Facebook took a leap forward last week when it announced its decision to switch to a local advertising sales model in 2018. Instead of continuing to route its sales outside of the US through international headquarters in Dublin, Facebook intends to record advertising revenue in countries with local teams and offices.

According to a public statement by Facebook’s CFO Dave Wehner, the company believes the new structure will provide governments and policy makers “greater visibility over the revenue associated with locally supported sales in their countries”.

The social media giant is bowing to mounting public pressure for greater tax transparency globally and likely pre-empting legislative changes in Ireland and the EU at large.

Yet, that leap may not be far enough.

During a December 5 2017 meeting, the Council of the European Union agreed that virtual permanent establishments (PE) should be explored for solving the challenges of taxing profits of the digital economy.

The council noted that while the concept of PE remains an essential principle for global allocation of taxing rights on profits, focusing on the physical presence, it has been challenged by the rise of the digital economy, which relies on the digital presence, leading in certain situations to a misalignment between where profits are taxable and where value is created.

“[The Council] takes the view that an appropriate nexus in the form of a virtual PE, together with any necessary corresponding amendments to the rules of transfer pricing and profit attribution, which would take into account where value is created in the different business models of the digital economy, should be explored,” it concluded in a document.

“Where a business is performing significant activities in a jurisdiction, its absence of physical presence should not per se prevent it from being subject to tax on its profits generated in that jurisdiction, provided an appropriate nexus reflecting value creation is used, taking into account the arm's-length principle,” the council document stated.

For taxpayers, however, virtual PEs could mean more reporting obligations and more uncertainty as they may be unaware of where a virtual PE would arise.

Julien Pellefigue, partner at French law firm Taj, Société d’Avocats in Paris, said proposals on virtual PEs were still a bit vague and therefore subject to arbitrary interpretation by tax administrations.

“An extensive interpretation of the digital factors, such as a local domain name, a local digital platform, a local payment system, could create virtual PEs for almost any company as every company involved in a B2C business tries to have a local website and a client register,” Pellefigue told TP Week. “Even if one were to accept this notion of virtual PEs, the allocation of profit to such a PE would be very difficult to perform. How do you define the value that an e-commerce company derives from the commentaries left by buyers from one country?”

The discussion around virtual PEs is not new, but it is a tricky concept because it would require modification of tax treaties, among other things. So far, the OECD has not recommended exploring virtual PEs, but has instead proposed to modify the existing definition of a PE under BEPS Action 7.

How virtual PEs create real challenges

Mustapha Ndajiwo, tax deputy manager at Nigeria’s Federal Inland Revenue Service, told TP Week that sales should be the determining factor in a virtual PE, be it direct sales, adverts or subscriptions cloud computing. “But there has to be a certain sales threshold, depending on the jurisdiction we are talking about. The global North may have a higher threshold, while the global South may require a lesser threshold due to their level of economic development and their desperate need and reliance on corporate taxes,” Ndajiwo said.

But this may not be that straightforward. The proposal requires collaboration between countries as well as political will, Ndajiwo said. Additionally, developing countries in particular may struggle to identify the location of the sales.

“For example, it is known how much Google has made in the UK. However, for a country like Nigeria this may be difficult [to know]. Even though these companies have annual reports, it is easy to move activities to other jurisdictions just as they have done with Ireland and Luxembourg. So the way to counter this is to use a multijurisdictional software that can ascertain the location of parties to transactions and also determine sales and threshold,” Ndajiwo said.

Another issue is to do with tax treaties, which likely would need to be changed. This would make the idea of virtual PEs a longer-term solution, in contrast to many other alternative solutions such as the equalisation tax.

“Treaties would disallow deeming any PEs in e-commerce,” Hans Mooij, independent tax adviser in The Hague, told TP Week. “You can see the European Commission considering other options that would not be affected by tax treaties, for example the equalisation tax. Another alternative would be some kind of VAT levy. There are for instance several local states in the US that have introduced that type of tax and it is very simple and basic. It is a tax based on the number of internet clients that a company through a server has, then you count the number of connections, put a fixed price on that, and that accounts for the taxable basis.”

The technical aspect

Isabel Verlinden, global head of transfer pricing at PwC, and Stefaan de Baets, senior counsel at PwC and former transfer pricing adviser at the OECD, told TP Week they had fundamental concerns about the concept of virtual PEs. The question would be whether a virtual PE option could be married with the authorised OECD approach (as set out in the OECD’s 2010 ‘Report on the Attribution of Profits to Permanent Establishments’).

“In case it does not, and we see no technical ground to say it does, one needs to instead look at whether direct tax is the solution at all. Indeed, if we look at the OECD guidance under BEPS actions 8-10 the application becomes troublesome as, for example, making a sale into a foreign country does not as a matter of principle lead to saying that the country of residency of the buyer is the source of the income,” they said.

“It can very well be that the ‘functional value creation’ is where the research and development and/or manufacturing or creation of the product or service took place. If you talk to a ‘technology guru’ they will say that innovation and the speed by which it is brought to the market is the single biggest creator of ‘economic rent’. We don't see how this can be captured properly under the existing rules nor how a virtual PE would come to the rescue.”

Determining where profits are made remains central to the debate.

“One could ask where the value is created; [through] user information gathering – free of charge, the infrastructure – use of the algorithm, the development of the algorithm, or the sale of advertising space as a result of use of the algorithm and the data collected?” Verlinden and de Baets said. “One could also raise the question why virtual PEs need to be created in case of the digitised economy, while other types of business would remain subject to the classic rules of taxation? In other words, the digital economy would be ring-fenced.”

The discussion on virtual PEs is another bump in the road on the way to finding a consensus on taxing the digitalised economy that works for all stakeholders and jurisdictions.

“Often with technological based solutions, the technology is not usually the difficult part of it, but the consensus to adopt is always the challenge,” Ndajiwo said. “Countries may likely continue to go unilateral if nothing is pushed forward by the OECD and this will see countries succeed more than each other due to their varying levels of development.”

The next step is for the ECOFIN Council to adopt the draft conclusions, which is expected to happen in December 2017. The conclusions will serve as a reference for further work on digital economy taxation at the EU level and the Council expects to release legislative proposals early in 2018.