The OECD Focus Group on the Artificial Avoidance of Permanent Establishment (PE) Status recently issued its Proposed Discussion Draft that proposes 14 possible changes to the definition of a PE under Article 5 of the OECD Model Tax Convention.
The proposals were a response to the OECD Action Plan on Base Erosion and Profit Sharing (BEPS) published in July 2013. The primary focus is on the perceived abuses associated with: (i) using a “commissionaire arrangement” instead of a local distributor arrangement in order to shift profits out of the country where sales take place; (ii) using certain specific activity exemptions to prevent the application of the PE rules; and (iii) certain uses of construction and insurance contract provisions.
This article discusses the Draft’s proposals regarding commissionaire arrangements and the activity exemptions.
With respect to the first focus area, the abuse of commissionaire arrangements can potentially occur when a foreign principal replaces a local distributor (that could give rise to a PE) with an “independent agent” (i.e., a commissionaire) without a substantive change in the functions performed in that country.
A commissionaire is a person who sells on behalf of a foreign principal in its own or its foreign principal’s name and who is economically and legally independent from the foreign principal.
The proposed changes would deem a PE to exist if a commissionaire’s activities are intended to result in the regular conclusion of contracts that are then to be performed by the foreign principal, unless the commissionaire performs these activities in the course of an independent business. These proposed changes represent a departure from the current OECD Model’s emphasis on whether the conclusion of contracts by the local agent binds the foreign principal.
The Draft contains four options addressing commissionaire arrangements:
A PE will result if a commissionaire habitually engages with customers in a way that results (i) in the conclusion of contracts in the name of the principal or (ii) the provision of property or services by the principal. An exception to this is a commissionaire that conducts business as an independent agent for a number of principals (in addition to the foreign principal) in the ordinary course of its business. If, however, such a commissionaire acts exclusively or almost exclusively for one enterprise or associated enterprises, then that person cannot be considered an independent agent. Moreover, under this option, even if contracts are not concluded in the foreign principal’s name, the principal would still be deemed to have a PE if such contracts are for the provision of products or services by the foreign enterprise.
This option is the same as Option A, except it addresses a commissionaire who habitually concludes contracts or negotiates the material elements of contracts in the name of the enterprise or provides for the provision or property or services by the enterprise.
This option is the same as Option A, except it replaces “contracts in the name of” with “contracts which, by virtue of the legal relationship between that person and the enterprise, are on the account and risk of” the foreign principal. Under this option, it is irrelevant whether the contract at issue is in the name of the enterprise. Rather, the emphasis is on whether the contracts are on the account and risk of the enterprise as a result of the commissionaire’s legal relationship with the enterprise
This option is a hybrid of Option B and Option C. This involves a commissionaire who “habitually concludes contracts, or negotiates the material elements of contracts which, by virtue of the legal relationship between that person and the enterprise, are on the account and risk of” the foreign principal.
Specific activity exemptions
With respect to the second focus area, Art. 5(4) of the OECD Model Tax Convention contains a list of activities that would exempt a “fixed place of business” from becoming a PE. The proposed changes to Article 5(4), if adopted, would put stronger emphasis on the intended “preparatory or auxiliary” nature of the activities, as well as disallow an enterprise from separating its business operation into several small operations in order to argue that each performs only preparatory or auxiliary functions.
The proposal suggests subjecting all subparagraphs of Art. 5(4) to a “preparatory and auxiliary” condition. These subparagraphs involve warehousing, delivery, purchasing, and information collection activities. Under the proposed changes, these types of activities must also be preparatory and auxiliary in nature to be exempted.
If Option E is not adopted, then the Draft proposes the following more targeted approach:
The proposal suggests removing “delivery” from Art 5(4)(a) and (b). This change echoes the view of the UN Model Convention that an enterprise’s warehouse, where other requirements are also met, should also give rise to a PE. The Draft gives a specific example that under the proposed change, an online retail business would have a PE if it maintains a large warehouse in the treaty country with a substantial number of employees for the main purpose of delivering goods to customers.
The proposal suggests removing purchasing activities from Art 5(4)(d), leaving “collecting information” as the only activity exempted under this subparagraph.
The proposal suggests deleting Art5(4)(d) so that neither purchasing, nor information collection, would be exempt activities.
The next two options address the breaking up of a cohesive business operation to qualify for one or more of the activity exemptions:
The proposal suggests that the activity exemptions should not apply to an enterprise’s fixed place of business if the same enterprise or an associated enterprise conducts business activities at one or more places that are complementary and part of a cohesive business operation and if at least one of these places gives rise to a PE.
The proposal suggests Option I, except that it also applies where none of the fixed places constitutes a PE, but the combination of the activities at the same place or at different places are more than preparatory or auxiliary.
Some of these proposed changes appear to be draconian and would bring within the definition of a PE those activities that would not normally constitute a sufficient taxable nexus. It remains to be seen which of these proposals, if any, may be adopted.