In July 2013, the OECD and G20 countries adopted a 15-point Action Plan on Base Erosion and Profit Shifting (“BEPS”). The first set of Action Plan components were released in September and discussed in a prior edition of this newsletter. See prior Tax News and Developments article OECD Delivers First Seven Components of its Action Plan on Base Erosion and Profit Shifting (BEPS), (Vol. 14, Issue 5, October 2014) located under publications at www.bakermckenzie.com. The OECD recently released two additional
discussion drafts for public comment regarding Action 7 and Action 10 (“Discussion Drafts”):
The Action 7 Discussion Draft (Preventing the Artificial Avoidance of PE Status) was issued on October 31, 2014, asking for public comments by January 9, 2015; and
The Action 10 Discussion Draft (Proposed Modifications to Chapter VII of the Transfer Pricing Guidelines Relating to Low Value-Adding Intra-Group Services) was issued on November 3, 2014, asking for public comments by January 14, 2015.
Below, is a summary of key points from each of the two Discussion Drafts.
The Discussion Draft for Action 7 proposes changes to the OECD Model Tax Convention (“Model Convention”) definition of Permanent Establishment (“PE”). The Discussion Draft proposes a series of potential changes to the Model Convention and offers multiple options for specific language/policy changes to address artificial PE avoidance. The Discussion Draft focuses on the following areas:
Specific Activity Exemptions
Income Attribution/Transfer Pricing
The OECD asserts that commissionaire arrangements have been put in place primarily to erode the taxable base of the country in which sales take place, thus improperly shifting income. A commissionaire arrangement allows an enterprise, the commissionaire, to sell products in a State in its own name but on behalf of a foreign enterprise that is the owner of the products. The foreign enterprise is generally able to avoid a PE because it is not concluding contracts in the State; rather, the commissionaire is selling the product and concluding the contract in its own name. The commissionaire enterprise earns a service commission from the foreign enterprise for its sales activities, which is taxed in the State. According to the OECD, the service commission earned by a commissionaire generally results in a smaller taxable profit than a distributor would earn for conducting similar activities.
The Discussion Draft maintains that commissionaire arrangements create a tax nexus via the contract formation activities of an intermediary (unless the intermediary in question is acting as an independent business) that will be fulfilled by a foreign enterprise. The Discussion Draft proposes the following potential revisions to the PE provision, to allow the State to tax the foreign enterprise in commissionaire and similar arrangements.
A. Option A replaces the requirement found in Article 5, Paragraph 6 of the Model Convention that a dependent agent must “conclude contracts” on behalf of a foreign enterprise to establish a PE, to instead require activities that “[result] in the conclusion of contracts.” Under Option A, a taxpayer would establish a PE when there is repeat engagement that leads to the conclusion of contracts in the name of, or the provision of property/services by, the foreign enterprise. Option A would also narrow the circumstances under which an intermediary would be treated as an independent agent by treating a person that acts exclusively or almost exclusively on behalf of one foreign enterprise as a dependent agent of the foreign enterprise.
B. Option B is similar to Option A but it addresses situations where contracts are not formally concluded by the person who is acting on behalf of the foreign enterprise. Thus, Option B provides that a dependent agent would establish a PE on behalf of an enterprise where it either “concludes contracts, or negotiates the material elements of contracts” in a Contracting State. Option B also tightens the requirements for independent agent status, as discussed in Option A.
C. Option C shifts the focus from “contracts in the name of the enterprise” to include consideration of the legal relationship and risk of the foreign enterprise, in determining whether a PE exists. Thus, Option C provides that a dependent agent would establish a PE on behalf of an enterprise where it “habitually engages with specific persons in a way that results in the conclusion of contracts which, by virtue of the legal relationship between that person and the enterprise, are on the account and risk of the enterprise.” in a Contracting State. Option C also tightens the requirements for independence as discussed in Option A.
D. Option D is a combination of Option B and Option C, and considers the elements of the contract negotiations, the legal relationship, and risk in determining whether a PE exists. Thus, Option D provides that a dependent agent would establish a PE on behalf of an enterprise where it either: (i) habitually concludes contracts or (ii) 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 enterprise. Option D also tightens the requirements for independence as discussed in Option A.
Specific Activity Exemptions
Article 5(6) of the Model Convention provides that activities that are merely “preparatory and auxiliary” will not rise to the level of a PE, and includes a list of specific, exempt activities that are treated per se as “preparatory or auxiliary activities,” regardless of their scope The Discussion Draft considers the use of the exempt activity categories to conduct substantial activities in a foreign jurisdiction--specifically, large-scale warehousing, purchasing and information gathering activities--as artificially avoiding a PE. The Discussion Draft proposes the following changes to correct this perceived problem.
E. Option E expressly limits the specific activity exemptions only to activities in those categories that are in fact preparatory or auxiliary.
F. If Option E is not adopted, Option F would remove specific activity exemptions for the delivery of goods. Of particular concern to the OECD is the use of the specific activity exemptions for an enterprise that sells goods online but maintains a large warehouse and delivery operation in the State. The Discussion Draft also addresses the artificial fragmentation of cohesive business activities to create multiple, related entities conducting merely “preparatory or auxiliary activities,” thereby avoiding the formation of a PE.
G. If Option E is not adopted, Option G would remove the exception for purchasing goods for an enterprise. The Discussion Draft discusses as examples of perceived abuse purchasing offices acting as the sole acquirer of related enterprise products and purchasing offices performing valuable services by expertly sourcing agriculture products from a number of small producers for export.
H. As an alternative to Option G, Option H would remove specific activity exemptions relating to a presence for the purchase of goods or the collection of information. The Discussion Draft raises concerns that the collection of information exception allows the repackaging of information into reports provided to other enterprises.
The Discussion Draft also addresses the artificial fragmentation of cohesive business activities to create multiple, related entities conducting merely “preparatory or auxiliary activities,” thereby avoiding the formation of a PE. The Discussion Draft proposes the following changes below to address this issue.
I. Option I limits the ability of associated enterprises in the same State to distribute cohesive business activities among themselves to avoid a PE, if at least one of the associated enterprises has a PE in the State and the activities of the other enterprises constitute complementary functions that are part of the same cohesive business operation.
J. Option J is a variation of Option I. It extends the limitation on the distribution of cohesive business activities to situations where none of the associated enterprises in the State would independently constitute a PE, but the combined activities of the associated enterprises are more than preparatory or auxiliary.
Article 5(3) of the Model Convention provides that a building site or construction or installation project lasting 12 months or less will not constitute a PE. The Discussion Draft raises specific concerns that this provision can be abused by splitting-up contracts to avoid the 12-month threshold, particularly in the context of construction projects and other service projects. The Discussion Draft seeks to limit artificially structuring contracts to fall below the 12-month threshold by splitting the contract among related enterprises. The Discussion Draft acknowledges that such abuse often would be covered by anti-avoidance rules but proposes the following options below.
K. Option K imposes an “automatic approach” to include the time spent by associated enterprises at the same site in determining whether a PE is formed.
L. Option L does not add a specific rule but instead relies on the general anti-avoidance rule proposed as part of the work on Action Item 6, and also adds a relevant example to the general anti-abuse rule.
The Discussion Draft seeks to address situations where insurance companies may have extensive business activities in a State without having a PE through the use of local independent agents or dependent agents that do not have the ability to conclude contracts. Specifically, the Discussion Draft considers when the activities of insurance agents or brokers should be sufficient to establish a PE even if they do not conclude contracts for their principal. The Discussion Draft provides the following options below to address this perceived abuse.
M. Option M deems that a PE shall exists (except in regard to reinsurance) when the insurance enterprise collects insurance premiums or insures risks in the State through a person other than an agent of independent status.
N. Option N relies on Options A and D to capture the activities of insurance companies that could create a PE. Options A and D reflect a shift away from focusing on the conclusion of contracts to determine PE to instead considering a wider range of activities and surrounding facts related to the conclusion of a contract.
Income Attribution/Transfer Pricing
The OECD acknowledges its continuing challenges in addressing the attribution of income to PEs and the need to coordinate with the work done on other elements of the BEPS Action Plan. Specifically, the Discussion Draft notes that the OECD is still determining whether substantial changes need to be made to the PE-related profit attribution rules, but that conclusions reached with respect to other elements of the BEPS Action Plan may result in substantial changes to the profits allocated to a PE.
The recently-released Discussion Draft for Action 10 only addresses part of Action 10. The original Action 10 in the OECD’s BEPS Action Plan called for:
“adopting transfer pricing rules or special measures to: (i) clarify the circumstances in which transactions can be recharacterised; (ii) clarify the application of transfer pricing method, in particular profit splits, in the context of global value chains; and (iii) provide protection against common types of base eroding payments, such as management fees and head office expenses.”
The Discussion Draft only addresses item (iii) of Action 10. The OECD proposes that this Discussion Draft will replace the full text of Chapter VII of the OECD Transfer Pricing Guidelines, as modified following comments and consensus.
The main updates to the OECD’s chapter on services transactions involve:
Adding the concept of low value-adding intra-group services (or “Low-Value Services”);
Broadening and clarifying the definition of shareholder activities; and
Updating example language for contract manufacturing and research services.
The definition of Low-Value Services is similar to the definition of services qualifying for the Services Cost Method in the US Treasury Regulations. The OECD provides that Low-Value Services are those that are supportive, not part of the core business of the company, do not use or create valuable intangibles, and do not involve the control of or creation of significant risk. Similar to the US Treasury Regulations, the Discussion Draft provides a “blacklist” of services which cannot qualify as Low-Value Services, specifically:
Services constituting the core business of the MNE group;
Research and development services;
Manufacturing and production services;
Sales, marketing and distribution activities;
Extraction, exploration, or processing of natural resources;
Insurance and reinsurance; and
Services of corporate senior management.
Examples of types of services which would likely meet the definition of Low-Value Services are provided, but not a specific “whitelist.” The examples include accounting; accounts receivable and payable; human resources; health, safety, and environmental; information technology; public relations; legal; tax; and other general clerical services.
The Discussion Draft specifies the steps in determining charges for Low-Value Services. First, determine a cost pool of Low-Value Services incurred by all entities of a MNE, excluding costs an entity incurs for performing services on its own behalf or direct costs for performing services for another entity. Second, determine reasonable allocation key(s) to allocate the pooled costs. Third, apply a single markup between 2% and 5% to all Low-Value Services.
A less burdensome benefits test is introduced for Low-Value Services than for services transactions in general, with the objective of mitigating the non-deductibility of management fees in recipient countries. The Discussion Draft states that “tax administrations should consider benefits only by categories of services and not on a specific charge basis.” The taxpayer is not “required to specify individual acts undertaken that give rise to the costs charged.” Therefore, with respect to Low-Value Services that benefit multiple entities, the intention is that recipient country tax authorities should not demand unreasonable detail in supporting why the services benefited entities in the recipient country.
Instead, the Discussion Draft adds specific documentation requirements that would, when met, constitute sufficient detail. Specifically, the documentation must include descriptions of the Low-Value Services, justification for why they qualify as Low-Value Services, calculation of the cost pool and identification of direct costs, and an application of specified allocation keys. Documentation meeting these requirements should constitute sufficient support for the recipient country tax authorities’ to allow management fee expense deductions.
Definition of Shareholder Activities
The definition of shareholder activities is broadened and clarified, and now comprises the following activities:
a) Costs relating to shareholder meetings, stock exchange listings, or the company’s board;
b) Costs relating to reporting requirements (including audit fees) of the parent company;
c) Costs of raising funds and costs of investor relations and dealing with other stakeholders;
d) Costs relating to compliance of the parent company with the relevant tax laws; and
e) Costs ancillary to the corporate governance of the MNE as a whole.
The 2010 OECD Guidelines did not explicitly identify parent company audit, tax, or investor relations as being shareholder activities. This Discussion Draft seeks to clarify that these activities are indeed shareholder activities, as well as provide for the common situation that group entities other than the parent may perform shareholder activities, and the appropriate transfer price for these shareholder services should be charged to the shareholder accordingly.
Updates to Examples
The section on examples of intra-group services is updated with new language regarding contract manufacturing and contract research services, stepping back from the 2010 OECD Guidelines’ broad generalizations regarding these types of services in favor of a more facts-and-circumstances approach to assessing whether a manufacturing activity should be compensated via a cost plus arrangement or whether another method should be used.