The Challenges E-Commerce Poses to the Determination of a Taxable Presence: The "Permanent Establishment" Concept Analyzed from a South African Perspective

• Author: Dr. Annet Wanyana Oguttu & Mrs Sebo Tladi
• Position: University of South Africa Oguttaw@uni sa.ac.za
• Pages: 213-223

This article was originally published in Kierkegaard, S. (2008) Synergies and Conflicts in Cyberlaw. IAITL. pp.221-235

Page 213

1. Introduction

Before any country can levy a tax on income, a connection or tax nexus must be established between itself and that income. For example, the residence nexus, by which residents are taxed on their world wide income and the source nexus, by which persons are taxed on income that originates within the geographical confines of the country.¹ If a multinational company incorporates a subsidiary company in another jurisdiction, the subsidiary is considered a separate legal entity that is liable to tax as a resident of that jurisdiction. But if a business entity is not considered a resident² of the jurisdiction in which it is situated, that jurisdiction may not levy taxes on its income unless the business profits of the entity can be attributed to a permanent establishment (PE) located in that jurisdiction.³ The significance of a PE is that, it gives the country in which it is situated (the source country) the right to tax its income, notwithstanding the fact that the PE has no separate legal existence.⁴

The PE is concept is based on the premise that there has to be a physical presence of the business before the source country can tax its profits.⁵ However, the advent of electronic commerce (e-commerce) makes it difficult to identify a taxable presence in a particular country.⁶ This article analyses the meaning of the PE concept and discusses the challenges that e-commerce poses to the PE concept. The article also provides a recommendation for the effective taxation of e-commerce transactions in a source country.

2. Defining the "PE" Concept

For South African income tax purposes a "permanent establishment" is defined in section 1 of the Income Tax Act,⁷ with reference to the definition of the concept in article 5 of the Organisation for Economic Cooperation and Development's (OECD Model Tax Convention. Section 108(1) of South Africa's Income Tax Act⁸ read with Page 214 section 231 of the Constitution⁹ provide inter alia that as soon as the double tax agreement is ratified and has been published in the Government Gazette, its provisions are effective as if they had been incorporated into the Income Tax Act.¹⁰ In interpreting the term "permanent establishment", which is a treaty term, it was held in CIR v Dowing,¹¹ that South Africa is bound to take cognisance of the guidelines for interpretation issued by the OECD in its commentaries on the concepts used in the OECD Model Tax Convention. Constitutionally, South African courts are also bound to apply customary international law.¹² This includes the OECD Model Tax Convention and its Commentary. ¹³ Article 5(1) of the OECD Model Tax Convention defines a PE as "a fixed place of business through which the business of an enterprise is wholly or partly carried on".¹⁴ From this definition, three elements can be identified, namely: a place of business, the place of business must be "fixed", and the business of the enterprise must be carried on through this fixed place of business. These elements are analysed below.

2. 1 Place of business

A PE will only exist if the enterprise has a physical presence in the source state.¹⁵ Under article 5(2) of the OECD Model Tax Convention, the following constitute a place of business: a place of management; a branch; an office; a factory; a workshop; and a mine, an oil or gas well, a quarry or any place of extraction of natural resources. The size of the premises and the equipment required to constitute a place of business depends on the nature of the business and it is irrelevant whether the premises are rented or owned.¹⁶ In the German "pipeline"¹⁷ case, it was held that it is not a requirement that the place of business be attached to the surface of the earth or that it is visible above the ground. Article 5(3) of the OECD Model Convention further provides that a contraction site or an installation project constitutes a PE provided it lasts for more than 12 months. It should be noted that the above mentioned activities in themselves are not conclusive evidence of the existence of a PE. The OECD makes it clear that these have to be viewed against all the other requirements discussed below.

2. 2 The place of business must be "fixed"

For a place of business to be fixed, two components have to be met, namely: a specific geographical spot (the location test); and there must be a certain degree of permanence at each geographical spot (the duration test). The location test requires that there must be a link between the place of business and a specific geographical point but the place of business does not necessarily need to be physically connected to the ground. In applying this test, the context of the business has to be understood. The key requirement is that the business should commercially and geographically consist of a coherent whole.¹⁸

Under the duration test, a certain degree of permanence is required in order for a PE to exist. The business should not be temporary in nature.¹⁹ In South Africa, the courts hold the view that the word "permanent" in "permanent establishment" does not refer to mere temporary use of premises for purposes of trade. In Transvaal Associated Hide and Skin Merchants v Collector of Taxes, Botswana²⁰ it was decided on the facts that the taxpayer's regular occupation of the shed at an annual rental showed that its occupation of the premises was permanent and not temporary. It should also be noted that the word "fixed" does not mean that no interruption of operations may occur, but operations must at least be carried out at a regular basis.²¹ Page 215

2. 3 Through which business is carried on

The business of the enterprise has to be carried on wholly or partly through the fixed place of business.²² The phrase "carried on through" infers that the business activities are carried on at a particular location that is at the disposal of the enterprise for that purpose.²³ A distinction has to be made between a PE "serving" an enterprise and one through which the businesses of the enterprise is carried on. To "serve" an enterprise, the activities of the PE may be the main activities of the enterprise or they may be auxiliary, substantial or insignificant.²⁴ Although the business of the enterprise needs to be carried on through the PE, this does not mean that a PE will only exist if individuals are present. Although the presence of individuals may be required for the setting up of a PE, their ongoing presence is not required.²⁵ The presence of fully automatic equipment operated and maintained by the enterprise in the host country may constitute a PE. However, if the enterprise merely sets up the machines and then leases them to other enterprises, a PE does not exist.²⁶

2. 4 Exclusions to the PE Concept

The OECD Model Convention sets out certain activities that are excluded from the PE definition.²⁷ The common feature with these activities is that they are, in general, preparatory or auxiliary activities. Although it is difficult to distinguish between activities that are of a preparatory or auxiliary nature and those that are not, the OECD is of the view that the decisive criterion is whether or not the activity of a fixed place of business in itself forms an essential and significant part of the activity of the enterprise as a whole.²⁸ A fixed place of business which has the function of managing an enterprise or even only a part of an enterprise cannot be regarded as doing preparatory or auxiliary activity, for such a managerial activity exceeds this level.²⁹

2. 5 Deemed PEs (dependent agents)

Although an enterprise may not have a fixed place of business in a host state, a PE is deemed to exist where a dependent agent has authority to conclude contracts on behalf of the enterprise and habitually exercises this authority in the source country.³⁰ The person making use of the authority must do so repeatedly and not merely in isolated cases.³¹ Persons (whether individuals or juristic persons) whose activities may create a PE should not be independent agents. According to the OECD, the factors which play an important role in deciding whether a person is a dependent or independent agent are: the amount of freedom the person has to enter into contracts on behalf of the enterprise. Where the person operates under detailed instructions and control, this indicates a dependent status; and, if the risk is born by the agent, then that person acts independently.³²

From the above, it can be concluded that there has to be a physical presence at a "fixed place of business" or "agency presence" in a given jurisdiction to establish a PE. The rationale for the PE concept has historically rested on two main grounds. Firstly, the presence of a PE was evidence that a foreign company conducted significant...