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Permanent Establishment in the Digital Economy
Permanent establishment is a tax concept that allows the source country to tax commercial profits derived from it by a resident of another country.
This concept is embodied in the Model Tax Convention on Income and on Capital (the Model Convention). The Organization for Economic Cooperation and Development (OECD) elaborated on the convention and official commentary on it. This convention underlies the majority of bilateral double-taxation treaties, including those concluded by Ukraine. Also, its wording and concepts were to a certain extent adopted by local Ukrainian legislation.
According to the traditional understanding of permanent establishment given in Article 5 of the Model Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.
As explained in the OECD commentary to Article 5 of the Model Convention, the above definition provides for 3 key features of permanent establishment:
- There must be a distinct place available in a specific country (some tangible facility, which can include not only premises or buildings but also equipment and machinery);
- This place must be fixed, meaning that it shall exist at a certain place within a certain period of time (usually, 6 – 12 months);
- The foreign enterprise shall carry out its business through this place, usually using dependent persons, such as employees or local exclusive intermediaries controlled by the headquarters and authorized to conclude/negotiate contracts on its behalf (dependent agents). In other words, the permanent establishment carries out the same business activities as its headquarters (all or some of them). For example, if the headquarters in State A trades in electronics and software, its permanent establishment in State B will be engaged in the same trading operations. If the presence in another country is limited to preparatory and auxiliary activities (such as gathering information, market study, etc.), then no permanent establishment exists.
The taxing mechanism is provided in Article 7 of the Model Convention. It establishes a general rule that profits of an enterprise of one state shall be taxable only in that state. The exception to this rule is the case when the enterprise carries on business in the other state through a permanent establishment situated therein. In such a case, the state where the permanent establishment is located has taxing rights over the profits attributable to the permanent establishment of the mentioned enterprise.
The same concept is followed by Ukraine and can be seen in paragraphs 14.1.193 and 141.4.7 of the Tax Code of Ukraine. Ukrainian courts and tax authorities widely use the OECD commentaries to the Model Convention in practice. Moreover, Ukraine has been actively implementing the steps of an international OECD project on combating tax base erosion and profit shifting (BEPS). One of the key steps of BEPS is to introduce a mechanism preventing the artificial avoidance of permanent establishment status.
Given this, Ukraine (as well as the rest of the world) is now facing the challenge of adapting the permanent establishment concept described above to a swiftly developing digital economy. The above-mentioned 3 key features of permanent establishment do not fully apply to e-commerce and thus loopholes for tax avoidance are created. This is especially the case with indirect e-commerce (such as online stores selling downloadable intangible goods).
Digitalization has replaced local intermediaries, which are included in the traditional permanent establishment concept as dependent agents, with online mechanisms for buying and selling goods and services (online stores and selling apps). These new mechanisms also remove tangibility from the seller’s presence in foreign states and thus create potential grounds for excluding numerous online businesses from the scope of permanent establishment, which is based on the criterion of physical presence.
To address the new challenges of the digital economy, the OECD commentary on Article 5 of the Model Convention was supplemented by the section on e-commerce. However, this is mostly focused on the old perception of permanent establishment tied to a tangible presence (a fixed place of business) in a certain state.
In particular, it is mostly dedicated to analysing whether the server on which the e-commerce website is stored can be seen as a fixed place of business. The commentary explains that since the website (as a combination of software and electronic data) does not itself constitute a tangible property, it does not have a location to which a fixed place of business can be attributed.
Accordingly, to identify permanent establishment features one needs to study closely the server underlying the website and the internet services provider operating it (if any). In particular, the following aspects of online business should be reviewed:
- whether the online seller of products (located in State A) being the website owner has also the rights to the server located in State B (such as owns or leases this server in State B);
- whether the online seller (located in State A) actually operates the server (located in State B) themselves or just buys some server-related services from an independent provider;
- whether the server (located in State B) is used to carry out the core business of the company located in State A, such as helps entering into purchase deals with regards to the products sold by such company; auxiliary functions such as display of goods or market study before entering the market of State B do not count as core business operations;
- whether actual sales take place using the website and server;
- how long the server has been existing at a given location in the given country.
However, the above traditional permanent establishment criteria may no longer be relevant in the swiftly developing digital world. The key problem of the current permanent establishment concept is that it is aimed at taxing profits at the place where the value is created. Yet in the digital world, it is difficult to identify the exact place where the value is created, especially with regard to intangible products, such as online services. As an option to deal with this challenge, the Oxford University Centre for Business Taxation expressed the opinion that it is more suitable to allocate taxing rights to the destination country, in which the buyers or consumers are located.
To adapt the permanent establishment criteria to the electronic world and selling models built completely on the internet, a new concept has been developed. This concept studies the economic or commercial footprint of a certain business in another state that could lead to a permanent establishment in that state. Physical presence in a given state is no longer seen as the core aspect of permanent establishment.
Within this new concept, a digital (online) presence or minimum economic substance should become a new criterion to qualify the permanent establishment of an entity in a given country. According to this new criterion, the following aspects of a foreign company’s business in a given state should be studied in order to qualify its permanent establishment in the latter state:
- Number of customers in this state (both B2B and B2C) exceeding certain threshold(s);
- Duration of relationships with such customers exceeding a certain time period (e.g., 6 months);
- Supply of goods or services to the customers in the said state through a website in a local language, offering delivery from suppliers in the state (mostly relevant for tangible products), using payment facilities from suppliers in that state or offering products sourced from local suppliers;
- Basing supplies to the given country on systematic data-gathering from the said country.
It should be noted that the above new concept has not been fully implemented even by OECD member states (to which Ukraine does not yet belong). However, the process has been started. Eventually, Ukraine will have to update its local rules on permanent establishments in line with the above new concept and to adjust them to comprise e-commerce activities concerning the Ukrainian territory.
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Halyna Melnyk
Tax Advisor and Deputy Director for Ukraine, PETERKA & PARTNERS, Leader of Tax Desk

Address:
40/85 Saksahanskoho Street,
Kyiv, 01033, Ukraine
Tel.: +380 44 581 1120
E-mail: reception@peterkapartners.ua
Web-site: www.peterkapartners.com
PETERKA & PARTNERS is the one truly CEE law firm that has built a pan-regional full-service practice with a unique fully-integrated infrastructure covering the region of Central and Eastern Europe through its own branches in the Czech Republic, Slovakia, Ukraine, Bulgaria, Poland, Romania, Hungary, and Croatia, with a team of more than 150 lawyers and tax advisors.
PETERKA & PARTNERS is best known for its unique, client-focused service model consisting of:
- A single delivery point for legal services throughout the entire CEE region;
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- Knowledge of the client’s business structures, corporate culture and standards shared among all offices to the client’s benefit;
- All services can be governed by a single agreement on the provision of legal services;
- A single fee structure for the entire region reflecting important regional synergies;
- Stability and a unified standard of legal services within the region.