REFORMING THE PERMANENT ESTABLISHMENT PRINCIPLE THROUGH A QUANTITATIVE ECONOMIC PRESENCE TEST

Abstract

SUMMARY The permanent establishment principle has shown remarkable resiliency, forming an accepted international income tax law principle since its inception roughly 100 years ago. The basic idea is that countries agree through their tax treaties that they will not tax profits associated with a nonresident's cross-border transaction unless those profits are attributable to a fixed place of business within their borders. Recent developments, including the acceptance by the OECD member states of the Ottawa Taxation Framework Conditions/1/ along with the new server/PE category, suggest that tax authorities and multinational businesses continue to be wedded to the PE concept. The PE's success is surely related to the flexibility of the concept. In fact, the physical presence requirement under the PE has undergone significant dilution over the past several decades. This paper argues for further evolution of the PE principle to take into account modern commercial practices, such as e-commerce, that permit nonresident firms to generate significant revenue in foreign markets without the need for a physical presence. The OECD model tax treaty/2/ and the U.N. model tax treaty/3/ should possibly incorporate a new PE fiction -- a quantitative economic presence test -- that enables source countries to tax above-threshold sales (for example, gross revenues in excess of US $ 1 million) despite the absence of any physical presence. Part I of this article briefly reviews the historical development of the PE principle as well as its success in eliminating international double taxation and promoting a relatively balanced sharing of tax revenue. Part II discusses how the PE principle has evolved to dilute the physical presence test. Particular attention is paid to the recent OECD initiative that introduces a new PE category: computer servers. Part III argues that the development of a quantitative economic presence PE would be consistent with the historical rationale for PEs and could restore a balanced sharing of tax revenue among countries without imposing overly burdensome compliance costs on multinational firms.

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