The Implications of BEPS Action 7 on the Attribution of Profits to Permanent Establishments.

Transcription

1 The Implications of BEPS Action 7 on the Attribution of Profits to Permanent Establishments. Name student: E.A.J. Groeneweg ANR: Name supervisor: First reader: Second reader: M.J. van Hulten M.J. van Hulten D.S. Smit Academic year: 2015/2016

2 The Implications of BEPS Action 7 on the Attribution of Profits to Permanent Establishments. Master thesis International Business Taxation / track: International Business Tax Law, Tilburg School of Law, Tilburg University Name student: E.A.J. Groeneweg ANR: Name supervisor: First reader: Second reader: M.J. van Hulten M.J. van Hulten D.S. Smit Academic year: 2015/2016 Completion date:

3 Preface With this master thesis there comes an end to my study at Tilburg University. I enjoyed writing the thesis and therefore I look back upon the writing process with fulfillment. The topic of the thesis proved to be more challenging than I expected at first, mainly because there is much uncertainty regarding the topic and, hence, a lot of different views can be found. Next to that, the topic forced me to work a lot with fictions, which in itself is always challenging in my opinion. Due to the good supervision I enjoyed by Mr Van Hulten I did not lose sight of what of I was doing. Therefore, my special thanks goes out to him. Furthermore, I want to thank everybody who has contributed to making my years of studying at Tilburg University an unforgettable time.

4 Abstract The BEPS-project that was launched by the OECD and the G20 has major implications for many areas in the field of international business taxation. One of the great institutions of international tax law, the permanent establishment concept, was not spared in this extensive project. The permanent establishment concept, which is laid down in Article 5 of the OECD Model Tax Convention, provides two thresholds of which one has to be passed before a State, other than the resident State of an enterprise, may tax that enterprise on the business profits that accrued in its territory. Now, the OECD intends to lower the threshold for Agency permanent establishments, and it intends to restrict the exemptions that applied to the threshold for fixed place of business permanent establishments. The aim of those proposed revisions is to prevent the artificial avoidance of the permanent establishment status. Revising the permanent establishment concept ultimately has implications for the taxation of business profits. In this thesis the current profit attribution rules are applied to situations in which PEs arise due the proposed revisions of BEPS Action 7. Then, the outcomes thereof are set off against the aims and goals of the BEPS-project. In short, the proposed revisions lead to situations in which applying the AOA has a questionable effect. Therefore, further guidance is provided in this thesis, which on the one hand tries to anticipate on guidance that the OECD might give themselves and on the other hand more in-depth guidance for specific situations and alternatives.

5 Table of contents. 1. Introduction The OECD Permanent Establishments Function of the PE concept Domestic tax law Art. 5 OECD Model Tax Convention Permanent establishments and BEPS Case law Profit Attribution to Permanent Establishments General remarks Methods for profit attribution The Authorized OECD Approach Step 1: the functional and factual analysis Step 2: determining the profits of the hypothesized separate and independent enterprise based upon a comparability analysis Profit attribution and BEPS Case law Applying the current profit attribution rules to situations in which PEs arise as a result of BEPS Action Approach Identifying situations in which PEs arise as a result of Action PEs that arise due to changes to Art. 5(5) and (6) PEs that arise due to changes to Art. 5(4) OECD MTC Testing the implications of the proposed revisions to the broader BEPS-project aims Additional guidance on profit attribution to Permanent Establishments General remarks Additional guidance following BEPS Additional guidance for specific situations Agency PEs Profit attribution issues arising from the scope of the dependent agent provisions Profit attribution issues with PEs that arise to the proposed revisions to Art. 5(4) OECD MTC Formulary apportionment: a viable alternative? Conclusion Bibliography ANNEX... 65

6 1. Introduction In the past decade there has been a paradigm shift in the field of taxation. 1 Where in the past taxation never received that much attention from the media and politicians, it has been in the spotlights for a couple of years now. This is to a certain extent due to the financial crisis that hit financial markets across the globe, starting in Corporations are ought to pay their fair share 2. Not in the last place the attention for taxation comes from a large project which was initiated by the OECD; Addressing Base Erosion and Profit Shifting ( BEPS ), which led to the development of the BEPS Action Plan. In brief, this broadly-based action plan aims to counter tax avoidance. To that extent the OECD recognized problematic areas in the field of international taxation that need to be addressed in order to combat base erosion and profit shifting. Two of these actions specifically addresses the current permanent establishment ( PE ) concept, and issues the need for amending the existing concept. One of those particular actions is BEPS Action 7, which is titled: Preventing the artificial avoidance of PE status. The OECD did extensive research on this subject, to which extent they consulted the public twice 3, which resulted in a final report on Action 7 in October Previous to the BEPS-project, the OECD already started evaluating the PE concept. 5 However, due to the launch of the BEPS-project that work seems to be on hold. 6 However, not everything the OECD intends to cover with Action 7 has been covered at this point in time. In first instance the OECD concluded that the current rules on the attribution of profits to PEs were appropriate and did not need revision. That conclusion triggered many reactions of commentators on the public discussion drafts, in which the need for additional guidance explicitly came forward. The OECD then acknowledged that additional work on profit attribution issues was needed, but at the same time the OECD said that it would be postponed, as further work on that specific subject needed to take into account the result of work done on other parts of the Action Plan, most significantly the Actions regarding transfer pricing. The OECD stated that they will present their results ultimately at the end of 1 J.F. Bianco & R.T. Santos, A Change of Paradigm on International Tax Law: Article 7 of Tax Treaties and the Need to resolve the Source versus Residence Dichotomy, Bulletin for International Taxation 2016 (Vol. 70), No. 3 2 S.A. Stevens, The Duty of Countries and Enterprises to Pay Their Fair Share, Intertax 2014 (Vol. 42), Issue 11, p OECD BEPS Public Discussion Draft, BEPS Action 7: Preventing the Artificial Avoidance of PE Status, 31 October January 2015.; OECD Revised Discussion Draft, BEPS Action 7: Preventing the Artificial Avoidance of PE Status, 12 May June OECD (2015) Preventing the Artificial Avoidance of Permanent Establishment Status, Action Final Report, OECD/G20 Base Erosion and Profit Shifting Project, Paris: OECD Publishing OECD Discussion draft on Art. 5 (Definition Permanent Establishment) Interpretation and application of Article 5 (Permanent Establishment) of the OECD Model Tax Convention (October 2012) 6 Y. Brauner, BEPS: an Interim Evaluation, World Tax Journal, 2014, February, p

7 2016, which is the deadline for negotiating a multilateral instrument, which is the objective of BEPS Action Work on the attribution of profits to PEs is a former extensive project of the OECD. 8 It is considered to be one of the most technical areas of international tax law, as it touches upon, and deviates from, multiple core principles of international tax law. After the introduction of BEPS Action 7 further guidance on the attribution of profits to PEs is demanded. 9 Since further guidance on profit attribution is not yet available, and since it is a highly controversial area of international tax law, work on the subject should have high priority. It follows from abovementioned reasons that the research question which stands central in this thesis will be: What will be issues with profit attribution to permanent establishments following from BEPS Action 7 and how could those be resolved? The motivation for this study is threefold. First off, the research question interacts with key areas of international tax law, such as the allocation of taxing rights, and areas which are of ever increasing importance, such as transfer pricing. In addition, the question deals with a subject which contains a lot of practical relevance. Enterprises that act internationally need to be able to adjust their strategy and business model with legal certainty, but there now may be a shift to the contrary. 10 Whereas international activity now may sooner lead to taxable presence in a country, tax authorities may intend to cease this opportunity to claim more taxes from foreign enterprises which conduct any economic activities in their territory. Because there is no guidance on profit attribution for those new situations, the number of disputes between MNEs and tax authorities might increase. Thirdly, the research question connects a number of BEPS Actions to each other, and since the BEPS-project is a huge and ambitious project of the OECD, this research may show how closely connected this huge project actually is. The methodology used to perform the research consists of various steps. First of all, I will examine profit attribution in situations in which new PEs arise by applying the current profit attribution rules. 7 OECD (2015) A Mandate for the Development of a Multilateral Instrument on Tax Treaty Measures to Tackle BEPS, Action 15 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, Paris: OECD Publishing OECD Report: The Attribution of Profits to Permanent Establishments, Parts I-IV 2008 and OECD Report: The Attribution of Profits to Permanent Establishments, Parts I-IV OECD (2015) Preventing the Artificial Avoidance of Permanent Establishment Status, Action Final Report, OECD/G20 Base Erosion and Profit Shifting Project, Paris: OECD Publishing J. Vreeswijk & A-L. Tan, The impact of BEPS Action 7 on operating models, International Tax Review 2016, February. Available at: 2

8 After this test I will draw a preliminary conclusion on the applicability of the current rules and guidance thereon. In order to provide an objective conclusion to this test, I will look at the applicability of the current rules from the perspective of the OECD s aims and goals for the BEPS-project. Finally, I will try to provide further guidance on how the attribution of profits to PEs is affected by the proposed amendments of BEPS Action 7 from two perspectives; from the perspective of the OECD s aims and goals for the BEPS-project and from my own perspective. Before coming to this part, useful background information and the legal frameworks of various concepts will be given. In the second chapter the OECD will be introduced. This chapter aims to provide background on the organization as well as their aims and goals throughout contemporary history, with a main focus on the work on attribution of profits to PEs and the BEPS-project. In the third chapter the PE concept will be explained. Since this is not the main focus of this thesis nor the subject of the research question, the concept will not be discussed as extensive as possible. Nevertheless, the various types of PEs and the proposed revisions of BEPS Action 7 will be highlighted. To continue, the fourth chapter is devoted to the rules on the attribution of profits to PEs. The legal framework for profit attribution will be explained. In this chapter the focus goes out to the AOA. In the fifth chapter I will test the current profit attribution rules of the OECD to situations in which new PEs arise. Chapter six will evaluate the outcomes against the goals of the BEPS-project and the broader, overarching, mission of the OECD. In chapter seven I will provide recommendations on how issues regarding profit attribution might be resolved. Lastly, chapter eight will give a conclusion. 3

9 2. The OECD Before examining the BEPS-project, the work on the attribution of profits to PEs or the Transfer Pricing Guidelines ( TP Guidelines ), it is logical to introduce the organization behind it first. The Organization for Economic Co-operation and Development, in short the OECD, was founded in 1961, but the organization has a predecessor. In 1947, just after the Second World War, the Marshall Plan was drafted in the United States ( US ) to help the slowly recovering European economies recover faster by giving aid to them. On the 16 th of April, 1948, many European countries signed the Convention for European Economic Co-operation of which Article I set up the Organization for European Economic Co-operation, the OEEC 11, which had as main objective facilitating the incoming aid of the Marshall Plan. The goals of this organization were, amongst others, to increase production and stimulate co-operation within Europe. In the following decade the OEEC was very successful in stimulating economic growth in Europe. At the end of the 1960s however, the OEEC became less effective as the economic steward of Europe 12 and something had to be done to reinvigorate the organization. In 1960 the initial draft convention for the OECD was signed in Paris. The convention officially entered into force on 30 September 1961, and this therefore is the moment that the OECD is officially born. The mission of the OECD differs from the mission the OEEC pursued. The overall mission of the OECD is: to promote policies that will improve the economic and social well-being of people around the world. 13 Those policies are according to Art. 1 OECD Convention focused on, in my words, fostering economic sustainable economic growth and expansion worldwide. Since 1961 many other countries joined the OECD, of which Japan was the first in Today, the OECD has 34 member countries worldwide, and also holds close relationships with countries that have emerged as economic giants in more recent years, such as India, Russia, Brazil and Indonesia. All taken together the OECD brings together the countries that account for approximately 80% of all trade and investment worldwide. The member countries and their strategic partners regularly meet to identify and analyze problems, in order to create and promote policies to resolve those problems. In the field of taxation such a problem is for example base erosion and profit shifting, and addressing base erosion and profit shifting soon turned into one of the biggest projects undertaken by the OECD. Although it is not the OECD s primary objective the organization can produce legal norms. These legal norms can take various forms. Art. 5 OECD Convention states that the Organization, in order to reach its goals, may: a) take decisions, which unless provided otherwise, are binding for all its Members; b) 11 See for a detailed overview of the history of the OECD: R.T. Griffiths, Explorations in OEEC History, Paris: OECD Publishing R. Clarke & L. Thompson, A majestic start: how the OECD was won, OECD Observer 2011, Issue 282/283, p As stated on their website, available at 4

10 make recommendations to Members; and c) enter into agreements with Members, non-members or other international organizations. Art. 6(1) OECD Convention hence sets forth that decisions shall be taken and recommendations shall be made by mutual agreement between the Member States, unless the Members have to agree unanimously in special cases. An important paragraph to notice is Art. 6(3) OECD Convention, which states that no decision shall be binding on a Member State until it has complied with the Member State s own constitutional procedures. Therefore, a legal act of the OECD is never directly applicable. If an OECD Member State does not abstain from a decision at the time of adoption by the Members, and it complied with all the Member State s constitutional procedures, it is legally binding. In fact, even though Decisions are not international treaties, they do entail the same legal obligations as international treaties do. 14 This also forces Members to implement the Decisions and to take all measures necessary to that end. Recommendations on the other hand may not be legally binding in its nature, but in practice those are often driven by a great moral force as a recommendation in intended to represent the political will of the Member States. 15 The OECD Model Tax Convention In the field of taxation, the OECD is most well-known for its Model Tax Convention( OECD MTC ). The aim of that model is to clarify, standardize and confirm the fiscal situation of taxpayers who are engaged in commercial, industrial, financial or any other activities in other countries through the application by all countries of common solutions to identical cases of double taxation. 16 The model tries to provide a means for settling on a uniform basis the most frequently occurring problems that arise in the field of international juridical double taxation. 17 In practice, the OECD MTC serves as a blueprint for States to model their DTCs with other States on. Hence, the OECD MTC and the OECD Commentary ( the Commentary ) thereon proved to be of great importance for levelling out differences in DTCs between OECD members, but also for DTC with non-members and even for DTCs between nonmembers. 18 The importance of the OECD MTC has grown over time, especially since its value is enhanced due to various technical factors, including in particular the high degree of stability of its provisions as well as the fact that the OECD started a dialogue on the OECD MTC with non-member countries a couple of years ago. 19 Nowadays, the OECD MTC is accepted as the expression of 14 As stated on the OECD s website, available at: 15 As stated on the OECD s website, available at: 16 OECD Introduction to the OECD Model Tax Convention and Commentary 2014, paras OECD Introduction to the OECD Model Tax Convention and Commentary 2014, para P. Pistone in M. Lang, P. Pistone, J. Schuch, C. Staringer, A. Storck & M. Zagler (eds.), Tax Treaties: Building Bridges between Law and Economics, Amsterdam: IBFD, 2010, p P. Pistone in M. Lang, P. Pistone, J. Schuch, C. Staringer, A. Storck & M. Zagler (eds.), Tax Treaties: Building Bridges between Law and Economics, Amsterdam: IBFD, 2010, p

11 internationally accepted tax practice and main source of soft tax treaty law worldwide. 20 To that extent, it became in fact a settled body of soft tax law, whose evolution is primarily through the Commentary on the MTC rather than changes to the MTC itself. 21 Due to the widespread use and influence of the OECD MTC the Commentary thereon is in practice often used for the purpose of tax treaty interpretation. However, the status of the Commentary is controversial. 22 The Commentary is not a binding legal instrument, but can, according to the OECD, be of significant assistance for the interpretation of tax treaties. In the Vienna Convention on the Law of Treaties ( Vienna Convention ) the internationally accepted rules for treaty interpretation can be found. Art. 31(1) Vienna Convention provides that: tax treaty provisions should be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of their object and purpose. Only if the Commentary is seen as providing the context for the terms of DTCs it could unequivocally be applied, but this is unlikely. 23 If States want the Commentary to be applicable for giving the context in which terms should be interpreted, they should explicitly state that the Commentary will be applicable. The question then is, considering the frequent amendments to the Commentary, whether the Commentary applicable at the time the DTC was concluded must be used for interpretative purposes, or that later versions of the Commentary may also be used. The first approach is called the static approach and the second approach is called the dynamic or ambulatory approach. In practice, both approaches are followed. At least, the OECD cannot claim that later versions of the Commentary should be applied to interpret the provisions of a previously concluded DTC according to Art. 30(3) Vienna Convention. 24 The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations The Transfer Pricing Guidelines give transfer pricing rules and guidance on how to apply them. Transfer pricing rules must be understood as to describe how (cross-border) transactions between associated enterprises, most often intercompany transactions in a MNE group, must be priced. The need for such rules stems from the fact that transactions between associated enterprises are not affected by market forces, such as supply and demand, in the same way as transactions between independent enterprises. 25 Transfer pricing rules are thus concerned with determining the conditions for transaction between 20 Pasquale Pistone in M. Lang, P. Pistone, J. Schuch, C. Staringer, A. Storck & M. Zagler (eds.), Tax Treaties: Building Bridges between Law and Economics, Amsterdam: IBFD, 2010, p Pasquale Pistone in M. Lang, P. Pistone, J. Schuch, C. Staringer, A. Storck & M. Zagler (eds.), Tax Treaties: Building Bridges between Law and Economics, Amsterdam: IBFD, 2010, p M. Erasmus-Koen & S. Douwma, Legal Status of the OECD Commentaries in Search of the Holy Grail of International Tax Law, Bulletin for International Taxation 2007, August, pp M. Kobetsky, International Taxation of Permanent Establishments, Cambridge: Cambridge University Press 2011, p M. Kobetsky, International Taxation of Permanent Establishments, Cambridge: Cambridge University Press 2011, p OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris: OECD Publishing 2013, para

12 members of a MNE group. At the heart of the transfer pricing rules lies the arm s length principle, which is codified in Art. 9 OECD MTC. In Art. 9 OECD MTC it comes forth as follows: where conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly. The Reports on the Attribution of Profits to Permanent Establishments. In 1995 the OECD issued its report Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. In that report the OECD stated that it would undertake further work to address the application of the arm s length principle to PEs. Since then, the OECD has undertaken a lot work on the attribution of profits to PEs. Between 2001 and 2006 the OECD issued various working hypotheses. This process finally resulted in the development of the Authorized OECD Approach ( AOA ) for the attribution of profits to PEs, which was presented in the 2008 Report on the Attribution of Profits to Permanent Establishments. The aim of this approach is to further align rules on profit attribution of Art. 7 with the transfer pricing rules of Art. 9 OECD MTC. 26 When the Committee approved the 2008 Report it recognized that some of the conclusions given in the 2008 Report differed from the Commentary previously given on Art. 7 OECD MTC. For that reason, the Committee decided to amend the Commentary on Art. 7 OECD MTC in order to incorporate some of these conclusions that did not conflict with the previous versions of the Commentary. After doing so, the Committee decided that this called for a revised version of Art. 7 OECD MTC, in order to allow a full incorporation of the conclusions of the 2008 Report in the OECD MTC. In 2010, the OECD presented an updated version of the OECD MTC which included a new Art. 7 that fully incorporated the legal basis for the AOA. The BEPS-project. In recent years, rising problems in the field of international taxation became a high priority subject for the OECD. The notion rose that in a worldwide changing business environment international common principles for sharing tax jurisdiction could not keep up. 27 The integration of national economies and markets has increased significantly, putting a strain on the international tax framework, which was developed over a hundred years ago. 28 The international common principles to share tax jurisdiction were found to be focused on national economies, so as to say on a low degree of global economic integration and co-operation. These principles include methods to eliminate double taxation and to 26 OECD Report: The Attribution of Profits to Permanent Establishments, OECD (2013) Addressing Base Erosion and Profit Shifting, Paris: OECD Publishing 2013, p OECD (2015) Explanatory Statement, OECD/G20 Base Erosion and Profit Shifting Project, Paris: OECD Publishing 2015, p. 4 7

13 prevent double non-taxation. Especially MNEs tended to search for flaws on the interface of domestic tax jurisdictions and international standards, in order to try to reduce or even eliminate their tax burden. The OECD then said that for addressing BEPS issues a holistic approach is needed. In addition, it was stated that a uniform approach is needed, as one single country or uncoordinated measures by many countries cannot address BEPS. This led to a global action plan in which the OECD identified 15 Actions to address BEPS, known as the BEPS Action Plan. The BEPS Action Plan is released in 2013 and endorsed by the G20. The BEPS Action Plan introduces fundamental changes to effectively prevent double non-taxation, and to situations in which no or very low taxation takes place as effect of the (geographical) segregation of income and the activities that produce that income. 29 The aim of the BEPS Action Plan is to provide countries with domestic and international instruments that will better align rights to tax with economic activities. 30 From that aim several goals must be distilled, which are: - Ensuring profits are taxed where economic activities generating those profits are performed and where value is created - Standardizing compliance - Reducing disputes over the application of international tax rules - Increasing legal certainty on international tax rules With the release of the Final BEPS Package in October 2015 and its subsequent adoption by the OECD, the G20 and all the other countries that participated in its development, a comprehensive package of measures has been agreed upon. The measures the package consists of range from the adoption of new minimum standards to the revision of existing standards. 31 Now, new challenges arise in a post-beps environment. 32 These challenges become apparent when the legal status of the BEPS outputs is considered. The proposed measures qualify as soft law, which makes them in itself not legally binding. However, it is expected that the measures will be implemented accordingly by the countries that participated in the project, but the implementation process has only just started. The European Union ( EU ) has endorsed the final package and actively encourages its Member States to follow the proposed revisions OECD (2013) Action Plan on Base Erosion and Profit Shifting, Paris: OECD Publishing 2013, p OECD (2013) Action Plan on Base Erosion and Profit Shifting, Paris: OECD Publishing 2013, p OECD (2015) Explanatory Statement, OECD/G20 Base Erosion and Profit Shifting Project, Paris: OECD Publishing 2015, p OECD (2015) Explanatory Statement, OECD/G20 Base Erosion and Profit Shifting Project, Paris: OECD Publishing 2015, p C(2016), 271, final, Commission Recommendation on the implementation of measures against tax treaty abuse, Brussels,

14 Some of the proposed measures may be immediately effective, such as the new guidance on transfer pricing. Hereby is meant that the revisions of BEPS 8-10 have to be considered part of the latest version of the Transfer Pricing Guidelines. However, this does not mean that a huge impact of the new guidance must be expected. The Transfer Pricing Guidelines are, as the name says, mere guidelines that can be used for the drafting of DTCs, or on which States can base their national legislation regarding transfer pricing. States may follow the guidance, but are not obliged to. In practice, many States have followed the TP Guidelines for the conclusion of DTCs. If States have concluded that the TP Guidelines are a source that may be consulted for tax treaty interpretation, it depends on whether that States allow static or dynamic interpretation. Only if a State s practice allows dynamic interpretation the revisions to the TP Guidelines have a direct impact. Opposed to proposed measures that may be directly effective, others require implementation, either in new tax treaties or in domestic law, or through amending existing tax treaties. The proposed revisions of Action 7 require tax treaty implementation. This could be done through renegotiating existing DTCs, however it is unlikely that this will happen, at least not on a significant scale, considering that there are around 3,500 DTCs in existence worldwide and amending a treaty is a costly exercise. Since many DTCs are based on older versions of the OECD MTC, the impact of Action 7 in the short term is questionable. However, over time the revisions are expected to be implemented. Theoretically, this could already happen in the near future, with the adoption of the multilateral instrument of BEPS Action 15. On the other hand, it must be noted that Member States may abstain from adoption, or create reservations to certain parts of the measure. This thesis concerns the issues with profit attribution resulting from the proposed revisions to the PE definition. Action 7 regards the PE definition, including profit attribution issues. Besides Action 7, a couple of the other BEPS Actions have a direct or indirect link with profit attribution issues. The greatest concern is the current functioning of the Arm s Length Principle ( ALP ). This for instance leads to BEPS issues as separation of income from the economic activities that produce that income, shifting income to low-tax jurisdictions, and the contractual allocation of risks to low-tax environments which would not occur between unrelated parties. Since the ALP is of vital importance for profit attribution to PEs under the current profit attribution rules, BEPS issues connected to the principle itself may also very well be identified in connection to profit attribution to PEs. 9

15 3. Permanent Establishments 3.1 Function of the PE concept. The PE concept can be found in domestic tax laws worldwide, DTCs and model tax conventions. It is arguably the most well-known concept in international tax law. If a DTC governs the tax relations between a foreign company s home state and its host state, then usually when a certain degree of economic penetration the PE threshold is reached, enough nexus to the host country exists and the host country receives taxing rights. 34 Reversely, this means that when the threshold is not met, i.e. income arising from the host state is small or not intimately connected to the economy of the host State, taxation by the host State is prohibited. This means that not every cross-border activity leads to tax liability. The justification of the PE threshold is threefold. First of all, it serves the broader goal of assigning profits to a source State. This can be regarded as a requirement of international justice. Secondly, when parts of income are attributed to the source State, this places a PE in a similar position as a local enterprise. In this, the PE concept aims at supporting neutrality between different forms of secondary establishments in that State. Thirdly, a threshold has practical justifications. By requiring a certain threshold for the applicability of the PE concept unnecessary compliance and administration costs are avoided. 3.2 Domestic tax law The definition of the PE concept is often wider under domestic law than under tax treaty law. Next to that, domestic tax law sometimes raises legal difficulties regarding the territorial scope for taxation of PEs as well as for determining taxable transactions. 35 Under most domestic laws residents are taxed based on their worldwide income, so they face unlimited tax liability, whereas non-residents are only taxed on their income which has its source in the State, so they face limited tax liability. Regarding the territorial scope of taxation of PEs, the difficulty lies in the fact that some States tax local PEs only on local income, where other States tax PEs by applying a special type of unlimited tax liability for local PEs. This difference regarding the territorial scope of taxation of PEs causes discrepancies between countries worldwide. 3.3 Art. 5 OECD Model Tax Convention Opposed to domestic law, the PE concept has developed under tax treaty law to the greatest extent, especially under the OECD MTC and the Commentary thereon. Art. 5 of the OECD MTC provides two PE thresholds. First, in art. 5(1) OECD MTC the PE threshold for a fixed place of business PEs is given and thereafter Art. 5(5) OECD MTC provides the PE threshold for an Agency PE. The wording of both 34 R. L. Williams, Fundamentals of Permanent Establishments, Den Haag: Kluwer Law International 2014, p E. Reimer, S. Schmid & M. Orell (eds.), Permanent Establishments, Alphen aan den Rijn: Kluwer Law International 2015, p

16 the threshold provisions will be given below. Since the threshold for a fixed place of business PE is not touched upon by the OECD in BEPS Action 7, it will not be discussed extensively. Furthermore, Arts. 5(2), 5(3) and 5(7) OECD MTC will only be stipulated, since BEPS Action 7 does not intend to revise those paragraphs. In contrast to those paragraphs, the wording of Arts. 5(4), 5(5) and 5(6) OECD MTC is highly relevant in the context of BEPS Action 7, therefore, their wording will also be given below. Art. 5(1) OECD MTC gives the general definition for physical PEs. Art. 5(1) reads: For the purposes of this Convention, the term permanent establishment mean a fixed place of business through which the business of an enterprise is wholly or partly carried on. From this definition several elements must be distilled. These are fixed, place of business and carrying on a business. To satisfy the fixed condition the duration (tempus) and the geographical fixation (locus) of a business activity must be tested. With place of business tangible property (situs) is meant. This can be immovable as well as movable property. Examples of place of business are an office, a workshop, but it could also be an oil well or a caravan. Together with the fixed condition, the place of business requirement provides a strong link with the land and the taxing powers of a State. 36 Thirdly, the requirement of carrying on a business must be fulfilled. This requirement can be divided into the right to use test (ius) and the business activity test. The business must be owned, rented or otherwise at the disposal of the non-resident company in order to fulfill the right to use test. To satisfy the business activity test it is mandatory that the business conducted really is the business of the nonresident company. Art. 5(2) OECD MTC provides a list of examples of potential PEs. It must be noted that a place mentioned in Art. 5(2) OECD MTC is not necessarily a PE. The requirements enumerated in Art. 5(1) OECD MTC must be met. Art. 5(3) OECD MTC hence gives special considerations for building - and constructing sites, as well as installation projects. After that, Art. 5(4) lists the specific activity examples. An activity at a place of business mentioned in Art. 5(4) does not constitute a PE. This paragraph has been one of the targets of BEPS Action 7. Because the proposed revision to the wording of this paragraph is an essential element of BEPS Action 7, it is worthwhile to take a look at the current wording of Art. 5(4) OECD MTC. The text of Art. 5(4) OECD MTC as it is currently applicable states: 36 E. Reimer, S. Schmid & M. Orell (eds.), Permanent Establishments, Alphen aan den Rijn: Kluwer Law International 2015, p

17 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 storing, display or delivery of goods 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. Thereafter, Paragraphs 5 and 6 of Art. 5 OECD MTC then deal with the Agency PE. This can be considered to be supplementary to the definition of a PE given in Art. 5(1) because of its first sentence stating notwithstanding the provisions of paragraphs 1 and 2. Article 5(5) OECD MTC is currently worded as follows: where a person other than an independent agent to whom paragraph 6 applies is acting on behalf on 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 The text of the currently applicable Art. 5(6) is: A 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 independent status, provided that such persons are acting in the ordinary course of their business. This definition in Art. 5(5) OECD MTC consists of various essential elements that require attention. First of all, there must be another person than the enterprise from one of the contracting States, this follows from the precondition acting on behalf of. This person must not be independent, by which both legally and economically independent is meant, as well as that a person may not be acting in his normal course of business. This person must have the authority to conclude contracts in the name of that enterprise and must habitually exercise that authority. This must then be done in the other Contracting State and the nature of the activities conducted must correspond with the activities of the enterprise. Especially the paragraphs regarding Agency PEs have been targeted by the OECD in BEPS Action 7. 12

18 Finally, Art. 5(7) OECD MTC states that if a company is controlled by another company, that company is not necessarily a PE of that other company. 3.4 Permanent establishments and BEPS When the OECD started identifying BEPS strategies, it stumbled upon tax avoidance strategies concerning PEs. These strategies essentially intend to avoid the PE status in another country, for instance by replacing arrangements with subsidiaries that always used to act as distributor by commissionaire arrangements, or through the splitting up of contracts or fragmentation of activities in order to stay under the PE threshold. In order to counter tax avoidance strategies with PEs, the OECD proposed to revise the PE definition in Art. 5 OECD MTC. Therefore, BEPS Action 7 is used, which specifically aims to prevent the artificial avoidance of PE status. BEPS Action 7 should, in conjunction with BEPS Action 6, restore taxation in situations in which taxation nowadays can be avoided or reduced to a very low amount because of tax treaty provisions and definitions. The OECD specifically targets the artificial avoidance of PE status through commissionaire arrangements and similar strategies. These strategies are commonly used in tax planning by MNEs and have been challenged in national courts on multiple occasions. A fortiori, the United Kingdom ( UK ) introduced a new tax, named the Diverted Profit Tax ( DPT ), which is aimed to counter aggressive tax planning that erodes the UK tax base. The tax should be applied in situations where profit is diverted either through insufficient economic substance or an avoided PE, which mainly targets commissionaire arrangements and similar strategies. However, the tax is controversial. 37 Recently, the Australian government announced that it will follow the UK s example and will implement a DPT as well. 38 What those arrangements and strategies entail will now first be clarified. First of all, it must be noted that the legal concept commissionaire only exists under agency law of certain civil law jurisdictions. In common law jurisdictions that legal structure does not exist. According to the OECD in BEPS Action 7, a commissionaire arrangement may be loosely defined as an arrangement through which a person sells goods in a State in its own name but on behalf of a foreign enterprise the principal that is the owner of these goods. 39 When a foreign enterprise makes use of this type of arrangements it is able to avoid having a PE in the country where the goods are sold, and, 37 P. Baker, Diverted profits tax: a partial response, British Tax Review 2015, 2, p See: 39 OECD (2015), Preventing the Artificial Avoidance of Permanent Establishment Status, Action Final Report, OECD/G20 Base Erosion and Profit Shifting Project, Paris: OECD Publishing 2015, p

19 for that reason, it is not taxable on its business profits derived there from those sales. This structure has been appraised by many tax advisors for many years, since it allowed an enterprise to reduce their tax exposure from sales activities. In more detail, the structure typically works as follows 40 : 1. A principal is typically an enterprise that is involved in the manufacturing and distributing of tangible property. 2. The commissionaire often is an associated enterprise or subsidiary of the principal, often within the same MNE group 3. The commissionaire will act as a sales agent for sales in the State in which it is located, and in doing so, it will not have to disclose its principal. When the commissionaire enters into a contract for the sale of goods, it will also take care of the subsequent invoicing and collecting, so allowing the principal to remain undisclosed. 4. The commissionaire then issues a purchasing invoice to its principal, in order to create a backto-back invoice that corresponds to the underlying invoice received from the customer 5. The legal title to goods is directly transferred from the principal to the customer. The commissionaire thus never takes title to goods it sells. 6. The principal remunerates the commissionaire for its services in its role as sales agent. Because the commissionaire never takes title to goods, it cannot be taxed on the sale of those goods. Also, by using a commissionaire arrangement an enterprise is able to avoid the application of Art. 5(5) OECD MTC concerning Agency PEs. For Art. 5(5) OECD MTC to be applicable a person in another state must have the formal ability to conclude contracts in the name of the enterprise, which is avoided by using a commissionaire arrangement. Commissionaires are sometimes compared to the undisclosed agent known under common law. However, the two legal structures do not fully resemble each other. 41 The confusion that may arise between common law and civil law practitioners stems from the different interpretations of the translation of the originally French term commissionaire. 42 Since a commissionaire often is an associated enterprise or a subsidiary the remuneration for the services it provides must be at arm s length. However, since a commissionaire typically assumes less risk and performs less functions than a distributor, the remuneration that has to be paid by the principal will consequently be much lower, as will be elaborated on later. Commissionaire arrangements were considered to be particularly attractive in certain situations. For instance, for US-based MNE groups, 40 J.B. Darby III, Commissionaire Arrangements are an Important Tool in International Tax Planning, Practical European Tax Strategies, 2006 (Vol 8), No. 7, p L. Parada, Agents vs. Commissionaires: A Comparison in Light of the OECD Model Convention, Tax Notes International 2013 (Vol. 72), No. 1, p J.F. Avery Jones & D.A. Ward, Agents as Permanent Establishments under the OECD Model Tax Convention, European Taxation 1993, May, p

20 which could obtain a foreign income tax deferral, if they deployed their distribution activities through a commissionaire. 43 The structure became popular in the 1990s. 44 Because MNE groups could potentially reduce their tax exposure significantly, the availability of the commissionaire structure triggered many business restructurings within MNE groups. The OECD recognized this practice and wrote a report on the transfer pricing aspects of business restructuring. 45 Therein the OECD recognized that since the mid-1990s business restructurings have often involved the conversion of fully-fledged distributors into low-risk distributors or commissionaires. 46 However, the OECD explicitly stated that it did not consider PE issues it its report. What must be kept in mind is that for the structure to be efficient, it is crucial that the commissionaire does not constitute a PE for its principal. The commissionaire structure has been surrounded by potential PE issues since it became popular. With similar strategies the OECD targets persons who typically operate as mere sales representatives/marketing agents. Sales agency contracts usually state that either: i) the agent has the authority to sign contracts for its principal; or ii) the principal itself signs the contract, with the sales agent merely acting as an intermediary a sales representative or marketing agent 47 for the sales. If a person acts as a mere sales representative or marketing agent it does not have the authority to conclude contracts for its principal, neither legally nor de facto. 48 Essentially, the functional capacity of an agent is stripped down. 49 There were some concerns whether so-called limited risk distributors ( LRDs ) would also be targeted by the OECD under similar strategies. 50 The OECD clarified that this is not the case. Hereinafter will be referred to marketing agents to describe what the OECD intends to target with similar strategies. To combat the artificial avoidance of the PE status through making use of commissionaire arrangements or marketing agents, the OECD proposes in BEPS Action 7 that sufficient nexus to a State, so a PE, shall exist if through the activities of a person contracts for the sale or leasing of goods or for the 43 A. Pleijsier, The Agency Permanent Establishment, Maastricht: Universitaire Pers Maastricht 2000, p ; D. Morgan, Selling out the centre, International Tax Review 1997, December/January, p D. Morgan, Selling out the centre, International Tax Review 1997, December/January, p OECD, Centre for Tax Policy and Administration, Report on the Transfer Pricing Aspects of Business Restructurings; Chapter IX of the Transfer Pricing Guidelines, 22 July 2010, available at 46 OECD, Centre for Tax Policy and Administration, Report on the Transfer Pricing Aspects of Business Restructurings; Chapter IX of the Transfer Pricing Guidelines, 22 July 2010, available at: see supra fn A. Pleijsier, The Agency Permanent Establishment, Maastricht: Universitaire Pers Maastricht 2000, p R. L. Williams, Fundamentals of Permanent Establishments, Den Haag: Kluwer Law International 2014, p R. L. Williams, Fundamentals of Permanent Establishments, Den Haag: Kluwer Law International 2014, p A. Pleijsier, The Agency Permanent Establishment in BEPS Action 7: Treaty Abuse or Business Abuse?, Intertax 2015 (Vol. 3), No. 2, p