When does e-commerce create a PE?

• Author: Levin, Leonard D.
• Position: Permanent establishment

The growth of electronic commerce faces an increasing risk of double taxation, unless steps are taken to develop a uniform approach as to whether an enterprise's Website is a taxable presence for that enterprise. The Organization for Economic Cooperation and Development (OECD) is working to reduce the risk by seeking to clarify how the permanent establishment (PE) concept should be applied to e-commerce. In September 1999, a subgroup of the Committee on Fiscal Affairs (which is responsible for updating the OECD Model Tax Convention) issued a draft commentary (the Proposal) addressing these concerns; see OECD, "The Application of the PE Definition in the Context of Electronic Commerce: Proposed Clarification of the Commentary on Article 5 of the OECD Model Tax Convention." The subgroup was scheduled to issue its final changes to the commentary in February 2000.

To place the Proposal in perspective, a short history of the PE concept is in order. First, if the source of an item of income can be determined, the right of a country to levy tax on business income usually depends, under income tax treaties, on whether a nonresident business has a PE in the source country (i.e., place where business activity occurs). (Only businesses not incorporated in the source country are of interest, because businesses incorporated in the source country are treated as residents of that country for tax purposes.) Absent a PE, the source country has no right to tax business income of a nonresident (even though the income has its source in that country).

Traditionally, tax systems in Europe and North America base the right to tax on physical presence. In the U.S., a state's right to tax generally requires nexus (a concept closely tied to physical presence). Thus, states have been unsuccessful in forcing out-of-state sellers to collect sales tax, unless the seller has physical presence in the state in which the buyer is located. Tax treaties, such as the OECD Model Tax Convention, and U.S. treaties (most of which are now based on the OECD model) have incorporated the physical presence test in the definition of a PE. Implicit in this concept is that some physical presence of the nonresident is required, whether personally or through an agent operating in the country. Absent a PE, the source of the income becomes irrelevant, and the income is effectively taxed only in the country of residence. Exceptions are made for ancillary functions that include physical presence...