax treatment as postal solicitations.

Another more practical problem is that defining servers as permanent establishments will open the door to tremendous complexity in the allocation of income between competing jurisdictions. It is all but impossible to determine the income attributable to any one server, and many Web sites are housed on multiple servers located throughout the world. Apart from the jurisdictional headaches, the location of a server is simply not a good proxy for where economic activity takes place and would therefore be a largely arbitrary tax standard.

Finally, countries that do not tie tax strings to the placement of servers within their borders will clearly benefit from increased server presence as companies seek the best treatment available. Because the location of a server is irrelevant from a technical standpoint, shifting servers would be an irresistible way to minimize liabilities. Indeed, tax advisors are already telling their foreign clients that in order to "avoid the possibility of an inadvertent permanent establishment in the India, [they should] use a Web server located outside of the India," which suggests India should clarify its position on the issue.^xxi Despite this reality, tax authorities in several countries and at least one OECD discussion paper have indicated that the presence of a server might be sufficient to create permanent establishment.^xxii

Regardless of what individual governments decide to do, the classification of computer servers as permanent establishments is not likely to survive without an international agreement^xiii The borderless nature of electronic commerce means that countries which make taxation contingent upon Web server location will encourage the migration of servers beyond their borders. Few governments would be willing to adopt such a policy unilaterally. An example of such policy competition can seen within the United States, where some states have been thwarted from taxing based on server presence by others that have disavowed that tactic.

The notion of a "permanent establishment," as embodied in tax treaties, is a crucial one. Where the concept is applicable, one treaty partner relinquishes its jurisdiction to tax the business profits of residents of the other treaty partner unless local activities rise to a certain threshold, i.e., unless they amount to a permanent establishment. Thus, the purpose of the permanent establishment concept is to define when a nonresident has established sufficient presence in a jurisdiction so as to warrant direct taxation of his business profits there. When a taxpayer’s presence is not sufficient (i.e., when no permanent establishment exists), source-based taxation is ceded in favor of residence-based taxation.

The development of electronic commerce (EC) has revolutionized the way businesses operate. It has also challenged the adequacy and fundamental validity of principles of international taxation such as physical presence, place of establishment etc., that have formed the basis for assessing tax liability.

With the advent of EC, even smaller corporations and individuals can aspire to have a global presence. Correspondingly EC has also bridged the gap between developed and developing countries. It has therefore become extremely essential to provide a legal and tax environment that is conducive to the growth and development of these technologies. The implications of the growth of EC on domestic and international tax systems has already been felt and considerable work on this subject has already been done by countries like U.S., U.K., Australia, Canada etc. They have identified the issues arising out of EC and have attempted to lay down the fundamental principles of taxation of EC. Most countries have advocated principles of neutrality, certainty, avoidance of double taxation and low compliance cost. This paper has examined the positions taken by these countries and other multilateral agencies like the Organization for Economic Co-operation and Development (OECD) in order to identify the options available for Indian tax authorities.

A substantive issue raised by these technologies is identifying the country or countries, which have the jurisdiction to tax such income. Whether a web server and an Internet Service Provider (ISP) will constitute a Permanent Establishment (PE) or not are questions which have been haunting policymakers. The traditional concept of source-based taxation may lead to a global migration to low tax or tax haven countries. Any attempt to artificially tax E-commerce will also accelerate such migration. Therefore residence-based taxation is being advocated by many countries, with the U.S. being one of its main proponents. However, determining residence itself is likely to be problematic.

Classification of income arising from transactions in digitized information, such as computer programs, books, music, or images is also an issue that requires consideration. The distinction between royalty, sale of goods, and services income must be refined in the light of the ease of transmitting and reproducing digitized information.