Foreign tax collectors threaten to ensnare internet sellers with “virtual” nexus

An Irish company taking orders over the internet from customers in Spain—but with no offices, salespeople, employees or assets in Spain—shouldn’t have to worry about paying Spanish income taxes, right? Until recently, the answer, under international tax law, would have been an unequivocal “yes”.

But a decision by the Spanish Central Economic-Administrative Court released earlier this year (R.G. 2107-07), as well as proposals by Australia and France, is putting that answer in doubt. Those countries are proposing rules that would change the concept of “permanent establishment”, the universal rule that requires a company to have a physical presence in a country before the country can impose income tax or value-added tax (VAT). If adopted, the rules could create new costs for any company that makes international sales over the internet.

The theory that threatens to upend the traditional view of income taxation of foreign companies is called “virtual permanent establishment”. Virtual permanent establishment stems from the growing realisation among countries that the traditional concept of permanent establishment is not well-suited to today’s digital economy, and that they are losing out on potential tax revenues as a result. As a French government report put it, digital companies “overturn the rules of the game and radically transform all sectors of the economy.”

Under the theory of permanent establishment, a company is liable for income tax or VAT in a country where it has a fixed place of business. “Fixed place of business” has traditionally been determined by physical assets such as an office, warehouse, factory, etc., or by the presence of an agent conducting business for the company.

However, sales over the internet can involve sellers and buyers located anywhere in the world, and the seller may do a large volume of business in a country without engaging in any of the activities that trigger a traditional permanent establishment. In some cases, there are not even any tangible goods involved, and the question of where the activities take place generally cannot be answered under current tax principles.

As countries look to increase tax revenue, the concept of virtual permanent establishment may give them another tool to impose taxes on companies currently beyond their reach.

Spain cracks down

In the Spanish case, Dell Products Ltd., an Irish member of Dell Computer Group, made sales in Spain through a website hosted outside of Spain. The website focused on the Spanish market. Dell Products Ltd. also used a Spanish Dell Computer Group affiliate, Dell España SA, to administer the website and review or translate content.

Based on these two facts, and despite the fact that Dell Products had no physical contact with Spain, the Spanish court held that Dell Products had tax nexus with Spain under the Spain-Ireland income tax treaty. The Spanish court determined that Dell Products had a “virtual permanent establishment” in Spain.

Virtual permanent establishment is also being explored by two other countries.

Data is digital “raw material”

Last January, the French Ministry of Economy and Finance and the Ministry of Industry issued a report that calls for a new definition of permanent establishment that encompasses income earned from digital activities with no fixed location and for a tax on data collection. The report focuses on data as the digital economy’s “raw material”.

French Technology Minister Fleur Pellerin is attempting to gather support for data taxation. But while the data tax portion of this proposal has garnered the most attention, it is the virtual permanent establishment idea that potentially could have the most impact on companies. And the proposed 2014 budget released by the French finance and budget ministers on Wednesday, while it contains tax hikes, does not include a data collection tax.

The French government plans to urge the Organisation for Economic Co-operation and Development (OECD) to recognise the concept of virtual permanent establishment. It will also ask the EU to adopt a consolidated corporate tax base for digital companies. Companies would choose a “state of identification”, and that country would collect corporate income tax from the company and allocate it among other countries where the company made sales.

Australia seeks balance

Australia, meanwhile, is also exploring how to collect tax from non-residents based on their digital sales in Australia. The Australian Treasury released a report in May discussing the problems of taxing a digital economy and “whether tax concepts developed for the industrial age are still applicable in the era of the digital economy.”

And a July report from the Australian Treasury declared that “to prevent the artificial avoidance of permanent establishment status, the rules need to be modified.” The report announced that Australia will explore “whether a better balance can be achieved by changing the rules so they rely on the level of economic activity rather than on a physical presence,” and it cited the French report. If Australia determines that it wants to adopt and promote virtual permanent establishment, it will soon have a bully pulpit: It chairs the G20 in 2014.

Virtual permanent establishment

The concept that a website or web sales alone can create a permanent establishment would upend the traditional concept that permanent establishment depends on physical presence. For example, a 2000 report by the OECD’s Committee on Fiscal Affairs, Clarification on the Application of the Permanent Establishment Definition in E-Commerce, went so far as to say that the presence of computer equipment owned and operated by a non-resident company can create a permanent establishment in the country, despite the absence of personnel located in the country. But the report explicitly stated that a website alone is not sufficient to create a permanent establishment because a website is not tangible property and therefore it has no location.

While the French government report does not supply details on how virtual permanent establishment would operate, some clues can be gathered from earlier discussions of the idea. The concept of virtual permanent establishment goes back as far as an OECD Centre for Tax Policy and Administration report from 2003, Are the Current Treaty Rules for Taxing Business Profits Appropriate for E-Commerce?

That report explored the concept of virtual permanent establishment as an alternative form of nexus that would apply to e-commerce. It suggested a variety of ways this might work, including creating a “virtual fixed place of business” (the electronic equivalent of the traditional permanent establishment), extending the definition of permanent establishment to include “virtual agency” (the electronic equivalent of dependent agency permanent establishment), and expanding the definition of “on-site business presence” to include virtual presence.

The OECD’s concept of “virtual fixed place of business” was based on where the website server was located and so still required something physical (the server) to create the permanent establishment. The “virtual agency” concept moves more away from physical presence by extending permanent establishment to places where “contracts are habitually concluded on behalf of the enterprise … through technological means.” Thus, a website through which sales are made in a jurisdiction might create a dependent agent permanent establishment even though the server is not located in that jurisdiction.

The “on-site business presence” alternative would look to a company’s economic presence within a jurisdiction when interacting with customers in that location. There would be a minimum threshold of economic activity before the on-site business presence permanent establishment would apply.

The report raises questions of how profits would be attributed under any of these three alternatives.

Many countries are paying more attention to figuring out how to capture more tax revenue from multinational businesses. Mostly, they have focused on so-called base erosion and profit shifting—the practice of moving profits into low-tax jurisdictions. Automatic exchange of information among countries has been the most-discussed technique for combatting tax avoidance. Virtual permanent establishment threatens to be the next.

Alistair Nevius ( is CGMA Magazine’s editor-in-chief, tax.