Attribution and allocation of income from electronic commerce (IV)

… Policy aspects
From a policy perspective, the strict functional analysis based on the functions
performed, assets used and risk assumed by the PE may not be adequate in the
field of electronic commerce. If the analysis were restricted to the technical functions of the server, then the amount of profits attributable to it would be limited.
This may not be fair. Indeed, according to some commentators, even if the intangibles such as the software and intellectual property rights belong to an enterprise sited in another state, their value (or increase of value) is also caused by the access to the customer base developed by the server.38 In addition, while it is true that the Internet has reduced the cost of intermediation, the profits attributed to this function should also take into consideration the broad and unlimited availability of the server.
In any event, there are no signs that the Swiss practice will change in the near
future. A solution to ensure proper and fair allocation of profits between a PE and the head office requires a broad international consensus.

Attribution and allocation of income from electronic commerce (III)

* Impact of treaties

Transfer pricing
With the exception of the treaty with the Netherlands, all Swiss treaties contain a provision similar in substance to article 9 paragraph 1 of the OECD model. It is
widely recognized that the domestic law rules for attribution and allocation of
income are in accordance with this provision.35 In general, however, Switzerland does not include a provision similar to article 9 paragraph 2 of the OECD model.
The treaties with the United States, the United Kingdom and Canada mention this rule but provide only for a facultative consultation. Thus, in practice, correlative adjustment may only be granted in the framework of the mutual agreement procedure.
Absent such an agreement, a transfer of funds from a Swiss company to
an associated foreign entity subject to an initial adjustment from a foreign tax
administration will be subject to the Swiss federal withholding tax of 35 per cent
as a hidden distribution of profits.
In this respect, electronic commerce transactions will be treated according to
the general rules applicable until now. No change of practice is to be expected.

 Attribution and allocation of profits to a PE
Most Swiss treaties have rules similar to article 7 paragraphs 2 and 4 of the
OECD model. Thus, Switzerland may use both the direct and the indirect
method of attribution of profits. As we have seen, the indirect fractional method – based upon the case law of intercantonal double taxation – is widely used in internal law, especially in the case where a Swiss resident enterprise maintains a PE abroad. This system is in accordance with treaty law, provided the result is not contrary to other treaty provisions. The Supreme Court has confirmed in particular that the fractional method of allocation may be used in the international context. In the case where the direct method applies, the rules used to determine income attempt to parallel the rules applicable in determining the profits of a subsidiary.

Attribution and allocation of profits between head office and PE

International allocation rules
For the purpose of allocating profits between the head office company and a PE,
Switzerland, on the international level, uses both the direct method (so-called
“objective method”), under which the PE is treated like an independent enterprise, and the indirect method described above (so-called “fractional method”).
The federal direct tax law recognizes that the fractional method is normally
applicable to a Swiss resident enterprise with a PE abroad.  Indeed, under article 6 paragraph 3 and article 52 paragraph 3 DTL the rules prohibiting intercantonal double taxation are applicable to Swiss residents with enterprises or a PE situated abroad, unless losses are reported in one or more of the countries involved.  According to the majority of commentators and the federal tax administration, however, the direct method of attribution is applicable to foreign residents with enterprises or PEs in Switzerland (article 6 paragraph 4 and article 52 paragraph 4 DTL). Historically, the direct method has been applicable where no proper documentation was available from the country of residence of the foreign company.

Implications for electronic commerce
To my knowledge, no specific method of allocation has yet been developed for
electronic commerce. According to the principle of neutrality, there seems to be no policy reason to treat electronic commerce differently from traditional commerce.
Therefore, the method of allocation applicable for electronic commerce
should correspond to the nature of what the customer purchases. He or she is
doing nothing other than buying a specific good (in digitized form) or a service.
As mentioned above, however, only in rare cases could the presence of a
server in the territory of a country qualify as a PE. This could be the case, for
instance, with a gambling server, which performs the core business of a gambling enterprise sited abroad. Consequently, the question of attribution of profits between the head office and a PE in another country – caused solely by the presence of a server in that country – should rarely occur. The situation would of course be different if, in addition to the server, there were human personnel engaged in activities that could be regarded as an essential part of the core business of the electronic commerce enterprise.
According to leading opinions, for a Swiss PE of a foreign company, the direct
method of attribution should apply. In particular, losses incurred by a foreign
company are not deductible from the taxable profits attributable to the Swiss PE (article 52 paragraph 4 DTL). The application of the direct method presents the same difficulty mentioned above for the attribution of profits to a Swiss subsidiary (transfer pricing) because the PE has to be treated as an independent
enterprise entering into arm’s length transactions with its counterpart.
The wording of article 52 paragraph 3 DTL indicates that the attribution of
profits of foreign PEs of Swiss companies could arguably be done in accordance
with the fractional (indirect) method. Should this be the case, it would be difficult to define the appropriate apportionment rule. In essence, electronic commerce is not the same as telecommunication or transport. At least, according to the principle of neutrality, the indirect method based on turnover should be applied, paying due regard to the functions performed by the head office and, if any, other PEs, similarly to Swiss companies entering into traditional commerce within different cantons. It remains doubtful, however, that the use of the fractional method is adequate in this situation. In my view, in the case, albeit limited, where a server as such could be regarded as a PE, the only appropriate method is also the direct method.

Therefore, as a general rule, the attribution of profits of the PE should correspond to the functions performed, assets used and risk borne by the server under the arm’s length principle. If the server alone constitutes the PE, the amount attributable to its function will most likely be insignificant. Under Swiss practice, the cost plus method could be applied since servers usually perform service functions.

 

Attribution and allocation of income from electronic commerce (II)

*Domestic law

– Attribution and allocation of profits between head office and
PE

This issue is relevant both for resident corporations with a PE abroad and foreign
corporations with a PE in Switzerland.

Intercantonal allocation rules
The method of allocation of income at the international level is strongly influenced by the rules applicable to intercantonal enterprises. There is currently no specific legislation for the avoidance of intercantonal double taxation but the rules applicable to this situation were established by the Supreme Court in a long and rich jurisprudence.  This case law seems particularly relevant to the field of electronic commerce because, already decades ago, the Supreme Court defined some rules of allocation of intercantonal transport (trains or boats), electrical and telecommunications companies whose activities bear some similarities to electronic commerce.
Intercantonal rules for the allocation of business profits are normally based on
the fractional method of allocation. In other words, the total profits of the enterprise are apportioned by reference to various formulae. When the fractional method is applicable, profits and capital are apportioned either on the basis of financial statements (so-called “direct fractional” method) or on the basis of other criteria such as production factors (labour, capital) or turnover (so-called “indirect fractional” method).
For train transport companies, in particular, railways and railway stations are
characterized as PEs. Profits are attributed in accordance with the frequency of
traffic in the various cantons involved (taking into account both persons and
goods).  In particular, the Court ruled that an allocation method based on the
length of the railways was unacceptable. Due to the importance of the headquarters, the canton in which the seat of the company is located is attributed a praecipuum of 20 per cent (preallocation).
For electrical companies, electrical antennas, transformer stations and other
types of similar installations are regarded as PEs in the place in which they are
located. The allocation of profits is based on the ratios of production factors (labour and capital) in each of the cantons involved.29 Production factors include, in particular, the central station, turbine, dynamo installations, dam, transformer stations, electrical antennae, etc. The factor capital is allocated according to the capitalized amount of salaries.
The allocation of profits of telecommunication companies is a recent example.
It arose with the privatization of the sector and, in particular, the constitution of Swisscom AG, the main service provider in the business. There is yet no court case on this field. The method of attribution applied today focuses on turnover and is based on various criteria (such as connection fees per canton)  The canton in which the company is incorporated gets a preallocation percentage (praecipuum) of 20 per cent.
To date, in the field of electronic commerce, no specific method of attribution
has been developed. From the above examples, it seems, however, that a method of allocation may be found which takes into account the extent to which an intercantonal activity participates in the value creation process. For transport, the frequency of passengers (including goods) is taken into account. For electricity, it is the infrastructure which is relevant. For electronic commerce, it should probably be the turnover generated by each customer, paying due regard to the functions performed by the head office (praecipuum) and, if any, other PEs.

Attribution and allocation of income from electronic commerce (I)

* Domestic law
– In general
There is no specific rule or established practice regarding attribution or allocation of income derived from electronic commerce. In this context, Switzerland tends to apply the general rules applicable to non-electronic commerce.
As mentioned earlier, resident enterprises are taxed on their worldwide profits.
For corporations, Switzerland applies a classical system under which profits are
first taxed at the corporate level and second, upon distribution, as income at the shareholder level. No tax credit is granted to shareholders receiving dividends.
Under certain conditions, a resident corporation can benefit from the participation deduction (articles 69 and 70 DTL) on participation income (including capital gain). Furthermore, Switzerland applies the exemption method for the avoidance of double taxation. Profits attributable to a foreign PE are exempt from tax.
For associated corporations, there is no tax consolidation system. A Swiss subsidiary, even if it is owned or controlled by non-residents, is treated as a resident entity subject to unlimited tax liability. In other words, each corporation is treated as a separate entity which should enter into arm’s length transactions with its associated counterpart. Under a very large body of cases, the tax authorities are allowed to readjust the accounts of associated corporations for any transfer of value (prestation appréciable en argent, geldwerte Leistung) which, to the knowledge of the transferring company, departs from what would have been granted to, or required from, a third party in similar circumstances. Such a transfer is then treated as a hidden profit distribution subject to profit tax and federal withholding tax. For the purpose of defining the proper arm’s length price of a transaction between associated enterprises, the Swiss approach, although rather pragmatic, applies the traditional methods recommended by the OECD in its transfer pricing guidelines.22 Article 58 paragraph 3 DTL provides for the three traditional methods of the OECD. While this provision refers only to hydroelectric enterprises, it is generally recognized that it reflects the general rules also applicable in other fields.  In electronic commerce, it will be difficult to define the proper arm’s length price of a transaction. In particular, it will be difficult to identify precisely what the transaction is.  This is especially the case for associated enterprises because the Internet offers vast possibilities of communicating and offering services internally through intranets, which are difficult to define and trace. In addition, proper analysis of the functions of the parties involved will have to consider the specific and rapidly changing value of the intangibles, as well as the consequences of disintermediation.
While many commentators tend to advocate the use of the profit split method in this area, similarly to global trading, Switzerland prefers to use more traditional methods of transfer pricing. It is true that, at the present time, there are few comparables in the digital sector, which will render the application of the comparable uncontrolled price (CUP) method difficult. In the near future, however, comparables may appear with the growth of electronic commerce. Furthermore, the cost plus method is generally used by Switzerland in the service sector. In particular, commercial and administrative services (such as market studies, research and development, advisory activities, or marketing) performed by a Swiss company for other associated enterprises are usually taxed under a cost plus method, in the sense that 5 per cent of the total costs (taxes included), or 1/12 (i.e. 8.33 per cent) of total salaries is required as the minimum relevant tax base (so-called service company status).  In many cases, in particular for ISPs, this tax regime should be applicable in Switzerland.

The income tax treatment of electronic commerce transactions derived from a source within Switzerland…

… Policy issues
Since, as we have seen, a server will as such be characterized as a PE only in very limited circumstances, taxation of electronic commerce transactions will in most cases be based on the residence of the taxpayers involved.
So far, the growth of electronic commerce has not prompted a re-examination
of the existing source concept in Switzerland or of the existing threshold of
source taxation in this country. This could also be due to the fact that Switzerland applies the exemption method in this context and thus should exempt profits attributable to the foreign PE. Taking into account the extended possibilities of moving and manipulating the server, a broad interpretation of the PE concept would open the door to tax planning. There is no policy reason to attribute a part of profits of “offshore” servers, which have been placed in a specific tax haven only for tax reasons.

The income tax treatment of electronic commerce transactions derived from a source within Switzerland…

… Administration

Non-resident persons subject to limited tax liability in Switzerland are taxable on that part of the income which is economically linked with Switzerland (article 6 paragraph 2 and article 52 paragraph 2 DTL). In general, each year, they are required to file a federal and cantonal tax return in the canton in which the conditions of the tax liability are met (article 106 DTL).
As we have seen, in most cases, the entry into electronic commerce transactions with Swiss customers without a PE or a fixed base in this country will not trigger direct tax liability in Switzerland. In particular, in most cases, a server in this country should not be regarded as a PE. Therefore, as of today, there is no tax compliance requirement in this situation.

In addition, electronic commerce payments from Swiss customers will not be
subject to withholding tax. These payments will generally be characterized as
business profits taxable in Switzerland only to the extent that they are attributable to a Swiss PE or fixed base. In this case, the foreign person acting in Switzerland through a Swiss PE will be subject to limited tax liability. A federal and cantonal tax return will have to be filed each year in the canton in which the PE (fixed base) is located.

 

Income from capital and royalties.

Domestic law
At the federal level, Switzerland levies a withholding tax on certain types of
investment income, lottery gains and insurance benefits (anticipatory tax) (see
articles 4, 6 and 7 of the Federal Withholding Tax Law (WTL)). For investment
income, the tax is due on: (a) dividends (including other distributions of profits)
by Swiss corporations; (b) interest from bonds and debentures from Swiss
debtors and from Swiss bank deposits; and (c) profits from Swiss investment
funds. The tax is levied at source by the payer (debtor of the income) at the rate
of 35 per cent. As a rule, refund of the anticipatory tax is only allowed for Swiss
residents. Non-residents may claim a partial or total refund only under the conditions of a double taxation treaty.
In addition, dividend, interest or royalties paid to a non-resident person are not subject to the federal or to the cantonal income (profit) tax provided that these types of income are not attributable to a PE or to a fixed base in Switzerland.
It is important to mention that royalties and licence fees paid to a non-resident
licensor for the use or the right to use a patent, trademark, copyright and similar types of intellectual property are generally exempt from Swiss tax. First, they are not subject to the federal withholding tax (anticipatory tax). Second, they may trigger a limited tax liability only to the extent that they are attributable to a Swiss PE. The principle of the so-called force of attraction of the PE is not applied in Switzerland. Therefore, in order to be attributable to a PE, royalties payments must be effectively connected with it.
It follows from the above that payments for electronic commerce transactions
from Switzerland cannot be subject to the federal withholding tax. This holds true if those payments are characterized as business profits or royalties. Thus, the crucial problem of characterization of electronic commerce transactions in this framework is not of such importance.

Treaty law
In most Swiss treaties business profits are taxable in the state of the enterprise
unless the enterprise carries on business in the other contracting state through a PE (article 7 OECD model). Royalties, however, are taxable in the beneficiary’s
country of residence (article 12 OECD model). A limited tax at source is allowed
under approximately half of the treaties with Switzerland. If the royalties are
attributable to a Swiss PE or fixed base, then the rules of business profits (or independent personal services) apply (article 12 paragraph 3 OECD model).
Following the 1992 version of the OECD model, the recent Swiss treaties
characterize royalties as payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience. Older treaties are based on a preceding version of the OECD model and add to this definition payments for the use of, or the right to use, industrial, commercial or scientific equipment.
The impact of the treaty provision on electronic commerce payments from a
source within Switzerland depends upon their characterization. According to
Swiss practice, even though no clarification has yet been issued by the federal tax administration, payments for the digital delivery of products are to be treated in the same way as payments resulting from the sale of physical goods. Indeed, the customer pays for the acquisition of a digital product (such as information, music, or videos). Accordingly, those payments are generally treated as business profits (or independent personal service as the case may be). Thus, the payments may be taxed in Switzerland only to the extent that they are attributable to a Swiss PE or a fixed base. This approach corresponds to the majority view expressed by the OECD technical advisory group on treaty characterization of electronic commerce payments.

Income from personal services.

Individuals without a tax domicile or residence in Switzerland are subject to a
limited tax liability in Switzerland if they engage in gainful activity in the country (article 5 paragraph 1 lit. (a) DTL; article 4 paragraph 1 lit. (a) THL). These persons are generally subject to tax at source (article 91 and 92 DTL; article 35 paragraph 1 lit. (a) and (b) THL).
Dependent personal services (wages in particular) performed in Switzerland
are taxed at source at the level of the employer. In practice, this rule applies to
individuals who work fewer than 30 days in Switzerland (otherwise they are subject to full tax liability) or work as frontier workers (Grenzgänger). We have
already noted that an interesting question arises regarding whether or not rules
applying to employees commuting daily from one state to another could be extended to employees “telecommuting” between their residence and the place of work.  So far, Switzerland has shown no sign of considering applying to
telecommuters the double taxation agreements concluded in the field of frontier workers.
The tax treatment of independent personal service in Switzerland is more
complex. The wording of the law does not exclude a priori the taxation of any
independent activity in Switzerland such as professional, industrial, commercial or trading activity. The relevant question, in this context, is whether the activity triggering a limited tax liability must be exercised within the Swiss territory or whether it is sufficient that such activity exercised abroad is linked to or has economic effect in Switzerland.
In a case rendered under the Federal Decree on Direct Tax Law, abrogated by
the DTL, the Supreme Court judged that, in the absence of a tax treaty, a non-resident individual – even without a fixed base of a physical presence in this country – could be subject to limited tax liability in Switzerland provided that the source of his or her gainful activity was in connection with rights or objects which were economically linked to Switzerland.  In this case, a Monaco resident with no physical presence in Switzerland was subject to tax on the sale of various Swiss real estates. It should be stressed that most of the selling orders were made via fax sent from Monaco.
Such a broad interpretation could have adverse tax consequences in the field
of electronic commerce. Indeed, one could interpret this case as allowing
Switzerland – in the absence of a treaty – to tax trading activities arising from a
server sited in Switzerland and operated by a foreign individual. By analogy with the Supreme Court case mentioned above, the income would indeed be connected with an object “economically linked to Switzerland”. It seems, however, doubtful that such a conclusion would be appropriate. First, there seems to be little in common with the use of a server in Switzerland and the sale of real estate. Second, this conclusion is not in accordance with the purpose of the law, which is to tax a gainful activity in Switzerland with a minimum of physical presence in this country.
Finally, the majority of commentators tend to argue that the above-mentioned
Supreme Court case is no longer valid under the new regime of the DTL.  It follows that the only relevant situations of a limited tax liability in Switzerland
without a physical presence are: (a) trading income from real estate in Switzerland; (b) director fees from Swiss companies; and (c) wages and salaries from a Swiss employer due to activities in the field of shipping, inland waterways and air transport.

Treaty law
Dependent personal services are generally taxable where the activity is performed (article 15 OECD model). Independent personal services are taxable
under most Swiss treaties only to the extent that they are carried out through a
fixed base in Switzerland (treaty provisions similar to the old article 14 OECD
model).  This concept bears many similarities to that of PE and reference is
hereby made to section 2.1.2.3 above. In any event, under a treaty the right to tax independent services is subject to the presence of a minimal infrastructure in Switzerland and thus the approach taken in the above-mentioned case of 1996 could not, in my view, be followed in such context.

PE (III)

Policy aspects
From a tax policy standpoint, I tend to favour a restrictive definition of the PE in the framework of electronic commerce. Indeed, in most – if not all – cases, a
website or a server should not constitute a PE under the current definition of article 5 of the OECD model.
Under article 7 of the OECD model, the state of the PE has the right to tax the
profits of an enterprise which are attributable to that PE. This rule is based upon
the principle that the enterprise has a substantial presence in that state. The concept of PE was developed at the end of the 19th century16 during a period when the world economy was based on physical transfers of tangible goods. Thus, the most logical and appropriate way to define the minimum threshold of taxation of the profits of a foreign enterprise was to rely on the physical presence (“place of business”) of that enterprise.
As many have observed, this approach is no more appropriate for the new
economy. Electronic commerce exists within a completely different technological environment (website, servers, ISP, etc.). In particular, the functions of the server are defined according to computer programs. In addition, the physical location of the server is of little relevance for the enterprise operating the website, and of no importance at all for the customer. The server may be placed anywhere in the world (including a tax haven or a satellite). The substantial presence test, under which the PE concept is based, is neither appropriate nor relevant in the field of electronic commerce.