BONUS CONTENT: Permanent Establishments and Digital Tax

“Nexus” is one of the loveliest tax words. (Although my favorite is still “maquiladora.”)

It’s a little vague and imprecise in the corporate/international tax space, however. It’s used as a term for the activities necessary in a given jurisdiction for a foreign enterprise to have a taxable presence there. But the related technical legal definition is the much less elegant “permanent establishment.”

It is nevertheless one of the most fascinating areas in international taxes, that remains one of the hottest and most disputed topics. In today’s evolving and largely digital economy, when are you actually there in a jurisdiction, to an extent that you have income which the local authority can tax? Is it just a matter of declaring that every business is present whenever an Internet browser can be accessed, and it’s all about correct apportionment? Is the presence of physical attributes still relevant? (If it’s relevant for determining economic substance, why not a P.E.?) Is there some middle ground that everyone can agree to?

Permanent establishments are mainly a creation of bilateral tax treaties, which are modeled by guidelines written by the Organization for Economic Cooperation and Development. Which means this is clearly the OECD’s purview. The organization tried to tackle this in its 2015 Base Erosion and Profit Shifting project, although there were enough unresolved issues that the topic was revisited in the Two-Pillar project which is still ongoing.

Understanding how the concept of P.E. has evolved over the past decade gives you perspective into the wider changes happening in global taxes.

By definition, a permanent establishment concerns an entity which is foreign to the jurisdiction where it’s earning income, in this case. This means it’s not a subsidiary, at least in that jurisdiction, because a subsidiary would be legally established and incorporated there as a local entity. This is a bit confusing and counterintuitive, but it’s a crucial point. Even though the income often ends up being apportioned the same way, through basic transfer pricing, there is a difference.

This gets to another point that can muddy the waters of these debates. You’ll often hear about digital permanent establishment issues, or times when a company can do business in a jurisdiction without having a physical presence there. Nine times out of ten, however, the company actually does have a physical presence there–it’s just not the entity or subsidiary which is earning the income. Think about a huge tech conglomerate like Facebook or Google–they’ll almost always have offices wherever they’re earning substantial income.

So, in theory, you could solve a lot of these issues through the “physical presence” framework, with some kind of formulaic income allocation or through new transfer pricing concepts which require that income be apportioned to the local subsidiary, depending on its activities.

Google, in fact, became one of the poster children for this debate as the original BEPS project kicked off. In 2013, Reuters published an investigation which claimed that Google’s United Kingdom subsidiary employed 1,300 salespeople in the U.K.--or at least they seemed like salespeople, because they called themselves that in LinkedIn and other online profiles and sometimes clearly worked on commission. Google, however, denied that it used salespeople in the jurisdiction, claiming that their U.S.-developed algorithms determined most of the pricing and ad placement.

This was a crucial distinction, because the use of salespeople, or agents who can sign a legally binding contract, is a key determinant of a permanent establishment. The sales were technically made to the Ireland subsidiary, where the income enjoyed a lower tax rate. If those people were genuine salespeople, the British tax authority should have been able to tax the Irish entity as a permanent establishment.

In hearings before the U.K. parliament, however, Google executives claimed that their workforce in the country was really involved in advertising and promotion, which do not create a P.E. under the relevant treaties. Anyone can go online and use Google’s system, they don’t need a salesperson to make the connection.

I used my newspaper background to understand this–at my first newspaper job with the Lorain Morning Journal in Ohio, there was a balding, suspenders-wearing ad director who knew the coverage area like the back of his hand, and could glad-handle and schmooze with local businesses to make deals. This is altogether different from Google’s ad business, or so its officials claimed. Others said this was just a fancy way for the Ireland entity to rubber-stamp the sales activity happening in the U.K.–what the rules are supposed to forbid.

A similar structure was the use of “commissionaire” arrangements where the seller is technically independent while still ultimately selling products or services for a larger enterprise. In both cases, as well as many others, the P.E. standard is never triggered. The OECD ultimately decided to tweak the definition for both independent and dependent agents to better capture these kinds of situations.

Aside from being one who “habitually exercises…an authority to conclude contracts,” an agent can be one who “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise,” under the 2015 changes.

Clear enough?

This may have been a case where more aggressive use of the older standard would have been enough, and what’s more important than the language itself is that the OECD identified the issue. At any rate, these practices tended to die out, at least among the major players, as they received more public focus and political scrutiny.

The OECD’s P.E. project also looked at other issues, such as when a large retailer (say, Amazon) sells products in a jurisdiction while ultimately only having “auxiliary” activities there like warehousing and distribution. The new language, which the U.S. ultimately “reserved” on, allows that such activities can be non-auxiliary in certain, vaguely-defined situations.

These changes resolved much, but they didn’t totally answer all of the questions being raised about P.E. standards in the digital age. Lingering political pressure to resolve digital-only activities and revenue led the OECD to return to the topic in 2017, for what ultimately became known as the Two-Pillar project.

Pillar One of the project, a new tax system capturing more of the digital space, is an entirely new system, leaving the old P.E. concept behind. Pillar One taxes a portion of sales-based revenue regardless of physical presence, to allow countries to tax digital transactions without targeting them specifically, in theory. The new system uses a “nexus” (that word again) standard based on sales and the size of the entity, not on workforce or the other P.E. factors.

Those still matter for the remaining transfer pricing regime, which is still intact–but the OECD powers decided that permanent establishments on their own weren’t enough.

Pillar One, if it ever gets implemented, won't cover the whole system. The P.E. rules are still very relevant for multinationals and will likely continue to flummox tax authorities for years to come.

Contact the author at amparkerdc@gmail.com.