Advances in digital technology have not changed the fundamental nature of the core activities that businesses carry out as part of a business model to generate profits. To generate income, businesses still need to source and acquire inputs, create or add value, and sell to customers. To support their sales activities, businesses have always needed to carry out activities such as market research, marketing and advertising, and customer support. Digital technology has, however, had significant impact on how these activities are carried out, for example by enhancing the ability to carry out activities remotely, increasing the speed at which information can be processed, analysed and utilised, and, because distance forms less of a barrier to trade, expanding the number of potential customers that can be targeted and reached. Digital infrastructure and the investments that support it can be leveraged today in many businesses to access far more customers than before. As a result, certain processes previously carried out by local personnel can now be performed cross-border by automated equipment, changing the nature and scope of activities to be performed by staff. Thus, the growth of a customer base in a country does not always need the level of local infrastructure and personnel that would have been needed in a “predigital” age.
This increases the flexibility of businesses to choose where substantial business activities take place, or to move existing functions to a new location, even if those locations may be removed both from the ultimate market jurisdiction and from the jurisdictions in which other related business functions may take place. As a result, it is increasingly possible for a business’s personnel, IT infrastructure (e.g. servers), and customers each to be spread among multiple jurisdictions, away from the market jurisdiction. Advances in computing power have also meant that certain functions, including decision-making capabilities, can now be carried out by increasingly sophisticated software programmes and algorithms. For example, contracts can in some cases be automatically accepted by software programmes, so that no intervention of local staff is necessary. As discussed below, this is also true in relation to functions such as data collection, which can be done automatically, without direct intervention of the employees of the enterprise.
These questions relate in particular to the definition of permanent establishment (PE) for treaty purposes, and the related profit attribution rules. It had already been recognised in the past that the concept of PE referred not only to a substantial physical presence in the country concerned, but also to situations where the non-resident carried on business in the country concerned via a dependent agent. Now, as it is possible to be heavily involved in the economic life of another country without having a fixed place of business or a dependent agent therein, concerns are raised regarding whether the existing definition of PE remains consistent with the underlying principles on which it was based. For example, the ability to conclude contracts remotely through technological means, with no involvement of individual employees or dependent agents, raises questions about whether the focus of the existing rules on conclusion of contracts by persons other than agents of an independent status remains appropriate in all cases.
These concerns are exacerbated in some instances by the fact that in certain business models, customers are more frequently entering into ongoing relationships with providers of services that extend beyond the point of sale. This ongoing interaction with customers generates network effects that can increase the value of a particular business to other potential customers. For example, in the case of a retail business operated via a website that provides a platform for customers to review and tag products, the interactions of those customers with the website can increase the value of the website to other customers, by enabling them to make more informed choices about products and to find products more relevant to their interests.
Similarly, users of a participative networked platform contribute user-created content, with the result that the value of the platform to existing users is enhanced as new users join and contribute. In most cases, the users are not directly remunerated for the content they contribute, although the business may monetise that content via advertising revenues (as described in relation to multi-sided business models below), subscription sales, or licensing of content to third parties. Alternatively, the value generated by user contributions may be reflected in the value of business itself, which is monetised via the sale price when the business is sold by its owners. Concerns that the changing nature of customer and user interaction allows greater participation in the economic life of countries without physical presence are further exacerbated in markets in which customer choices compounded by network effects have resulted in a monopoly or oligopoly.
These various developments must be understood in light of their relationship to more traditional ways of doing business. For example, while having a market in a country is clearly valuable to a seller, this condition by itself has not created a taxing right in the area of direct taxation to this point. It is also true that data about markets and about customers has always been a source of value for businesses as illustrated by phenomena such as frequent flyer programmes, loyalty programmes, the creation and sale of customer lists, and marketing surveys (in which customers participate for no remuneration), to name a few. The traditional economy also benefited from “network” effects in ways that are perhaps less obvious than the network effect present in social networks. Sellers of fax machines, for example, were dependent on a sufficiently broad supplier of purchasers in order to ensure that their product had value. The digital economy has, however, enabled access to markets with less reliance on physical presence than in the past. In addition, the digital economy has enabled collection and analysis of data at unprecedented levels, and has enhanced the impact of customer and user participation in the market, as well as the degree of network effects. It has been suggested that the lower marginal costs in digital businesses coupled with increased network effects generated by higher levels of user participation may justify a change in tax policy.
Another specific issue raised by the changing ways in which businesses are conducted is whether certain activities that were previously considered preparatory or auxiliary (and hence benefit from the exceptions to the definition of PE) may be increasingly significant components of businesses in the digital economy. For example if proximity to customers and the need for quick delivery to clients are key components of the business model of an online seller of physical products, the maintenance of a local warehouse could constitute a core activity of that seller. Similarly, where the success of a high-frequency trading company depends so heavily on the ability to be faster than competitors that the server must be located close to the relevant exchange, questions may be raised regarding whether the automated processes carried out by that server can be considered mere preparatory or auxiliary activities.
Although it is true that tax treaties do not permit the taxation of business profits of a non-resident enterprise in the absence of a PE to which these profits are attributable, the issue of nexus goes beyond questions of PE under tax treaties. In fact, even in the absence of the limitations imposed by tax treaties, it appears that many jurisdictions would not in any case consider this nexus to exist under their domestic laws. For example, many jurisdictions would not tax income derived by a non-resident enterprise from remote sales to customers located in that jurisdiction unless the enterprise maintained some degree of physical presence in that jurisdiction. As a result, the issue of nexus also relates to the domestic rules for the taxation of non-resident enterprises.