BEPS: Practical Impact on Business Strategies Focus on Permanent Establishment Giammarco Cottani Ludovici, Piccone & Partners Bogotá, 17 November 2016
Agenda Action 7: Permanent Establishment Status Commissionaire arrangement Preparatory and auxiliary activity exemption Fragmentation of activities Permanent Establishment in digital economy Action 7 Discussion Draft: Profit Attribution to Permanent Establishment 2
Action 7: Prevent The Artificial Avoidance of the PE Status Develop changes to the definition of PE to prevent the artificial avoidance of PE status in relation to BEPS, including through the use of commissionaire arrangements and the specific activity exemptions Work on these issues will also address related profit attribution issues. 3
Commissionaire: A Typical Case X Co, resident of State X, is specialized in selling medical equipment At the end of 2000, these goods were sold in State Y by Y Co, a subsidiary of X Co, which is a full-fledged distributor As a result of the restructure of the group, in 2001 the functional profile of Y Co was converted into that of a commissionaire (i.e. transfer of tangible assets, inventories and customer lists to X Co) According to the commission contract, Y Co concludes contracts related to the sales of medical equipment with third parties in its own name but on behalf of X Co 4
Commissionaire: Changes Proposed to Art.5(5) & (6) Art.5(5) and amended Commentary on Art.5, para.32: commissionaire constitutes a PE if the entity: a. acts on behalf of the non-resident company b. does not qualify as an independent agent provided under para.6 c. habitually concludes contracts in name of the non-resident company, or negotiates the essential elements of contracts d. plays a principal role in the negotiation which substantially leads to the conclusion of the contracts (routinely concluded by the non-resident company) Practical impact: 1. presumably broaden the scope of the term conclusion of contracts 2. reinforce the requirements of independence for applying the exception under para.6 3. attribution of profits: OECD issued discussion draft on profit attribution to PE in July 2016, but the Italian International Decree has already addressed this topic by referring to AOA under Art.7, c.5, letter b 4. limited impact of Action 7 currently as Italian jurisprudence has anticipated BEPS 5
Boston Scientific case (Cass. 3769/2012) BS BV For determining the non-existence of a PE, the commissionaire: must not have the ability to bind the principal against a third party; the management process of orders must depends on the approval of the principal Delivery of goods BS ITALIA Sales of products Sales of products Commission contract the orders of purchases are processed by the commissionaire and sent to the principal, which executes the orders economically and logistically, with the commissionaire having no warehouse on its own must be independent from the principal in terms of the risk profile of the enterprise in case of product deficit, clients are only able to act vis-a-vis BS ITALIA ITA MKT BS ITALIA is able to determine by themselves to extend credit to clients 6
The Requirement of Independence: The IFF Case (Cass. 40327/2014) Sales of goods IFF LUX IFF Italia Delivery of goods Manufacturing contract The court rejects the existence of a PE of the Luxembourgish company at the Italian company due to: the impossibility for IFF Italia to determine by itself the type and quantity of the goods produced; the lack of autonomy of accepting the orders; IFF Italia is not involved in the management of product quality disputes. It is irrelevant that: the products are stored in the warehouse of IFF Italia; the goods are delivered to clients from IFF Italia. ITA MKT The non-existence of PE in Italy is substantially by virtue of IFF Italia s lack of wide and general autonomy related to management, decision-making, and programming. 7
Preparatory or Auxiliary Activity Exemption: 2015 Final Report Art.5(4) is changed in such a way that the requirement of preparatory or auxiliary ( p&a ) nature that was previously provided under letter e and f is not applicable to all the activities under para.4 Amended commentary on Art.5, para.21.2 provides that an activity that has a preparatory character is one that is carried on in contemplation of what constitutes the essential and significant part of the activity of the enterprise as a whole Example: a fixed place used for warehousing, exhibition, or delivery of goods for the non-resident enterprise The determination of the p&a character must be made based on the facts such as size of the space used regarding the business of the enterprise Practical impact: potential uncertainty (which may lead to more disputes) regarding the interpretation of the terms essential and significant part of the activity and a significant portion of the assets or employees 8
Practical Impact: An example of a controversial case The toll manufacturer (i.e. manufacturer on order) produces all the products sold from the non-resident enterprise to other group members The activity of the toll manufacturer includes packaging and the transformation from semi-finished products to finished goods The quality control on both the raw materials supplied by the non-resident enterprise and the finished goods are carried out by the toll manufacturer The toll manufacturer is responsible for ensuring that the products are consistent with the EU standards and obtaining the relevant certificates In light of the changes made to Art.5(4) OECD MC, the toll manufacturer, if the conditions under para.1 are satisfied, could be considered as constituting a PE as it plays an essential part of the activity which is the core business of the nonresident enterprise 9
Fragmentation of Activities: The OECD Position The current OECD Commentary on Art.5, para.27.1 specifically addresses the case where a single undertaking is artificially divided into several operations in order to claim the nonexistence of a PE for each operation due to its p&a character BEPS Action 7 inserts a new para.4.1 the key element of which is the identification of complementary functions that are part of a cohesive business operation The exemption referred to in para.4 does not apply to a fixed place used by the non-resident enterprise if (i) the same enterprise or (ii) a closely related enterprise carries on a business in the same or another place and I. that place or other place is a PE for the same enterprise or the closely related enterprise; II. 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; and III. 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 constitute complementary functions that are part of a cohesive business operation 10
The Fragmentation in the Jurisprudence: The CEPU Case (Cass. 20597/2011) CEPU San Marino It is possible to confirm the existence of a PE fees based on sales of the non-resident enterprise in case of multilocations managed in a unitary way The determinant element is the economic Sales of goods warehouse warehouse warehouse advertising fees integration of various locations fragmented throughout the territory and the fact that they are all subject to the direction of the foreign Supply of goods enterprise for achieving its business purpose ITA MKT 11
Action 7: PE in Digital Economy Amazon order of delivery online order delivery of goods New Art.5(4) PE Parent Co. online deals New Art.5(5) & (6) Sub Co. solicits orders and negotiates all details of the contract 12
July 2016 Action 7 Discussion Draft: Arm s Length Principle under Art.9 vs AOA under Art.7 X Co 100% Y Co (DAPE) contracts Country A Country B delivery of goods X Co engages Y Co as its sales agent in country B; Y Co does not have any other principal than X Co Y Co is responsible for: identifying customers, soliciting, placing and processing customer orders providing marketing and advertising services by implementing locally the marketing and advertising strategies devised by X Co, with X Co reimbursing all the relevant costs warehousing the inventory; determining and monitoring the appropriate inventory levels required to fulfil customer orders setting the parameters within which credit can be extended to customers X Co concludes contracts with the customers, retains the title to inventory until it is delivered to customers and contractually bears the credit and inventory risks Y Co constitutes a Dependent Agent PE ( DAPE ) of X Co under the new Art.5(5) & (6) as it substantially negotiates all the elements of the contract and plays a principal role leading to the conclusion of contracts 13
July 2016 Action 7 Discussion Draft: Arm s Length Principle under Art.9 vs AOA under Art.7 Step 1: Analysis under Art.9 What is the arm s length price for the controlled transaction between X Co and Y Co? X CO (Country A) Sales income 200 -COGS (40) Gross profit 160 OPEX -Sales commission to Y Co (30) -Reimbursement of advertising expenses to Y Co (7) Operating Profit 123 Funding return from Y Co 2 Net profit 125 Though X Co is the legal owner of the inventory, the inventory risk is actually borne by Y Co; X Co as the legal owner is only entitled to an appropriate funding return. Y CO (Country B) Income from sales commission 30 -OPEX (other than advertising expenses by X Co) (8) -Bad debt losses (4) -Inventory losses (3) -Warehousing (6) Operating profit 9 Funding return to X Co (2) Net profit 7 Though the credit and inventory risks are contractually allocated to X Co, but the actual conducts of the parties indicate that Y Co is the entity that has control over these risks as well as the financial ability to bear these risks. 14
July 2016 Action 7 Discussion Draft: Arm s Length Principle under Art.9 vs AOA under Art.7 Step 2: Authorized OECD Approach ( AOA ) under Art.7 How much profit may be attributed to the DAPE of X Co in country B? Economic ownership of the receivables of 200 is allocated to the DAPE due to the analysis of the significant people functions it performed. Issue: the same functional profile renders 30 income to Y Co but 200 to DAPE; different analysis between Art.9 and Art.7? Credit and inventory risks are economically allocated to the DAPE, but actually assumed by Y Co (same reason as the analysis under Art.9). The funding return is allocated to DAPE as the economic ownership of inventory is allocated to it. DAPE (Country B) Sales income 200 -COGS (170) Gross profit 30 OPEX -Sales commission to Y Co (30) -Bad debt losses (0) -Inventory losses (0) -Warehousing (0) Operating profit 0 Funding return from Y Co 2 Net profit 2 What about countries that do not adopt AOA? 15
Conclusions The threshold of PE status has been largely lowered as a result of BEPS Action 7 Establishment of PE is not the end of the story; profit that may be attributable to the new types of PEs might be limited There are still a lot of uncertainties with regard to the profit attribution to PEs, especially in terms of: the interaction of AOA with the application of arm s length principle under Art.9 lack of consistent adoption of AOA among all the countries pending guidance by OECD 16
Thank you.