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OECD releases public discussion draft on permanent establishment

INSIGHT ARTICLE  | 

In January 2015, the Organisation for Economic Co-operation and Development (OECD) released the highly anticipated public discussion draft on BEPS Action Item 7: Preventing the Artificial Avoidance of Permanent Establishment Status. Generally speaking, a country cannot tax a taxpayer's business income unless the taxpayer has permanent establishment (PE) in that country. In the most recent discussion draft, the OECD addressed its concerns about common arrangements that, in its view, artificially avoid permanent establishment status. The OECD outlined a number of recommendations to address these concerns. They include changing the language of the United Nations Model Tax Convention and the OECD Model Tax Convention. Both the UN Model and the OECD Model Conventions define the term PE as a "fixed place of business through which the business of an enterprise is wholly or partly carried on."

Commissionaire arrangements

Under the current model treaties, PE status likely exists if an agent (other than an independent agent) has the authority to negotiate and conclude contracts. In order to avoid this status, many enterprises have set up arrangements through which a person sells products in a given state in its own name but on behalf of a foreign owner. This arrangement, known as a commissionaire arrangement, allows a foreign enterprise to sell its products in a state without creating PE status, since the person that has the ultimate authority to negotiate contracts or conclude sales in the state is independent from the entity that derives the profits. The OECD provides the following example of such an arrangement:

XCO is a company resident of State X that specializes in the sale of medical products.

Until 2000, these products were sold to clinics and hospitals in State Y by YCO, a company resident of State Y. XCO and YCO are members of the same multinational group.

In 2000, the status of YCO is changed to that of commissionaire following the conclusion of a commissionaire contract between the two companies. Pursuant to the contract, YCO transfers XCO its fixed assets, its stock and its customer base and agrees to sell in State Y the products of XCO in its own name, but for the account of and at the risk of XCO.

As a consequence, the taxable profits of YCO in State Y are substantially reduced.

Article 5 of the model treaties provide that a PE is deemed to exist if a person has "authority to conclude contracts in the name of the enterprise." The OECD recognizes that there is significant debate around the meaning of the term conclude contracts in the name of the enterprise. One of the OECDs primary concerns is in situations where a contract is negotiated, or the terms are agreed to, in a host country, and the contract is executed in another country. To address the ambiguities and to mitigate commissionaire arrangements, the OECD suggested the following language changes to the Model Treaty:

  1. Replace the term "conclude contracts" with "engages with specific persons in a way that results in the conclusion of contracts"
  2. Replace the term "conclude contracts" with "concludes contracts, or negotiates the material elements of contracts"
  3. Replace the term "contracts in the name of the enterprise" with "contracts which, by virtue of the legal relationship between that person and the enterprise, are on the account and risk of the enterprise" and to replace the term "conclude contracts" with "engages with specific persons in a way that results in the conclusion of contracts"

Specific activity exemptions

Under the OECD Model Treaty, the following specific activities can be performed in a contracting state without creating PE status:

a) The use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise

b) The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery

c) The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise

d) The maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise

e) The maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character

f) The maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) to e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character

The OECD expresses concern that these exceptions provide multinational enterprises with too much opportunity to carry on a business in a contracting state without reaching PE status. In the report, the OECD states that "regardless of the original purpose of the exceptions laid out in subparagraph a)-d), these exceptions lead to the erosion of taxable bases of the countries these activities occur on."

Of particular concern is the term "delivery" in subparagraphs (a) and (b). The OECD notes that for multinational entities with an online selling platform, these exceptions allow the enterprise to have a significant presence in a contracting state, including employees, without creating a PE. In order to minimize the ability for multinationals to derive a tax-free profit in a contracting state, the OECD recommends subjecting all of the specific activity exemptions to the requirement that the activity be limited to preparatory or auxiliary activities. The OECD also suggests removing the term delivery from subparagraph (a) and (b).

Another concern the OECD addresses is the exception for purchasing goods or merchandise in subparagraph (d). The OECD recognizes that the rationale for the exception for purchasing activities was likely based on the view that no profits could or should be attributed to such activities. The OECD lays out an example of how this exception could be beneficial for an organization:

A multinational group operates four different manufacturing plants in an emerging economy (State S).

A corporate member of the Group (resident in State T, which applies an exemption or territorial system) has a purchasing office in the same jurisdiction through which it purchases the output of the four manufacturing plants.

Since it purchases large quantities, the purchasing office claims that it is entitled to purchasing discounts from the manufacturing plants.

The purchasing discounts reduce the profits attributable to the manufacturing plants. To the extent that these profits would be attributable to the purchasing office in State S, they would also escape taxation in State S if that office did not constitute a permanent establishment. Also, the discounts would escape taxation in State T to the extent that the domestic exemption or territorial system of the country attributes the discount to State S.

Considering this example, and similar situations, the OECD suggests either limiting subparagraph (d) to only collecting information, or getting rid of subparagraph (d) altogether.

Finally, the OECD addresses arrangements where an enterprise maintains several fixed places of business within the meaning of subparagraphs (a) to (e) that are separated from each other locally and organizationally, but in reality are part of one larger multinational group. Each individual activity may not separately constitute a PE but when viewed together, the activities would constitute PE since they would not fall under the specific activity exemptions. The OECD commentary to Article 5 contemplates a situation where a cohesive operating business voluntarily fragments into several small operations in order to argue that each entity in a contracting state is engaged in preparatory or auxiliary activity even though the aggregate set of activities would not qualify for any PE exceptions if viewed as a whole. The OECD suggests an alternative solution that generally would look at the multinational group's activities in its totality to determine if these activities are involved in complementary functions that are part of a larger business operation.

Splitting up contracts

Article 5(3) of the OECD Model Treaty states that a building site or construction or installation project constitutes a permanent establishment only if it lasts more than 12 months. The UN Model Treaty in Article 5(3) generally provides a shorter six-month standard. In attempting to avoid PE status, multinationals often split up contracts to work around the time limitation provisions of the treaties. The OECD recognizes that domestic anti-abuse rules can mitigate use of this tactic but also states that specific treaty language may be appropriate. Thus, the OECD proposes two alternative treaty updates to address this issue.

The first alternative is an update to the language of the treaty that prevents the splitting up of contracts by aggregating the periods of time associated with the same general building site or construction project. If varying entities within the same multinational group work on the project at disparate times, under the suggested language their activities would be tacked on to each other to calculate the 12-month rule. The second alternative is a largely discretionary facts and circumstances test that allows the tax authority to examine whether the purpose of structuring an arrangement or transaction was for the principal purpose of obtaining a tax benefit, and if so, the tax authority would be permitted to assess permanent establishment status on the entity performing the work.

These provisions will make it more difficult for taxpayers to simply break their contracts into shorter duration engagements for the purpose of avoiding PE status.

Insurance

Finally, the OECD lays out changes it wishes to see in the context of the insurance industry. The commentary on Article 5 of the OECD Model Treaty provides that "an insurance company of one state may be taxed in the other state on its insurance business, if it has a fixed place of business within the meaning of paragraph 1 or has dependent agents within the meaning of paragraph 5." The commentary goes on to state that "because agencies of foreign insurance companies sometimes do not meet either of the above requirements, it is conceivable that these companies do large scale business in a State without being taxed in that State on their profits from such business." The OECD notes that some OECD member countries include a specific provision which stipulates that insurance companies of a state are deemed to have a permanent establishment in the other state if they collect premiums in that other state through an agent or insure risks situated in that territory through such an agent. To address this issue, the OECD suggests the following provision:

Notwithstanding the preceding provisions of this Article, an insurance enterprise of a Contracting State shall, except in regard to re-insurance, by deemed to have a permanent establishment in the other contracting State if it collects premiums in the territory of that other State or insures risks situated therein through a person other than an agent of an independent status to whom paragraph 6 applies.

The OECD also notes that the insurance issue could be addressed by some of the other changes they suggested to the PE rules and that there is a possibility that no specific rules may be needed for the industry.

The new report shows that the OECD is evolving the concept of PE to address situations where the current rules allow significant economic activity before attributing PE status. These proposals, if adopted, will significantly expand the concept of PE and likely will result in taxpayers having taxable presence in more jurisdictions where they currently do not. Early adoption of similar provisions can be seen by the UK in their diverted profits tax legislation. It is possible that other countries may follow suit.

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