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Published: Fri, 02 Feb 2018
Increased Risk of Unintended Permanent Establishments
The Organisation of Economic Co-operation and Development (OECD) Council approved the revised Commentary on the seventh edition of the OECD Model Tax Convention, and the Final Report on the attribution of profits under Article 7 of the OECD Model Tax Convention, to Permanent Establishments (PE) on the 17th and 18th of July 2008. The Report and Commentary sought to provide clearer guidelines on the attribution of profits; most commentators agree this objective has been achieved. This paper will focus on the question of whether The Report and revised Commentary, in addition to providing clearer guidelines on Article 7 also increase the risk of discovering an unintended permanent establishment. This paper will conclude that the Report and revised Commentary provide an incentive for a permanent establishment to be found to co-exist with an already existing subsidiary of the MNE in the source country. This paper will also explore the consequences of an unintended permanent establishment, and the possible actions the taxpayer may take in response.
(INTRO IS LONG-WINDED) perhaps divide the sentence with a full stop. And say It also approved the report.
The Organisation of Economic Co-operation and Development (OECD) Council approved the revised Commentary on the seventh edition of the OECD Model Tax Convention, and the Final Report on the attribution of profits under Article 7 of the OECD Model Tax Convention, to Permanent Establishments (PE) on the 17th and 18th of July 2008 . The Report and Commentary sought to provide clearer guidelines on the attribution of profits; most commentators agree this objective has been achieved . Perhaps, the more interesting point to be gleaned from this Report and the revised Commentary that followed it is that the OECD’s guidelines on interpreting Article 7, could broaden the tax base of source countries, and leave MNE’s (multinational enterprises) with unintended permanent establishments. The Report and revised Commentary provide an added incentive for a permanent establishment to be found to co-exist with an already existing subsidiary of the MNE in the source country.
The potential for discovery of unintended permanent establishments, in light of the report and commentary is heightened. Thus, the Report and Commentary provide a new wave of opportunity for taxing authorities of source countries, and the possible corollary of this will be an increase in threats posed to the interests of MNE’s.
Please note this paper will focus on the revised Commentary and part I of Report, thus leaving part II (applies to financial institutions), III (applies globally traded financial instruments) and IV (applies to insurance companies), and all their repercussions outside the scope of this paper
The concept of the permanent establishment is an important facet of International taxation. The general rationale is that a source country only has taxing rights over foreign Enterprises that have a permanent establishment in the source country’s territory. The idea of the permanent establishment is reflected in the language of the U.S. tax code; a foreign Enterprise is liable to pay US taxes on income ‘which is effectively connected with the conduct of a U.S. trade or Business’ . The concept of the permanent establishment is also defined in Article 5 of the Model Treaty. Article 5 of the Model Treaty lists examples of a fixed place of business; the list, though lengthy, is by no means exhaustive. Generally, the term permanent establishment means a fixed place of business through which the business of an enterprise is wholly or partly carried on, the permanent establishment is not a temporary place of business, nor is it a place of preparation that is auxiliary in character. An agent of an Enterprise can also constitute a permanent establishment in a source country if the agent routinely concludes contracts in the name of the principal, however the definition does not extend to independent agents.
On 17 July 2008, changes to the commentary on Article 5 were approved by the OECD council. The new commentary clarifies that “the existence in one State of a permanent
establishment of one company of the group will not have any relevance as to whether another
company of the group has itself a permanent establishment in that State” Put simply, it is possible to have side-by-side permanent establishments in the same tax jurisdiction. Once it has been determined that a permanent establishment exists, the question to then be answered, is how much of the Enterprise’s taxable income should be attributed to the permanent establishment.
‘Functionally Separate Entity’ approach vs. ‘Relevant Business Activity’ approach
Paragraphs 1 and 2 of Article 7 of the OECD draft Model Treaty states that: The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment. …(W)here an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.
Prior to the report, there were divergent opinions among source countries, as to the correct interpretation of Article 7 . The two interpretations of Article 7 have been the ‘functionally separate entity’ interpretation, and ‘relevant business activity’ interpretation.
The ‘functionally separate entity’ interpretation attributes to the permanent establishment, profits it would have earned “at arms-length if it were a separate and distinct entity performing the same or similar functions under the same or similar conditions” , whereas, the ‘relevant business activity’ interpretation refers only to profits of the business activity in which the permanent establishment participated. The problem of having two conflicting interpretations of Article 7 is highlighted when the source country uses one interpretation and the Enterprise’s resident country uses another, because this leads to double or less than single taxation .
The ‘relevant business activity’ interpretation is generally seen by the OECD to be the more ambiguous of the two interpretations . The ‘relevant business activity’ interpretation only includes profits from business activities in which the permanent establishment participated, also, the profits attributed to the permanent establishment in the ‘relevant business activity’ approach is limited to the profits made by the whole enterprise from the specific activity, and the profits of the Enterprise are those made from transactions with third parties and associated enterprises . Further, the interpretation is more restrictive when interpreted to mean that profits can only be attributed to the permanent establishment when the activity of the Enterprise is carried out in the source country’s jurisdiction . Contrarily, profits attributed to a permanent establishment based on the ‘functionally separate entity’ approach interpretation are not limited to the profits of the Parent Company or Enterprise, but rather determined by the profit the permanent establishment would have earned if it was a separate legal entity dealing with the enterprise at arms-length. In other words, the ‘functionally separate entity’ approach, through a mechanism analogous to the ‘arms-length’ approach under Article 9 of the Model Treaty, allows for the attribution of profits to the permanent establishment, irrespective of the worldwide profits of the Head Office .
The fiction of a Separate Entity increases the possibility of an unintended Permanent Establishment.
The basic premise of the ‘functionally separate entity’ approach is that profits should be attributed to a permanent establishment as if it were a legally separate entity, detached from the Enterprise and engaged in arms-length dealings with the latter. This fictional arrangement is somewhat similar to the pricing of transactions between related parties as stated in Article 9 and the OECD Guidelines (transfer pricing). However, in a related-party transaction between parent and subsidiary, or brother/sister corporation – the entities are usually separate legal entities and have separate accounting records. The same cannot be said of the permanent establishment. “[T]he permanent establishment and the head office are part of the same legal entity, it is not possible to transfer risks, with any legal effect, from one to the other. A permanent establishment is simply a fiction for the purposes of allocating taxing rights; it is still the same legal entity as the head office”
The fiction of ‘functionally separate entity’ is aided by a two-step analysis. The first is the factual and functional analysis, and the second is the pricing of the ‘dealings’ between the permanent establishment and the Enterprise or Head office. The results from the two analyses are supposed to allow for the calculation of the profits or losses of the permanent establishment, thereby deciding what the permanent establishment’s taxable income is.
The factual and functional analysis allocates risks and assets to the permanent establishment. The risks are allocated in accordance with the functions performed by the people in the permanent establishment, and the assets are also allocated to permanent establishment according to the functions of the people in the permanent establishment to the extent that their actions are relevant to the economic ownership of the assets, and assumption of risk. The Functional and factual analysis takes into consideration the facts and circumstances in determining the apportionment of risk and assets.
The July Report directs us to apportion risk to the permanent establishment, in proportion to the extent the people in the permanent establishment are involved in ‘active decision making’ that accepts or manages the risk. Further, the report states that capital follows risks. Therefore, the capital would be attributable to the part of the organisation that bears this risk.
The risks and assets of the PE can then be transferred to the enterprise, giving rise to an economic transaction, which in turn gives rise to a taxable event. These transactions are otherwise known as ‘dealings’. The following example illustrates the point:
An Enterprise that has its head office in Country A (subject to U.S. GAAP for purposes of this paper) desires to expand its operating capacity in Country B, where it already has an existing subsidiary. It routinely sends employees of the Head Office from Country A to Country B, to assist the existing subsidiary in carrying out the planned expansion. The employees sent to Country B are given some discretion in their decision making, e.g. the hiring of more staff in Country B, overseeing the installation of new equipment in Country B, and marketing the products of the Enterprise as well as its subsidiary in Country B. The question of whether or not the employees seconded to Country B, create a permanent establishment for the Head Office is one of fact, and will hinge upon the requirements of Article 5. Assuming the bilateral tax treaty between Countries A and B is based on the OECD Model Treaty, it is possible the head office will be deemed to have a permanent establishment alongside the existing subsidiary under Article 5 (1) – a fixed place of business through which the business of the Enterprise is carried on wholly or in part. The discovery of this unintended permanent establishment then raises the question of how much of the Head Offices profits, reported in Country A, should be attributable to its new permanent establishment in Country B.
Following on the above hypothetical, the taxing authority of Country B (the source country) could argue, based on the ‘facts and functional’ analysis that the employees seconded to Country B, bore the risks of the decision to implement methods of marketing the subsidiary and the head office through ‘active decision making’. If the risks and assets associated with it is apportioned to the employees seconded, (the deemed permanent establishment), and the permanent establishment is not a registered enterprise in Country B, and files no tax returns in Country B, the report says the Head office and the permanent establishment are deemed to have entered into a fictional transaction, otherwise known as a ‘dealing’ and the pricing of this transaction is to be decided by analogously applying the rules in Chapter I of the ‘Guidelines’. The methods used in the ‘Guidelines’ for determining the pricing are CUP, cost-, and resale price. The report provides for additional profit-splitting methods like TNMM, and profit split where the three aforementioned methods cannot be relied upon.
Taxpayers are encouraged to keep documentation of the ‘dealings’. The taxing authorities are required to give effect to the documentation maintained by the Enterprise as long as they reflect the economic substance of the activities, and the documentation shows the pricing and terms are comparable to what would have otherwise been the case if the two parties were legally separate entities. Although the report states that the documentation requirements are not meant to be more burdensome than the requirements under Article 9, some commentators argue that the documentation requirements for the dealings under Article 7 are more burdensome than those currently required under Article 9.
The preceding paragraphs have shown that the OECD has authorised an approach to Article 7 that supports the ‘fiction’ of intra-company transactions within one legal entity. They have also shown the OECD’s preferred methods for attributing profits between the Enterprise and the permanent establishment. These developments will not only bring much desired consistency to this area of International Tax, but could well be a signal of intent on the part of the OECD to encourage Source Countries to pro-actively seek out means to tax MNE’s.
Based on the facts illustrated in the above hypothetical, the profits attributed to the new permanent establishment will not be determined by the overall profits of the Enterprise, but rather, the fiction of the Separate Entity allows Country B, to attribute profits to the activities of the seconded employees, (to the extent it carried on business for the head office in Country B) as though the seconded employees were an independent economic and legal entity providing a service for an arms-length price. One effect of this arrangement is that Country B, has an incentive to actively seek out permanent establishments within its tax jurisdiction. In comparison, the ‘Relevant business activity’ approach would only reach the percentage of the profits attributable to the actions of the permanent establishment. An Indian case decided in 2007 serves as an example.
In the case of Rolls-Royce PLC v DDIT , the Income Tax Appellate Tribunal (Delhi) held that the Indian subsidiary of Rolls-Royce PLC(RRPLC); Rolls-Royce India Limited(RRIL), incorporated in U.K, which had an office in India, constituted a permanent establishment of RRPLC in India. The Tribunal’s conclusion in this respect was founded on Article 5(1) (among others) of the Double Taxation Avoidance Agreement (DTAA) between the U.K. and India. Briefly, Article 5(1) of the DTAA states that a permanent establishment will be found to exist where any non-resident or foreign enterprise has a fixed place of business in the Source country. The Tribunal mentioned inter alia, that the Indian Office, although registered in the name of the subsidiary (RRIL), is maintained by the Head Office (RRPLC), and available for use by employees of the latter. Furthermore, RRIL’s Indian office provided RRPLC with services like arranging visits to India, planning conferences, indentifying potential market opportunities for RRPLC, and taking orders for the RRPLC. The above stated activities of RRIL’s Indian office led the tribunal to conclude that RRPLC did have a permanent establishment in India. Global profits of RRPLC deriving from sales to Indian customers were attributed to the permanent establishment based on the activities conducted in India by RRPLC’s permanent establishment. The court held that 50% of the global profits (from sales to Indian customers) were a result of manufacturing, 15% as result of Research and development, and 35% of the profits were a result of marketing. As a result, 35% of the global profits of RRPLC as a result of sales to Indian customers were held to be subject to Indian tax because of the marketing activities of the RRIL’s Indian office on behalf of RRPLC. The Court adopted the relevant business approach in the Rolls-Royce case. If the facts of the Rolls-Royce case were different, and the Enterprise made an overall loss, there would be no profits attributed to the permanent establishment, based on the ‘relevant business activity’ interpretation. This is highlights the benefit of the ‘functionally separate entity’ interpretation to tax authorities, and also, perhaps, the new incentive for tax authorities to seek out permanent establishments.
The Application of the Report and Commentary
The findings of the Report are to be fully implemented in the new Article 7 of the OECD Model Treaty scheduled to be released in 2010. However, elements of the ‘Report’ not conflicting with the present Article 7 have been engrafted to the existing commentary. As a result, the ‘functionally separate entity’ interpretation can be used by tax authorities when considering the meaning of Article 7, or similar provisions in bilateral treaties.
Consequences of Unintended Permanent Establishments
One natural result of an unintended permanent establishment is an unforeseen tax liability. If the resident country, in the example above – Country A, has a foreign Tax Credit system, and does not dispute the tax levied on the permanent establishment by Country B, then the effects of the unintended permanent establishment, and new rules on attribution of profits may be limited, except for a possible difference in tax rate, which may be significant, depending on the mechanics of Country A’s Foreign Tax Credit system. If Country A, however, dispute the findings of Country B with regards to the attribution of profits to the deemed permanent establishment, the Enterprise could find itself subject to double taxation.
A second possible consequence of seconding employees to Country B in the above example could find themselves subject to tax in Country B. As pointed out by the TEI in its response to the commentary , where an unintended Permanent establishment is found to exist, not only will the MNE’s find themselves potentially subject to double taxation, but they could under Article 15 of the Model Treaty, find its employees having to pay income taxes in the source country. Article 15(1) and (2) state that if individuals exercise their employment in the source country, and are there for over 183 days, and the cost is borne by the permanent establishment, then their income will be taxable in the source country. The question of whether or not the permanent establishment has ‘borne the cost’ as a result of risks and costs being attributed to it under the fact and functional analysis is not explored in the ‘Report’. Consequently, this could potentially broaden the tax base of the source countries, and create cases of double taxation if the source countries decide to explore this avenue of taxation. It remains to be seen whether the OECD will adopt the recommendations of TEI and provide clarity with regards to the relationship of the attribution rules under Article 7, and costs borne by the permanent establishment under Article 15.
Admittedly, double income taxes for employees may be an insignificant matter for large Multi-National Enterprises, but the same may not be true for start-up companies/individuals who provide goods and services internationally, and who are without the financial power of the larger MNE’s. This point resonates with reports by the UNCTAD (United Nations Conference on Trade and Development) and the OECD on the trends of FDI (foreign direct investment), both reports point out increased FDI by non-multinational enterprises.
A third possible consequence of unintended permanent establishments could be a Financial Restatement for the Head Office/Enterprise. Multinational Enterprises that use U.S. GAAP in reporting financial statements are subject to FIN48 , which states the threshold for recognising uncertain tax positions in a financial statement. A tax position is ‘a position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods’ . FIN48 informs us that a ‘tax position’ also extends to a decision not to file a tax return. Thus, a decision by the Head Office (in the above hypothetical) not to file tax returns for the work conducted by its employees seconded to the source country (the deemed permanent establishment), or a decision not to include its increased tax liabilities on its statements, as a result of profits being attributed to the deemed permanent establishment, would constitute a tax position, and bring it under FIN48 .
After a ‘tax position’ is taken, the question of whether or not the tax benefit accruing from such a position should be recognised is also addressed in FIN48. The recognition rule involves a two-step approach. Step one is that a tax position should only be recognised if the Taxpayer believes the position has a more-likely-than-not chance of being sustained by the relevant tax authority . Then, after it is determined that a tax position meets the more-likely-than-not standard, further examination is conducted to determine how much of the benefit the Taxpayer is allowed to recognise on its books, based on the likelihood of the position being sustained after settlement between the Taxpayer and the taxing authority. This is determined by measuring the tax benefit that has a more than 50% cumulative probability of being realized after examination under the FIN48 rules. Based on the example shown below, if a company has $100 of tax benefit that is more- likely- than-not to be sustained by the taxing authority, the tax benefit to be ultimately recognized in the financial statement is $60, because this figure has over 50% cumulative probability of occurring.
Possible Estimated Individual Probability Cumulative Probability
Outcome of Occurring (%) of Occurring (%)
$ 100 10 10
$80 20 30
$60 25 55
$50 20 75
$40 10 85
$20 10 95
$0 5 100 Figure 2
A ‘tax position’ as described by FIN48 has been said to extend to the allocation of income between jurisdictions . This means that any ‘tax position’ taken by an MNE as a result of the attribution rules in Article 7, now clarified by the OECD Report and Commentary, could have far reaching consequences, and in more extreme situations, a miscalculation of the sustainability of a stated tax position could lead to a financial restatement.
An unintended permanent establishment could also lead to the discovery of a ‘material weakness’ in the internal controls of the Head Office. Section 404 of the Sarbanes-Oxley Act states that companies should examine their internal controls affecting financial reporting annually, and to correct any deficiency found. Failure to correct any deficiency means the company will have to report it as a material weakness in statement by management, certified by the company’s Auditor.
In the above hypothetical, an unintended Permanent establishment in Country B, that creates significant tax liabilities, that compel the Head Office in Country A to re-state its financial reports will put the Head Office under the spotlight, and attract questions from the regulatory authorities in Country A as to how and why material weaknesses in the Head Office were not disclosed by the company and its auditors . Therefore MNE’s may well want to re-examine their presence in any and every tax jurisdiction.
Possible Taxpayer Responses
One way of limiting the effect of unintended permanent establishments is to maintain contemporaneous documentation showing ‘a dealing that transfers economically significant risks, responsibilities and benefits’. Tax authorities are to give effect to such documentation, if the documentation reflects the economic substance of the ‘dealing’, and the arrangement of the ‘dealing’ does not differ from comparable arms-length arrangements between legally separate entities. The usefulness of this provision will depend upon the internal procedures of the Head Office/Enterprise. That is, if they documented the activities undertaken by the seconded employees in Country B in a way that satisfies the requirement of the OECD Report and Commentary. Further, in a situation akin to the above hypothetical, it would be rare for an Enterprise to maintain contemporaneous documentation for a permanent establishment that it does not intend to create, or one that it does not anticipate will be created.
Although not mentioned in the Report or the Commentary, it is possible that the OECD may adopt the Tax Executive Institute’s recommendation and include in the new Article 7, a ‘grace period’ for Enterprises to come up with the contemporaneous documentation. However, as the Model Treaty stands now, Enterprises will do well to extensively document activities carried out in foreign tax Jurisdictions, no matter the vehicle of its operation.
Going back to the above hypothetical, one other way the Enterprise can limit the effect of the unintended permanent establishment is to indefinitely transfer employees seconded to the subsidiary in Country B. This scenario does not change the existence of a permanent establishment in Country B, for a subsidiary can also be a permanent establishment, however the benefit of using the subsidiary is that, unlike an unintended permanent establishment, it would have separate accounting records, thereby making it easier to fulfil requirements of maintaining contemporaneous documentation.
If the Enterprise fails to maintain contemporaneous documentation that allows it to avoid taxation in Country B, the Enterprise may still use the Mutual Agreement Procedure, available under Article 25 of the OECD Model Treaty , to minimize the effects of the unintended permanent establishment. The Enterprise will have to present its case to the competent authority in Country A, and the competent authority will thereafter, if it finds that the Enterprise has good ground for its objection to paying taxes in Country B, endeavour to resolve the matter with the competent authority of Country B. If the Enterprise wishes to follow this route, it must do so within a set time frame (3 years in the Model Treaty).
In addition to the Mutual Agreement Procedure (MAP), the Enterprise may enter into an Advance Pricing Agreement (APA), either unilaterally with the competent authorities of Countries A and B respectively, or bilaterally – between Country A, the Enterprise, and Country B. The advantage of the MAP, when compared to the APA, is that, by definition, APA’s envisage a prospective agreement, and as stated earlier, unintended permanent establishments, are usually just that- unintended. However, recent developments in some tax jurisdictions allow for the retroactive application of APA’s (rollbacks) to past fiscal years not barred by statutory limitations. Furthermore, there have also been developments that allow APA’s to be used in resolving issues relating to the attribution of profits to a permanent establishment.
When the issue of an unintended permanent establishment arises, the Enterprise may seek to engage the competent authority of Country B in an APA agreement that looks back to past fiscal years when the permanent establishment has been operating in Country B, as well as to the future activities and dealings of the permanent establishment. The object of the exercise would be to meet an agreement that least disturbs tax reserves and past financial statements. If this fails, then the Enterprise may want to consider bilateral APA’s (if possible, rollbacks) and MAPs.
The July 2008 Report and Commentary on the Attribution of Profits to permanent establishments have brought a degree of clarity to this area of the International tax regime, but their interpretation of Article 7 coupled with the existing commentary on Article 5 allowing for multiple permanent establishments increases the risk of unintended permanent establishments by providing source countries with an incentive to actively seek them out. This paper has shown that the OECD’s Authorised approach, when compared to the ‘relevant business activity’ approach has the potential to broaden the tax base of source countries.
An unintended permanent establishment brings with it a myriad of consequences. Only a portion of those consequences have been explored in this paper, most notably the effects of undisclosed tax liabilities to financial statements. The issue of undisclosed tax liabilities may be further exacerbated if the Enterprise in question is a publicly traded company, because of the potential effects any such exposure could have on investor-relations, and the market value of the Enterprise.
This paper has also explored the possible taxpayer responses to an unintended permanent establishment, the available remedies (APAs and MAPs) could help reduce future tax liabilities, but their application to past economic activities of the permanent establishment is less certain. Furthermore, the outcome of any such agreement is dependent on the disposition of the competent authority and therefore is largely outside the taxpayer’s control. Against this backdrop, an old adage, ‘prevention is better than cure’ rings true, and in this spirit, does the writer respectfully submit that MNE’s would do well, in light of the OECD Report and Commentary, to take a second look at their world-wide operations.
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