Permanent establishments and technology – an evolving issue

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The integration of international economies and markets has experienced significant growth in recent years, which has led to the growing importance of technology-driven assets, making digitalization a key value driver to many multinationals. As a result of economic headwinds and governmental expenditure, tax authorities around the globe are increasingly challenging taxpayers in relation to potential permanent establishments specifically with regard to technology-driven assets.

Permanent establishment

The definition of Permanent Establishment (PE) included in the tax treaties is crucial in determining whether a non-resident enterprise has to pay income tax in another state. Generally, the OECD has identified in Article 5 of the 2017 Model Tax Convention, the following types of PEs:

• Fixed place of business PE
• Agency PE
• Services PE

The accelerating pace of technology innovation is now critical in almost every industry, and the trend is likely to continue going forward. With the development and use of artificial intelligence gaining momentum, the change in how businesses operate is becoming more radical and the pace of change is ever increasing. Taxation of smart technologies (e.g., smart servers) has been a focal point of discussion for a while but without significant impact for many businesses so far. AI and robotic process automation (RPA) involving smart algorithms conducting key decisions with minimal human intervention is becoming widespread and may become game changers. This implies that there will be more focus on technology-related assets from a tax perspective too.

The emergence of new and often intangible-related key value drivers has created new business models while at the same time eroding the need for physical proximity to target markets. This challenges the effectiveness of existing profit allocation and nexus rules to distribute taxing rights on income generated from cross-border activities in a way that is acceptable to all countries.

Attribution of profits to PEs

Article 7 of the model tax convention provides that profits should be allocated to PEs as if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions.

In general, the OECD has provided guidance on the attribution of profits through the Authorized OECD Approach (AOA). The AOA has been widely adopted by a number of countries in order to correctly allocate profits to a PE; however, not all countries adhere to the AOA, and there may be local deviations in determining the appropriate amount of profit to a PE.

Technology and platforms, PE?

Within the technology industry, companies are increasingly able to operate in certain markets without having the need of physical presence. Additionally, there is a significant increase in the utilization, processing, and commercialization of vast amounts of customer data stored in data centres, as well as the implementation of country-specific smart algorithms and localized platforms. The application of smart servers, increased commercialization of data, AI and RPA, in for example automated trading, has become increasingly important within the tech industry, decreasing the need for local people having an impact on the preparatory and auxiliary nature of the technology assets.

Interplay with BEPS Action 1 and digital service taxes

The overall goal of BEPS Action 1 and digital service taxes (DSTs) is to address and modernize the tax framework for the digital economy. In doing so, it identifies large multinationals and ensures that profits from cross-border transactions are reallocated accordingly to the specific countries in which the goods and services are sold, even if they do not have a physical presence (nexus) there.

The aim of Action 1 of BEPS and DSTs is to allocate more taxing rights to market or user jurisdictions in situations where value is created by a business activity through participation in the user or market jurisdiction that is not recognized in the current framework for allocating profits.

Furthermore, local DSTs and the taxable base thereof may not align with the taxable base as determined through the application of the AOA.

The tax authorities are increasingly focused on the digital economy by applying article 5 of the model tax convention as a starting point, using the guidance on BEPS Action 1, or alternatively by implementing local DSTs or considering implementing DSTs if Pillar One is not adopted.  As a result, multinationals utilizing technology assets to facilitate sales in local markets or operating local data centres may face increased scrutiny. This raises the risk of a higher tax liability under local DSTs and potentially under Pillar One, even if they do not have a PE.