Action 7 of the G20/OECD BEPS Project addresses the artificial avoidance of permanent establishment status. A Revised Discussion Draft (RDD) was released on 15 May 2015, and will be open for public comment until 12 June 2015. There will be no further public consultations, and the working party will be asked to finalise its recommendations at a meeting on 22-26 June 2015, ahead of the likely adoption by the G20 Finance Ministers at their meeting in September 2015.
Particular relevance to the UK and Australia
Action 7, and the release of the RDD is of particular interest in the UK and Australia. Each of these countries has pre-empted the global process for strengthening the definition of permanent establishment (PE) and thereby restoring source country taxing rights, by legislating to tax profits which have been artificially ‘diverted’ away from, and are therefore outside the taxing rights, of the two countries. Both countries have been criticised for acting unilaterally, and will welcome the G20 process ‘catching up’.
The revised discussion draft
The RDD articulates the working party’s preferred responses to the Action 7 issues, viz, the artificial avoidance of PE status:
- through the use of commissionnaire arrangements and similar strategies
- through the abuse of the specific activity exemptions
- by the splitting-up of contracts
- in the case of insurance companies
The RDD also updates the OECD’s views of the interaction between the attribution of profits to a PE, and transfer pricing aspects of the BEPS project.
Commissionnaire arrangements and similar strategies
The OECD approach is based on the following policy consideration:
"…where the activities that an intermediary exercises in a country are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, that enterprise should be considered to have a sufficient taxable nexus in that country unless the intermediary is performing these activities in the course of an independent business."
A commissionnaire arrangement “…may be loosely defined as an arrangement through which a person sells products in a given State in its own name but on behalf of a foreign enterprise that is the owner of these products. Through such an arrangement, a foreign enterprise is able to sell its products in a State without having a permanent establishment to which such sales may be attributed for tax purposes; since the person that concludes the sales does not own the products that it sells, it cannot be taxed on the profits derived from such sales and may only be taxed on the remuneration that it receives for its services (usually a commission).”
The extent of ‘similar strategies’ is not addressed in detail, and remains a grey area. Having regard to the policy formulation above, it should apply to those sales arrangements which are not commissionnaire arrangements, but where a non-resident vendor is provided with sales ‘assistance’ in the source country by staff of either a source country PE of another non-resident company, or a related source country incorporated company.
Whatever the precise scope of the targeted structures, the proposed changes focus on the ‘agency’ provisions of the PE article of the Model Tax Convention (MTC): Art. 5(5) and (6), and will insert replacement sub articles together with extended Commentary.
Where a source country commissionnaire, PE or affiliate (collectively, source country ‘sales force’) are sufficiently involved in the selling activities by which the non-resident makes the source country sales, the ‘sales force’ will be deemed a PE of the non-resident vendor. The sales revenue will be attributed to that PE and subject to source country taxation.
Option B of the original discussion drafts has been chosen as the preferred basis for delineating the degree of nexus required of the non-resident vendor with the source country in order to deem the existence of a PE.
In summary, the proposed replacement Art. 5(5) provides:
- where a person (S) in Country S acts on behalf of RCo (a non-resident)
- habitually concludes contacts
- negotiates the material elements of contracts
- in the name of the RCo
- for the transfer of the ownership of, or for the granting of the right to use, property owned by RCo or that RCo has the right to use
- for the provision of services by RCo
then S is deemed to constitute a PE of RCo in Country S and the sales revenue will be taxable in Country S unless S:
- performs only preparatory or auxiliary services which would not give rise to a fixed place PE by virtue of the specific activity exemptions
- meets the requirements of an independent agent acting in the course of its own business
The language of Art. 5(5), ‘on behalf of’, is to be read by reference to observable commercial arrangements rather than by reference to the common law of agency, or the civil law of agency/commissionnaires. S will be acting ‘on behalf of’ the non-resident vendor where it habitually concludes or negotiates contracts, and one of the three specific outcomes applies.
Significant new Commentary is proposed, including examples, which responds to the concerns raised by many commentators that Option B included many new concepts, which were insufficiently well understood in international law.
Of particular interest, in relation to the use of standard contracts which cannot be altered during the sales process, the commentary says: “In this example, SCO’s employees are negotiating the material elements of the contract that are concluded with RCO. The fact that SCO’s employees cannot vary the terms of the contracts does not mean that there is no negotiation but rather means that the negotiation of the material elements of the contracts is limited to convincing the [customer] to accept these standard terms”.
Exception 1: Art. 5(4)
Where the source country activities are not performed through a source country resident company, and would not constitute a fixed place PE because of the de minimis exemptions in Art. 5(4), then there will be no deemed PE under Art. 5(5). See below for comments regarding changes to the specific activity exceptions in Art. 5(4).
Exception 2: Art. 5(6)
There will be no deemed PE under Art. 5(5) if the source country presence carries on an independent business, and it acts for the non-resident vendor in the ordinary course of that business.
This will be easier to make out where the source country entity is unrelated, and acts for many unrelated non-residents.
But it is more difficult in the case where the two are related, and the source country entity acts exclusively, or nearly exclusively, for the associated non-resident enterprise.
Under the RDD proposal, where there is a vote/value relationship between the source country entity and a non-resident vendor of at least 50%, then the source country entity will not be taken to be an independent agent, and the Art. 5(6) exception will not apply.
This 50% connection requirement is a watering down of the original position, which would have denied independent agent status where the source country entity acted exclusively for one non-resident, or for more than one associated non-resident.
Specific activity exemptions: Art. 5(4)
The RDD has adopted Option E (from the original discussion draft) as preferable (interestingly, this was a working party majority view, rather than the more common consensus view.)
All the specific exceptions will remain under Option E (i.e. delivery and purchasing activities will now not be deleted), but all the potentially excepted activities are now made subject to the overall requirement of being ‘preparatory or auxiliary’. The new language reads “…provided that such [specific exemption] activity or, in the case of sub-paragraph f), the overall activity of the fixed place of business, is of a preparatory or auxiliary character.”
Significant additional commentary has been added in response to comments that there is very limited jurisprudence around the concepts of ‘preparatory or auxiliary’.
New anti-fragmentation rule
With the greater power of reporting systems, it has been possible for multinational groups to ‘fragment’ their operations in source countries so that on a stand-alone basis, each ‘fragmented activity’ falls within one of the specific activity exemptions of Art. 5(4).
A new anti-fragmentation rule is proposed which would deny access to the Art. 5(4) exceptions where connected enterprises are present in a source country at the same or at different locations, and the business activities carried on by these connected enterprises constitute “…complementary functions that are part of a cohesive business operation”.
Splitting-up of contracts
In some cases, a PE will not exist if the source country presence exist for less than a specified number of days in a period. This threshold can be circumvented where commercially coherent contracts are split, and performed by different group companies, with each company being in-country for less than the threshold number of days.
The MTC already contains guidance against such abuses, but it is limited in application.
The RDD has adopted the ‘Principal Purposes Test’ (PPT), rather than the ‘automatic rule’.
In effect, the PPT is a general anti-avoidance rule, and will apply where the objective purpose of split-contracts is to avoid the creation of a source country PE.
The RDD also includes the ‘automatic rule’ as an alternative for use by countries which may have domestic difficulties using a general anti-avoidance rule. The ‘automatic rule’ will aggregate the presence of associated enterprises in the source country in determining whether to PE threshold has been exceeded.
The ‘automatic rule’ is considered inflexible, and is not the preferred option, but it is necessary in some cases.
The original discussion draft considered whether special PE rules should be added for non-resident insurance companies which operate in a source country through a large network of exclusive agents. Comments pointed out the difficulty in determining how much profit should be attributed to such a deemed PE, given that remuneration for risk is the value created by an insurance agency, and that occurs outside the source country.
The position adopted in the RDD is that there should be no special PE rule for non-resident insurance companies; the issue of PE should be addressed under amended Art. 5(5) and (6).
Attribution of profits to a PE, and transfer pricing
Where a PE exists, or is deemed to exist, the next step is to attribute profits to that PE. The changes provided to the scope of PE raise the question – how does that impact the attribution of profit to that PE?
The RDD concludes that this work cannot be advanced before the transfer pricing work (actions 8-10) and the substantive work on PEs (Action 7) has been completed.
It was acknowledged that additional guidance is required on attribution of profits to a PE, particularly outside the finance sector. This work will be scheduled for 2016, after the substantive BEPS changes have been agreed.
The positions outlined in the RDD are unlikely to face material alteration before the final recommendations are made in September 2015. Affected taxpayers should be reviewing their existing arrangements against the changes proposed in the RDD, and take remedial action where appropriate.