Genuine Nexus or Perpetual Allegiance ? Some considerations on the Diverted Profits Tax

1
Draft Version – 2015 TRN Conference
Genuine Nexus
or Perpetual Allegiance ?
(Some Considerations on the ‘Diverted Profit Tax’ Proposal)
Abstract
By Marco Greggi1
According to very recent press releases and draft papers circulated on qualified
network the British Government is considering to introduce a new tax on profits realized
by non-resident corporations on the British territory, even when a permanent
establishment does not exist.
The so-called Diverted profits tax (also known as Google Tax) is essentially aimed
at those multinationals active on the Internet, which have access to the consumer
market of the UK without maintaining there any kind of structure that could be
considered as a Permanent establishment according to the traditional definition of it
(see for instance Article 5 OECD Model Convention).
Consistently with International Treaties (OECD inspired) a State is supposed to
have the power to tax a non-resident company only when the latter has on its own
territory a fixed seat trough which the business is “wholly or partially” carried on. IT
Multinationals (including Amazon, Google and many others) are in the position to carry
on businesses in the UK (as a matter of fact everywhere around the world and in most
of the European countries) without triggering the “permanent establishment clause”,
thus being liable to tax there. They can do this using intensively the Internet
infrastructure and basing their business model on e-commerce transactions.
This situation has been considered as unsatisfactory by various stakeholders and,
eventually, by the Government itself, which submitted the draft for the new Tax.
1
Marco Greggi is Associate Professor of Taxation law at the University of Ferrara, Italy, and can be reached
at marco.greggi@unife.it

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In this respect, the British Government is neither alone nor the first that has been
somehow tempted by such a solution. In the recent past France, Spain and, to some
extent, Italy as well have considered ways and means to attract a wider taxable base in
their own jurisdictions. Most of these proposals concerned VAT, other addressed the
notion of permanent establishment, some of them were backed by academic literature,
while some other were not.
Invariably, all of them failed to reach the scope.
To a non-British academic, however, the UK proposal appears to me more
sophisticated and, to some extent, fascinating. Apparently, this tax is supposed to
address two kinds of situation.
The first covers taxpayers that are somehow abusing of the traditional
“Permanent establishment” definition: basically, It extends the scope of the latter with
regulations that are not so different from the traditional anti-abuse provisions.
The second is much more stimulating and complex, under a theoretical
perspective.
The definition of “Diversion” seems to suggest (at least to a non-Common lawyer)
the notion of “taken away from” or “distracted”. According to this basic assumption, the
non-resident companies appear as taking away something that was supposed to belong
to the UK, just like their activities and their profits. They alleged (ad are alleging) to the
UK anyway and therefore are supposed to pay the tax.
If a tax like this is introduced, it is going to reshape the notion of “Genuine link”
or “Genuine nexus” extending both of them to unprecedented extension and eventually
generating possible conflicts with the tax jurisdiction of other States (most notably those
where the MNE of the case are resident).
Following a theoretical perspective, we are shifting from the notion of “Nexus”
to the one of “Allegiance”, and the change will not be painless both for taxpayers and
for States in terms of potential double taxation.
The limits and constrains of EU law which are relevant and compelling also in the
field of direct taxes when fundamental freedoms are at stake make member States to
draft bills and (new) taxes consistently with the possibility for a EU company to invest
and making profits without being made liable to tax without reasonable ground.
We witness, in this respect, a kind of paradox.
On the one side, States are trying to attract a larger taxable base, insisting on the
"allegiance" of some profits to their tax jurisdiction even if the genuine link is feeble. On
the other side, however, an opposite driver contrasts this sort of “Enhanced” force of
attraction: namely EU law and freedom of establishment (or free movement of capital,
inter alia, depending on the circumstance of the case).

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To strike a delicate balance between these two drivers is the goal of the legislator
and to propose a feasible solution consistent with the different needs is the role of the
academic research.
On the top of all this, the current British proposal (which is kept in the highest
consideration by tax policy makers in other Countries, such as Italy) should also try to
be implemented in the framework of the BEPS action plan proposed by the OECD.
From a purely linguistic perspective, there is no doubt that the notion of tax
"diversion" is new to the legal panorama, but it seems also evident that the philosophy
inspiring the Government in the UK is somehow similar to the one OECD has pursued so
far (and starting from 2013). If this is the case, however, the domestic law proposal
should be consistent with OECD recommendations in order to be more compatible with
similar changes that the other states shall introduce in a short time.
Apparently, diverted profits should mirror the base erosion, with the profits
being considered as the taxable base which is unfairly taken away from the state tax
jurisdiction. In these situations two possible solutions can be imagined: one of them is
based on the use of permanent establishment in order to capture more profits. It is a
solution that also other states have used in the past, just like Italy in the world famous
Philip Morris case (but apparently the British proposal seems to go beyond this). Another
should bring the legislator to consider a more comprehensive alternative, based on an
approach similar to the US one, and grounded on a formulary apportionment scheme.
The discussion in this respect is not new to the academic community, neither in
Europe nor in the world.
The main problem still consists in assessing a reliable and reasonable formula in
order to attribute a fair tax base to all the states involved. National jealousy and a short
minded cost-benefit approach in the past prevented unanimity in the European Union.
The British solution appears, to a non UK reader, able to catch the momentum
that we are experiencing (in terms of a more urgent need to deal with tax avoidance
worldwide) and to offer a new starting point for the discussion, in Europe and beyond,
to possibly solve once and for all the situation. Despite the personal views on that, it is
evident that the tax game changed form a loose-win scheme to a loose-loose one at
least for European states, if no comprehensive solution is implemented. Experiences
shows that the diversion of profits (or the base erosion) phenomenon hits every state in
the Union and beyond with now winners in this game of global tax competitions but Tax
havens.
Whatever the solution will (possibly) be, however, some questions remain on the
ground: namely how to deal with the genuine nexus that has anyway to exist between
income and the state which wants to exercise its taxing power on it; how to make the
new rules clear and accessible to taxpayer in order to minimize legal uncertainty in cross
border investments; how to deal with the well settled network of double taxation
conventions, which would be potentially jeopardized by new provisions on diverted
profits and eventually how to assess the economic impact of such new provisions in

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terms of new businesses discouraged to invest in the UK (or Italy, or Europe more in
general) if such a tax proposal would be actually implemented.
The aim of the paper shall be: (1) To discuss the legitimacy of this extension
together with (2) The effects on the long run that this tax might determine and (3)
Compare the pros and the cons of such a decision, taking into account the European
constraints applicable (EU law and EU Treaties).
Details:
Marco Greggi
Department of Law
University of Ferrara
Corso Ercole I D’Este, 37
44100 Ferrara
Italy
Mail marco.greggi@unife.it
Phone and Fax +39 532 455968
http://ssrn.com/author=1128803
http://ferrara.academia.edu/MarcoGreggi

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Draft Paper
Summary
(Some Considerations on the ‘Diverted Profit Tax’ Proposal).......................................... 1
Abstract ........................................................................................................................ 1
1. Setting the Framework: addressing avoidance in the BEPS era ............................... 5
2. Diverted Profit Tax: New Answers to Old Problems ................................................. 9
3. A view from outside: the Italian attempts to address the same issue (a path of
successes and failures) ................................................................................................... 13
4. DPT as an Attempt to Re-define the Concept of Taxable Income: from Residence
to Allegiance. .................................................................................................................. 16
5. DPT at the Others: External Limits to the Power to Tax (EU Law and DTCs). Some
Concluding Remarks ....................................................................................................... 19
6. DPT as a Model for the European Union ?.............................................................. 22
7. Bibliography ............................................................................................................ 23
1. Setting the Framework: addressing avoidance in the BEPS
era
International Taxation is experiencing an era of unprecedented changes. It’s true, to
some extent, that every decade appears to be a time of change and virtually in every
natural and social science (including law) development is made through change of
paradigms and theories. But there is no doubt, that the beginning of the second decade
post millennium is offering an almost endless list of themes to be debated or discussed
in the agenda of policymakers and Governments.
We experienced very recently the fall of bank secrecy2, the impressive improvement of
the collaboration between Tax administrations3, the implementation of a common
reporting standard for the exchange of information4, the need for a more coherent
development of tax systems in Europe5, at least, right after the explosion of the global
crisis, and much more than that.
2
(Johannesen & Zucman, 2014).
3
(Owens, 2002), (Oberson, 2003; Tanzi, 1996).
4
(Radcliffe, 2014).
5
(Hemmelgarn & Nicodème, 2009).

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The eruption of the Global financial crisis had another remarkable effect in the
development of (almost) every national tax system: a different attitude towards tax
avoidance and tax evasion. Almost in the same period, some regional areas of the globe
witnessed a rampant approach by the judiciary (before) and by tax legislators (after)
towards evasion and avoidance6.
The well know development of the abuse of law doctrine in Europe7 is a clear example
in this respect, but also the US re-designing of the anti-avoidance rule is another one8.
The outstanding contribute of the British academic literature to the development of an
anti-avoidance rule9 together with the European recommendations about that10, can be
considered other examples of the changing tide in International taxation.
Eventually, when the OECD launched in 2013 the BEPS project it was saluted by
Academics and practitioners around the world, with some remarkable exceptions11, as
an innovative attempt to deal with all these issues (and with many other more) all
together.
As a matter of fact it was, and still is, an attempt to codify what was already happening
in most of the OECD belonging Countries, at least for what concerns the struggle against
tax avoidance. Most of the issues on the BEPS agenda were (and still are) being
addressed by each State individually, while the organization of Paris is trying now to
provide some common background and harmonised solutions to that via soft law
(pursuing and holistic approach12 as it clearly points out).
Base Erosion and Profit shifting were not born in 2013, but two years ago they became
a sort of priority for the OECD, and to some extent, even for developing Countries not
belonging to it.
In the BEPS initiative a number of Actions are envisaged, encompassing potentially all
the hot topics in international taxation. Many other Authors13 have already analysed
them in details, and found out that despite the heterogeneous nature of most of them,
they can be ascribed to five different clusters (or groups) in relations to the field they
cover and the legal instruments they recommend.
Group I, Action 7 is perhaps the closest to the Diverted Profit Tax (DPT from now on) in
the UK as it was implemented in Finance Bill 201514.
6
(Greggi & Sidoti, 2013).
7
(Greggi, 2008a).
8
(Gravelle, 2009).
9
See inter alia (Freedman, Loomer, & Vella, 2009; Freedman, 2004, 2006).
10
(Commission, 2015).
11
(Brauner, 2014).
12
(Schoueri, 2015).
13
(Brauner, 2014).
14
The analysis in the forthcoming pages is based on the Discussion draft by the British Government and
circulated on the Governmental website. The full text has been retrieved at
https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/385741/Diverted_Pro
fits_Tax.pdf.

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OECD is convinced, for example, that the definition of Permanent establishment (PE
from now on) must be re-written in order to take into account the different ways and
means trough which business is carried on these days on a global scale. At the same
time, the Double Taxation Conventions (DTCs from now on), where the definition of PE
is enshrined in most of the cases, if not present in the domestic legislation, need a
different interpretive approach.
There is no room here to summarize the proposal of the OECD in this respect, nor this
research is intended to follow a path that has been already traced by other Authors. It
can be useful nonetheless to summarize the conclusion suggested by the OECD or, at
least to emphasise the points of it that are more relevant for the Diverted Profit Tax
project and its current implementation in UK Tax law.
The basic impression received is that in the attempt to deal efficiently with base erosion
and profit shifting OECD is in the position to overtake as well the traditional rules
regulating taxing power, and that have been judges as outdated by relevant academics.
The opinion however is that while this attempt is in progress, but it entails a sort of jump
back to the past: to concepts and way to tax that echo something similar to the notion
of (tax) allegiance. This is true for the provisions concerning Exit taxation in many
jurisdiction, this is true for those regulations affecting expatriates or CFC … this is also
true for the UK model of DPT where, notwithstanding the residence abroad of the
taxpayer, the UK claims its right to tax profits generated on its territory15.
There are priorities in the OECD’s inspired BEPS Project that trace an actual and effective
change of paradigm in comparison to the recommendations of the past. The first of the
two is more systematic and is addressed to the Tax Treaties universally known as Double
Taxation Conventions.
Traditionally they are signed by States (consistently with OECD model of with one of the
others currently used) in order to minimise the risks of possible international juridical
double taxation. They follow therefore a functional approach, consistent with a limited
scope, and possible application only in qualified circumstances (that is, when there’s a
clear and actual risk of double taxation). It’s for this reason that the mainstream doctrine
is reluctant in recognizing the existence of an International taxation law as legal system,
with some remarkable exception in this case as well16.
In the BEPS initiative OECD made clear that this point and this way of interpreting
international taxation (system) is, to some extent, outdated and needs to be improved17.
Treaties should be aimed ad granting effective taxation, preventing at the same time
cases of double taxation and double non-taxation as well. In this way the source State
would be obliged (under the Treaty) to exempt from taxation income generated in its
territory only insofar that very same income is actually taxed in the residence State
consistently with the provisions applicable therein. There is no doubt that this change
15
See Part 1, Sec. 2 “Avoidance of UK Taxable Presence”.
16
(R. S. Avi-Yonah, 2007).
17
(Saint-Amans & Russo, 2013).

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of attitude of the OECD is far from being just another technicality of the Commentary or
of the Treaty preamble, but rather it can be considered a clear evidence of change in the
priorities and goal pursued by the international organization.
Effective taxation now is as just important as the prevention of double taxation in
international fiscal relations.
This way of thinking has arguably played a remarkable role in the inception of the DPT
in the UK, being this new tax aimed at preventing double non taxation (or a level of
taxation a lower that the one due in the UK). This is true particularly in the first of the
two situations in which DPT may be applied: that is, to the hidden permanent
establishment (Part 1, Section 2).
The second BEPS action which probably played a role in the development of DPT (ether
explicitly or implicitly) is the one related to the need for a more comprehensive notion
of Permanent establishment, including the necessity to address in a different way the
digital economy18 . DPT is not explicitly addressed to businesses operating on the
Internet or in delivering digital products (or services), but it has been intended to tackle
a number of situations in which MNE active on the Net (Amazon Inc., for instance) or in
the Net (Apple Inc., just to mention one) were able to shift their profits form the ordinary
tax liability the UK to elsewhere.
The conclusion in this respect is that while DPT is a unilateral, national-based answer to
some of the most critical challenges to international taxation these days, nonetheless it
fits well in the BEPS initiative. It appears to be a feasible way to address most of the
issues OECD pinpointed in the framework of that project.
Both the cases in which DPT is applicable under the UK law (according to the Discussion
draft) are situations in which the taxpayer has implemented a business structure (hidden
PE) or operation (Tax mismatch), that are to some extent inconsistent with the principles
of the law and ends up in a sort of abusive behaviour.
To some extent, if a critic has to be attributed to the DPT, is that it could have been
drafted in a more courageous way, addressing diverted profits even when taxpayer had
them in an operation which is not abusive in its nature, just like not all base erosions
and profits shifting addressed by the OECD derive from tax avoidance. In other words,
without the need to demonstrate (or to assess) that the circumstances of the case were
abusive in nature.
In the subsequent development of the tax, it should be considered as the Transfer
pricing regulations that are intended by the mainstream doctrine19 as not aimed at
addressing tax avoidance, but rather constitute an item of ordinary corporate income
tax.
18
(OECD, 2014).
19
(Schön, 2012).

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2. Diverted Profit Tax: New Answers to Old Problems
Some of the papers and reports20 released right after the publication of the DPT draft
bill insist on its nature as an “Anti-avoidance proposal”. It is an appropriate evaluation,
even if not entirely accurate. At first glance DPT is an answer to one of the most debated
and discussed issues in international taxation, the struggle against which lasts for
decades: tax avoidance.
In a historical moment in which many Countries all around the word have changed their
policy against tax avoidance (or abuse of law, depending on the legal context) via the
implementation of tailor-made provisions, GAARs, or anti-avoidance rules with a
broader scope, the UK apparently takes a step forwards. DPT operates on the principles
establishing the Nexus between source of income and tax liability, attracting to the UK
tax jurisdictions items of income that would be otherwise lost. It does that fine tuning
two concepts academic literature and practitioners’ experience are familiar with: the
notion of Permanent establishment and Transfer pricing regulations.
While the instruments used are well known and currently applied in everyday practice,
DPT adds something different to them: basically it acknowledges the fact that the
number of abusive operations based improper transfer pricing operations is so high that
a more comprehensive approach to them is needed.
For what concerns the situation with the Permanent establishment, apparently it tries
to go a step beyond to what academic literature pointed out years ago: reaching in part
conclusions that have been proposed by US academics21. If accepted in their entirety
and pushed to the extreme, would redraft the notion of income and, more precisely, the
nexus between the entity producing income and the place where it currently originates.
For decades it has been taught that tax income is supposed to be taxed in the hand of
the recipient, which is the subject that actually creates it.
In classical definition of income22 this assumption would make sense.
If we consider income as new wealth originated by some activity or anyway any capital
increase, it sound obvious that the activity of the case might be attributed to a qualified
individual (or to a legal entity as well). The progressive globalization of the markets and
the intrinsic cross-border nature of many businesses made necessary to adapt these
conclusion to the new situation in general and to the concurring taxing power of the
States in particular23.
The notion if permanent establishment is nothing more than a sophisticated instrument
born to strike a balance between the taxing power of the latter. It has nonetheless
demonstrated the incapacity to stand the test of time, but yet nothing else was
20
(Hooper, Mat, Beer, & Richards, 2015; PwC, 2014).
21
(R. Avi-Yonah, 2012).
22
(Simons, 1938).
23
(Tanzi, 1996).

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conceivable in order to better the address the conflict if taxing power in a more efficient
and reasonable way.
Now the DPT, to some extend appears to suggest that income should be taxed where it
is generated: to some extend it appears to confirm the thesis by Professor Reuven Avi
Yonah that he illustrated years ago24 and on which he came back recently25 writing in
favour of a Destination based Corporate Tax (DBCT).
Income ‘is’ where it is ‘originated’ and it should be taxed in that place as well: in the past
this thesis was challenged on a number of situations and using a remarkable number of
arguments26. Two of them were particularly relevant: (1) the practical difficulty to
calculate income liable to tax and (2) the possible confusion between ‘income’ and
‘consumption’ if the first of the two is taxed in the place where it originates (according
to this position taxing income where it is generated even without a PE, would end up in
taxing consumption instead).
Both these critics and possible way to overtake them will be addressed in § 4 below.
The UK law is not so ambitious (not at least the Discussion draft) however, being DPT
dependant on the assessment of a in improper behaviour by the taxpayer, namely the
attempt to erode taxable base in the UK while Professor Avi Yonah’s proposal is more
systematic and not intended to address abusive operations.
OECD made familiar to the scientific community worldwide, the notions of ‘Erosion’ and
‘Profit shifting’: in no paper, report or discussion draft by the OECD ‘Diversion’ or
‘Diverted’ are used. The word refers to qualified situations generated by the attempt of
the taxpayer to minimize improperly tax liability, and it seems to draw the distinction
between these situations and the other that normally occur using the argument of
fairness and equity27. It happens at least on three occasions in the bill draft to read
words such as “fair and just28” making reference to the amount of income which is liable
to tax in the UK despite the absence of a PE or the arrangements of the contract of the
case.
Diversion, at least to a non-native English reader and interpreter, appears to make
reference to something that is different from what should or ought to be29: a deviation
from the normality of taxation or the abandonment of a paradigm. Under a theoretical
perspective the definition is indeed stimulating because mentioning ‘diversion’ should
also entail the clarification of ‘from what’ and ‘to where’.
In this case it could be obvious to argue that ‘diversion’ is from the tax liability in the UK
to a tax liability elsewhere: ‘diversion’ in this respect is similar to ‘shifting’, then, in the
24
25
26
(Altshuler & Grubert, 2010; Morse, 2009).
27
See the Consultation Draft on DPT, Part 1, Article 8 (3).
28
See also Consultation Draft on DPT, Part 1, Article 8 (6) (a).
29
“divert, v.”. OED Online. June 2015. Oxford University Press.
http://www.oed.com/view/Entry/56070?redirectedFrom=divert (accessed August 10, 2015).

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OECD’s lexicon. Considering the UK Tax a simple implementation of the OECD guidelines
and recommendations in the framework of the BEPS Action Plan would be reductive and
unfair instead.
In some perspectives ‘diversion’ appears to be a more complicated adjective. This is true
particularly when it is embedded to the notion of “justice 30 ” in taxation and
“reasonableness31” in the implementation of it. References to fairness and justice are
not so frequent in the OECD reports, while on the other hand in the UK definition
element making implicit reference to avoidance and abuse are present32 and they are
not necessary present in the BEPS Reports addressing similar situations.
In other words where ‘Diversion’ is generated by a behaviour which is close to avoidance
and abuse of law; ‘Erosion’ and ‘Profit shifting’ may be generated by business
combinations or market decision which are not necessarily qualified in this sense.
Evidence of this situation may be drawn from the text of the law (Discussion draft). DPT
is a punitive tax, to some extent, being applicable with a rate (25%) which is higher than
the ordinary corporate tax in the UK (20%). The British legislator decided, on one side,
to draft a brand new tax for companies falling into one of the cases covered by the law,
and, on the other side, to make ‘diversion’ of profits much more expensive than the
ordinary taxation. Even if there are specific provisions aimed at addressing a potential
international double taxation, there is no doubt that the conditions under which the tax
is triggered are cases qualified as ‘unjust’ and ‘unfair’ by the legislator. Injustice and
unfairness justify the higher tax ordinarily due and further fines if due.
Under the law, DPT has to be applied in two cases different from each other, but with a
common background: the absence of a significant nexus of the taxpayer to the UK
territory from which, however, a significant part of its income is generated.
DPT is applied in situations where the behaviour of the taxpayer or its business model,
defies the ordinary rules defining nexuses traditionally used to justify the power to tax
in the source state: in this respect it is indeed an original and innovative tax, because it
extends further on tax liability of off shore taxpayers.
The first of the two cases covered by the DPT is the one related to the ‘Hidden PE’.
The basic assumption in this case is that the foreign taxpayer (non-resident in the UK) is
developing onshore a business activity generating sensible profits without matching any
of the conditions currently listed in the DTC in force between the UK and a third country
30
Consultation Draft on DPT, Part 1, Article 8 (3).
31
The principle of reasonableness is extended also to the foreign tax to be credited. See for instance
32
See Consultation Draft on DPT, Part 1, Article 28 (1) extending to DPT Section 206(3) FA 2013 (as a
matter of fact the general anti abuse rule is applicable also to DPT).

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empowering the first to tax it. The reference in this case is traditionally to article 5 OECD
Model convention and the definition of Permanent establishment33.
Non-scientific literature often makes reference to this tax as the “Google tax34”, making
reference to Google Inc. and the other big MNE which are working consistently with the
same business model adopted by Google Inc. (or Apple Inc.) and its satellites worldwide.
As a matter of fact, the business operating in the digital economy are those in which the
distinction between the place where profits are generated and the one where they are
actually taxed is the most remarkable one.
Profits from advertising, for instance, are originated by clients resident in several
Countries all around the world, but actually taxed on Apple Inc. (or, more precisely, on
one of its subsidiaries) in low tax jurisdiction35.
Google Inc. (or any other company working in the same way Google does) is able to
deliver its high value service (advertising, data mining, etc.) in various Countries without
maintaining there any of the structures generating a PE under article 5 OECD Model
convention (or consistently with the double taxation convention of the case).
In this situation (business) profits are taxable only in the residence State: it’s all in all a
conclusion which occurs often in international taxation. It’s not infrequent to have this
sort of segregation between the source State and the residence State: the conflict
between them and the need to allocate appropriately the taxing power is one of the
ever-lasting field of discussion in academia and in the practitioners’ world. Never in the
past this discussion reached the climax concerning digital economy however, nor the
amount of taxable income ‘diverted’ climbed to the amount that is currently shifted
elsewhere.
The quantitative element of the phenomenon, therefore, is perhaps one of the key
element that urged the UK legislator to react in this way. It is for sure the same factor
that grounded the proposal by Italian Congressman Francesco Boccia in Italy, who was
the one who tried to introduce a similar tax a couple of years ago in the peninsula. His
attempt however was not so successful as the British one (nor was so sophisticated) and
even now in Italy the issue of ‘Diverted profits’ is left unaddressed under statutory law.
The British law in this respect made liable to tax in the UK profits generated by a non-
resident entity if it does appear clear that the non-resident corporation has acted and
developed its business in a way to prevent the existence of a PE36. This test is made
consistently with the principle of reasonableness37: this increases dramatically the level
of uncertainty for the businesses, and that has risen critics by the first commentators of
33
(Frecknall Hughes & Glaister, 2001). See also (Kobetsky, 2011; Reimer, Urban, & Schimid, 2011; Skaar,
2000).
34
(Bowers & Syal, 2013).
35
(Duhigg & Kocieniewski, 2012).
36
(Skaar, 2000).
37
Consultation Draft on DPT, Part 1, Article 2 (1) (c).

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the proposed law38. It is however an unavoidable consequence to increase uncertainty
when the tax base is made wider or more items are attracted to taxation beyond those
traditionally listed by the OECD in either the Model or the Commentary.
The second situation in which DPT is applicable is less peculiar that the first one, as it
makes reference to the taxpayer who pursues tax mismatches. Basically, DPT is triggered
here on transactional basis, and makes extensive reference to the Transfer pricing rules
and procedures. When the taxpayer (either UK resident or not) enters into one or more
transaction without an effective economic substance, with the purpose to divert profits
elsewhere from the UK, and enjoy an aggregated lower taxation (the transaction of the
case originates a cost tax deductible on UK resident company and a profits on a parent
one resident in a low tax jurisdiction), then the spread between what has been actually
paid and what ought to is charged with the DPT in the UK39.
The conditions under which the ‘Diversion’ is assessed are those detected using the
principle of “just and reasonableness in taxation40 ” and in business planning. Any
transaction deprived of a considerable business purpose or not in line with the “state of
the art” for the business of the case might trigger DPT if a tax saving occurs.
DPT becomes another instrument similar to TP regulations with which is now possible
to the HMRC to address cases in which the flow of revenue for the State is at risk.
The two instruments are not equivalent in any case, nor it is their effect. In case of TP,
the prices of the transaction are adjusted consistently with the arm’s length principle41
and taxable income increased in the UK, while DPT accept as correct the terms of
agreement the parties entered into, but the spread between the amount paid and the
one which was supposed to be under arm’s length negotiation is taxed under DPT.
The first commentators, particularly from the business community42 observed that
while in theory this approach could seem all in all reasonable, in practice it is much more
complicated (and uncertain) when the time comes for calculating “what income would
have been if” for the purpose of DPT. In other words, the amount of the ‘diversion’ is
anything but certain.
3. A view from outside: the Italian attempts to address the
same issue (a path of successes and failures)
While DPT should be a law passed and in force in the UK only as from April 1st 2015 and
apparently there are no similar taxes in other Countries of the European union, the
rationale underlying it has been shared by others in the past: even in Countries with a
very different legal tradition.
38
(PwC, 2014).
39
The legislator sets a threshold of 80% for the application to be made possible.
40
41
HMRC’s introductory notes to DPT Discussion draft, page 1.
42
(Hooper et al., 2015).

14
The notion of “Hidden permanent establishment”, for instance, has been used by the
Italian judiciary some six years ago in deciding a case which drew the international
attention and ultimately led to some changes to the OECD Commentary itself: the Philip
Morris case43.
There is no room here to summarize in details the circumstances of the case: a full
translation of it has been made available in English after its publication44. On that
occasion the Italian Supreme Court had to decide on a business structure of the
American multinational trough which it was in the position to earn a remarkable amount
of profits from entities resident in Italy (essentially, royalties) without maintaining in the
peninsula any PE. It was not a case concerning the use of Internet or computer
technologies, but the situation was somehow equivalent to the one faced when dealing
with MNE operating in the field of computer technologies.
There was in particular one element that drew the attention of the judges: the existence
in Italy of a subsidiary that has been operating in the interest of the non-resident
company even beyond its statutory commitments. More precisely, the subsidiary
company carried on (also) an activity that was in the interest of the non-resident entity,
and not of its own.
This peculiar situation moved the Court to decide that there was, in the Country, a
“Hidden PE” of the non-resident company. This PE was discovered considering a number
of benchmarks that were confirmed in the specific situation:
(1) The remarkable amount of profits made in Italy by the non-resident;
(2) The fact that even it had no business structure here, nonetheless it was able to
operate with the support of third parties (the subsidiary);
(3) The separation between the place where the profits were made and the palace
where they were supposed to be paid under the ordinary rules appeared inappropriate
ad unfit to the circumstances of the case (the Judges never used the Italian equivalent
for ‘Diverted profits’ but the meaning conveyed was the same.
This is not a DPT, but rather the attempt by a judge to reach the same result interpreting
the classic rules of international taxation, and in particular the concept of permanent
establishment. That interpretation of the law (as it is) and of the traditional rules
regulating international taxation law is still alive in the Italian Tax Court. Many other
cases45 have been decided considering the position taken by the Supreme Court in Philip
Morris, either confirming it when the situation was the same, or alternatively obliging
judges to distinguish.
Currently, the notion of permanent establishment in Italian case law has been
progressively eroded, and the Italian judiciary is more than ready to recognize the
43
Supreme Court (Italian) case n. 7682 decided on May 25th
2002.
44
(Greggi, 2008b).
45
Supreme Court (Italian) case n. 16106 decided on July 22nd
2011.

15
existence of a PE in Italy even beyond the situations listed in domestic law or in the
double taxation applicable to the case. Notably, in the most complicated situations
Italian judges apply together the abuse of law doctrine with a judge-made DPT approach:
to some extent, any diversion or any business combination aimed at diverting profits
from Italy could be considered as an abuse of law and therefore be deprived of any
effect for tax purposes.
Some Italian judges ended up in implementing also the second branch of the DPT using
TP regulations in a very innovative way. The reference in this case is to qualified business
arrangement between resident companies and others (either resident or non-resident)
entities whose purpose is to make the most of possible tax mismatches. According to
the newly drafted DPT46 the spread between the tax changeable on the effective
transaction and the one that would have been alternatively paid without it is the ew
taxable base.
It has been observed above47 that in this situation an important role is played by the
current TP regulations applicable to the case.
In Italy, obviously, no DPT is currently in force, but rules applicable to TP has been
progressively extended by the judiciary48 to cover cases that would not be ordinary
being addressed by them, nor were considered either by the OECD49 or UN50 while
drafting their recommendations.
According to some Italian judges of the supreme Court51 TP regulations aren’t technical
provisions aimed at regulating complicated cases in international taxation and based on
complex methodologies to find the appropriate prices to be paid, or payment to be
obtained for some trade of goods or delivery of services.
They are evidence of an overarching principle in taxation: the one according to which
every business or business transaction should be considered for tax purposes in the light
of the principles of “normality” and “fairness”.
Even from a linguistical point of view the words used by the Italian judges echo the ones
used by the British legislator where it mention the concept of “justice and fairness” in
calculating the tax that would have been paid if the transaction of the case would not
have occurred.
In Italian literature these cases are sometimes mentioned as of “Internal Transfer pricing”
to distinguish them from the orthodox application of TP regulation: even in this situation
their application has been strengthened via the use of abuse of law doctrine that is used
as well to decide most of the cases in favour of the Revenue service
46
Consultation Draft on DPT, Part 1, Article 10 (3) (a) and (b).
47
(Hooper et al., 2015).
48
Supreme Court (Italian) case n. 17995 decided on July 24th
2013.
49
(Calderon, 2007).
50
(UN, 2013).
51
Supreme Court (Italian) case n. 17995 decided on July 24th
2013.

16
In the eyes of some Italian judges (the most confused ones, perhaps) any TP case is also
a case of abuse of law. Taxpayers would allegedly be abusing of their freedom to
negotiate and settle their businesses in the way they find more convenient, hence the
principle of “normality” (the way in which arm’s length is translated in Italian in some
situation) in business transaction is used to limit their freedom and prevent any abuse.
Prices paid and / or profits earned for tax purposes are the ones that would have been
if the taxpayer of the case would have kept a “normal” behaviour.
Even if the ultimate consequences are undoubtedly different (in the UK this situation
this open the floor to the application of a new tax while in Italy it determines a higher
tax liability for corporate tax purposes), the way of thinking is similar, and so are the
conceptual instruments used both by the UK legislator and by some Italian judges.
The issue of the ‘diversion’ in therefore well-known in Italy, and is considered to be
coincident with any ‘divergence’ from the general canons of fairness, normality, and, all
in all, necessity to do business at arm’s length prices and costs.
4. DPT as an Attempt to Re-define the Concept of Taxable
Income: from Residence to Allegiance.
In the former chapter DPT has been addressed in a practical – down to the ground -
perspective, with a specific focus on the provisions in the law, their consequences, the
interaction between (possible) anti-avoidance rules and, eventually, comparing it with
similar remedies in other jurisdictions (the Italian one has been used in this case).
It was observed that the British attempt can be placed in a midway between just another
anti avoidance provision, or something capable of changing drastically the nexuses
(notably Source ad residence) regulation international taxation law.
Tax avoidance (or the abuse theory) is explicitly mentioned52 in both the situations in
which DPT is applicable, either in the “Hidden PE” or in “Mismatching agreement”. In
either case the behaviour of the taxpayer avoiding ordinary corporate income tax is
labelled as inappropriate, if not deserving an adequate reaction by the Tax Office at all.
This chapter is aimed at observing how, in a purely theoretical perspective, DPT could
be considered the blueprint of a brand new way of dealing with taxation of income in
some circumstances.
Ever since it was born a branch of taxation, International tax law has been built of few
internationally recognised principles 53 aimed at solving the never-ending struggle
between the Source state and the Residence state.
The most relevant studies in international taxation (at least under a quantitative point
of view) are income-centric, and, being based on Conventions and Treaties, their
52
Consultation Draft on DPT, Part 1, Article 2 is headed “Avoidance of a UK Taxable presence”.
53

17
purpose is to try and strike a balance between the power to tax of different sovereign
States involved, in order to facilitate international interactions, business opportunities
and a more harmonized way to develop national economies.
The role of the OECD in taxation is functional to this purpose: to mediate between the
intrinsic unilateral approach to taxation of the States (for which the behaviour of the
other Countries is irrelevant) and the multilateral nature of commercial relations
(involving different jurisdictions, including tax ones).
The most recent development of the BEPS actions have demonstrated that the situation
is slowly changing54. Under the BEPS view, for instance, Treaties should be considered
as tools to guarantee an effective international taxation (thus preventing double non
taxation) and not only being functionally limited to minimize the risks of double
taxation55.
Source and Residence, on the other hand are not concepts that are clearly suffering from
the time passing by56.
Historically, the Residence nexus was privileged for reason of certainty, clarity and
reasonableness. Since income has to be taxed, the recipient of it is liable to tax, so it
does make sense to tax where the owner of income actually is.
This position is confirmed particularly in the case of business (active) income, where the
tax treatment of permanent establishment is to some extent an exception to the general
rule of this income being taxed where the recipient is.
Source State maintains its power to tax (either unrestrained or quantitatively limited) in
other circumstances or for other kind of income. Some Authors also observed that this
approach to the conflict between source and residence also ended up in a facilitation
for the most developed countries (residence States)57.
In literature, however, there has always been some uncertainty about the nexus to be
used in these cases58: production (of income), ownership (of it), or else ? Being income
a subtle, complex and ambiguous concept (a least when used by lawyers) there is no
surprise that nexuses normally used to justify power to tax may be different and in some
circumstances not so well defined.
The DPT paradigm wants income to be taxed where it is produced, when other
conditions are met. This is not a Copernican revolution, with source State taking over
residence, but rather a situation in which insisting on this distinction is perhaps not
entirely appropriate and accurate as well.
54
(Saint-Amans & Russo, 2013).
55
See BEPS Action 6, directed to a fairer allocation of taxing rights worldwide. (Devereux & Vella, 2014).
56
(Devereux & De La Feria, 2015).
57
(Kobetsky, 2011), see in particular page 35.
58
(Couzin, 2002).

18
In theory, DPT (in the first of the two cases mentioned by the UK law) targets income
where clients pay for services and good delivered. If one MNE is making billion of profits
in the UK, out of UK resident individuals or companies, it does make sense that those
profits should be taxed in the UK as well, as a matter of coherence of the tax system.
The reference to a possible “Hidden PE” in the UK or, alternatively, an abusive behaviour
aimed at concealing the existence of a fixed place of business, appears to be a sort of
last fig leaf. It’s nothing more than a tribute to the traditional way of interpreting
international tax law rules and a possible way to make DTP more compliant with EU law
and International tax treaties currently in force (see § 5 below). This is probably the
reason why the application of this tax is in connection with a potentially abusive
behaviour of the taxpayer.
A bolder approach to taxation of non-resident qualified entities (MNE in particular)
would make possible (and recommended) to tax income where it is actually generated:
to some extent in the source State.
The access to the markets makes possible the generation of profits in a globalized
economy. When so much income (the British proposal set a discretionary threshold to
£ 10mn of UK total sale revenues of the taxpayer together with corporations connected
for the application of the DPT59) is originated in one Country or, more precisely, from a
cluster of clients resident therein, it is reasonable and appropriate to tax those profits
where they are generated. In this respect diversion would occur if the liability to tax
would emerge elsewhere.
Prominent academics both in the US60 and in the UK61 have in the past supported the
possible implementation of a destination based corporate tax (DBCT).
DPT could be considered as the first attempt to get rid of concepts, just like the one of
‘Residence’ for tax purposes, that for years have haunted any international taxation law
discussion, and perhaps ease the access to the academic debate of other parameters
that should facilitate the apportionment of of taxing power between States.
Tax Allegiance could be one of these. Allegiance, in historical terms (and in a middle age
scenario) meant the ‘belonging’ of individuals to the supremacy of King, Emperor or to
another sovereign or quasi-sovereign subject. As a doctrine in taxation it is currently
applied62 by some Countries, notably the US, for purposes different from the one
analysed in this paper.
Its application to the modern international taxation law would determine a remarkable
change in the identification of the Nexuses (genuine or not) legitimating the power to
tax of a State on an entity, moving the system to a more itemized (or less
comprehensive) way to tax income generated.
59
Consultation Draft on DPT, Part 1, Article 12.
60
61
(Devereux & De La Feria, 2015).
62
(Edrey, 1990; Merrill, 1935; Norr, 1961).

19
Extending the scope of a DPT would entail, as a consequence, that no matter where a
MNE is resident- or is planning to move – because it will be in any case liable to tax in
the Country where its market (or part of its market) is. The relationship of allegiance will
be regulated according to the access to the market, effective or potential client, and also
the use of legal infrastructures (contract liability, consumer protection, sale agreements,
delivery rules, etc.) of the State of the case.
Academic literature have also recently recorded some dissenting opinions63 about this
possibility (or, more precisely, to the opinion in favour of a DBCT as a possible
development of DPT).
While some of these critics are related to external conditions in which this change of
paradigm would occur (EU law, International treaties, WTO regulations, etc.) others are
concentrated on the ultimate effects it would entail: a mutation in the genetic code of
income taxation, approximating it to a Consumption tax (and in EU, possibly, to VAT).
Even if some similarities would emerge, distinction would prevail anyway. First of all DPT
and a possible evolution of it (the DBCT) focus on territoriality. The shift towards
consumption is relevant only to assess where the tax should be applied, not in the
calculation of the tax base.
No doubt that, in practice, this would give rise to a number of technical issues, including
the need to apportion costs incurred off shore and that could not be reflected in the
most appropriate way following TP regulations (DPT in this respect shall reflect a 30%
disallowance of those expenses). This is not the first case, nor the most important, in
which this kind of problems emerge in taxation law however.
DPT on the other hand cuts a Gordian knot allowing foreign tax to be credited towards
the DPT in order to minimize the risks of possible double taxation (in the residence state).
The picture emerging from this situation is that DPT (or a possible, future, DBCT) does
not overlap with Consumption tax, but needs a very careful regulation by the legislator
in order to minimize the uncertainties related to the deductibility of the costs incurred
abroad, but related to the sale of goods in the domestic territory.
5. DPT at the Others: External Limits to the Power to Tax (EU
Law and DTCs). Some Concluding Remarks
Changes of legal paradigm are rarely painless, and never in taxation.
While most of the criticism related to this tax and the possible perspective use of the
‘Allegiance’ nexus can be overtaken in the ways and with the means analysed in § 4
above, the compatibility with Treaties (built as they are on notions of Source and
Residence), WTO agreement and, for European states EU law, is a bit more delicate.
63
(Altshuler & Grubert, 2010; Morse, 2009).

20
In the case of Tax treaties this way of allocating taxing power to the source state (o more
appropriately, to the state income belongs to) could collide with the termism an
conditions parties agreed on when the treaty was signed.
The way in which the UK has drafted the DTP demonstrates that this risk can be
minimized, if not entirely removed. According to the UK law the tax paid in the
Residence state can be credited in the UK64 in order to prevent any overlapping of the
two taxing power. The more the Source State taxes income generated in the UK, the less
will be the tax liability for DPT purposes. This clearly makes sense in the way DPT was
conceived: an instrument to extend the taxing power of the UK in cases where there is
a high risk of tax avoidance and where the Source state has a low taxation (or nil). In
most of the situations under the highlight of the newspapers recently65 (such as the case
of Google Inc., inter alia) the discussion arose because as a matter of fact the MNE of
the case was able to enjoy a quasi-double non taxation thanks to the skilful use of
friendly tax jurisdictions and tax planning schemes66.
DPT in this respect is straightforward: the lower is the tax liability in the Residence state
the higher will be DPT in the UK, the higher shall be the first, the larger shall be the tax
carved out from the UK.
The way in which DPT has been drafted appears to be in line with OECD Treaties’
mainstream interpretation and, more than that, on the most recent development in the
framework of the BEPS initiative67. In the BEPS action plan the goal to be pursued with
Treaties should be also the prevention of double non-taxation68, and if one of the two
States leave part of the taxable base virtually untouched, then the power to tax of the
other State comes back in again, and can be rightfully exercised.
WTO regulations should be considered as well69, but in this case the nature of the tax
should prevent most of the risks of possible incompatibility. WTO system is mainly
devoted to regulate indirect taxes, including customs fees and tariffs, together with VAT.
There have been situations in the past where direct taxation was also considered and
found incompatible with WTO law, such as the FSC case70.
In FSC struggle, however, the tax measure under scrutiny by the Judicial body of the
WTO had an intrinsic different value. It was found to be a sort of dumping measure to
promote exportations by US companies71 , thus generating a kind of inappropriate
competitive advantage equivalent to the one that it is possible to have fine tuning
indirect taxes.
64
Consultation Draft on DPT, Part 1, Article 19.
65
(Bowers & Syal, 2013).
66
(Loomis, 2011).
67
See references to Action 6 above.
68
Ibid.
69
(Daly, 2006).
70
(Clark, Bogran, & Hanson, 2001).
71
(Stehmann, 2000).

21
Here the tax is aimed to create a level playing field between the resident companies (or
those resident in ordinary tax jurisdiction) and those residing in other States but
operative in the UK with a kind of stealth business infrastructure. Both the purpose of
the law (its ratio) and the limited scope should make DPT compatible with the state of
the art of WTO regulations. The situation could be a bit more complicated with a DBCT,
considering the wider scope, but the result should be the same.
Eventually, the last profile of discussion concerns EU Law in general, with the principles
of Freedom of establishment72 or, alternatively Free movement of capitals73 on the
frontline.
Freedom of establishment prevent member states to enact measures aiming at reducing
the mobility of business in the EU market. Even if ECJ case law has demonstrated in many
situations its unpredictability, it is hard to consider DPT as a limitation of this kind.
Obviously it makes access to another market more expensive in a tax perspective, but
gives priority to taxation in the Source State, and still is not applicable without the
assessment of a ‘Hidden PE’ in the first case and of an abusive scheme (tax mismatch)
in the second. The conditions for its application make it consistent with the
proportionality test74 always applied by the Judges in Luxembourg. In this respect, the
only concern would arguably come from the different tax rate applicable (25% versus
20%, which is the standard for UK companies).
Free movement of capitals is a freedom that cannot be used when the case is potentially
covered by freedom of establishment, as the ECJ has often ruled 75 , but appears
appropriate to discuss the compatibility of DTP in this perspective as well since the
possibility to invoke the first of the two freedoms is not clear at all.
Free movement of capital can be theoretically used even in the cases covered by DPT,
since ‘capital’ has to be interpreted in its broader sense76.
But even with this concession, only the second of the two situations addressed by DPT
should be considered. The first one, as it makes reference to a PE should fall inevitably
in the freedom of establishment (and more precisely in the secondary freedom of
establishment). The purpose of the tax and its nature should make it compatible even
with the free moment of capital: it does not make the investment more burdensome,
or, at least, is it aimed at making a level playing field for every business in the UK.
Moreover, the possibility to have the foreign tax credited in full on the DPT in the UK
should remove and doubts of incompatibility in this respect.
72
Article 49 TFEU.
73
Article 63 TFEU.
74
(Zalazinski, 2007).
75
(Hemels et al., 2009).
76
(Hemels et al., 2009).

22
6. DPT as a Model for the European Union ?
These days witness an increasing debate on UE Tax law in general and on the possibility
to conceive new taxes to support the European budget77. In this context, very often legal
opinions are mixed with political ones78 and reaching consensus and unanimity is hard
if not impossible: the experience of FTT is a clear example of this79.
DPT if properly conceived could be a good answer in this respect, if applied to non-EU
resident companies and entities. In this way, any doubt of incompatibility with EU law
would be wiped out, and the flow of revenue would benefit directly the European
budget.
It could be also interesting, from a scientific perspective, but in my view also appropriate,
that the next step towards tax harmonization in the Old continent would be taken
addressing the way in which European companies are taxed while investing in other
states of the Union, where they are not incorporated in. In this respect, the notion of
‘Allegiance’, a possible new nexus to be used in International taxation, would be referred
to Europe as a whole and not to single States part of it.
77
(Freedman, 2006).
78
(Heinemann, Mohl, & Osterloh, 2008).
79
(Greggi, 2013).

23
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