On 15 May 2015 the OECD released a revised discussion draft of BEPS Action 7: Preventing the Artificial Avoidance of permanent establishment Status (Paper), which addresses Action 7 of the OECD's Base Erosion and Profit Shifting (BEPS) Action Plan. The BEPS Action Plan is discussed in more detail in our earlier Alert, OECD releases BEPS Action Plan
Action 7 involves consideration of the permanent establishment definition in double tax treaties, which, if satisfied, gives rise to a taxable presence. In this Alert we consider the main proposals for reform of the permanent establishment definition in the OECD Model Convention (Model Convention) that were raised in the Paper. Changes to the Model Convention are a signal for changes to double tax treaties, as those treaties are renegotiated or amended. The Paper has narrowed the proposed changes to the Model Convention from the earlier discussion draft the OECD issued in October 2014 to a number of key changes.
In this Alert we highlight the major changes proposed in the Paper, and provide our comment on the potential impact of those changes. We also include as an Appendix a draft version of Article 5 of the Model Convention to show how Article 5 would look if the proposals in the Paper were implemented in Australia's double tax treaties.
Artificial avoidance of permanent establishment status through commissionnaire arrangements and similar strategies
Commissionaire arrangements are agency arrangements where the commissionnaire is legally and economically separate from the principal, and negotiates contracts with customers. A commissionnaire can enter into sales contracts in its own name, but on behalf of the principal, where the commissionnaire does not usually bind the principal. In theory the customer cannot sue the principal as there is no contractual relationship between the principal and the customer. Often a commissionnaire arrangement does not lead to apermanent establishment for a principal.
The Paper proposes that where activities that an intermediary performs in a country are intended to result in the regular conclusion of contracts to be performed by a non-resident entity, the non-resident entity should be considered to have a permanent establishment in that country, unless the intermediary is an agent performing these activities in the course of an independent business.
The Paper proposes three key changes to paragraphs 5 and 6 of Article 5 of the Model Convention to address this concern:
- broadening the agency rules to include not just where an agent 'concludes contracts', but also where it habitually 'negotiates the material elements of contracts';
- extending the agency rules to not just include concluding contracts,but also circumstances where the parts of the contracts that relate to the transfer of the ownership or use of property, or the provision of services, will be performed by the non-resident entity; and
- amending the exception to Article 5, by refining the requirements for an agent to be considered to be 'independent' from the non-resident entity and hence excluded from the concept of being a permanent establishment of that enterprise. The proposal is that an agent is not 'independent' where the agent acts 'exclusively or almost exclusively on behalf of one or more enterprises to which it is connected', and connection arises where the non-resident 'has control' over the agent (or vice versa) or there is common control. The control concept is to be tested having regard to all the facts and circumstances, and is not just a beneficial interest or voting interest test (although those are specified as features of control).
Concerns have previously been raised regarding cases where a large network of exclusive agents are used to sell insurance for a foreign insurer. The Paper does not propose to include a specific rule for insurance enterprises in the Model Convention, instead leaving this issue to be addressed through the general changes to paragraphs 5 and 6 of Article 5 described above.
A number of new examples are also proposed to be provided in the Commentary on Article 5 in order to provide additional guidance on the changes to Article 5.
The proposals may give rise to a permanent establishment for offshore entities with distribution arrangements, particularly where an Australian entity acts almost exclusively to distribute an offshore entity's products. In that context, at issue is what the meaning ofconnected is, and particularly the concept of control where a distribution agreement comprises a significant element of a distributor's business. The concern is that there may be absolutely valid distribution agreements, not designed to achieve base erosion or profit shifting, that may, following the proposed changes, prove to be problematic for non-residents.
In addition, in our view, the meaning of what are material elements of a contract will prove to be a fruitful source of debate. While it is clear that price will be a material element, the Paper proposes (unsurprisingly) that what is material will be determined on a case by case basis. Terms such as material which import a degree of weight, are inherently vague in nature, and difficult to interpret.
Artificial avoidance of permanent establishment status through specific activity exemptions
Article 5(4) of the Model Convention contains a list of specific activity exemptions where a permanent establishment does not arise – including the maintenance of a stock of goods for the purpose of storage, display, delivery or processing, or the maintenance of a fixed place of business for purchasing goods or collecting information. The Paper proposes modifications to this paragraph so that each of the exceptions is available only for activities which are of a 'preparatory or auxiliary character'.
The Paper proposes amending commentary on Article 5(4) to provide further guidance on the meaning of the phrase 'preparatory or auxiliary' which must be met for any of the exemptions to apply. The proposed commentary states that a preparatory activity 'is one that is carried on in contemplation of the carrying on of what constitutes the essential and significant part of the activity of the enterprise as a whole ... it will often be carried on during a relatively short period, the duration of that period being determined by the nature of the core activities of the enterprise'. An auxiliary activity is described as 'an activity that is carried on to support, without being part of, the essential and significant part of the activity of the enterprise as a whole'. An example provided in the paper suggests that if a warehouse is large and the storage arrangements are long standing in nature, that this will suggest it is not a 'preparatory' or 'auxiliary' function.
The Paper also proposes an 'anti-fragmentation rule'. This rule is intended to prevent the specific activity exemptions applying to activities of a non-resident entity which have been fragmented between 'connected enterprises'. The concern expressed is the fragmentation of a 'cohesive business operation' into several small operations in order to argue that each is merely involved in 'preparatory or auxiliary' activities. The proposal in the Paper is that where small offices of a connected enterprise carry out functions that are 'complementary' to one cohesive business operation then the anti-fragmentation rule will apply, and a permanent establishment will arise. What constitutes a 'connected enterprise' is dealt with in the commentary in relation to commissionnaire arrangements, and includes beneficial control, voting control in common, and where there is economic control.
These proposals also go beyond targeting base erosion and profit shifting concerns. It is also clear that the proposals, particularly in the anti-fragmentation rule, constitute a substantial change to what was considered a permanent establishment to date. For example, offices of enterprises which are only connected economically can in principle together comprise a permanent establishment of a non-resident entity. Concepts such as what a connected enterprise is and what a cohesive business operation is for the purposes of the anti-fragmentation rule are vague and imprecise. The proposed changes to the Model Convention are not targeted at abusive situations, and it may have been better to apply an anti-abuse rule rather than adding an additional anti-fragmentation rule which is of potentially wide and uncertain application.
Artificial avoidance of permanent establishment status by splitting contracts
Amendments to the commentary have also been proposed in order to prevent the perceived abuse of the exception currently contained in Article 5(3) of the Model Convention, which allows a 12-month threshold time period for the creation of permanent establishments for building sites or construction or installation projects. The abuse was the ability to split contracts to ensure that each period of work was less than 12 months.
There are two proposed additions to the commentary to address this abuse:
- an example in the commentary to clarify that a new anti-abuse rule could apply to such circumstances. This rule was proposed as result of the work on BEPS Action 6: preventing treaty abuse, and imposes a principal purpose test – for more information on the principal purpose test see our Alert: BEPS Action 6; and
- a rule to determine the onsite period (for the purposes of the 12-month threshold) by adding connected activities (each exceeding 30 days duration) carried on by connected enterprises, which could be included in treaties where there was no anti-abuse rule, or used by countries who wished to add additional protections.
This proposal seems, at least in part, appropriately targeted at abusive situations, but in our view it should only apply in cases of abuse. Concepts such as what are connected activities and connected enterprises may well be the source of debate.
Profit attribution to permanent establishments and interaction with action points on transfer pricing
The Paper acknowledges that further guidance and examples are required regarding the rules related to the attribution of profit to permanent establishments. The Paper advised that follow-up work on the attribution of profits issues related to permanent establishments will be undertaken after September 2015, when final recommendations on the OECD's work on transfer pricing will be available. This work will aim to be provided before the end of 2016.
Comments by Board of Taxation regarding profit attribution
Article 7 of the Model Convention deals with the determination of profits attributable to a permanent establishment, as opposed to the recognition of permanent establishment issues dealt with in Article 5. There are two different approaches to applying Article 7 – the relevant business activity approach and the functionally separate entity (FSE) approach.
In Australia, the Board of Taxation has previously considered the issues regarding the attribution of profits to permanent establishments under an FSE approach. In particular, in April 2013,the Board of Taxation released the review paper Review of Tax Arrangements Applying to Permanent Establishments, which considered the advantages and disadvantages of Australia adopting the FSE approach to determination of profits attributable to a permanent establishment under Article 7 of the Model Convention. The Board made 14 observations on Australia adopting the FSE approach, including a key advantage that the FSE approach would more explicitly and directly allow recognition of all internal derivatives that meet specified thresholds, which is of particular relevance to banks, and a key disadvantage that the FSE approach could impose significant additional compliance costs for non-financial sector entities and small to medium sized entities.
Following consideration of comments received on the Paper, the OECD Working Party will be making final recommendations to the G20 Finance Ministers' meeting on 8 October 2015.
It remains to be seen the extent to which changes to the Model Convention will be adopted into Australia's double tax treaties.
However, if implemented, the proposed changes would have wide-reaching effects including broadening the circumstances in which a permanent establishment may arise in Australia and its treaty counterparties. This is particularly relevant to agency arrangements which involve the negotiation of contracts in one country and their conclusion in another. This may also lead to increased compliance costs where businesses must resolve new areas of uncertainty in their arrangements, including where material elements of contracts are being negotiated, whether entities are connected and whether overseas activities would be considered to have a preparatory orauxiliary character.
How Article 5 would look if the proposals in the Paper were implemented
1. For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.
2. The term “permanent establishment” includes especially:
a) a place of management;
b) a branch;
c) an office;
d) a factory;
e) a workshop, and
f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.
3. A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.
4. Notwithstanding the preceding provisions of this Article, the term 'permanent establishment' shall be deemed not to include:
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;
f) the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) to e), provided that such activity or, in the case of subparagraph f), the overall activity of the fixed place of business, is of a preparatory or auxiliary character.
4.1 Paragraph 4 shall not apply to a fixed place of business that is used or maintained by an enterprise if the same enterprise or a connected enterprise carries on business activities at the same place or at another place in the same Contracting State and
a) that place or other place constitutes a permanent establishment for the enterprise or the connected enterprise under the provisions of this Article, or
b) the overall activity resulting from the combination of the activities carried on by the two enterprises at the same place, or by the same enterprise or connected enterprises at the two places, is not of a preparatory or auxiliary character, provided that the business activities carried on by the two enterprises at the same place, or by the same enterprise or connected enterprises at the two places, constitute complementary functions that are part of a cohesive business operation.
5. Notwithstanding the provisions of paragraphs 1 and 2, but subject to the provisions of paragraph 6, where a person is acting in a Contracting State on behalf of an enterprise and, in doing so, habitually concludes contracts, or negotiates the material elements of contracts, that are
a) in the name of the enterprise,
b) for the transfer of ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or
c) for the provision of services by that enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise, unless the activities of such person are limited to those mentioned in paragraph 4 which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph.
a) Paragraph 5, shall not apply where the person acting in a Contracting State on behalf of an enterprise of the other Contracting State carries on business in the first-mentioned State as an independent agent and acts for the enterprise in the ordinary course of that business. Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is connected, that person shall not be considered to be an independent agent within the meaning of this paragraph with respect to any such enterprise.
b) For the purpose of this Article, a person shall be connected to an enterprise if one possesses at least 50 per cent of the beneficial interests in the other (or, in the case of a company, at least 50 per cent of the aggregate vote and value of the company’s shares or of the beneficial equity interest in the company) or if another person possesses at least 50 per cent of the beneficial interest (or, in the case of a company, at least 50 per cent of the aggregate voting power and value of the company’s shares or of the beneficial equity interest in the company) in the person and the enterprise. In any case, a person shall be considered to be connected to an enterprise if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same persons or enterprises.
7. The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other.