by Kristina Dautrich, Senior Director, Alvarez & Marsal Taxand LLP, Washington DC
The cloud is being touted as the next big thing in computing. IT departments have begun using cloud computing as a cost-effective way to grow their infrastructure. However, many tax professionals are unsure of the impact that cloud computing could have on a company’s tax footprint and effective tax rate.
Thomson Reuters Canada recently published my article “Server as a Permanent Establishment: Are your server’s activities creating a taxable presence that you are unaware of?” The topic is of considerable interest everywhere, including in Australia. What follows is an edited version of that article, reprinted with permission from Alvarez & Marsal Taxand, LLC.
Recent developments in India have added more uncertainty to this complicated area of taxation. In a 7 February 2012 decision, India’s Authority for Advance Rulings (AAR) ruled that a foreign company’s server may constitute a permanent establishment (PE) for tax purposes, and the profits arising from it are taxable in India. According to Abhishek Goenka (Partner) and Sharath Rao (Director) at BMR Advisors in India, “The issue of a server or other IT infrastructure constituting a PE is very fact specific and may impact web hosting companies that have any Indian presence in the form of servers, cargo industries where tracking equipment is placed in India, and telecommunication companies where leased equipment is used to provide continuous connectivity.”
The AAR determined that the presence of a server in India is sufficient physical presence to constitute a taxable presence in the country. Accordingly, companies with servers in India may be subject to Indian tax on any profits attributable to the servers. In the absence of this ruling, companies may have been able to locate their servers in India without the fear that they would be subject to Indian tax due to the server’s activities. Clearly the existence of a PE is an extremely important concept in that once a PE has been established, the country in which it is located has the full authority under the applicable treaty to tax business profits attributable to the PE.
Servers as permanent establishments
As a PE is a fixed place of business that constitutes a physical presence in a jurisdiction, at first glance, it seems logical that a server could constitute a PE. Servers are tangible objects that, when placed in a particular country, constitute a physical presence. Furthermore, servers are capable of storing and transmitting large amounts of data that companies use to conduct business. In the case of web-based companies, servers store and transmit every piece of information for an entire business. For web-based companies, the server is the business.
It seems clear that under the fixed-place-of-business principles, a server may constitute a PE. However, under most treaties, having a fixed place of business in a country may not be enough to create a taxable presence. For example, under the OECD Model Tax Convention on Income and on Capital, the term PE does not include:
- the use of facilities solely for the purpose of storage, display of or delivery of goods or merchandise belonging to the enterprise;
- the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
- the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
- the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information for the enterprise; or
- the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character.
Accordingly, even if a server can constitute a PE, the mere presence of a server in a jurisdiction should not be enough to create a taxable presence. The server must perform certain activities in order to create a PE under the traditional concepts of the term. Determining what activities a server must perform in order to constitute a PE has proven very difficult and is still a work in progress.
In January 1999, in the midst of the Internet boom, the OECD Committee on Fiscal Affairs set up a technical advisory group (known as TAG) on monitoring the application of existing treaty norms for taxing business profits. TAG has been charged with opining on the topics governing the taxation of e-commerce activities.
TAG has stated that, despite it being difficult or even impossible to trace the location from which e-commerce transactions are performed, it is on the other hand fairly easy to:
- pinpoint a server in a low-tax jurisdiction;
- divide business functions related to a commercial transaction between separate servers; and
- have websites hosted by Internet service providers, or ISPs.
TAG has realised what is both patently obvious and extremely difficult about the taxation of e-commerce – the fact that the concept of a PE was created during a time when bricks-and-mortar businesses were all that existed. Accordingly, a PE premised on a physical presence within a jurisdiction was adequate. However, with the intangible nature of e-commerce, this traditional view of a PE has been greatly undermined.
Although the OECD’s final views on the taxation of e-commerce have yet to be released, the organisation has released the following insights:
- Websites do not constitute PEs.
- Website hosting facilities should not produce PEs for the entity carrying on business through the website.
- ISPs should not represent an agency position and give rise to a PE.
- Servers located in a jurisdiction for a suitably long period may be considered fixed and constitute a PE.
The OECD has suggested that when an enterprise operates computer equipment at a particular location, a PE may exist at the server location even though no personnel of the enterprise are present at the location of the server. Thus, in the OECD’s view, fixed, automated equipment that can perform important and essential business functions (ie servers) may be sufficient to create a PE at the equipment location without the presence of human beings.
The OECD addressed the application of the PE article in the context of e-commerce in a commentary published in December 2000. According to the commentary, an enterprise may be considered to have a PE at the location where it maintains a server. Such a server, however, may constitute a PE only if the enterprise has the server at “its own disposal”.
The OECD’s stance seems to be that a server may only constitute a PE when the automatic functions carried out by the equipment have been set up by the principal enterprise and continue to be operated, controlled and maintained by the same principal enterprise. This level of activity by the principal enterprise establishes the fact that the server is appropriately permanent, fixed and at its own disposal. Thus, it would seem that under the OECD’s view, the leasing of server space in a particular country to simply house and use proprietary data should not create a PE. Conversely, an enterprise that owns a server in a designated location in a particular country, operates the server, and controls and maintains the equipment may have a PE under the OECD’s view.
The recent developments in India, combined with the lack of direct authority (in the US, Australia or otherwise, although the provisions of the Privacy Amendment (Enhancing Privacy Protection) Bill 2012 (still before the Australian Parliament) could have some impact) in dealing with the server as a PE issue should raise a red flag for companies that conduct business using servers in various countries. This includes many, if not most, multinational companies. A risk exists for companies with servers in foreign jurisdictions. They may have a taxable presence in those jurisdictions, the US and Australia included, and not even know it.
Cloud computing in a tax context is certain to be a topic of much discussion in the months ahead.