Cyberspace Challenges the Physical Presence Test (Tax)

Posted by Bennie Groenewald on 26 January 2018.

Bennie Groenewald

LLM Tax Law, B.Proc, HDip Tax

The Tax Shop Head Office

More about Bennie Groenewald

After having qualified and practiced as a Commercial lawyer Bennie worked in the Banking and Financial services industry for 25 years across multiple market segments in South Africa, Sub-Saharan Africa and the UK, the last 14 years of which in senior and executive leadership positions. During this time, he dealt extensively with cross-border banking and finance including project finance, asset finance, debt capital markets and derivatives, including the legal aspects thereof. In recent years, Bennie has played an active leading role in investment, credit and risk management as well as sound corporate governance.
Bill Gates, the entrepreneur, philanthropist and co-founder of Microsoft, warned in December 2000 that “The Internet will have (a) profound effect on the way we work, live and learn” and added that “The Internet is becoming the town square for the global village of tomorrow”.  1
Globalisation has amongst many other things created opportunities for taxpayers to minimise or even avoid tax liabilities thereby eroding the domestic tax base of many countries.
Although there are several definitions for e-commerce, it means in short “any commercial transaction conducted wholly or partly by using the Internet”. The view is that multi-nationals can effectively establish structures that separate business profits from the value-added activities of their businesses. The OECD has recognised this challenge and in dealing with the digital economy, it examined “…the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus or taxable link under current international rules…”
The real challenge for tax authorities today is how to ensure that profits are reported where the economic activities that generate them are carried out and where value is created.
Charles M Allan wrote2 that taxes are not raised to finance government spending, even though in some countries this may be the motive, (my emphasis) but rather for a government to deliver the social goods and reduce the reliance on private sector investment.
Tax regimes in general recognise territorial taxation by the source country and personal taxation by the resident country.3   E-commerce, however, challenges these concepts by making it difficult to establish a norm or justify and implement a practical tax dispensation.
After more than a decade since the challenges of e-commerce emerged, many countries have yet to pass legislation or guidelines relating to the taxation of e-commerce. With the developments in information technology over the years, digital transformation has given rise to an e-commerce economy with unprecedented consequences and infringement on tax collection.
Conducting business by using computer networks has brought a digital economy with strong indicators of economic growth, job creation and world trade that ignores the boundaries of countries and has transformed the world into a digital market place. At the heart of Ethereum, a cryptocurrency, is the Ethereum Virtual Machine which is one big decentralised computer.
The Internet and computer technology have created what is known today as ‘cyberspace’ in which geography is irrelevant. This phenomenon ignores geographic coordinates and, hence, a physical presence, a point of place or location bears very little relevance.
In dealing with the scope of jurisdiction of the Internet, Dan L. Burk stated that “…the unique nature of the Internet may necessarily trigger constitutional limitations designed to limit governmental regulation originating outside the state’s physical borders.”4  With this dimension of no physical space, cyberspace calls for creative thinking by states to conceptualise this digital transformation into law and especially tax law. The long-standing principle of sovereignty, that is to say, that a state has jurisdiction over its territory and subjects, does not recognise the reality brought about by the digital transformation of business.
The concept of a ‘virtual presence’ has raised the question of how one should conceptualise, define and apply that in a tax system where tax principles still prescribe a physical presence test, for example, the Permanent Establishment (“PE”) test contained in Double Tax Treaties between South Africa and other states.
In Cyberlaw it is stated that “The Internet has bridged the geographic remote, and allows access to the entire digital world without moving away from one’s PC.”5
Furthermore, the challenge that tax authorities are faced with is that besides e-commerce ignoring geographic locations and physical presence, it brings buyers and sellers into the same virtual space or market place.
Governments, however, are now confronted with the reality that globalisation and digital transformation (may) lead to double non-taxation.
The peculiar features of many multi-national enterprises, today, demonstrate in my view that it is no longer unusual for business to have a virtual and no physical presence in several countries. A recent study by the author in this regard, concludes that the emergence of the digital economy has affected the ability of taxing authorities to impose and collect tax on e-commerce transactions and corporate profits generated in a virtual and growing market.
The European Union share the view of the OECD that the challenges posed by the digital economy lie in the difficulty to define tax jurisdiction without the need for a physical or legal presence and as a consequence, avoiding the Permanent Establishment status requirement. Commentators explain that governments are challenged more and more by multi-nationals with organisational structures that result in zero-tax and stateless income.
My view is that the rules have not kept up to date with technology and the developments giving rise to the growing digital economy and that even after the OECD’s final report on international tax reforms published in 2015, the principle of taxing rights or the appropriate place to tax business profits with regards to e-commerce, remains a controversial subject.
South Africa is party to 87 DTA’s6  in terms of which the country has agreed to the terms and conditions contained in these tax treaties. Of relevance in this context is Article 7 (1) of the model tax treaty used by South Africa, that provides that a Contracting State will only tax the profits of an enterprise if such enterprise carries on business in South Africa through a permanent establishment. South African domestic tax law recognises the concept of ‘permanent establishment’, the effect of these double tax treaties is that it limits South Africa’s taxing rights as a Contracting State in the event of there being no permanent establishment.
This study has showed that a permanent establishment as per the current definition in Double Tax Agreements between South Africa and other Contracting States and which definition is aligned with the OECD Model Tax Treaty, requires a physical presence or PE nexus which is not a requirement necessary to conduct e-commerce via the Internet in another country.
The fundamental justification for a government to impose taxes is according to International Commercial Tax based on the services provided by a government. A government has “…no justification, no jurisdiction to tax unless there is an appropriate connecting factor, i.e. a recognised basis of economic allegiance.” This study contends that the activity giving rise to e-commerce business profits and the geographic location thereof do not by virtue of technology, necessary take place in the country where a transaction is concluded. It is submitted in the alternative, that a foreign enterprise does not benefit from services provided by the host government and as a consequence there is no connecting factor.
It is submitted that there is merit in formulating a new PE nexus allowing for the allocation of taxing rights on cross-border business profits. Such a reform measure will allow the state of source to preserve its sovereignty on the taxation of business profits that are derived by foreign enterprises relating to activities effectively linked to its jurisdiction.
The impact of the digital economy on tax principles has to be addressed. A good starting point may be to also recognise a foreign enterprise’s digital presence (an ‘impermanent establishment’ or ‘virtual permanent establishment’) by expanding the conventional physical presence concept.  This could be achieved with the adoption of a new Article 5(8) in the OECD Model Tax Convention based on a paper presented by P Hongler and P Pistone. The objective should be to define ‘virtual presence’ based on the principle of ‘value creation’. Such a definition may include the following criteria:
  • An enterprise resident in one Contracting State that has a digital business facility or presence in another Contracting State will be deemed to have a virtual establishment in that other Contracting State,
  • The digital business facility must be suitably qualified to provide access to a web-based electronic application, that is an online market store, advertising or database,
  • Such facility must reflect a substantial and ongoing interaction with the economy of that other Contracting State, that is an engagement with consumers, resident in that other Contracting State, using the facility,
  • Certain de minimis thresholds may be implemented for example, a minimum number of users and the total amount of revenue generated per annum by virtue of the said facility.  8
The adoption of a new ‘virtual permanent establishment’ principle by states will be made easier if a universally recognised and accredited ‘world tax organisation’ can be established in future. It is considered that the OECD could play this role.
It is submitted that current principles of taxation applied in many countries fail to adequately address the unique features of e-commerce which may question the legal justification of a taxing authority to claim taxing rights in this regard. Part of the problem is that the digital economy is thriving due to the lack of a regulatory sandbox, circumnavigating governments’ sovereignty.
[1] In Shaping the Internet Age, Posted December 1, 2000 by the Internet Policy Institute of Microsoft by Bill Gates Chairman and Chief Software Architect, Microsoft Corp.
[2] Charles M. Allan, Theory of Taxation, published by Penguin, 1971 as quoted by RC Williams, Income Tax in South Africa, Cases & Materials, Fourth Edition, @5 a reference work of tax principles and case law.
[3] Reuven S. Avi-Yonah et al, US International Taxation: Cases and Materials 3rd Edition 2010.
[4] Virginia Journal of Law and Technology, published by the University of Virginia in Spring 1997, 1 Va. J.L. & Tech.3, paragraph 6, written by Dan L. Burk, Chancellor’s Professor of Law at the University of California, Irvine accessed through
[5] Cyberlaw @ SA II by Reinhardt Buys and Francis Cronje, Second Impression of 2008, Van Schaik Publishers, at 101.
[6] SARS, Status overview of all DTAs and Protocols
[7] International Commercial Tax, Tax Law Series by P Harris and D Oliver, 2010, published by Cambridge University Press, at 43.
[8] Blueprints for a New PE Nexus to Tax Business Income in the Era of the Digital Economy, working paper by Peter Hongler and Pasquale Pistone, 20 January 2015, published by IBFD.