Permanent Establishment: a new tax regime for the modern digital economy?

What is the new definition of Permanent Establishment?

The definition of Permanent Establishment (PE) is continually evolving and, for many, becoming more fluid and uncertain. It is fair to say that tax authorities are looking to expand the interpretation of PE so as to adapt to the way that doing business has changed over the years, in particular the explosion of online retailing.  This is done with a view to taxing profits that otherwise would not have been subject to domestic taxation. 

While the definition of PE has for years been provided by the tax treaties in place between the different countries, and reference for any interpretation was the OECD Tax Treaty Model, taxpayers must now take into account further changes, both in the international and domestic Italian definition. With Action 1 (Addressing the Tax Challenges of the Digital Economy), and Action 7 (Preventing the Artificial Avoidance of Permanent Establishment Status) of BEPS; the EU Directive Proposal n. 147 of 2018; as well as the amendments brought to art.162 of the Italian legislation (Presidential Decree n. 917/1987); a new expanded definition of PE has been developed, with the consequence that the OECD Tax Treaty Model has been significantly and materially amended. 

OECD Tax Treaty Model: what's new?

In particular, the amendments to Art. 5 of the OECD Model Convention provide a PE exemption for specific activities (so-called “negative list”); the new definition of dependent agent PE; and the introduction of an “anti-fragmentation" rule. 

In addition, a new concept of PE has been developed but it has not included in the current version of art. 5: that of the so-called significant economic presence (SEP). This means that even if it does not have an office, store or physical presence, a business may be eligible to pay tax by virtue of an online and economic presence. This emerging notion of PE is not supported in any legislation or case law, and it is not clear what cases fall under this new definition. Today's businesses no longer require a physical presence in order to operate and the location of sales and marketing staff may not necessarily be an indication of the location of the real value of the enterprise. 

Is the new definition of Permanent Establishment immediately enforceable?

Although the OECD commentary to the Tax Treaty Model has been amended to reflect the changes promoted by the BEPS n. 7, the new definition of PE is not immediately applicable; rather it requires a re-negotiation of the Tax Treaties in place (in line with what recently happened with Chile). The developments on the Multilateral Convention to implement tax treaty related measures to prevent base erosion and profit shifting - so called “MLI” - should also be considered.. Indeed, BEPS rules could be applied following the ratification of the MLI by the different countries, taking into account the circumstance that the different States could have  put some  reservations/options in the application of the MLI.

In any event, since the MLI does not include a definition of Permanent Establishment in line with the Significant Economic Presence notion, tax treaties will need to be amended. 

Significant Economic Presence: developments of the new concept

Significant Economic Presence (SEP) was initially developed/conceived as a way to expand the scope to tax businesses beyond the definition of Permanent Establishment (PE).  This was done in order to provide tax authorities with an instrument to tax the revenue deriving from de-materialised and digital business that were not falling within the existing rules. 

PE has always been linked to the physical presence. Indeed, the same OECD commentary to the Tax Treaty Model clearly made reference to an example of an internet website being a mere combination of software and electronic data, with the consequence that no PE could be detected based on the theory of "fixed place of business" unless certain equipment/devices playing a significant role in the business activity could be detected. Based on these principles, the presence of a server on which the website is stored was considered significant enough to ensure its location became the designated 'fixed place of business' PE of a foreign enterprise.  

SEP may be seen by many as the creation of a new nexus for taxing profits realised by non-resident digital enterprises. This was confirmed by the OECD Public Consultation document, which stressed that in order to create the nexus between the foreign entity and the revenues generated in the relevant country,  the digital and economic means will not be sufficient: this should be considered alongside  other factors such as the existence of a user base or billing and collection in local currency; the responsibility for the final delivery of goods to customers; or the provision by the enterprise of other support services, such as after-sales service or repairs and maintenance.

Some countries, such as Italy, have immediately imported the SEP principle in the PE definition, meaning they have unilaterally applied the concept, without waiting for the consenus of the worldwide tax community. Italy, is, therefore, looking to develop its own approach to  SEP PE. It  is important to identify whether the concept may help in creating a real new case of permanent establishment; an additional nexus to attract to taxation profits; or an anti abusive provision finalised to challenge the conducts of multinational groups aimed at concealing the presence of a PE through artificial means. However, this new SEP concept is still under the debate of the scholars and Italian Tax Authorities have no longer issued any clarification on how to interpret SEP or which indexes may lead to the conclusion that a foreign entity may have a SEP in Italy. In any event, the SEP PE principle for Italian purposes is applicable only in absence of a Tax Treaty.

How does this overlap with Digital Service Tax? (DST)

The notion of SEP has also been used in the context of the OECD discussions on the web tax or digital service tax, representing one of the options under Pillar One to identify the nexus for attracting taxation revenues of digitalized businesses. 

The more recent public consultation document "Secretariat Proposal for a "Unified Approach" under Pillar One" seems to have opted for other options, abandoning the SEP principle. However, it will be important to ensure that, in the discussions relating to the taxation of the digital economy, specific attention will be given to the concept and its interpretation, to avoid having countries develop unilateral interpretations of the principle with consequent overlapping of the same with domestic definitions of PE based on the SEP rule.