Permanent establishment issues are raised by a secret Netflix tax settlement

Following the company's settlement in a dispute, in-house experts are concerned about the scope of permanent establishment rules in Italy and whether local authorities are analyzing data in Netflix's disclosures to determine the correct amount of tax due.

Netflix should have paid more taxes in Italy, according to the Italian tax authority, Agenzia delle Entrate, because it relied on servers and a digital infrastructure to deliver content to local users. The claim was made as the EU attempted to impose digital taxes on other large technology firms.

Netflix is said to have settled the investigation on May 20, but the agreement has raised new questions among tax experts about whether cables and servers are legally considered a PE in the EU. The Italian authorities have successfully argued that servers are a form of PE, as evidenced by tax investigations against Apple and Amazon.

The case, according to Maarten Koper, international tax director at the Al-Dabbagh Group in Geneva, could jeopardize the OECD's two-pillar solution for e-commerce PE and profit allocation issues.

If more tax administrations and judges took the Italian approach to PE issues and profit allocation, pillar one might not be necessary, according to Koper.

"Italian tax authorities are very aggressive in pursuing tax cases they feel strongly about," he continues.

Tax experts are also concerned that the Italian tax authority used country-by-country reporting (CbCR) data to determine Netflix's outstanding tax bill from 2015 to 2019.

This is a problem for businesses because aligning many CbCR reports is more expensive in order to avoid tax authorities challenging inconsistencies in certain tax positions and drawing negative conclusions from data-driven results.

Netflix did not respond to a request for comment in time for the publication of this article.

Netflix was accused of tax evasion by the authorities, who claimed that the company's structure booked certain profits from Italy in other countries instead. Netflix is not named in the investigation, but the company's identity has been confirmed by Bloomberg, Reuters, and other news organizations.

Despite similar cases such as Apple's settlement on back taxes in France being made public, Leonard Wagenaar, director of transactions tax at EY in London, claims that media and other reports from the Italian authorities show no key tax details such as the definition of PE.

"We don’t know a lot of detail on what happened here and neither the Italian tax authorities nor Netflix is sharing much," says Wagenaar, who is following the investigation through media reports.

The Italian tax police's checks based on data-driven insights from e-audits prompted Milan prosecutors to launch an investigation into the use of cables and servers as a form of PE in Italy, according to the available details in the case.

However, it is unclear who among Netflix's employees had access to the servers or what they did with it. According to Reuters and other media outlets reporting on Netflix's May 20 announcements, the company agreed to settle the tax dispute for $59 million. From 2015 to 2019, the agreement covers taxes, penalties, and interest costs.

Netflix also established an Italian entity in April 2022 as part of its corporate structure, which, according to in-house lawyers, would more definitively fix its local tax burden than a cables and servers PE.

The streaming industry is the most recent digital company to alter its business model in order to increase revenue in EU countries, including Italy. Netflix has offices in France, Poland, and Spain, as well as one in Rome. It is already in the process of reporting revenue from EU customers to local tax authorities.

According to some tax professionals, Netflix's final tax bill was calculated using data from local CbCR reports, and that the final bill is much higher than the settlement.

"From the numbers, it seems the Italian PE makes a substantial margin on sales," Wagenaar says.

According to some tax experts, profit allocated to a PE is determined by the company's economic activity rather than the number of employees. They also claim that the Italian tax authorities calculated how much profit to allocate the newfound PE using Netflix's CbCR reports and the profit split method from transfer pricing.

"Yet there were hardly any human-on-ground activities in Italy, so I do not see how profit allocation can be that much," says Wagenaar, who has dealt with PE issues before.

Because the reporting framework has led tax authorities to ask taxpayers more detailed questions in recent years, several organizations have had to coordinate their global tax functions to comply with CbCR. Even Netflix's global tax policy director, Giammarco Cottani, stated at an IFA tax conference in 2021 that group coordination is critical to avoiding tax challenges from authorities.

"This puts pressure on the company to review what they are filing, how they are filing and prepare for questions that are not going to be limited to what is in the documentation," Cottani said.

Netflix's local CbCR reports, on the other hand, allegedly did not match its local filings in other countries.

Companies must share information with tax authorities that is consistent and fair with the storyline in other countries' disclosures. According to reports, the Italian tax administration analyzed data from several CbCR reports to uncover some missing details in Netflix's case.

The settlement agreement put an end to the Italian investigation before any legal conclusions could be reached by a national court or even a higher EU court.

Netflix's most recent annual financial report includes a general warning that adverse court judgments could have an impact on the company's global provision for income taxes, deferred tax assets, and tax liabilities, as the company's ultimate tax determination in Italy and other countries is still uncertain.

Meanwhile, some in-house tax counsel in Italy say the concept of PE has become even more ambiguous following the May 20 settlement, when cables and servers were considered to be another type of PE.

"The mere presence of servers should not result in the creation of PE," says one tax executive at a Milan-based telecommunications firm.

"It has to be shown how the employee or others acting at the direction of Netflix had access to the servers, which seems difficult," she adds.

The Italian authorities could have argued that the PE activity is streaming, but we do not know if they did. However, several intangible assets in Netflix's content streaming system are not located in Italy, and the alleged Italian PE via servers would have to pay other entities in Netflix's structure to even use the streaming platform.

"Many people would argue that tech companies should report a sizeable margin in their sales markets even if there is hardly any physical presence," says Wagenaar. "But that is a moral argument and outside the existing international tax framework."

Because of the differing approaches to PE and profit attribution in different countries, there have been numerous international calls for a treaty-compliant digital tax to address situations like the current one. The treatment is at least one of the reasons for the OECD's two-pillar solution, as pillar one deals with profit reallocation to markets in order to more fairly allocate profit under transfer pricing rules.

"The OECD’s pillar one is trying to solve that problem," Wagenaar says, "but if existing rules already require a substantial profit allocation to a PE created by servers, then why do we need pillar one?"

Tax laws are being re-examined around the world, and financial statements may be subject to multiple interpretations in a quarter or even a year. Meanwhile, tax authorities are increasingly scrutinizing corporate tax positions, so this could not be the last investigation.

By fLEXI tEAM