Taxation of e-commerce:
The Challenge of E-commerce to the Definition of a
The OECD’s Response
Jean-Philippe Chetcuti. All Rights Reserved.
commerce - a definition
commerce comprises the electronic sale by online stores of downloadable ‘soft
merchandise’ such as music, e-books, e-newsletters, photos and video
recordings, software and documents (direct e-commerce), the electronic ordering
of tangible products (indirect e-commerce), online securities transactions as
well as the provision of financial or other services.
It also includes the subscription to and use of an internet service
provider (ISP) or an online service provider (OSP), and has also been held to
cover electronic data interchange (EDI), electronic fund transfers (EFT) and all
credit and debit card activity. E-commerce
transactions can be ‘business-to-business’ (B2B) or
fundamental characteristic of e-commerce, which distinguishes it from
traditional commercial activity, is that it is conducted by electronic means.
Thus, the marketing of products or services is carried out through the
enterprise’s web site; customers browse online catalogues and use secure
online-shopping cart systems; orders are made via interactive online order
forms; payment is effected by credit card via secure payment systems; and
delivery is either arranged by traditional means (mail, shipment, etc.) or
alternatively by allowing the downloading of digitalised products from the web
site onto the consumer’s computer.
characteristics of e-commerce
is characterised by the following features.
Potentially virtual – the presence of an enterprise
in another country may be wholly based on the hosting of a web-site on a server
located there. 
and less labour intensive – the main enterprise no longer requires
intermediaries in foreign countries to be able to conduct business there. Moreover, e-business activities require far less human
intervention, if any, than that otherwise required to trade by in a traditional
– the scope of market-penetration is unlimited and knows no borders;
– business is transacted on a non-face to face basis and therefore the seller
and the consumer may not know each other.
same advantages, which have revolutionised the way commerce is conducted, now
present fiscal and other legal difficulties which were inexistent under the
pre-internet legal order. Never has
a technological innovation or invention ever challenged the world’s economic
and legal foundations so drastically. It
comes as no surprise that the tax impact of e-commerce has been dubbed “the
most consequential tax issue of the new millennium”.
concept of Permanent Establishment
tax treatment of cross-border commerce is the subject of bilateral tax treaties
which are often negotiated versions of the OECD Model Tax Convention.
According to Article 7 of OECD Model, the source country may tax the
profits arising from commercial activity carried out within its borders by a
foreign entity through a substantial physical presence in the source country.
To justify source taxation, such presence must reach the level of a
‘permanent establishment’ by satisfying the following three prerequisites,
namely that there must be a distinct place, such as premises, or in certain
instances, machinery or equipment (“place-of-business test”), that this must
be established with a certain degree of permanence (“permanence test”), and
that business must be carried on through the place, usually by personnel of the
enterprise (“business-activities test”).
the presence does not reach the level required by the OECD Model by satisfying
these requirements, the source state is not entitled to charge income tax on the
profits arising from the international transaction; rather, the residence
country will have the right to tax the profits of its resident.
requirement of a PE in source countries is comparable to the US substantial
physical presence test. Constitutionally,
in the US, a state is entitled to impose state and local sales taxes an
enterprise of another US state only if such business maintains a substantial
physical presence within the former state.
considerations - the rational behind the PE principle
the concept of PE 
answered the internationally-felt need for a quantitative criterion for
ascertaining the taxability or otherwise of foreign commercial activity in the
source state. The PE principle
provided sufficient evidence that a foreign company’s business within the
source country was substantial enough to justify the imposition of fiscal
compliance burdens on the foreign company in that country.
concept satisfied the requirement of certainty and predictability of tax law in
that it provided multinational companies with relatively clear rules to
determine in advance whether and in what way their activities abroad would be
taxed by foreign tax authorities. Furthermore,
the PE principle presented states with an internationally equitable rule for
sharing the benefits of cross-border commerce – source country taxation
rewards importing countries for opening to foreign businesses the commercial
opportunities available within their markets, while net-exporting countries
obviously reap the benefits of taxing value added at the production stage.
The Challenge of E-commerce
the advent of the Digital Age, the international tax community saw the PE
concept face its first major challenge. With
the dotcom boom at its peak, e-tailing ventures selling digitalised products
appeared, tapping into the global online market and capitalising on the lower
overheads associated with on-line trading.
of Physical Intermediaries
multinational corporations have sought to penetrate foreign markets by setting
up physical intermediaries within the targeted markets.
For instance, retailers have carried out their marketing campaigns via
sales offices operating in the foreign market. These physical intermediaries
often constituted PEs under tax treaties, triggering source-based taxation.
picture changes with the availability of e-commerce opportunities.
E-tailers such as Amazon.com effect the greater part of their market
research, advertising, marketing and sales through a web site. This increases competitiveness, transferring transaction
costs, including product selection, to customers so that the cost-savings for
the online retailer is tremendous.
Thus, the Internet can be seen as an “agent of disintermediation”
because it removes the necessity for certain intermediaries.
Even stockbrokers have felt the pinch of online competition.
E*trade.com permits retail stock trading without brokers, along with
Charles Schwab, Datek Online, CyberInvest.com, Ameritrade, Inc., 5Paisa.com and
a multitude of other e-brokers now in the trade.
the multinational corporation, disintermediation means shifting part of their
business operations from their physical intermediaries in source countries to
their e-commerce base in the country of residence, thereby centralising their
administrative, sales, marketing and after-sales operations and outsource
non-essential functions to foreign affiliates.
For source countries, this means a loss of source-generated taxable
profits and, as long as international tax rules insist on the physical presence
requirement, their tax base will suffer further erosion.
of Human Intermediaries
latest internet technologies can now also perform those tasks traditionally
carried out in source countries by dependent agents or employees employed by
multinationals. Complex contracts
can be concluded remotely and new business relationships created online.
The processes of order collection, contract negotiation and payment
collection can now be automated. The
removal of dependent agents habitually concluding contracts in the source state
means that a PE may no longer be present under most tax treaties.
The same result can be achieved by replacing dependent agents with
independent agents acting on instructions to perform the same tasks.
Meanwhile, customer relationships are maintained via the company’s
Under the current international tax regime, no tax can be chargeable by the
source state for the corporation’s activities in its market.
and the ‘cybermediary’
opportunities are created especially in the B2B sector for the role of the
‘cybermediary’, an online company engaged in facilitating business
transactions online, without having fixed places of business within source
“infomediaries”, like Vertacross.com and Ariba.com operating in the
e-procurement business bring buyers and sellers together on the Internet,
greatly reducing transaction costs for both parties. These new intermediaries are performing operations outsourced
to them by multinational corporations.
more and more businesses going virtual and with a greater portion of source
state activity carried out without a PE, source states are justified to fear
that their tax legal entitlement to tax foreign activities within their markets
is steadily being curtailed. Furthermore,
the anonymity of internet transactions means that internet activity is difficult
to trace; residence states’ tax authorities too could lose their ability to
detect taxable business activity. E-commerce
ventures would be able to elude fiscal liability altogether.
Sites and Servers
the destabilisation of the traditional concept of PE, attention has quickly
shifted onto servers and web sites for their possible qualification as a PE.
Can a server, telecommunications device (such as a cable used in
transmission), computer terminal, or web page be considered a PE?
web site of an e-commerce business is a combination of software and electronic
data stored on and operated by a server.”
have described a web site as “a company’s or an individual’s collected web
It is clear from these two definitions that a web site is intangible and as such
cannot alone make up a “place of business”.
To satisfy the latter requisite, there has to be a facility such as
premises or, in certain circumstances, machinery or equipment. 
internet server consists of tangible computer equipment networked to the
internet. A server is usually
dedicated to the storage and internet accessibility of web sites, email accounts
and databases and software programmes resident on the server can automatically
administer the electronic transmission of digitalised e-commerce products or
services to end consumers. E-commerce
ventures may use the web hosting services of ISPs who allocate and make
available to them sufficient server space for their e-commerce requirements.
Alternatively, such firms may own or lease a server so as to command a
higher level of control over the server.
Typical e-commerce models
foreign e-commerce operations are carried out by means of servers located in the
target markets. Dotcom ventures can
adopt various working models or server combinations.
An e-commerce transaction can involve a number of servers strategically
located in different countries. The
firm’s web site and its online store can be hosted on different servers or on
one and the same server situated anywhere in the world and accessible by online
consumers from any part of the world. For
the downloading of the ‘soft merchandise’ purchased from the e-store, the
web site then retrieves the data from a server elsewhere on which the data is
stored and sends it electronically to the customer (refer to Figure 1 supra).
Alternatively, the consumer is (either voluntarily or unknowingly)
redirected to another server which holds the firm’s data (refer to Figure 2).
Tax planning reasons apart, servers are usually so located so as to
optimise the downloading process of ‘soft merchandise’ onto purchasers’
(in-)applicability of traditional PE-based taxation
to Prof. Hinnekens, the fundamental distinctions and categories that previously
guided traditional international tax law have been blurred by this relatively
recent phenomenon. Hinnekens doubts
whether “tomorrow’s business may … be effectively taxed under application
of yesterday’s rules.” 
Thus, the geographical categories of PE and residence for tax purposes
now face renewed challenges, as do the distinctions between preparatory services
and core activities, between goods and services, between services transactions
and property transactions, and so on.
the application and enforcement of traditional tax rules is more difficult in
cyberspace than in the brick-and-mortar business world.
Events which would normally give rise to tax liability in the latter
world are likely to escape detection by fiscal authorities in the electronic
world and unintentional non-taxation would result.
Dotcoms can potentially exploit these new business avenues to gain a
competitive tax advantage over their traditional competitors.
It is therefore evident that governments worldwide must react to this new
threat to their fiscal effectiveness.
The OECD’s Reaction
1998 OECD Ministerial Conference of Ottawa
confirmed leading role in taxation and e-commerce
1998 OECD Ministerial Conference
confirmed the OECD’s mandate, first proposed in November 1997, to assume the
international leadership in coordinating the work on electronic commerce and
taxation. The OECD and the European
Union would co-operate on consumption tax issues while the World Trade
Organisation and the World Customs Organisation would
concentrate on tariff issues and on customs issues respectively.
application of existing tax rules to e-commerce
preference for traditional principles relies on the view that radical changes to
the international tax system are unwarranted because e-commerce simply places
pressure on existing problems, such as international transfer pricing.
the twenty-nine OECD MSs, including the US ,
represented at the Ottawa Conference agreed with the Committee on Fiscal
Affairs’ recommendations 
that “[t]he taxation framework for electronic commerce should be guided by the
same taxation principles that guide governments in relation to conventional
commerce.”  Any new administrative measures should be directed toward the
application of existing taxation principles and should not be intended to impose
a discriminatory tax treatment on e-commerce 
“at this stage of development in the technological and commercial
environment”. Likewise, it was agreed that the canons of taxation generally
applicable to taxation of conventional commerce should equally apply to
e-commerce, namely: neutrality, efficiency, certainty, simplicity,
effectiveness, fairness, and flexibility.
was agreed that five Technical Advisory Groups should be created to implement
the CFA’s recommendations. These included individuals from the industry and
representatives from OECD member and non-MSs.
Moreover, several OECD Working Parties were formed to produce reports and
discussion papers on various e-commerce tax issues.
for net e-commerce importing and exporting countries
OECD MSs endorse the view that servers can constitute PEs in some circumstances,
while acknowledging the importance of a fair sharing of the tax base
internationally. Net e-commerce importers facing the prospect of losing their
grip on taxable PEs, are actively pursuing consensus on mechanisms which serve
to protect their tax base, such as the taxability of servers as PEs under
existing international tax principles. Alternatively,
in the (re-)negotiating stages of bilateral tax treaties, net importing
countries may be willing to give up server/PE criteria in exchange for other tax
concessions granted by net exporting countries. 
on the Application of the PE Definition in E-Commerce
Draft Commentary on Article 5 concerning
the application of the current definition of PE the context of e-commerce, issued
by Working Party No. 1 on Tax
Conventions and Related Questions, was adopted by the CFA on 22 December 2000.
sites and servers
approved changes to the commentary on Article 5 distinguish between web
sites and servers for PE purposes so that web sites stored on a server should
not constitute a PE. 
On the other hand, “the server on which the web site is stored and through
which it is accessible is a piece of equipment having a physical location.
Such a location may constitute a ‘fixed place of business’ of the
enterprise that operates that server”
as long as the server is fixed at a certain place for a sufficient period of
The permanence test looks at whether the server has actually been moved,
irrespective of whether it can or cannot be moved.
distinction is also made between the web site operator and the server operator,
who may or may not be the same person. The former enterprise “carries on
business through the web site’ but does not necessarily operate the server.
In the case of web hosting arrangements, the enterprise’s web site is
hosted on a server operated by an ISP. A PE may only arise where the server is
at the disposal of the online enterprise who owns or leases it, and can never
arise in the case of ISP hosting.
web sites and agency
makes it clear that ISPs cannot constitute dependent agents because they do not
have authority to conclude contracts in the name of the enterprise, because they
do not do so regularly or because they “constitute independent agents acting
in the ordinary course of their business, as evidenced by the fact that they
host the web sites of many different businesses.”
Neither can a web site constitute a dependent agent as it is not itself a
‘person’ in the sense of Article 3 of the OECD Model.
this requires that the functions performed at that place be significant as well
as an ‘essential’ or ‘core’ part of the business activity of the
[the server] functions form in themselves an essential and significant part of
the business activity of the enterprise as a whole, or where other core
functions of the enterprise are carried on through the computer equipment …
there would be a permanent establishment.
new additions to the Commentary on Article 5 provide an indicative list of
examples of core functions in the case of e-tailers. These “depend on the
nature of the business carried on by the enterprise” and need not all occur in
any given case: “the conclusion of the contract with the customer, the
processing of the payment and the delivery of the products,” all of which are
performed automatically online.
or auxiliary activities
indicative list of activities generally considered preparatory or auxiliary
includes providing a communications link, advertising goods or services,
relaying information through a mirror server, gathering market data or supplying
information. Whether these or other server activities should be
characterised as auxiliary or preparatory in nature “needs to be examined on a
case-by-case basis having regard to the various functions performed by the
enterprise through that equipment.”
Thus online advertising, the provision of an online catalogue or the
provision online of information to prospective customers by an e-tailer does not
create a PE. On the other hand, an
online advertising agency’s online adverts or the online research activities
of an online market analyst are likely to constitute core activities and this
contribute to establishing a PE.
new Commentary also indicates that servers can constitute PEs even if no on-site
human intervention is involved or necessary, in the same way as automatic
pumping equipment used in the exploitation of natural resources can make up a
PE. The CFA’s decision to allow the taxation of business
profits generated by servers seems to have precedent.
By analogy, servers may be compared to “automatic equipment” such as
vending and gaming machines which thought to suffice for the purpose of a PE.
On the other hand, it is not unknown for tax treaties to contemplate
‘fictions’ which favour source country taxation despite the absence of any
real PE, as in the case of foreign athletes or artists generating earnings
without a PE. 
Such precedents support arguments that source countries should tax
e-commerce profits from sales within their jurisdictions even in the absence of
of requirements for a Server-PE
a server to constitute a permanent establishment, it has to meet the following
The server on which web site is hosted and its location have to be at the
foreign enterprise’s disposal – owned / leased and operated by the
enterprise – not web hosting;
The server must be is located in the taxing state – a “fixed place of
Core business activities have to be performed through the server, as
opposed to preparatory or auxiliary functions, without the need for human
Conclusion: Problems solved?
problems posed by the technology of the New Economy seem insurmountable.
It is debatable whether the OECD’s clarification of the definition of a
PE has helped restore the equitable sharing of tax revenues between residence
and source countries, and this for a number of reasons.
are highly mobile and flexible in nature. A
server need not have any geographic connection either to the source country or
to the residence country. Therefore
e-businesses may own or lease a server located anywhere in the world and can
conduct its business activities via this server in such a way as to ensure that
their profits will either be taxed exclusively by the residence country or by
some low tax jurisdiction.
Moreover, servers can transfer their programs almost instantaneously to a
server in a different jurisdiction as necessary.
Furthermore, the server can be maintained or programmed remotely by
employees located outside of the source country or serviced by experts in the
flaw of the OECD’s position is that it ignores the possibility of e-commerce
functions being transferred to the end consumer’s computer.
Web servers often plant small programs or applets in the user’s
computer which then performs a portion of the processing itself.
Alternatively, e-commerce functions can be decentralised via peer-to-peer
networking where users trade digital products without resorting to any
centralised server location. All
these possibilities render the task of determining the location of a PE very
difficult, if not impossible.
Ultimately, networking technologies have created a breading ground for
tax planning opportunities which encourage the relocation of servers across
borders. The current PE rules can easily be circumvented either by carrying on
only preparatory or auxiliary activities in the source state, or by using the
server of a local ISP to carry on the core business activities of the foreign
enterprise, or by positioning the server and establishing a PE in low or no tax
jurisdictions. Similarly, domestic
vendors too can very easily create a PE in lower tax jurisdictions elsewhere.
problematic matter is that of enforcement and administration.
How can tax authorities determine the income attributable to software
functions within servers, to a server or web site?
How about the significant compliance costs that could burden
multinational businesses having to comply with fiscal obligations in every
jurisdiction where their servers are located?
These are the questions that face the international fiscal order in the
years to come. Meanwhile,
efforts by regulators to transpose conventional international tax principles
into the virtual world seem to be failing.