A Long-Term Solution for Taxing Digitalized Business Models: Should the Permanent Establishment Definition Be Modified to Resolve the Issue or Should the Focus Be on a Shared Taxing Rights Mechanism?

The issue arises as to how can the market jurisdiction tax digital business models, in particular, highly digitalized businesses from an international direct tax perspective? It has been argued that creating a new nexus by introducing a digital permanent establishment (PE) or a significant economic presence test seems to be an ideal long-term solution. However, does that solution really resolve the issue or simply create tax uncertainty for businesses? First, by referring to the work on BEPS Action 7, the authors argue that not all states like to amend the PE definition. Moreover, for states that adopted the amendments to counter artificial avoidance of the PE status, the authors argue that the profits attributable to the PE will be restricted to the limited functions performed by the PE or, when the PE does not perform any functions, the profits attributable will be negligible. This is illustrated by specific references to online retailers that operate through local warehouses, as well as online advertisers that operate through related local marketing intermediaries. The analysis is based on the premise that the market jurisdiction follows the authorized OECD approach and considers that the concept of ‘significant people functions’ relevant to risk assumption for the purpose of Article 7 of the OECD Model is similar to the concept of ‘control over risk’ relevant to risk and return allocation for the purpose of Article 9. Conversely, if the concept of ‘significant people functions’ includes day-to-day risk mitigation functions, it could be argued that the risks associated with these functions should be allocated to the PE even though they are performed at the level of the head office and consequently, the PE would be entitled to additional income. Thus, the tax outcome would depend on how one interprets the concept of ‘significant people functions’. On the other hand, alternate approaches (such as formulary approaches) can be used if the market jurisdiction does not adopt the authorized OECD approach. Therefore, tax uncertainty does exist, as attribution of profits under the current framework is unclear and lacks uniformity. Second, the authors argue that prior to introducing a new nexus in the form of a digital PE or a significant economic presence, the approach to profit attribution needs to be investigated. To resolve the attribution issue for the new digital nexus, both academics and the OECD have proposed several solutions, such as modifying the existing attribution framework, relying on deemed profit methods or formulary apportionment. Undoubtedly, these solutions will require a significant departure from existing attribution standards, which themselves are unsettled. Consequently, developing special attribution rules for digitalized businesses only would breach the principle of equality. Moreover, tax uncertainty can arise if the new attribution framework for the digital nexus is not accepted in a clear and uniform manner. Overall, the authors are of the opinion that traditional businesses and digitalized businesses should be treated equally. As a result , unless and until new nexus rules and new attribution rules are developed and applied for ‘all enterprises’, a digital PE or a significant economic presence PE targeted at digitalized businesses should not be pursued. Nevertheless, if States wish to tax highly digitalized businesses, the authors assert a ‘shared taxing rights’ mechanism, in other words, a new distributive rule that could be built into tax treaties to tax specified digital activities or services that operate on a remote basis. In a subsequent article, the authors will undertake a detailed analysis of the solution.