Investing in data centres: understanding permanent establishment issues

VAT

For the purpose of Value Added Tax (VAT) regulations, the concept of a permanent establishment (PE) is crucial for defining the areas of competence among EU member states. This concept ensures that the place of tax connection for service provisions is detected, thereby avoiding "conflicts of competence" that could lead to double taxation or non-taxation of income. Established EU jurisprudence emphasises the importance of this concept, referencing multiple landmark cases, such as Berkholz (1985), DFDS (1997), and Welmory (2014).

The notion of a PE introduces an exception to the general rule that the tax connection point coincides with the place where a taxpayer has established their economic activity's seat. For determining the presence of a PE, the requirements outlined in Article 11 of Regulation 282/2011/EU are pivotal. This regulation defines a "fixed place of business" as any establishment other than the headquarters, characterised by a sufficient degree of permanence and an appropriate structure in terms of human and technical resources.

Key elements that identify a PE for VAT purposes include:

1. Temporal Requirement: The presence of a structure with a sufficient degree of permanence in the State's territory.
2. Objective Requirement: The necessary presence of human resources along with technical means.

The structure must be capable of receiving and using services for its own needs or providing services. Simply having a VAT identification number is insufficient to assume the existence of a PE; the human and technical/material factors are essential.

Additionally, the legal status of the entity is not significant by itself. Even a subsidiary can constitute a PE for its parent company, but this depends on material conditions and economic realities, as emphasised in the Dong Yang Electronics case (2020). The presence of a subsidiary alone does not infer the existence of a PE.

In terms of verifying a PE's existence, the human and technical resources must be "permanently present," and these criteria generally need to operate cumulatively. The sufficiency and adequacy of the structure in human and technical terms must be assessed on a case-by-case basis.

The only reference for determining the existence of a PE for VAT purposes is Article 11 of Regulation 282/2011/EU, not Article 192-bis of the VAT Directive. Only if the conditions in Article 11 are met can one analyse the PE's involvement in specific transactions.

In order for a foreign entity to ensure not having a PE for VAT purposes in the country where investments are made, it will be essential to set up local entities that owns or have at their disposal all necessary infrastructure, including land and buildings, as well as all equipment and technology required for operations. Moreover, technical support services should be provided by local entities acting independently, with their own employees and resources, ensuring that the foreign entity does not directly engage in contractual or operational activities in Italy without appropriate local involvement.

This approach prevents the foreign entity from establishing a PE for VAT purposes, as long as the local entity handles the necessary resources and services. The presence of a PE cannot be inferred without the existence of human and technical resources through which the foreign company operates its economic activity in Italy. This guideline is crucial for avoiding the establishment of a PE inadvertently and ensuring compliance with VAT regulations.

Free of charge supply of (residual) heat is subject to EU VAT

On April 25, 2024, the Court of Justice of the European Union (CJEU) delivered its judgment in case C-207/23 (“Y KG”). 

The case involved a German plant that produced biogas and which made (residual) heat from the production process available free of charge to neighbouring farmers, which used the heat for heating asparagus fields. The CJEU ruled that these free of charge supplies were so-called deemed supplies subject to VAT on the cost price, resulting in a true tax cost.

Why is this important?

This ruling underscores that (residual) heat cannot be made available free of charge by the producer without an additional tax burden for the producer across the EU Member States, even where the recipient would use such heat for its own business purposes.

This is important for every data centre supplying or anticipating to supply (residual) heat to other businesses, communities or private individuals in the EU as part of the energy transition. Data centres would have to determine the cost price of their deemed supplies, which may include direct manufacturing costs and financing costs. Data centres would also have to determine whether free of charge supplies may result in a clawback of input VAT previously recovered on their design, build or operational costs incurred. 

The issue could be resolved if data centres would charge sufficient consideration for the supply of (residual) heat, but this may not be commercially viable for each energy transition use case. 

Recommended actions

Data centres should take proactive steps to understand the implications of this EU VAT case. We recommend benchmarking the facts against your (residual) heat use cases to determine impact and next steps.

Italy

Before investing in data centres, it is crucial to understand the concept of Permanent Establishment (PE) as interpreted by Italian tax authorities, especially in the context of the digital economy. Recently, Italian authorities have adopted an innovative approach to challenging the presence of a PE for foreign companies, a move highlighted by Netflix's settlement with the Italian Revenue Agency.

The case of Netflix involved the availability of a network of servers used exclusively for providing streaming services to Italian customers. The Italian authorities argued that these servers constituted a PE under the concept of a fixed place of business. This approach marks a shift in the interpretation of PE, reflecting an evolving and increasingly fluid definition. Traditionally, PE has been understood through the lens of physical presence, such as offices or branches. However, the digital economy's growth necessitates new interpretations.

Historically, the definition of PE has been governed by tax treaties between countries, guided by the OECD Tax Treaty Model. With initiatives like BEPS (Base Erosion and Profit Shifting) Actions 1 and 7, the EU Directive Proposal 147 of 2018, and amendments to Article 162 of the Italian legislation, the scope of what constitutes a PE has expanded. The OECD Model Convention now includes exemptions for specific activities, a new definition of dependent agent PE, and an "anti-fragmentation" rule. Furthermore, the concept of Significant Economic Presence (SEP) has emerged, proposing that businesses can have a PE based on their digital and economic presence, even without a physical office.

Despite these changes, the new definitions are not immediately enforceable. They require renegotiation of existing tax treaties and the ratification of the Multilateral Convention (MLI) to implement BEPS measures. This process allows countries to make reservations or opt out of certain provisions, meaning full global consensus is still lacking.

SEP, designed to address tax challenges posed by digital businesses, aims to create a nexus between foreign entities and revenues generated within a country. This concept considers factors such as a user base, local billing, and after-sales services, in addition to digital presence. Italy has adopted the SEP principle unilaterally, without waiting for global consensus. This has led to some confusion, as the concept is still debated among scholars and lacks detailed guidance from Italian tax authorities.

Investors must be aware that while SEP and other new PE definitions aim to tax profits of non-resident digital enterprises, these interpretations can significantly impact business operations and tax obligations. The Netflix case exemplifies the need for companies to carefully evaluate their business models and the potential for PE establishment in Italy.

In conclusion, understanding the evolving definitions of PE and SEP is vital for foreign companies, especially in the digital economy, when considering investments in data centres in Italy. These changes reflect a broader trend of tax authorities adapting to modern business practices, but they also bring uncertainty and the need for diligent planning and compliance.

For more information, please contact Giuliana Polacco and Andy Van Esdonk.

To access Investing in data centres: understanding Permanent Establishment issues – Corporate Income Tax, click here.