In a communication it published on 21 September 2017, the European Commission set out several options for taxing companies that are active in the digital economy. What would these options mean for your business?

This ‘Tax Bit’ is the third in a series in which we assess all the options the Commission has put forward. This time, we discuss the option of introducing the concept of the Significant Economic Presence nexus (as also addressed in the ECOFIN conclusions of 5 December 2017).

Please also see our note, “Taxing the digital economy under discussion in the EU”, for more background information.

Option III – Significant Economic Presence (Virtual Permanent Establishment)

New Rules to Define Taxable Presence

Until now, international tax rules have used physical presence (a ‘permanent establishment’ – PE) to allocate taxing rights. Nowadays, by virtue of digital technologies, businesses are able to have a significant economic presence in a market without necessarily having a substantial physical presence.

The European Commission contemplates a legislative proposal which would introduce new nexus rules on the basis of which tax could be levied in a Member State, in situations in which there is no substantial physical presence but a ’significant economic presence’ or a ‘virtual permanent establishment’. The question is how to determine a significant economic presence.

The ECOFIN on 5 December suggested taking into account elements mentioned in the OECD’s BEPS Action 1 report regarding the digital economy: revenue-based, user-based and digital factors. In addition, policymakers need to decide if a certain degree of permanence (e.g., a relationship with customers/users over 'x' months) will be required before a virtual PE is recognised.

Digital factors

In the framework of the pending proposal for an EU Common Corporate Consolidated Tax Base (CCCTB), the European Parliament has proposed a deemed (digital) permanent establishment when a non-resident taxpayer provides access to or offers a digital platform such as an electronic application, database, online market place, storage room, or offers search engine or advertising services on a website or in an electronic application.

Other potential digital factors are a local domain name or local payment options.

Revenue-based factors

This could be the revenue generated from sales to residents of a given State. The scope of the ‘virtual PE’ would depend on which remote transactions are covered and on the revenue threshold applied.

A further attention point is the principle of tax neutrality: according to EU case law, tax policy choices and tax rules should provide for similar treatment for comparable situations. Anti-abuse provisions could also be necessary to protect the revenue-based nexus, for instance to prevent artificial fragmentation of remote sales activities with customers of the same country between several foreign affiliated enterprises.

User-based factors

These would include, for example, the number of registered users per month (or per year), the volume of digital contracts concluded, and/or the volume of the digital content collected by the taxpayer. The digital content may cover not only personal data but also user created content, such as product reviews and search histories.

New transfer pricing and profit attribution rules

Once the significant economic presence is determined in different jurisdictions, it is necessary to determine (i) what creates value and (ii) where that value is created in order to allocate (taxable) profits to these jurisdictions.

International transfer pricing rules, as updated by BEPS Actions 8-10 recommendations, allocate profits based on an analysis of the functions performed, assets used and risks assumed, taking into account the arm’s length principle. The OECD seems to put increasing emphasis on the place where the significant people functions are performed. Under current transfer pricing rules, profits cannot be allocated to a State in which no functions, assets and risks are present.

The current transfer pricing rules, therefore, would have to be revised in order to allocate profits to the jurisdictions where a significant economic presence is located. It is unclear which direction the EU will take in the development of new profit allocation rules. New rules might be introduced which, for the question where value is created, are linked wholly or partly with the demand side (destination principle).

Some technical issues

Depending on the solution to be proposed by the European Commission, there are a number of issues that will have to be taken into account. We mention a few:.

Digital factors

An open question is how those must be allocated to a certain jurisdiction. What, for example, makes a domain name local? Many domain names end with ‘.com’ and are used internationally. Local websites can be recognized by a local ‘address’. For instance: .nl (Netherlands) or .dk (Denmark) or a website in a certain language. In such situations, it can be defended that a website has a certain nexus with a State, although often users from another country will also visit these websites. Similar problems play arise with digital platforms.

Value allocation

Settling for the destination principle still leaves open the issue of value allocation between the different destination-based factors. Value can be allocated, for example, on the basis of sales, but also on the basis of the data used by (digital) companies (e.g., product reviews and search histories). This gives rise to the question how to value the data and what the difference is between the value of raw data compared with data that has been aggregated.

An alternative would be methods based on fractional apportionment (a predetermined formula or based on variable allocation factors determined on a case-by-case basis). To date, the OECD has not been in favour of fractional apportionment methods but, since the CCCTB would involve a fractional apportionment, it cannot be excluded that this solution forms part of the EU proposals.

The relationship with current rules on PE should also be addressed. For instance, could one taxpayer have two permanent establishments (one physical and one virtual)? And should the exemption of auxiliary services in article 5(4) of the OECD Model Tax Convention be deleted? As has been mentioned previously by many, it may be difficult to ring-fence the digital economy in a meaningful way. It would even be more challenging to introduce a fundamental change of profit allocation rules to a ring-fenced part of the economy. Such a fundamental change would immediately trigger the question why the same principles should not be applied to a physical permanent establishment.

Finally, there is the possibility that deemed profit methods for the allocation of profits will be proposed, for example, a profit split method with an upfront allocation of a partial profit to the market jurisdiction. Such methods could be incorporated relatively easily in the current transfer pricing methods. Under a deemed profit method, part of the profit could be split to the jurisdiction in which the market is located (the State in which there is a ’significant economic presence’).


Within the EU, a directive would likely be adopted to ensure coordinated implementation of the agreed reform. The implementation of such directive would require changes to domestic tax law and very likely to existing tax treaties (also with non-EU countries). It is unclear how tax treaties with non-EU countries could be modified if the non-EU country refuses to accept the amendment. An implementation via the Multilateral Tax Instrument (MLI) could also be contemplated.

Political support

On 5 December 2017, the ECOFIN agreed that the EU would actively participate in ongoing discussions at OECD level. The Commission will nonetheless in parallel publish proposals for the EU early in 2018. The ECOFIN called on the Commission to assess thoroughly all options, including temporary measures, such as an equalisation levy based on revenues from digital activities (see our first ‘Tax Bit). The notion of the concept of a significant economic presence (and adjustment of transfer pricing rules) is expected to gather political support from the EU. To date, the OECD has also expressed a preference for the ‘virtual PE’ option.