May 30, 2019

Digital Economy – The Emerging PE and Attribution Issues

1. Background

1.1 Do you remember the first thing you ever bought or sold online?  As we have been living in a digital economy for an entire generation, many of us would need to take a stroll down the memory lane. In fact, it was just over 20 years ago in Ottawa in 1998, when the OECD together with Canadian government held the first international ministerial meeting on electronic commerce, which may appear shorthand for what we now call the digital economy. It is worth recalling that in 1998, Google was in its infancy and Facebook, YouTube and Twitter were still a long way off. Many mobile phones still sported visible antennas and the price of internet access was steep. Truly, we have come a long way off. [1]

1.2 Almost a century ago (in the era of League of Nations), value creation in different jurisdictions in a cross-border business was pictorially described as below[2]:

“The oranges upon the trees in California are not acquired wealth until they are picked, not even at that stage until they are packed, and not even at that stage until they are transported to the place where demand exists and until they are put where the consumer can use them. These stages, up to the point where wealth reached fruition, may be shared in by different territorial authorities.”

1.3 The above paragraph highlights the value creation in multiple jurisdictions and value realization in the market jurisdiction, which is typical of a transnational business carried on by a Multi-National Enterprise (“MNE”). Prior to the advent of digitalization, the MNE could not do significant business in a market jurisdiction without having some kind of a physical presence in that market jurisdiction. This led to the allocation of taxing powers between Residence Jurisdiction and Source Jurisdiction primarily upon presence or absence of a tangible physical nexus in the form of Permanent Establishment (“PE”) in the market jurisdiction.  Explosive growth and development of information and communication technology have enabled MNEs to sell goods and services in a market jurisdiction without having the need of a traditional brick-and-mortar PE in market jurisdiction thereby avoiding payment of the legitimate share of taxes in the market jurisdiction where the MNE derives a significant share of revenues.

2. Explosive growth of Internet users in the world[3]:


[As on January 15, 2019    Source:]

3. Worldwide Retail E-Commerce Sales[4]


4. India’s Retail market and e-commerce market[5]


[Source: Economic Times dated February 26, 2019]

5. Tax Issues thrown up by an exponential growth of the digital economy in the last two decades[6]

(i) The exponential expansion of information and communication technology has made it possible for the businesses to conduct themselves in ways that did not exist earlier and has given rise to new business models that rely more on digital and telecommunication networks, do not require physical presence, and derive substantial value from data collected and transmitted through digital networks. These new business models have created new tax challenges for tax authorities around the world in terms of nexus, characterization, and valuation of data and user contribution. These challenges have been recognized by the international community and have since been accepted and endorsed by the G-20 and OECD in the form of Base Erosion and Profit Shifting Project (“BEPS”) Action 1.

(ii) The ambiguities in taxation of income arising from the digital economy and the resultant tax disputes are also a constraint for the taxpayers, who may end up getting subjected to inconsistent approaches on the part tax authorities, a situation which at best should be avoidable.

6. Forms of Prevalent Businesses in Digital Economy

The BEPS Report on Action 1 lists some of the more prevalent forms of digital businesses in paragraphs 118 to 121, as under: Business – to – business models

118.The vast majority of e-commerce consists of transactions in which a business sells products or services to another business (so-called business-to-business (B2B)) (OECD, 2011). This can include online versions of traditional transactions in which a wholesaler purchases consignments of goods online, which it then sells to consumers from retail outlets. It can also include the provision of goods or services to support other businesses, including, among others: (i) logistics services such as transportation, warehousing, and distribution; (ii) application service providers offering deployment, hosting, and management of packaged software from a central facility; (iii) outsourcing of support functions for e-commerce, such as web-hosting, security, and customer care solutions; (iv) auction solutions services for the operation and maintenance of real-time auctions via the Internet; (v) content management services, for the facilitation of website content. management and delivery; and (vi) web-based commerce enablers that provide automated online purchasing capabilities.[7] Business-to-consumer models

119. Business-to-consumer (B2C) models were among the earliest forms of e-commerce. A business following a B2C business model sells goods or services to individuals acting outside the scope of their profession. B2C models fall into several categories, including, for example, so-called “pureplay” online vendors with no physical stores or offline presence, “click-and-mortar” businesses that supplemented existing consumer-facing business with online sales, and manufacturers that use online business to allow customers to order and customize directly.[8]

120. The goods or services sold by a B2C business can be tangible (such as a CD of music) or intangible (i.e. received by consumers in an electronic format). Through digitization of information, including text, sound, and visual images, an increasing number of goods and services can be delivered digitally to customers increasingly remote from the location of the seller. B2C e-commerce can in many cases dramatically shorten supply chains by eliminating the need for many of the wholesalers, distributors, retailers, and other intermediaries that were traditionally used in businesses involving tangible goods. Partly because of this disintermediation, B2C businesses typically involve high investment in advertising and customer care, as well as in logistics. B2C reduces transaction costs (particularly search costs) by increasing consumer access to information. It also reduces market entry barriers, as the cost of maintaining a website is generally cheaper than installing a traditional brick-and-mortar retail shop.[9] Consumer-to-consumer model

121. Consumer-to-consumer (C2C) transactions are becoming more and more common. Businesses involved in C2C e-commerce play the role of intermediaries, helping individual consumers to sell or rent their assets (such as residential property, cars, motorcycles, etc.) by publishing their information on the website and facilitating transactions. These businesses may or may not charge the consumer for these services, depending on their revenue model. This type of e-commerce comes in several forms, including, but not limited to: (i) auctions facilitated at a portal that allows online bidding on the items being sold; (ii) peer-to-peer systems allowing sharing of files between users; and (iii) classified ads portals providing an interactive, online marketplace allowing negotiation between buyers and sellers.”[10]

7. Characteristics of Digital Economy

Digitalised business models have the following 3 characteristics:

i. Scale without Mass

ii. Heavy reliance on intangible assets

iii. Data & user participation.

8. Distortions caused by Digital Economy

The most demonstrable distortion caused by digital businesses is horizontal inequity i.e. non-resident enterprise selling goods and services in source jurisdiction does not pay taxes on the income earned from sales in source jurisdiction because of the absence of PE, while at the same time domestic enterprises of source jurisdiction engaged in similar business activities have to pay tax. If this distortion is not addressed to in a timely manner, this may lead to obvious undesirable economic effects in the economy of source jurisdiction, and consequently impede the transnational flow of goods, services, capital and personnel.

9. Overarching Principles of Tax Policy

Following well-established principles of tax-policy have to be kept in mind while addressing the distortions caused/ being caused by the digital economy:

i. Equity:

Taxpayers in similar circumstances should bear a similar tax burden

ii. Neutrality:

Economic choices available for carrying on businesses should be tax-neutral

iii. Efficiency:

Minimum compliance costs to the taxpayer and minimum administration costs for governments

iv. Certainty and simplicity:

Tax rules to be simple and easy to understand for the tax-payers

v. Effectiveness and fairness:

Taxation should produce the right amount of tax at the right time avoiding either double taxation or double non-taxation.

vi. Flexibility:

Taxation systems and policies should be flexible and dynamic enough to ensure they keep pace with technological and commercial developments.

10. Options suggested by OECD and their fundamental features[11]

During the course of deliberations on Action Point 1 of BEPS Project, OECD recommended a two-pronged approach:

10.1 There should be a significant salutary impact of other BEPS measures on BEPS concerns caused by Digital Economy, namely:

(i) Changes suggested by BEPS Action 7 which could control artificial avoidance of PE status.

(ii) Changes suggested by BEPS Action 8-10 strengthening transfer pricing rules.

10.2 Pending the evaluation of impact of other BEPS measures on BEPS effects caused by the digital economy, OECD considered various other options but stopped short of adopting any of those options as OECD recommended standard.  Rather it left it to the countries to consider/ adopt any of the options either alone or in conjunction with other options, subject to the countries having regard to principles of existing treaty obligations.

10.3 The following table evaluates the fundamental characteristics of these 3 options:

Options Analysis[12]

11. Analysis of current scenario:

11.1 In view of a wait-and-watch approach adopted by OECD and allowing the countries to adopt unilateral measures in the interim, some countries, have decided to impose a Withholding Tax on the gross amount of revenues derived by an MNE from source jurisdiction. Some details are below:

(i) India imposes 6% Equalisation Levy on specified base-eroding digital businesses. This levy has been kept out of the tax treaty network, hence there are issues on the ability of the affected non-resident to take a foreign tax credit of taxes withheld in India.[13]

(ii) EU recommended 3%. However, some countries in EU have opposed this levy, namely Ireland, Sweden, Denmark and Germany.

(iii) USA has opposed the imposition of digital tax as it would hit the tax bills of the US tech giants like Facebook, Google, Amazon by forcing them to pay taxes to the governments where they do business, instead to low tax jurisdictions like Ireland or Luxembourg.

(iv) UK is proposing Digital Services Tax

(v)               Bangladesh imposed a VAT on digital businesses.

11.2          It is evident that these measures are unilateral and uncoordinated among countries. By their very nature, they are ad hoc, inconsistent and lack clarity, leading to imposition of a disproportionate tax burden on the MNEs in multiple tax jurisdictions. Such measures cannot provide a lasting solution to the problem.

12.              Possible Features of SEP based new economic nexus[14]

(i)                 The new PE nexus may consist of the following elements:

(a)                Specified sale and service transactions carried out digitally;

(b)                user threshold;

(c)                a de minimis revenue threshold

(ii)               For this purpose, a new article 5(8) may be introduced in the OECD Model / Article 5(9) in the United Nations Model with the following suggested wording-

“If an enterprise resident in one Contracting State provides access to (or offers) an electronic application, database, online market place or storage room or offers advertising services on a website or in an electronic application used by more than 1,000 individual users per month domiciled in the other Contracting State, such enterprise shall be deemed to have a permanent establishment in the other Contracting State if the total amount of revenue of the enterprise due to the aforementioned services in the other Contracting State exceeds XXX (EUR, USD, GBP, CNY, CHF, etc.) per annum.”

(iii)             The advantage of this method is that the allocation of taxing powers can be implemented in line with the arm’s length principle or through a mix of arm’s length principle and formulary apportionment. As regards the former scenario, it may be necessary that the current OECD Transfer Pricing Guidelines be amended in order to apply to income allocation between an enterprise and its PE based on digital presence.

13.              Dual Approach-Withholding tax coupled with an option of SEP based net taxation[15]

(i)                 This option considers both the options of installing a withholding tax mechanism as the primary response to these challenges and the option of using withholding taxes in support of a SEP-nexus based solution.

(ii)               Nexus-based solution should prove superior to the withholding tax solution since it is consistent with the OECD’s approach to the matter (it is likely to be more efficient, i.e. less wasteful) and it would likely be easier to fine-tune in order to reach a stable balance between source and residence taxation.

(iii)             Consequently, a practical way could be to impose a global consensus-based standard X%[16]    final withholding tax on all base-eroding business payments to registered non-residents, with specific, again global consensus-based exemptions to payees registered to be taxed in the source jurisdiction under a net taxation scheme. Such net taxation scheme may be a nexus-based solution or an elective scheme to avoid the withholding tax proposed here. This proposal depends on a reliable, global consensus-based standard, quick, cheap and automatically shared registration system shared by at least the major economies, such as the BEPS countries.

(iv)             Payments to unregistered payees will be subject to a higher percentage of  withholding tax as compared to non-residents covered in (iii) above. These would include payments to accounts in or owned by low- or no-tax jurisdictions (say, a 15% general corporate tax threshold). This tax may be non-final and partially refundable upon filing.

(v)               B2C transactions should initially be exempt as non-base eroding. Yet, if countries are already concerned with the revenue division implications of such a decision, a complimentary final withholding tax of X%[17] could be collected on all payments cleared by financial institutions, unless the payees register to be taxed under any net taxation scheme.

(vi)             The withholding tax scheme is not perfect; however, in the case that countries cannot reach agreement on a nexus-based scheme, it permits a simple, if crude, response to the challenges of the digital economy. As such, however, it requires monitoring and perhaps tweaking over time based on experience gained. Therefore, the scheme should be accompanied by a review mechanism.

(vii)           Furthermore, the multilateral instrument (Action 15) may be used for efficient standardization of the solution. Advances in reporting (e.g. CbC) and automatic information exchange, as well as all monitoring aspects (Actions 11-13) also fit well with the necessary review mechanism.

14.              Long Term Perspective

14.1          In the long-term, it appears that a net basis taxation on the basis of SEP as a nexus, in addition to the traditional brick and mortar PE, may turn out to be the most effective measure to address the taxation problems of the digital economy.

14.2          Basis of SEP based PE threshold:

(i)                 The nexus should be uniform globally. As an example, gross revenues from digital businesses derived by an MNE from a source jurisdiction amounting to say X Million US Dollars or equivalent amount in local currency in a tax year. In other words, this basis cannot work if every country were to decide its own threshold without having any regard to the global pattern.  A cue can be taken from the 750 Million Euro threshold which triggers the filing of Country by Country Report on transfer pricing under BEPS Action Point 13.

14.3          SEP-based PE-Income Computation:

(i)                 Net income from SEP-based PE could be computed either on Attribution Basis under Arms’ Length Principle or Formulary Apportionment or may be a mix of the two. The author recognises that OECD has always preferred Attribution Basis over a Formulary Apportionment basis. But one cannot forget the old adage that “Necessity is the mother of invention”. Unique problems do call for unique solutions. There are obvious constraints in applying Attribution principle which is essentially based on Arms’ Length Principle. In a digital business it is likely that most of functions performed, assets utilized and even some of the major risks will not be located in source jurisdiction. Only sales, revenue realisation and post-sale warranty obligations will happen in source jurisdiction.  Under these circumstances, how effective it will be to apply Arms’ Length Principle, is anybody’s guess.

(ii)               However, in case, global consensus is reached on Attribution basis, it will be further desirable to apply all principles applicable to computation of business income as contained in Article 7 of double tax treaties, as far as possible, since SEP based PE will also be a PE at par with traditional brick and mortar PE. In particular, there should be allowed as deduction expenses incurred for the purposes of the business of SEP-based PE, including a reasonable allocation of executive and general administrative expenses, research and development expenses, interest and other expenses incurred, whether in source state or elsewhere.

15.              Role of Multilateral Instrument:

Since the SEP-based PE will require an amendment to existing double tax treaties, the proposal suggested herein can be efficiently achieved only through Multi- National Instrument.

PS: The views expressed herein are the views of the author and not necessarily the views of AZB & Partners.


[5] reference from

[6] references taken from
[7] para of article

[8] para at

[9] Ibid
[10] para at

[11] reference taken from

[12] Ibid
[13] Reference from

[14] Some inputs from IBFD Working Paper “Blueprints for a New PE Nexus to Tax Business Income in the Era of the Digital Economy” authored by Prof Peter Hongler and Prof Pasquale Pistone available at

[15] Some inputs from IBFD Working Paper “Withholding Taxes in the Service of BEPS Action 1: Address the Tax Challenges of the digital Economy ” authored by Prof Yariv Brauner and Prof Andres Baez available at

[16]  This is a conscious departure from the Paper of Prof Yariv Brauner and Prof Andres Baez
[17] Ibid




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