Introduction

On 22 March 2017 the Organisation for Economic Cooperation and Development (OECD) issued the Additional Guidance on the Attribution of Profits to Permanent Establishments. This report is contextualized within the OECD's Base Erosion and Profit Shifting (BEPS) project and the related 15 Action Plans, as developed with the G20.

In order to ensure that the proposed measures are implemented, the OECD recently issued:

  • a new version of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital and related commentary; and
  • a framework for the Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent Base Erosion and Profit Shifting, which aims to amend existing double taxation treaties.

This article examines how the OECD's recommendations concerning permanent establishments have been implemented in Italy.

Definition of 'permanent establishments'

The Additional Guidance on the Attribution of Profits to Permanent Establishments is a continuation of the measures set out in BEPS Action 7 concerning methods to prevent the artificial avoidance of permanent establishment status.

The OECD's recommendations concerning the definition of a 'permanent establishment' have been transposed into Italian law through the revision of Article 162 of the Income Tax Code (in the context of the Budget Law 2018).

The main amendments introduced by the revised Income Tax Code can be summarised as follows:

  • The list of activities that do not constitute a permanent establishment (ie, a 'negative list') has been aligned with Article 5(4) of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital. The exemptions listed are applied if the activities, or a combination thereof, have a "preparatory or auxiliary character".
  • The anti-fragmentation rule set out in Article 5(4)(1) of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital (and Article 13(4) of the Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent Base Erosion and Profit Shifting) has been introduced and a permanent establishment can be recognised where a combination of activities are performed in different places by closely related enterprises, provided that:
    • at least one of these activities, if individually considered, constitutes a permanent establishment; or
    • a combination of the activities performed exceeds a "preparatory or auxiliary character".
  • The requirements of Article 5(5) of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital regarding permanent establishments that habitually conclude contracts through intermediaries on behalf of non-resident companies have been added to the Income Tax Code, with the exception of activities on the negative list and independent agents that operate in the ordinary course of business.
  • The amendments to the Income Tax Code do not include the splitting-up of contracts, where the time needed to configure a permanent establishment (eg, in the case of construction sites, as set out in Article 162(3) of the code) is fragmented into more contracts by closely related enterprises in order not to exceed the maximum allowed time.
  • Article 162(2)(f)bis of the Income Tax Code includes the following definition of what constitutes a 'permanent establishment': "a significant and continuous economic presence in a country in such a way so as not to make its physical presence consistent in said territory". This definition appears not to be inspired by Action 7, nor the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting. However, from a literal point ("constructed in such a way"), it seems to be formulated similar to an internal anti-abuse or an anti-elusive disposition, as the "principal purpose test" set out in Article 7 of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting.

Attribution of profits to permanent establishments – new indications

As anticipated in BEPS Action 7, the Additional Guidance on the Attribution of Profits to Permanent Establishments confirms the following:

  • The rules and guidelines for allocating income to permanent establishments remain unchanged following the extension of Article 5 of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital and continue to be governed by the principles contained in Article 7 in the 2010 edition and, most recently, in the 2017 revised version.
  • The methodologies developed by the OECD remain unchanged with respect to the 2010 Report on the Attribution of Profits to Permanent Establishments. The functionally separate entity approach, developed by the OECD in the 2010 Report on the Attribution of Profits to Permanent Establishments (ie, the authorised OECD approach), is based on a two-step analysis that aims to establish the income that permanent establishments would have achieved if they had been separate and independent entities carrying out the same activities with their head office. The first phase requires a functional and factual analysis carried out in line with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations on the assumption that a permanent establishment and its parent company are separate entities, each performing functions, using assets, assuming risks and entering into transactions between themselves and with related companies and third parties, identifying the significant activities and responsibilities assumed by the permanent establishment. In the second phase, the remuneration between a parent company and its permanent establishment, assumed to be separate companies, is determined by applying Article 9 of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital's transfer pricing rules for transactions between associated companies, taking into account the functions performed, the assets used and the risks assumed, in accordance with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.

The Additional Guidance on the Attribution of Profits to Permanent Establishments is therefore limited to:

  • reviewing previous guidelines;
  • providing general principles consistent with the previous guidelines and applicable to new cases of permanent establishments; and
  • illustrating specific practical examples.

In an Italian context, the functionally separate entity approach is included in the new version of Article 152(2) of the Income Tax Code following the amendments introduced by Legislative Decree 147/2015 (the Internationalisation Decree), albeit sometimes formulated differently in the treaties to which Italy is a party, especially for those stipulated before the revision of the 2010 Model Tax Convention for the Avoidance of Double Taxation on Income and Capital.

Examples reported in Additional Guidance on the Attribution of Profits to Permanent Establishments

Example one: warehousing, delivery, merchandising and information collection activities The first example proposed in the Additional Guidance on the Attribution of Profits to Permanent Establishments concerns changes to Article 5(4) of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital. This would affect the new Article 162(4)bis of the Income Tax Code regarding activities that are exempted from being considered permanent establishments on the condition that they have a "preparatory or auxiliary" character.

The example concerns a non-resident company located in country R which sells goods directly to consumers in country S via an online platform. However, the company has in country S:

  • a warehouse for the storage of goods, the receipt of orders and the execution of deliveries; and
  • another office located in another place with respect to the warehouse which is responsible for the promotion (merchandising) of products and collecting consumer information.

Both sites (the warehouse and the office) perform functions that, considered individually, do not constitute a permanent establishment under the Income Tax Code's exemption.

The combination of activities carried out in the two locations, which have complementary functions and form part of a unitary business operation, excludes their preparatory or auxiliary character under the anti-fragmentation rule referred to in Article 5(4)(1) of Model Tax Convention for the Avoidance of Double Taxation on Income and Capital, meaning that two permanent establishments of the non-resident entity are located in country S.

The authorised OECD approach should be applied in this case and an appropriate arm's-length method employed.

The Additional Guidance on the Attribution of Profits to Permanent Establishments then provides the following examples concerning the new provisions on intermediaries set out in Articles 162(6) and (7) of the Income Tax Code:

  • the sale of the graphic components of a program (widgets) by a commissionaire permanent establishment located in country S, which is also responsible for marketing and warehousing activities;
  • marketing activities for the sale of advertising space on a site owned by a company located in country R, performed by a service provider permanent establishment located in country S; and
  • the procurement of widgets by a permanent establishment located in country S in the name of and on behalf of a company in country R whose core business consists of the purchase and sale of such widgets.

Example two: commissionaire structure (related intermediary) Example two concerns activities performed by non-independent agents that habitually conclude contracts on behalf of non-resident companies, as covered by Article 162(6) the Income Tax Code and Article 5(5) of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital.

Under step one of the authorised OECD approach, a functional and factual analysis shows that the commissionaire performs significant people functions relevant to the assumption of inventory risk and the disposition of said inventory. As a result, the permanent establishment is deemed to be the economic owner of the inventory and the related inventory risk is therefore attributable thereto. The commissionaire is remunerated through a commission and has no credit rights towards final customers. An internal deal between the permanent establishment and its head office is recognised, consisting of the sale of goods by the head office and its branch.

Under step two of the authorised OECD approach, the profits attributable to the permanent establishment for the sale of goods are recognised as the arm's-length profits that the head office would have made with an independent entity performing the same function and bearing the same risks as the permanent establishment. For tax purposes, the profits attributed to the permanent establishment are determined by considering the revenues from the sale of goods to final customers minus the cost of goods sold and the commission paid to the permanent establishment, and further additional expenses related to, the permanent establishment.

Additional factors that could affect this analysis include:

  • legal aspects of the agreement between the head office and its permanent establishment (eg, agency agreements, power of attorney) and their economic relationship;
  • the permanent establishment's remuneration after the reconstruction operated by the authorised OECD approach from an economic point of view;
  • whether the performance of marketing and warehousing activities by the intermediary is required to constitute a permanent establishment (considering the requirements needed to recognise the existence of a 'dependent agent' under the new definitions provided by BEPS Action 7 and the amendments made to the Income Tax Code, including the exemptions indicated for activities of a "preparatory or auxiliary" nature).

Example three: sale of advertising online (related intermediary) Example three concerns the case of an intermediary which, on the basis of a service agreement, carries out marketing activities for the sale of advertising space in the permanent establishment's country of residence, deciding the volume, type and form of advertising to be carried out.

The conclusions reached are as follows:

  • A permanent establishment that acts as the principal in the routine conclusion of sales to final customers, and without material modifications to the terms and conditions by the non-resident entity, must be recognised as such.
  • Functional and factual analysis shows that sales are carried out by an intermediary's personnel, who are also responsible for deciding the methods of advertising to be carried out. Consequently, internal dealing between a head office and its permanent establishment must be considered with regard to the sale of advertising space.
  • Remuneration for internal dealing is determined according to the transfer pricing rules established by the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations as the price that the head office would have obtained from an independent counterpart for the sale of advertising space.
  • For tax purposes, remuneration for internal dealing and remuneration paid to an intermediary for performing such services (and any other operating expenses) is deductible.

Example four: procurement of goods (related intermediary) Example four is similar to example three, but the intermediary operating in country S is responsible for concluding purchase agreements (widgets), and not for their sale, in the name and on behalf of the principal.

A permanent establishment is recognised and internal dealing between it and its parent company is assumed, consisting of the sale of inventory from the first to the second. The arm's-length remuneration relating to price follows the transfer pricing rules indicated in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and considers – due to the fact that warehouse management is carried out by intermediary staff – the assets used and the risks assumed in the performing of such functions, attributing them to the permanent establishment. In determining the permanent establishment's income, the costs for the purchase of goods from third parties, the commission paid to the intermediary and the permanent establishment's operating expenses are deductible.

Comment

The OECD's recommendations on the definition of a 'permanent establishment' have been transposed into Italian law through the amendments to Article 162 of the Income Tax Code.

Article 162 now includes updates with regard to the 'negative list' of activities that do not constitute a permanent establishment, the anti-fragmentation rule and details of the requirements that give rise to a permanent establishment based on the activities of intermediaries habitually concluding contracts on behalf of non-resident companies ("dependent agent permanent establishment"). However, Article 162 makes no reference to the splitting-up of contracts, where the time needed to configure a permanent establishment is fragmented into various contracts. In addition, a new case has been added, whereby a permanent establishment can also be deemed to exist when "a significant and continuous economic presence in the territory of the country [is] built in such a way as not to make its physical consistence in the territory".

As regards the attribution of profits to permanent establishments, Article 152(2) of Income Tax Code transposes the OECD's functionally separate entity approach. Under this approach, the arm's-length standard applies where a permanent establishment is a distinct entity, so that its attributable profits are those that it would have earned if it had been a separate and independent enterprise engaged in similar activities under the same or similar conditions, taking into account the functions performed, the assets used and the risks assumed.

For further information on this topic please contact Marco Abramo Lanza, Oliviero Cimaz or Valentina Bertolini at Studio Legale Tributario Biscozzi Nobili by telephone (+39 02 763 6931) or email (marco.lanza@slta.it, oliviero.cimaz@slta.it or valentina.bertolini@slta.it). The Studio Legale Tributario Biscozzi Nobili website can be accessed at www.slta.it.

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