Section 5 - Principles for Allocating Taxing Rights, Factors that contribute to Profitability & Historical Review of Existing Rules

42. While endorsing the BEPS Action plan, the G-20 Declaration also emphasized the need to ensure that profits are taxed where economic activities deriving the profits are performed and their value is created. The profitability of a business is dependent upon the supply of goods or services to those wishing to pay for it. The primary economic activities that lead to profits of any business are production and sale.

5.1 Factors that contribute to profits of an Enterprise & Role of Public Resources and Taxation

43. The economic theory makes its obvious that the price of the goods and services that it can seek from the buyers, the volume of its sales, and costs that it incurs for production are the primary determinants of its profits. The market price as well the volume of sales, in turn, results from the interaction of demand and supply within a market, and are contributed by factors on both demand side and supply side. The supply side factors are related to production and marketing, whereas the primary demand side factor that influences the price of a good or service and the profitability of the enterprise supplying them, is the paying capacity of consumers.

44. The paying capacity of consumers is a function of the state of that economy, including availability of public goods, law and order, market facilitation, infrastructure as well as redistribution of resources (subsidies) to the consumers directly or indirectly, using public resources. The profits arise only when an economic good produced by supplier is paid for by a consumer during the sale transaction. The performance of sale, thus has two limbs – the buyer and the seller and their interaction leads to creation of value and profits. By stabilizing, promoting, preserving and augmenting the paying capacity of the consumers, the Government and the public resources belonging to that economy play a vital role in contributing to the profits generated by enterprises having a significant economic presence in that jurisdiction, and the resultant value of the enterprise. This also serves as the primary justification for collection of taxes by that jurisdiction on profits and income earned by any enterprise having a significant economic presence therein.¹⁷

45. Similarly, factors that contribute on the supply side include the availability of economic stabilization, supply of public goods, law and order, market facilitation, infrastructure as well as subsidies provided to enterprises directly or indirectly. These factors contribute significantly to the ability of the enterprise to produce at competitive prices, and their provisioning from public resources provides a justification for the jurisdiction in which supply side activities are carried out by an enterprise to impose a tax on its profits or income.

46. In case of purely domestic enterprise, the demand side factors as well as the supply side factors are contributed by the same jurisdiction, which also levies taxes on it. However, in case of a multi-national enterprise, producing and selling in different jurisdictions, the contribution of demand and supply side factors to its profitability are made from the public resources of different tax jurisdictions, both of which can claim justification for taxing it. The possibility of resultant double taxation can be detrimental to the enterprise and its ability to carry its business across borders. Therein lies the origin of Double Taxation Avoidance Agreements, commonly referred to as “tax treaties” that evolved in the last century keeping in view the business models that were the focus on international trade and taxes at that point of time.

5.2 Historical Overview of International Taxation Rules

47. Action I Report finalized by the Task Force in 2015 provides a detailed historical overview of the conceptual basis for allocating tax and rights, wherein it recognizes two aspects to a state’s sovereignty: the power over a territory (“enforcement jurisdiction”) and the power over a particular set of subjects (“political allegiance”). It reports that relationship to a person (i.e. a “personal attachment”) or on the relationship to a territory (i.e. a “territorial attachment”) were usually adopted as the basis for taxation.18 It describes the significance of source in such taxation in paragraph 26 as under:

“26. With respect to the taxation of inbound investments of non-resident companies, both a worldwide tax system and a territorial tax system impose tax on income arising from domestic sources. Hence, the determination of source of the income is key. Sourcing rules vary from country to country. With respect to business income, the concept of source under domestic law often parallels the concept of permanent establishment (PE) as defined under tax treaties. Such income is typically taxed on a net basis. For practical reasons however, it may be difficult for a country to tax certain items of income derived by non-resident corporations. It may also be difficult to know what expenses a nonresident incurred in earning such income. As a result, taxation at source of certain types of income (e.g. interest, royalties, dividends) derived by non-resident companies commonly occurs by means of withholding taxes at a gross rate. To allow for the fact that no deductions are allowed, gross-based withholding taxes are imposed at rates that are usually lower than standard corporate tax rates”

48. The existing tax treaties have their origins in the Model of Bilateral Tax Treaty drafted in 1928 by the League of Nations, the details related to which are provided in paragraphs 28 to 32, which are reproduced below for ease of reference.

“2.3.2.1 A historical overview of the conceptual basis for allocating taxing rights 28. As global trade increased in the early 20th century, and concerns around instances of double taxation grew, the League of Nations appointed in the early 1920s four economists (Bruins et al., 1923) to study the issue of double taxation from a theoretical and scientific perspective. One of the tasks of the group was to determine whether it is possible to formulate general principles as the basis of an international tax framework capable of preventing double taxation, including in relation to business profits.2 In this context the group identified the concept of economic allegiance as a basis to design such international tax framework. Economic allegiance is based on factors aimed at measuring the existence and extent of the economic relationships between a particular state and the income or person to be taxed. The four economists identified four factors comprising economic allegiance, namely (i) origin of wealth or income, (ii) situs of wealth or income, (iii) enforcement of the rights to wealth or income, and (iv) place of residence or domicile of the person entitled to dispose of the wealth or income.

29. Among those factors, the economists concluded that in general, the greatest weight should be given to “the origin of the wealth [i.e. source] and the residence or domicile of the owner who consumes the wealth”. The origin of wealth was defined for these purposes as all stages involved in the creation of wealth: “the original physical appearance of the wealth, its subsequent physical adaptations, its transport, its direction and its sale”. In other words, the group advocated that tax jurisdiction should generally be allocated between the state of source and the state of residence depending on the nature of the income in question. Under this approach, in simple situations where all (or a majority of) factors of economic allegiance coincide, jurisdiction to tax would go exclusively with the state where the relevant elements of economic allegiance have been characterised. In more complex situations in which conflicts between the relevant factors 18 Paragraph of economic allegiance arise, jurisdiction to tax would be shared between the different states on the basis of the relative economic ties the taxpayer and his income have with each of them.
30. On the basis of this premise, the group considered the proper place of taxation for the different types of wealth or income. Business profits were not treated separately, but considered under specific classes of undertakings covering activities nowadays generally categorised as “bricks and mortar” businesses, namely “Mines and Oil Wells”, “Industrial Establishments” or “Factories”, and “Commercial Establishments”.3 In respect of all those classes of activities, the group came to the conclusion that the place where income was produced is “of preponderant weight” and “in an ideal division a preponderant share should be assigned to the place of origin”. In other words, in allocating jurisdiction to tax on business profits, greatest importance was attached to the nexus between business income and the various physical places contributing to the production of the income.
31. Many of the report’s conclusions proved to be controversial and were not entirely followed in double tax treaties. In particular, the economists’ preference for a general exemption in the source state for all “income going abroad” as a practical method of avoiding double taxation4 was explicitly rejected by the League of Nations, who chose as the basic structure for its 1928 Model the “classification and assignment of sources” method – i.e. attach full or limited source taxation to certain classes of income and assign the right to tax other income exclusively to the state of residence. Nevertheless, the theoretical background enunciated in the 1923 Report has survived remarkably intact and is generally considered as the “intellectual base” (Ault, 1992: 567) from which the various League of Nations models (and consequently virtually all modern bilateral tax treaties) developed (Avi-Yonah, 1996).
32. Before endorsing the economic allegiance principle, the group of four economists briefly discussed other theories of taxation, including the benefit principle (called at the time the “exchange theory”), and observed that the answers formulated by this doctrine had to a large extent been supplanted by the theory of ability to pay. Several authors consider that the decline of the benefit theory is undeniable as far as determination of the amount of tax liability is concerned, but not in the debate on taxing jurisdiction in an international context (Vogel, 1988). Under the benefit theory, a jurisdiction’s right to tax rests on the totality of benefits and state services provided to the taxpayer that interacts with a country (Pinto, 2006), and corporations, in their capacity as agents integrated into the economic life of a particular country, ought to contribute to that country’s public expenditures. In other words, the benefit theory provides that a state has the right to tax resident and non-resident corporations who derive a benefit from the services it provides. These benefits can be specific or general in nature. The provision of education, police, fire and defence protection are among the more obvious examples. But the state can also provide conducive and operational legal structures for the proper functioning of business, for example in the form of a stable legal and regulatory environment, the protection of intellectual property and the knowledge-based capital of the firm, the enforcement of consumer protection laws, or well-developed transportation, telecommunication, utilities and other infrastructure (Pinto, 2006).”

5.3 Permanent Establishment: Historical Overview

49. It can be observed that the initial conceptualization of Permanent Establishment based on physical presence was undertaken keeping in view certain industries of that time and the business models employed by them, such as mines, oil wells, factories and commercial establishments. These industries, part of the brick and mortar businesses, were based on physical presence, and based on their analysis, physical presence was conceived as a reliable threshold indicative of the intent and capacity of an enterprise of having a significant participation in the economic life of an economy. It is also not difficult to appreciate that the high costs of transportation and communication at that point of time ensured that most enterprises intending to cater to the needs of a significant market would usually prefer to locate itself in close proximity to the markets in which that enterprise intends to have a significant share, in which case, the demand side as well as supply side factors, contributed by public resources, arose in the jurisdiction where it was physically located, and aptly justified the allocation of taxing rights to that jurisdiction on the basis of physical presence. The concept of permanent establishment as a threshold for taxation of business profits in the source jurisdiction is elaborated in paragraph 35 of the Report as under:

“35. The PE concept effectively acts as a threshold which, by measuring the level of economic presence of a foreign enterprise in a given State through objective criteria, determines the circumstances in which the foreign enterprise can be considered sufficiently integrated into the economy of a state to justify taxation in that state (Holmes, 2007; Rohatgi, 2005). A link can thus reasonably be made between the requirement of a sufficient level of economic presence under the existing PE threshold and the economic allegiance factors developed by the group of economists more than 80 years ago. This legacy is regularly emphasised in literature (Skaar, 1991), as well as reflected in the existing OECD Commentaries when it is stated that the PE threshold “has a long history and reflects the international consensus that, as a general rule, until an enterprise of one State has a permanent establishment in another State, it should not properly be regarded as participating in the economic life of that other State to such an extent that the other State should have taxing rights on its profits”.5 By requiring a sufficient level of economic presence, this threshold is also intended to ensure that a source country imposing tax has enforcement jurisdiction, the administrative capability to enforce its substantive jurisdiction rights over the non-resident enterprise.”

5.4 Evolution of Permanent Establishment since its initial conception¹⁹

50. The concept of Permanent Establishment has also evolved since its original conceptualization in the last century. These include the interpretational expansion in the Commentary on OECD Model Tax Convention, of the phrase “fixed place of business” that literally means a business that is completely immobile, to include businesses having a commercial and geographical coherence within a particular jurisdiction. 20 The scope of permanent establishment has also evolved beyond the physical presence to include “a person acting on behalf of an enterprise and habitually exercising an authority to conclude contracts on its behalf”²¹. Further, provision of services beyond a threshold duration²², construction activities beyond a threshold duration23, and collection of insurance premiums24 have now been recognized as alternative thresholds that constitute permanent establishment, without the need to satisfy the “fixed place of business”. Each of these developments can be seen to have resulted from the need of international taxation rules to adapt to the new business models that have evolved and become prevalent over time in international commerce. With time, the differences in preferences and willingness of different economies to agree with such expansions, arising expectedly from their own fiscal interests, have also become clearly documented in the form of parallel evolution of the OECD and the UN Model Tax Conventions, with significant differences in the definition of permanent establishment. These differences have become more contrasting in rules on attribution of profits to a permanent establishment.25 In the light of these developments, it becomes clear that the concept of permanent establishment based on physical presence would need to be updated in view of the new business models characterizing digital economy in the same way as it has been updated earlier to adapt to the need of service industries, construction industries and insurances. However, the persistence of differences between countries preferring source based taxation and those preferring residence based taxing rights26 also indicates that such expansion will be resisted by those who stand to lose, and may not be as easy to achieve as it might appear from an almost apparent need to do so.

5.5 Tax on gross payments in the absence of a PE

51. The Model Tax Conventions developed by the OECD and UN provide for certain categories of income to be taxed in the jurisdiction in which they arise without the need for satisfying the permanent establishment based threshold. These have been elaborated in paragraph 38 and 39 of the Report on Action 1 (2015) as under:

“38. By virtue of separate distributive rules which take priority over the PE rule, some specific items of income may be taxed in the source jurisdiction even though none of the alternative PE thresholds are met in that country. These include:
• Income derived from immovable property (and capital gains derived from the sale thereof), which generally may be taxed by the country of source where the immovable property is located.
• Business profits that include certain types of payments which, depending on the treaty, may include dividends, interest, royalties or technical fees, on which the treaty allows the country of source to levy a limited withholding tax.
39. In the case of outbound payments of dividends, interest, and royalties, countries commonly impose tax under their domestic law on a gross basis (i.e. not reduced by the deduction of expenses) by means of a withholding tax. Bilateral tax treaties commonly specify a maximum rate at which the source state may impose such a withholding tax, with the residual right to tax belonging to the state of residence.6 However, where the asset giving rise to such types of income is effectively connected to a PE of the nonresident enterprise in the same state, the rules for attribution of profits to a PE control (Article 10(4), 11(4) and 12(3) of the OECD Model Tax Convention).”

52. These exceptions to the permanent establishment threshold indicate the adaptation of permanent establishment based rule of taxing income to the needs of simplicity and predictability, which are recognized as important principles in designing a tax.27 If the existence of a permanent establishment is seen as an evidence of significant participation of an enterprise in the economic life of a jurisdiction, then the taxing of these payments at a concessional rate on a gross basis provides a simple alternative way of taxing income on the basis of a simple presumptive thumb rule, without getting caught in the difficulties that arise in determining the existence of a permanent establishment and the profits that may be attributable to it. The simple tax rule for taxing these payments also suggests an alternate to the complex methodology inherent in permanent establishment based taxation of income, and a way to avoid the potential disputes that can arise from its application.

5.6 Committee’s Observations

53. In view of the extensive analysis of these aspects provided in the BEPS Report on Action 1 and the observations made above, the Committee is of the view that the physical presence based threshold for taxing income in the economy from where the payments arise, was conceptualized in an era when it reasonably indicated the significant economic presence of an enterprise in the economy of a jurisdiction. The evolution of the definition of permanent establishment, both in terms of its interpretation, as well as in terms of alternate conditions that give rise to it, is an evidence of the adaptation of this rule to the evolving ways in which business conducts itself. It signifies the dynamic evolution of taxable nexus with business modes, and justifies its further evolution to the needs of new business models of digital economy.

54. At the same time, the lack of universal acceptance of a single definition of permanent establishment rule and the divergence in the preference for attribution rules indicates a wedge between preferences of different countries that may not be easy to fill up. In this light, the gross taxation of payments in the jurisdiction where they arise, at a concessional rate of tax, offers a potential option that has already been relied in tax treaties as an alternative to the permanent establishment based rule. In broad terms, both these alternatives allocate taxing rights to jurisdictions that contribute to the profitability of an enterprise by way of demand or supply side factors provisioned by public resources belonging to that jurisdiction.

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17. A Special Report by Bloomberg BNA titled “Multistate Tax Report 2015 Survey of State Tax Departments, Vol 22, No. 4, reports that 31 of the states in the United States now resort to “significant economic presence” criteria for establishing tax nexus, instead of the ‘physical presence”, and thereby tax intangible digital goods and services provided through the digital or telecommunication networks. The introduction of the reports states as under: “To avoid potential revenue loss, an increasing number of states are rejecting the bright-line physical presence test. States are adjusting to the new economy by taxing out-of-state businesses based on their ‘‘economic presence’’ within their borders. They are also adopting new rules aimed at taxing out-of-state companies’ receipts from services and intangibles that are attributable to in-state customers. …..For example, the taxation of digital products and services (software downloads, Web hosting, and Software as a Service transactions) has become a popular area for states to expand beyond the taxation of tangible personal property to intangibles and services as well.”

18. Paragraph 20 of the BEPS Report on Action 1 (2015)

19. Paragraph 36 of the BEPS Report on Action 1(2015)

20. Paragraph 5.3 and 5.4 of the OECD Commentary on Article 5

21. Paragraph 5 of Article 5 of OECD and UN Model Tax Conventions

22. Paragraph 3 (b) of Article 5 in the UN Model Tax Convention

23. Paragraph 3 of Article 5 of OECD and UN Model Tax Conventions

24. Paragraph 6 of Article 5 in the UN Model Tax Convention

25. The amendment of Article 7 of OECD Model Tax Convention in the last decade has not been accepted by many countries like India, that prefer greater taxing rights for the source jurisdictions.

26. Economies that are net exporters of capital and technology may prefer greater allocation of taxing rights to the jurisdiction of which taxpayer is a resident; economies that are net importers of capital and technology may prefer greater allocation of taxing rights to the jurisdiction from where the payments arise.

27. Ottawa Taxation Framework, 1998

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