1. ATTRIBUTION OF PROFITS TO A SERVER
Presentation by Catherine Bobo 08/06/2016 at UCT Law
School Kramer Building
2. Agenda
Definition of a server, website and permanent establishment
Different approaches by other countries on taxation of a digital
economy.
Can profits be attributed to a server even if there is a permanent
establishment?
Can we tax a server?
Current position in South Africa
Recommendations by the Davis Tax Committee for the digital
economy
3. Definition of a server
Server
A server can be defined as any computer that is in any form which can comprise of anything from a simple personal
computer to a mainframe of a server. In most instances a server is equipped to handle client applications, storage
security and provides the ability to add more clients.
a server can be situated in one country and be used predominately in another country. Consequently a server can be
viewed as tangible property that a company may possess; due to the fact that it is located physically in a certain
location and that location can constitute the place of business. A server need not be located where the business is
managed as a business can locate a server anywhere in the world. (R Buys R & F Cronje F Cyber law: The Law of the
Internet in South Africa 2 ed (2004) at 303
According to paragraph 42 of the Commentary of the OECD Model Tax Convention it mentions that a server is a
storage system where a website is stored and it is through the server that an enterprise can access information.
Furthermore a server can be a piece of equipment which has a physical location. That location may constitute a fixed
place of business of the enterprise that operates the server.
A computer can be an email server or a web server or both. In most instances in relation to electronic commerce
servers might handle thousands of synchronized users, it can manage the transactions of those users and deliver
information to clients.
4. Definition of a website
• A website should also be considered in this analysis as it also forms part of a server. A website is located on the World
Wide Web. It comprises a home page, which is the initial document where consumers or individuals who form part of an
enterprise would see when a web address is accessed.( L Olivier & M Honiball International Tax: A South African
Perspective (2008) at 104-105)
• According to the OECD Commentary Paragraph 42.2 “an Internet website, which is a combination of software and
electronic data, it does not constitute physical property. It therefore does not have a location that can constitute a 'place of
business' as there is no 'facility such as premises or, in certain instances machinery or equipment as far as the software and
data constituting that website is concerned”.
• The above concept of a website shows us that a website is an intangible component of electronic commerce, this component can be set up
anywhere but difficulties arise when one needs to ascertain the place of business of company that conducts business on a website or an
application. A good example of enterprises that have been profiting from a website or an application include Google, Facebook, Uber and
Airbnb only but to mention a few.
• Despite the fact that these companies may have a head office or a place of effective management in a specific country the relevant
consideration is how they account for taxes in relation to the profits they have obtained in various countries around the globe where
transactions have been conducted through their respective websites. As intangible property, it does not provide a regular link between the
place of business and a specific physical geographical point and so it cannot qualify as a permanent establishment.
• As intangible property, it does not provide a regular link between the place of business and a specific physical geographical point thus it
cannot qualify as a permanent establishment
• Debatably therefore it can be difficult for the tax authorities in the different countries to make sure that taxes are paid by the respective
enterprises that benefit from the resources of each and every country the enterprise obtains profits.
5. Definition of permanent establishment(PE)
Section 1 of Income Tax Act 'permanent establishment' means a permanent establishment as defined from time to time in Article 5 of the Model Tax Convention on Income
and on Capital of the Organization for Economic Cooperation and Development.
Article 5(1) of the Model Tax Convention on Income and on Capital of the OECD defines a PE as a fixed place of business through which the business of an enterprise is
wholly or partly carried on.
Article 5(2) mentions The term "permanent establishment" includes especially:
a) a place of management;
b) b) a branch;
c) c) an office; …
From this definition there are three major components that are present, these are:
1. there must be a place of business,
2. which must be fixed
3. the business must be carried through this fixed place of business
German case (BFH judgment of 30.10.1996 (II R 12/92) BStBl. 1997 II S. 12) dealt with a running underground pipeline it was held it is not a requirement that the place of
business be attached to the surface of the earth or that it is visible above the ground. It is critical to understand that the concept of a place of business is dealt with on a case by
case basis and thus the place of a business in most instances is difficult to ascertain.
Permanent establishment only comes into existence when the enterprise has physical manifestation where they obtained their source of income.
6. Example of how Internet Companies operate.
Take for example a South African advertiser puts an advertisement on social networking site Facebook, the fees for that
advert worth R1 million are paid to Facebook Ireland. The invoices in most instances come from Facebook Ireland
even if the payments eventually are made in South African Rands. Although Facebook might have subsidiaries in South
Africa these arms may provide specific services such as customer services but all transactions are handled by the
Ireland office. In terms of this transaction Facebook is incorporated in Ireland, the advertisement is to sell clothes in
South Africa and the server is located in Bermuda. Which country has taxing rights over the R1 million?
Facebook is
incorporated
in Ireland
ZANDO Online
Clothing Shop.
Facebook
Marketing and
Customer service
arm in South Africa.
server is
located in
Bermuda Pays R1
million
Sends an
invoice
7. Class discussion
Which country has taxing rights over the R1 million?
1.Bermuda? Why?
2.Ireland? Why
3.South Africa ? Why?
8. EXCLUSIVE CONTROL AND AGENCY
• When an enterprise conducts its business via a website that is hosted on the server of an Internet Service
Provider (ISP), such hosting arrangements do not result in the enterprise having control over the server even
though the website of the enterprise is hosted on a specific server at a specific location. In most instances the
enterprise would not have physical presence where the server is located thus the component where the enterprise
conducts its business is not traceable.
• Case study on Uber: Uber is uses Google's S2 Geometry Library. The server is owned by Google but Uber uses
some part of the server. According to the OECD Commentary if one uses a server on their own then where that
server is located that is its fixed place of business, but once some other party comes in and uses it then it won’t
be regarded as a fixed place of business. The enterprise needs to have total control over the server for it to be
regarded as a permanent establishment of the enterprise.
• Looking at the concept of agency where a server is owned by someone other than the enterprise, can the
enterprise claim that the server constitutes a permanent establishment for tax purposes? If an enterprise has
ownership over a server and operates it, the server can create a Permanent establishment for the enterprise
wherever it is situated.The place where that server is situated institutes a permanent establishment because the
server is at the enterprise's disposal.
• When an enterprise has a server at its disposal, the server must be static at a certain place for a sufficient period.
In order for a server to be considered as a having a permanent establishment it should be under the control of the
enterprise and be situated stagnantly in a certain space or country.
• The PE concept as defined in article 5 of the OECD Model Tax Convention refers not only to a substantial
physical presence in the country concerned, but also to situations where the non-resident carries on business in
the country concerned via a dependent agent.
9. Davis Tax Committee’s views
The OECD Commentary makes it clear that a server, is distinct from mere websites (which cannot fulfil the geographical situs
condition) could constitute a PE where the equipment is fixed and the supplier has the server at its own disposal. The OECD
acknowledges that no PE would be created if the e-commerce activities carried on via the server are restricted to preparatory or
auxiliary functions which are excluded under paragraph 4 of Article 5. So in the instance of the Facebook example above the
auxiliary functions include advertising of goods or services
OECD mentions an example of activities which would generally be regarded as preparatory or auxiliary:
- Advertising of goods or services
The Davis Tax Committee is of the view that taxation challenges are also posed by large internet-based companies, such as Google
or Facebook which are doing major business in countries by remitting very low amounts of corporate income tax in the countries
they operate in. The argument is the presence of such companies in any given country does not often amount to the level of creating
a PE.
Companies like Facebook or Google can collect user data in one country and use that data to sell targeted advertisements to
advertisers in another country. Revenues collected from advertisements targeted to users in one country are then funneled through
subsidiaries in low tax jurisdictions, thus avoiding PE status in those countries in which the advertisements are collected.
10. Different approaches by other countries on taxation of a digital economy.
United Kingdom
France
The UK takes the view that a server
used by an e-tailer (a retailer selling
goods via electronic transactions on the
Internet), either alone or together with
web sites, could not as such constitute a
PE.
The existence of a server in
France would constitute a PE for
an enterprise
11. Can profits be attributed to a server even if there is a permanent
establishment?
Treating a server as a significant value driver, creates uncertainties in determining whether profits
can be attributed to a server. Problems arise because many cloud computing services can be provided
without any people or very few people involved.
Having a server as a value driver is also problematic because cloud vendors often use mirror servers.
Mirror servers are servers located in different locations that duplicate the software and data stored on
core servers and perform identical functions for security and efficiency purposes. Thus, different
servers, potentially located in different countries, may be utilized at different times throughout the
day. This creates significant uncertainties in determining how much profit to allocate to the server
activity and to each server.
Formulary apportionment minimize the significant uncertainties and transaction costs that MNEs
(Multinational Enterprises) currently face in trying to determine the arm’s-length price for cloud
transactions that have no easily identifiable equivalent transaction and for tax administrations trying
to enforce the arm’s-length standard especially as the cloud model continues to evolve.
Various commentators have suggested a variety of factors to be taken into account to apportion
income among jurisdictions under the formulary approach. Factors often considered in apportioning
an MNE’s worldwide income include assets, payroll and/or sales
Formulary apportionment is a method of allocating profit earned (or loss incurred) by a corporation or corporate group to a particular tax jurisdiction in which the
corporation or group has a taxable presence.
12. Why use Formulary Apportionment?
Formulary apportionment on the basis of sales would minimize or altogether eliminate the
amount of income allocated to the location of mobile assets, such as servers.
It also better addresses existing issues of how to allocate income generated by intangible assets
by allocating income to the location where the intangible property is used, which would
eliminate the need to make the difficult determination of which entity or entities are the true
economic owners of the asset.
Moreover, in the cloud computing context, a sales factor that bases sales on the location of the
customer may also better align taxation with the location of value creation because cloud-
related income generally has a noticeable economic connection to the customer’s location.
The formulary apportionment is a plausible method to use as it allocates the income to the
location where the intangible property is used. Furthermore the method mentioned above looks
at the source of where the income is created.
13. Taxing a server
Non-residents are only subject to tax in South Africa on any income derived from a source in South
Africa.
The definition of gross income in Income Tax Act that deals with South African sourced income of non-
residents can be applied to tax non-residents involved in electronic transactions in South Africa.
The source basis of taxation for non-residents should be read with the double taxation agreements entered
into by South Africa in terms of section 231 of the Constitution and section 108(2) of the Income Tax Act.
In accordance with the source provisions under section 9 of the Income Tax Act, it is usually required that
the non-resident must conduct some activity or operate via a some degree of physical local presence
before business profits could be regarded as derived from a source in South Africa and thus be subject to
taxation.
However, the source rules in section 9 do not cover rules that deal specifically with electronic
transactions. This implies that reference has to be given to common law principles. The common law
source rules rely on the principle of originating cause.
14. Taxing a server
• South African source rules
1. what is the originating cause and where is the source located
(Lever Brothers Case)
2. If activities that led to the creation of the income where in
South African then the taxpayer is taxed in South Africa.
(Epstein Case)
3. Look at main activities, work or functions giving rise to the
income in question (Transvaal Associated Hide And Skin
Merchants Case)
4. Look at where transaction occurred that is the source (Blacks
Case)
15. Treaty context
Under Articles 5 and 7 of the typical South African DTA (mostly
based on the OECD Model DTA), a company resident in the other
Contracting State is only subject to tax on its business profits
derived from South Africa if it has a PE in South Africa.
To determine whether there is an e-commerce PE in South Africa,
one has to first refer to section 1 of the Income Tax Act, which
states that the meaning of a PE for South African purposes is as
defined from time to time in Article 5 of the OECD Model Tax
Convention.
16. Current position in South Africa
Non-residents are only subject to tax in South Africa on
any income derived from a source in South Africa.
Companies like Facebook (looking at the above example)
can avoid tax in South Africa because the originating cause
of their income is not in South Africa. The originating
cause would be where the server is located. Facebook does
not have a location in South Africa, only ancillary
transactions which do not qualify as a PE.
17. Recommendations by the Davis Tax Committee
1. South Africa should not attempt to come up with provisions such as “link taxes” that other European
countries have attempted to come up with. Taking a unilateral approach to reworking the PE rules for e-
commerce is unlikely to work. It is best to address the issue in a multilateral, coordinated manner
2. To enable South Africa to impose tax on non-resident suppliers of goods and services via e-commerce
to South African customers, new source rules that deal with the taxation of the digital economy need to
be enacted.
3. Currently non-residents are only required to submit tax returns for trade carried on through a South
African PE. If SARS cannot assess whether a nonresident has a PE in South Africa, how will such non-
residents be taxed? SARS doesn’t keep a separate register for inbound foreign companies. There is a
need to isolate and focus on foreign multi-nationals and get them to submit tax returns
4. From a policy perspective, it is also important to create a level playing field so that South African
companies dealing with digital goods and services are able to compete with the likes of Google.
Companies like Kalahari have raised their concerns with regards to this issue.
