In June this year, Singapore announced that it is joining the inclusive framework for the global implementation of base erosion and profit shifting (BEPS) project proposed by the Organization for Economic Co-operation and Development (OECD) as a BEPS Associate.

Background of BEPS project and Singapore’s role

The key principle underlying the BEPS project is that profits should be taxed where the real economic activities generating the profits are performed and where value is created. To counter the existence of loopholes, gaps, frictions or mismatches in the interaction of countries’ domestic tax laws as a result of which BEPS may occur, the OECD has come up with 15 Action Plans.

As a BEPS Associate, Singapore will work with other participating jurisdictions to ensure consistent implementation of measures under the BEPS project, and a level playing field across jurisdictions. Singapore has also committed to implementing the 4 minimum standards under the BEPS project, namely the standards on countering harmful tax practices (Action Plan 5), preventing treaty abuse (Action Plan 6), transfer pricing documentation (Action Plan 13), and enhancing dispute resolution (Action Plan 14).

Permanent Establishment (PE) redefined

This article focuses on Action Plan 7 of the BEPS project, which identifies 2 main problems with the current definition of PE under Article 5 of the OECD Model Tax Convention (MTC).

Article 7 of the MTC provides for the taxation of profits of an enterprise in a country in which it has a PE and where the said profits are attributable to the PE. The definition of “Permanent Establishment” is in turn defined under Article 5 of the MTC. The definition currently focuses on 2 aspects – (i) a fixed place of business in the country and (ii) a dependent agent in the country with contracting authority. The definition also provides for certain situations under which a company will not be deemed a PE (Exceptions). The definition of PE thus has important consequences for enterprises that carry out activities in more than one country.

Action Plan 7 of the BEPS project identifies 2 main problems with the current definition of PE under Article 5. The first is the use of tax avoidance strategies such as the use of commissionaire arrangements to avoid having a PE status. The second is the exploitation of the Exceptions under Article 5.

Amendments were thus proposed to enable taxing rights to be properly shifted towards countries where profits are properly sourced. We will examine in this article the amendments proposed to counter the 2 problems identified above. (The proposed amendments to Article 5 may be found at the end of this article.)

Tax avoidance strategies (such as commissionaire arrangements)

The OECD, in the public discussion draft released on BEPS Action Plan 7, gave an illustration of a commissionaire arrangement entered into by a medical products company under which the company was found not to have a PE to which profits from the sale of its products could be attributed and taxed, under the current wording of Article 5.

The company XCo was a resident of State X. XCo sold its products to clinics and hospitals in State Y through YCo, a resident of State Y. XCo and YCo were members of the same multinational group.

In 2000, XCo and YCo entered into a commissionaire arrangement. Under the arrangement, YCo transferred its fixed assets, stock and customer base to XCo. XCo would then be the owner of the medical products but YCo would sell the products in State Y in its own name.

The effect of such a commissionaire arrangement under the current wording of Article 5 is that the foreign owner of the goods will not have a PE in the country of sale to which the sale profits can be attributed and taxed. The local seller of the goods also cannot be taxed on the profits of the sales as it does not own the products that it sells and will at most, be taxed on the commission it receives.

To address such arrangements, the OECD proposed amendments to Article 5(5) and 5(6) of the MTC such that where an intermediary’s activities in a country are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, the foreign enterprise should be considered to have a sufficient taxable nexus in that country unless the intermediary performs the activities in the course of an independent business.

The key proposed amendments to Article 5(5) were as follows:

  • The focus is on the actual activities of the intermediary, as opposed to its authority to conclude contracts;
  • The intermediary does not need to actually conclude contracts to be a PE;
  • The contract need not be in the name of the foreign enterprise;
  • New concepts such as “principal role leading to the conclusion of contracts” and routine non-modification of the contracts by the foreign enterprise were introduced.

The requirements of the intermediary habitually carrying out the activities and being an agent (i.e. “acting on behalf of”) remains.

As for Article 5(6), the Article was given a complete overhaul whereby specific classes of independent agents such as brokers, general commission agents were removed as exceptions to being regarded a PE and the general concept of “person carrying on business as an independent agent” was introduced. It is further specified that in order for an agent to be independent and avoid being regarded as a PE, the agent cannot act exclusively or almost exclusively for an enterprise it is “closely related” to.

Exploitation of Exceptions under Article 5

Currently, Article 5(4) provides for certain situations under which a company will not be deemed a PE where a place of business is used only for the activities listed. Apart from Article 5(4)(e) and (f), the Exceptions are not restricted to preparatory or auxiliary activities.

The OECD envisaged that an enterprise should not be able to avoid having a PE in a country by using the Exceptions under Article 5(4) where it carries out activities which are not preparatory or auxiliary, or by fragmenting a cohesive operating business into several small operations, each of which by itself appears to merely be engaged in preparatory or auxiliary activities.

As a result, the “preparatory or auxiliary” restriction has now been extended to all situations under Article 5(4). Relevant factors to consider as to whether an activity is preparatory or auxiliary in nature may include the presence of the intended substantive business, the period of time the activity has been taking place and the nature of the activity (e.g. whether it is a supporting or non-essential activity).

In addition, a new anti-fragmentation rule has been introduced under Article 5(4.1) as an exception to Article 5(4). This targets enterprises which have a place of business in a country not deemed to be a PE under Article 5(4) (Para (4) Place). Where this enterprise (or its closely related enterprise) has another place of business in the country in addition to the Para (4) Place and (i) such other place of business is a PE or (ii) the overall combination of activities is not preparatory or auxiliary in nature, but constitutes complementary functions that are part of a cohesive business operation, then the Article 5(4) Exception will not apply.

The anti-fragmentation rule is wide-reaching as can be seen from the following scenario provided in the OECD’s public discussion draft. RCo is a resident of State R and manufactures and sells appliances. It has a wholly-owned subsidiary SCo in State S which owns a store selling appliances purchased from RCo. RCo maintains a warehouse in State S where it houses large appliances. When SCo makes a sale of a large appliance, SCo employees will go to RCo’s warehouse and take possession of the appliance for delivery to the customer. The ownership of the appliance passes from RCo to SCo only when the item leaves the warehouse.

In such a case, RCo’s warehouse in State S will not fall within the Exceptions under Article 5(4) as the provisions of the anti-fragmentation rule are met. Specifically, RCo and SCo are closely related enterprises, SCo’s shop is its PE and the business activities carried on by RCo at the warehouse and SCo at its shop constitute complementary functions that are part of a cohesive business operation. Hence, regardless of whether RCo’s warehouse carried out only auxiliary storage purposes, it will be considered RCo’s PE in State S as a result of SCo’s activities.

Other amendments

The OECD is also concerned about the abuse of the exception given under Article 5(3) where a building site, construction project or installation project constitutes a PE only if it lasts more than 12 months. Instead of an amendment to the Article, OECD proposed that a principal purposes test rule be added to the MTC to deal with any abuse of Article 5(3).

Enterprise response

The proposed redefinition of PE will affect all enterprises that carry out activities in more than one country. It will be advisable for companies to begin reviewing their business structures and consider the possible tax implications that may arise once the amendments to Article 5 take effect. To mitigate these tax implications, PE planning will have to be done. We recommend that PE planning be undertaken systematically in the manner shown in the diagram below.

Businesses which have not carried out any PE planning previously should conduct a PE survey, which involves a consideration of (i) the trade and business processes of the enterprise (e.g. the location and extent to which each of these processes take place), (ii) the trading rules and mandates and (iii) the forms and interfaces of the enterprise (e.g. if these impose any perimeters on PE planning). With the information gathered from the PE survey, the enterprise can determine the baseline for PE exposures in different jurisdictions for forward planning.

Companies which have previously carried out PE planning should also carry out a re-survey as to the enterprise’s current position is the light of the new rules so that the current baseline in PE planning can be determined.

With the baseline ascertained, arrangements to avoid or mitigate the PE exposure can be considered holistically by relocation, and process or contractual modifications.

OECD MODEL TAX CONVENTION (2014)

ARTICLE 5 PERMANENT ESTABLISHMENT

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) 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 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.

5. Notwithstanding the provisions of paragraphs 1 and 2, where a person — other than an agent of an independent status to whom paragraph 6 applies — is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the 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.

6. An enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

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.

OECD BEPS ACTION 7

CHANGES TO PARAGRAPHS 4, 5 AND 6 OF ARTICLE 5 PERMANENT ESTABLISHMENT

Changes to the existing text of Article 5 appear in bold for additions and strike through for deletions

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 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

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.

NEW ANTI-FRAGMENTATION RULE

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 closely related 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 closely related 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 closely related 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 closely related 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 other than an agent of an independent status to whom paragraph 6 applies is acting in a Contracting State on behalf of an enterprise and has, and habitually exercises, in a Contracting State, an authority to conclude contracts, in doing so, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are

a) in the name of the enterprise, or

b) for the transfer of the 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.

6. An enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business

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 closely related, 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 purposes of this Article, a person is closely related 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. In any case, a person shall be considered to be closely related to an enterprise if one possesses directly or indirectly more than 50 per cent of the beneficial interest in the other (or, in the case of a company, more than 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 directly or indirectly more than 50 per cent of the beneficial interest (or, in the case of a company, more than 50 per cent of the aggregate vote and value of the company’s shares or of the beneficial equity interest in the company) in the person and the enterprise.