The Italian tax authorities have recently adopted an innovative and unique approach to the issue of whether a foreign company, active in the digital economy, created a permanent establishment (PE) in Italy. A recent public communication of the Milan public prosecutor’s office announced that Netflix Inc. had reached a settlement with the Revenue Agency on the basis that the availability of a network of servers used exclusively to provide a streaming service to Italian customers qualified as a PE by creating a “fixed place of business.”
This development is a sign that the definition of a PE is continually evolving, becoming more fluid and uncertain. The tax authorities are clearly looking to expand the interpretation of a PE, adapting it to the ways in which businesses have changed over the years, particularly with respect to the explosion of the online and digital economy. As a result, as with the 2002 Philip Morris case (Ministry of Finance (Tax Office) v Philip Morris (GmbH), No. 7682/05, May 25, 2002), the Italian tax authorities are now adopting an analysis of the business model of enterprises that uses an interpretation that goes beyond the literal wording of legal provisions in order to tax profits that would otherwise not be subject to domestic taxation.
From the information provided by the public prosecutor’s office (the precise terms of the settlement are confidential), it seems that in the Netflix case the tax authorities considered that the sole presence of an advanced technological infrastructure on Italian territory, at data centers belonging to third parties, that was used exclusively by Netflix with the purpose of facilitating the transmission of information (thus qualifying the data centers as servers), could be considered to be a fixed place of business, even in the absence of any staff in Italy, because the relevant role of the so-called “content delivery network” was not ancillary or auxiliary to the business activity. As a consequence of the settlement, Netflix had to pay approximately 56 million euros ($63.31 million) for taxes, interest and penalties for the fiscal years open to tax assessments (2016 to 2019).
Definition of Permanent Establishment
The definition of PE under Italian legislation was changed with effect from Jan. 1, 2018, to reflect the amendments to Article 5 of the OECD Model Tax Convention, following the OECD/G20’s adoption of the Action 7 report “Preventing the Artificial Avoidance of Permanent Establishment Status” of the BEPS project. The new definition explained in more detail the PE exemption for specific activities (the so-called “negative list”), expanded the definition of PE under the dependent agent theory, and introduced the supposed “anti-fragmentation rule.” (See article 162 of the Italian consolidated income tax law.)
Moreover, under the new definition, a PE is deemed to exist in the case of a “significant and continuous economic presence,” i.e., a presence that has been arranged in such a way that its physical presence in Italy is not apparent.
However, the definition does not include any more reference to servers. Indeed, until 2018, equipment and devices which allowed for the collection and transmission of data and information related to the sale of goods and services were clearly not considered to give rise to a PE, as they fell within the negative list.
Significant Economic Presence
The notion of significant economic presence was conceived and has been developed as a way to expand the PE cases beyond the initial definition in order to capture revenue deriving from evanescent and digital businesses that do not fall within the existing rules.
Historically, the identification of a PE has always been linked to the physical presence of persons or equipment. In this regard, the Commentary on Article 5 of the OECD Model Convention (2017) (see paragraphs 122–131) clearly made reference to an example of an internet website being a mere combination of software and electronic data, with the consequence that no PE could be detected based on the theory of “fixed place of business” unless certain equipment/devices played a significant role in the business activity.
With the application of the concept of significant economic presence, a new nexus for taxing profits realized by nonresident digital enterprises may arise. But in its public consultation document “Addressing the Tax Challenges of the Digitalization of the Economy” (2019), the OECD underlined (at paragraph 51) that for there to be a nexus between the foreign entity and the revenue generated in the relevant country there should, in addition to digital and economic aspects, be other factors. For example, the existence of a user base or billing and collection in local currency, responsibility for final delivery of goods to customers, or provision by the enterprise of other support services, such as after-sales service or repairs and maintenance.
The concept is, therefore, still quite broad and may be difficult to understand in the context of its immediate and unilateral introduction into the PE definition. It will indeed be important to see whether the concept is considered a real new case of a PE, an additional nexus to tax profits, or an antiabuse provision to challenge the conduct of multinational groups attempting to artificially conceal the presence of a PE.
From an international perspective, the concept of significant economic presence is not immediately applicable because, although the OECD Commentary on the Model Convention has been amended to reflect the changes promoted by Action 7 of the BEPS project, the implementation of the new definition of a PE requires a renegotiation of any tax treaties in place between countries or the ratification of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, i.e., the MLI. BEPS rules could be applied following ratification of the MLI by different countries, taking into account the fact that the different states could have made some reservations/options in the application of the MLI. In any event, as the MLI does not include a definition of PE in line with the concept of significant economic presence, tax treaties will need to be amended.
Contrary to past years, the risk management approach could be supported by having a preliminary dialogue with the Revenue Agency. Indeed, there are multiple ways to start a positive discussion with the Revenue Agency before a tax audit is launched.
In particular, it is possible to file a ruling request with the Revenue Agency when a new and large investment of at least 20 million euros is planned in Italy, with significant and lasting employment benefits. Interested investors may raise any type of question regarding the overall tax treatment applicable to the investment, including whether it is anticipated that an analysis may be undertaken to determine if a PE exists. Moreover, the same query could also be addressed to the advance pricing agreement team. (See article 31-ter of Presidential Decree No. 600/1973.)
In certain cases, taxpayers who are already active in Italy may also want to pursue a specific procedure which is aimed at assessing on a voluntary basis whether a PE of a foreign entity could be deemed to be present in Italy (see article 1 bis of Law Decree No. 50/2017, converted in Law No. 96/2017) by accessing the cooperative compliance program at a later stage. (See Legislative Decree no. 128/2015.)
The Italian tax authorities are trying to adapt the current rules relating to PEs to the new business models. However, in the absence of any clear support found in current legislation, they are apparently trying to stretch the old rules to fit these new economic concepts.
For this reason, with the removal of the server exemption from the negative list of the domestic legislation, which should apply where it is more beneficial to the taxpayer than any treaty, the tax authorities should remind themselves of the definition of PE under the theory of the fixed place of business adopted by the OECD Commentary for the old economy.
Cables or pipelines were in the past objects of attention and analysis by the tax authorities. And when there was a cross-border transportation of products, the foreign entity could have been considered as having a PE if the facilities were used to transport property belonging to other enterprises and the cable or pipeline were at its disposal. In practice, even though the foreign entity did not have any personnel in the country where the products were sold, having the cable or pipeline at its disposal could not be considered an ancillary or auxiliary activity for the generation of revenue. (See German Bundesfinanzhof (Federal Tax Court) in case No. IIR 12/92 dated Oct. 30, 1996.)
This approach has been confirmed by the OECD Commentary (2017), which states that an internet website, being a mere combination of software and electronic data, cannot constitute a fixed place of business PE if it is not paired with certain equipment located in the territory of the state at the disposal of the foreign entity, while the server on which the website is stored may also be considered a piece of equipment so as to constitute a fixed place of business PE of a foreign enterprise (see paragraph 123).
Considering the above and taking into account how the tax authorities are trying to approach the new economy with well-known concepts or interpretations regarding the fixed place of business theory, businesses are advised to plan their activities in Italy cautiously, limiting any type of risk and avoiding having at the disposal of a foreign entity equipment or devices that may be considered relevant and essential for the activity and to clearly provide explanations in documents and contractual arrangements.