In the Final Report on Action 7, Preventing the Artificial Avoidance of Permanent Establishment Status, the OECD proposes to significantly decrease the threshold for having a permanent establishment ("PE"). Companies with a foreign presence will need to reconsider their strategy due to the increased risk of having PEs when these rules are introduced in local law and tax treaties.
Implications for companies with a foreign presence
If the lower PE threshold is introduced in local law and tax treaties by way of a multilateral instrument, this will significantly increase the risk of companies having a permanent establishment. In past decades, many companies pursued a strategy that was aimed at avoiding PEs. Such a strategy may now require substantial changes to the business model, or may simply no longer be viable at all.
What the Final Report on Action 7 says
The OECD proposes to lower the PE threshold as follows:
- A dependent agent may also exist if one does not exercise the authority to conclude contracts, but exercises a principal role leading to the conclusion of contracts. This proposal is mainly aimed against the use of commissionaire structures.
- The list of exclusions from the PE definition become subject to the requirement of being preparatory or auxiliary, rather than being deemed preparatory or auxiliary.
- An anti-fragmentation rule is introduced, under which activities performed by closely related companies that are part of a cohesive business operation will be taken into account in determining whether the activities of one or more of those companies constitute a PE.
Actions to consider
Companies should consider whether a strategy aimed at avoiding a PE is still a viable option or whether to embrace the PE. Both choices may require certain changes to companies' business models that could have a significant impact on intercompany agreements, VAT treatment, customs reporting and IT systems.
For example, companies may consider the following options:
- Moving from a commissionaire structure to a reseller / limited risk distributor model.
- Embracing the PE and separating IP to another entity with no presence in the PE jurisdiction.
- Embracing the PE and transferring IP to an on-shore jurisdiction.
Embracing the PE may mitigate uncertainty and the risk of retroactive tax assessments, penalties and potential double taxation when tax authorities assess a PE in the future.
Finally, although many tax authorities may feel that they can recover a pot of gold by assessing a PE, this will not necessarily be the case if the current authorized OECD approach with respect to profit attribution continues to be followed since important intangibles, risks and related significant people functions that may attract profits could be present outside the PE jurisdiction. Companies should consider their transfer pricing strategy with respect to the profit attribution between head office and PE, since that may mitigate the risk of an increased tax burden from foreign tax authorities that assess a PE.
The OECD has proposed to significantly decrease the threshold for having a PE. Companies with a foreign presence will need to reconsider their strategy due to the increased risk of having PEs once these rules are introduced in local law and tax treaties by way of a multilateral instrument. Companies may consider what changes may be required to their business model in order to pursue a strategy aimed at avoiding a PE, and whether this is feasible. Companies may also consider whether it would be preferable to embrace the PE in order to mitigate uncertainty, along with how a proper transfer pricing strategy could mitigate the risk of an increased tax burden.