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International Taxation of E-commerce Business Income

Article by: Dr. Dennis Ndonga (Lecturer, Murdoch University Australia)

rapid growth of cross-border e-commerce has challenged the existing international
tax principles that are structured around national boundaries and State
sovereignty. Most tax regimes generally assert jurisdiction to tax business
income based on the principles of residence-based and source-based taxation. The
residence-based system imposes taxes based on the taxpayer being a resident or domiciled
in that jurisdiction. Source-based rules, on the other hand, focus on the
location of the economic activity generating the income, and tax is levied on
income derived from a particular jurisdiction irrespective of the residence of
the income earner. Most international tax rules have been enshrined in
bilateral agreements and model tax treaties. However, most developed countries
have modelled their bilateral tax treaties around the Organisation for Economic
Co-operation and Development’s (OECD’s) Model Tax Convention (MTC).[1]
Though the MTC does not have any binding effect upon
any State (as it is does not classify as an OECD decision under the OECD
constitution), over eighty countries (both OECD Member States and non-members)
have ratified it. The MTC has had a profound effect on international treaty
practice, with many countries using it as a template for their bilateral

governing international taxation of business income

rules governing source-based taxation of business income is prescribed in
Article 7 of the MTC. Article 7 relies on the Permanent Establishment (PE)
concept as the central element for requiring a contracting State to tax
non-resident companies on business profits derived from sales made within their
jurisdiction. Article 5 defines a PE as a fixed place of business through which
a company either wholly or partially carries out its activities. This
definition includes both physical intermediaries such as an office or factory; agents
who are under the control of the foreign company; as well as computer servers
on which the foreign vendor’s website is located.

to applying the PE concept to e-commerce taxation

ability to operate in a borderless environment has enabled them to exploit
loopholes within the international tax rules especially when it pertains to
source-based taxation of foreign e-commerce firms. The key challenges concern
the application of the PE concept to e-commerce transactions particularly with
taxing physical intermediaries and servers.

  1. Taxing
    physical intermediaries

MTC’s provision on source-based taxation that focuses on a company’s physical
presence in the host jurisdiction is centred on traditional foreign investment
patterns. Multinationals investment strategies stemming from the 1960s were
themed around consumer proximity, with the physical location of their
activities being a key component of their business model. Such corporations would
try to break into new markets by establishing foreign-owned subsidiaries to
provide sales, advertising and promotion services to local consumers in those
economies. However, the growth of e-commerce and digitized goods and services
has promoted disintermediated business models whereby suppliers are able to
bypass traditional intermediaries and directly connect with consumers. E-retailers
are able to sell goods to consumers in different countries without the need to
establish subsidiaries or contract local sales agents. At the same time, such
retailers have the flexibility of linking their website domain names to any
server across the world, thus making it hard to verity the location of the
machine or its users. This lack of physical location, coupled with the lack of
physical contact between international sellers and consumers has made it
difficult for tax authorities to impose income taxes to e-commerce firms based
on the PE principle.

  • Taxing
    computer servers

MTC recognises servers on which an e-retailers websites are stored can constitute
a PE of the company so long as the server is fixed at a certain place for a
sufficient period of time, and is utilised by the foreign vendor to perform
comprehensive commercial activities. The MTC defines comprehensive commercial
activities as activities that comprise of the company’s core functions as
distinguished from auxiliary functions (such as advertising and gathering
market data).

taxation of profits generated by server PE’s does raise certain difficulties
that are attributable to the mobile and malleable nature of these devices.
First, servers can be remotely operated without the need to be physically
located in the same jurisdiction as its users. They further have the capacity
to rapidly transfer their programs to other servers located in other
jurisdictions. These factors allow e-retailers to avoid taxation in source
countries by simply ensuring that the servers that perform all their essential
services are operated from tax havens while utilising their servers located in
the source country for auxiliary services. Second, servers have the ability to
shift the processing to the end-users computers through the use of applets.
Applets like ActiveX and JavaScript can be sent from a server to
an end-user’s computer to perform calculations or other simple actions in order
to free up more resources for the server to accommodate more users. This would
make it difficult for tax authorities to claim that a particular server in
their jurisdiction is a PE if it fails to perform any core functions. Lastly,
server arrays can be employed to avoid the PE definition under the MTC. Server
arrays are linked servers situated in different jurisdictions that switch
signals from one server to another depending on the shifts in traffic volumes.
Server arrays could be used to fragment e-commerce transactions into different
functions which independently would amount to auxiliary services, but when
linked together via the internet create a core business function that is not
discernible to tax in any of its host jurisdiction.

under the OECD BEPS Action Plan

5 October 2015 the OECD released its final report on an Action Plan on Base
Erosion and Profit Shifting (BEPS Action Plan).[2]
The report aimed at curbing tax planning strategies that exploit gaps in tax
rules by allowing corporations to artificially shift their profit generating
assets and activities to low or no-tax jurisdiction. The BEPS Action Plan did
devote some sections to identifying the challenges posed by the digital
economy. Action 7 in particular proposes some changes to the PE rule in order
to prevent its artificial circumvention.

report widens the scope of agency PE under Art. 5(5) and (6) of the MTC to
include commissionaire arrangements. Prior to this amendment the MTC definition
of PE only covered dependent agents who were under the control of and transacted
on the foreign company’s name. This definition failed to cover arrangements
whereby the foreign company could contract with agents in the source country
who would sell their products and transact for their benefit while utilising
their own (the agents) name, thereby creating the illusion of being
independent. In such cases the relevant tax authority in the source state would
be restricted to imposing taxes on the commission received by the agent for
their services, but not the business profits on the sale of products they did
not own. This modification only covers one aspect of e-commerce business model
where physical intermediaries are contracted. It nonetheless fails to account
for electronic intermediaries like intelligent software and online brokers who
are frequently utilised to conduct sales for foreign companies in source

7 has further provided for a new anti-fragmentation rule to Article 5(4) of the
MTC, when it comes to classifying the nature of transactions/activities that
are exempted from the PE definition. The original provision had outlined a list
of activities (e.g. storage, display or delivery of goods) which would not
amount to a PE, even if they were carried out through a fixed place of
business. The listed activities were generally considered to be non-value
adding activities. However, the provision was subject to abuse with retailer
using the blanket exemption to avoid taxation on activities that did in fact
constitute an essential part of their business, with significant value
addition. The new anti-fragmentation rule provides a superseding precondition
to the listed activities requiring them to be preparatory or auxiliary in
nature. It notes that the exemption will not apply where the overall activity resulting
from the combination of activities of a company, or of two closely related
companies (located at either the same jurisdiction or two separate
jurisdictions), is not of a preparatory or auxiliary nature. Though the
modification would have an impact on fragmentation activities that are carried
out through a physical place of business, it does not extend to e-commerce
fragmentation activities carried out through virtual presence through the use
of electronic apps and software. Such e-tools could be used to perform specific
logistics or advertising activities as part of a single cohesive e-commerce
transaction, and in essence exceed what is considered to be preparatory of


is evident that the problems facing the international taxation of e-commerce
income still persist. As discussed above, the current international tax
principles have failed to fully respond to the technological issues posed by
cross-border e-commerce. Part of this failure is attributed to the insistence
on maintaining aspects of the traditional principles of source-based taxation.
Meaningful progress in this area may require a complete overhaul of the
traditional principles and reformulation of new principles that are reflective
of the current cyber-age of globalization.



[1] OECD
Committee on Fiscal Affairs, Model Tax
Convention on Income and on Capital: Full Version
(OECD Publishing, 2014).

[2] OECD, BEPS 2015 Final Reports (2015) available at:
http://www.oecd.org/ctp/beps-2015-final-reports.htm (accessed 21 Aug 2018).

6 December 2019
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