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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
In a recent commentary, I discussed the final language of the BEPS Action 7 work on Preventing the Artificial Avoidance of Permanent Establishment Status,1 to be incorporated into Article 5(5) of the OECD Model Tax Convention on Income and on Capital (OECD Model). As noted in that commentary, the revisions to the deemed permanent establishment (PE) standard ultimately approved by the OECD/G20 introduced a new threshold for creating direct tax nexus of a nonresident. Under the new threshold, a dependent person can create direct tax nexus for the nonresident if that person "habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification" by the nonresident, and those contracts are for the transfer of ownership or the right to use property owned by the nonresident, or for the provision of services by the nonresident.2 This new standard will put PE pressure on many sales and marketing operations that are now structured as service providers to the nonresident supplier.
The final Action 7 report also, however, provides new guidance to be included in the Article 5 Commentary that generally provides PE protection if the sales and marketing entity is restructured into a reseller. This commentary will discuss the reseller option, and address the most common issues that have emerged so far in planning a structure to fall within the scope of the new Commentary guidance.
The broad statement of the general rule that creates a deemed PE if the in-country activity leads to contracts "for the transfer of ownership [or] … the provision of services" had given some commentators concern that commercial structures involving drop shipments of goods or indeed any sales through limited risk distributors might be described under the new PE standard. Those concerns have been addressed in new Commentary, to be included in the Article 5 Commentary. The new paragraph 32.12 states as follows:32.12 The cases to which paragraph 5 applies must be distinguished from situations where a person concludes contracts on its own behalf and, in order to perform the obligations deriving from these contracts, obtains goods or services from other enterprises or arranges for other enterprises to deliver such goods or services. In these cases, the person is not acting "on behalf" of these other enterprises and the contracts concluded by the person are neither in the name of these enterprises nor for the transfer to third parties of the ownership or use of property that these enterprises own or have the right to use or for the provision of services by these other enterprises. Where, for example, a company acts as a distributor of products in a particular market and, in doing so, sells to customers products that it buys from an enterprise (including an associated enterprise), it is neither acting on behalf of that enterprise nor selling property that is owned by that enterprise since the property that is sold to the customers is owned by the distributor. This would still be the case if that distributor acted as a so-called "low-risk distributor"as long as (and not, for example, as an agent) but only if the transfer of the title to property sold by that "low-risk" distributor passed from the enterprise to the distributor and from the distributor to the customer (regardless of how long the distributor would hold title in the product sold) so that the distributor would derive a profit from the sale as opposed to a remuneration in the form, for example, of a commission.
The strike-out and underlined text shows deletions and additions to this Commentary which were added after the last public Discussion Draft.3 Many of the interpretative questions arising from the new guidance deal with the significance of those late additions.
The first addition makes it clear that there is no need for the reseller to take possession of the goods that are sold to customers. Goods can be drop-shipped by the provider to the customer. The example given in the new Commentary makes it clear that the reseller may acquire only flash title in the goods delivered to the customer. In the case of digital goods, delivery can be made through electronic transmission directly from the nonresident supplier to the user. Similar principles apply to the provision of services, in that the service can be delivered directly by the nonresident, and does not need to be performed by the reseller itself.
The express reference to a "low-risk distributor" makes it clear that an allocation of commercial risks between the nonresident supplier and the reseller that minimizes the risks borne by the reseller does not in principle disqualify the structure from providing the intended PE protection.
The new Commentary provides one example of a reseller that achieves PE protection. In the context of a structure that involves flash title, the Commentary notes that PE protection is achieved when the reseller acquires title from the supplier and passes title to the customer. There is no example given that addresses digital goods, where the user agreements frequently describe the transaction as the grant of a right to use as opposed to a "sale" of an item of property. In many cases, the user agreement will be granted by the IP owner, and not by the reseller which deals with the user. That arrangement is favored by many companies in order to best protect their IP rights in the digital good. However, if that sales intermediary is the entity that is contracting in its own name with the user to deliver the digital good, there is no reason to consider that such IP protection arrangements should detract from the status of the sales intermediary as a reseller.
There also is no example that addresses services, where again there is no "title" to the item that is being delivered. Given that the Commentary clearly refers to services being sold through resellers, however, the absence of a services or digital goods example should not be an impediment to enterprises in those sectors taking advantage of the reseller PE protection. Similarly, there is no basis to exclude entities acting as licensees/sublicensors, lessees/sublessors, or in other similar commercial capacities from this protection.
The more interesting issues are raised by the two additions to the text emphasizing that the reseller should not be acting "as an agent," and that the distributor should "derive a profit from the sale as opposed to a remuneration in the form, for example, of a commission." As noted, those two statements were added to the draft Commentary after the last public Discussion Draft. There is no text in the final Action 7 report that illuminates the purpose of those late additions.
The new text raises the concern that there was some backtracking at the last minute on the concept that all resellers provide absolute PE protection. In particular, some concern has been raised that these additions might encourage a tax authority to challenge a reseller arrangement as providing PE protection, if the compensation mechanism for the reseller entity resembles too much those typically used for sales and marketing service providers.
Such a challenge would be an inappropriate limitation on the clear rule established by the Commentary that a reseller provides PE protection. Instead, those additional statements should be interpreted to confirm the principle that if the sales entity is acting as a reseller, as described under applicable commercial law, then the PE protection has been achieved.
Commercial law provides definitions that distinguish the status of an agent from that of a reseller. For example, California law distinguishes the two as follows: a reseller arrangement is present when a party contracts to buy goods from another party to sell as his or her own. In that case, the buyer is only liable to the selling party as a debtor for the price of the goods purchased. In contrast, an agency relationship arises if one party takes the goods as the property of the principal, subject to the control and right of recall of the principal, and the principal has the right to receive the proceeds when such goods are sold, less the selling party's commission.4 An agent represents the principal in dealings with third parties.5 The contract's designation as an agency (or consignment) contract is not necessarily determinative. California courts, in determining the nature of the commercial arrangement, will look to the particular rights of the parties involved.6 Therefore, if the distribution contract is governed by California law and the relationship is described under California law as a reseller, that should end the PE issue.
Relying on a commercial law distinction would seem to provide a firmer interpretative backbone to the rule than relying on other possible points of reference, such as financial accounting standards for distinguishing between gross and net revenue recognition. Entities that sell goods or services in their own name do not always report the full customer revenue as their own gross receipts. Financial accounting standards describe the circumstances when a seller may appropriately report its revenue as net of certain payment obligations it may have to other parties.7 Those standards generally focus on the allocation of commercial risks between the parties, as opposed to the strict commercial law relationship. In many cases, a close facts and circumstances analysis is required to determine whether gross or net revenue reporting is the most appropriate in the circumstances. Furthermore, in the case of a multinational group which may have to prepare various separate entity accounts under multiple accounting standards, there might be some ambiguity as to which of the possible accounting standards should apply, while parties normally would designate a single controlling law as the law of the contract.8
As such, using financial accounting standards does not seem as appropriate as basing the distinction on commercial law principles. The application of tax treaties is based on many legal distinctions, including those defining the character of revenue, the exercise of authority to conclude contracts, and the like. Undefined terms generally are defined by reference to the law of a Contracting State, not to extra-legal principles.8 Therefore, following the commercial law distinction between a reseller and an agent is more appropriate than importing financial accounting standards into the analysis. That said, as a practical matter, companies that wish to establish the PE protection of a reseller might consider carefully whether it would be more prudent to allocate risks and obligations between the parties so as to allow gross reporting of the reseller's revenue under applicable accounting standards.
The least desirable result would be if a separate body of law were to develop, in the Commentary or elsewhere, that distinguishes these relationships only for tax treaty purposes. There does not seem to be any unique policy issue latent in the treaty distinction that is not well served by adopting a commercial law definition to distinguish the two cases.
The last sentence, warning that the reseller should "derive a profit" rather than a "commission," raises the concern that somehow the choice of transfer pricing methods might sneak into the question of whether the entity is acting as a reseller. In many cases, transfer pricing methods used for reseller structures are similar to those seen in commissionnaire or sales agency models (and vice versa). For example, the same transfer pricing method might be used to set a commission methodology that compensates the sales agent with a percentage of revenue recognized by the nonresident, and a resale price mechanism that determines the intercompany price as a percentage of the reseller's revenue.
The transfer pricing method should not affect whether the sales entity is regarded as acting as a reseller. The adequacy of the transfer price will be tested under the arm's-length principle, and will be subject to adjustment if the price is determined not to be at arm's length. The last sentence in the new Commentary should be interpreted as a description of the result of adopting a reseller structure, as opposed to a prescription that certain transfer pricing methods will remove PE protection from a structure that is a reseller under applicable commercial law. Unfortunately, however, the late entry of that text into the Commentary provides some opportunity for mischief, so cautious taxpayers may wish to take steps to ensure that the commercial arrangements with the reseller include some of the commercial risks and rewards that typically are assumed by an entity that takes title to the goods it sells.
This commentary also appears in the May 2016 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, Nauheim and Scott, 938 T.M., U.S. Income Tax Treaties — Income Not Attributable to a Permanent Establishment, and in Tax Practice Series, see ¶7130, Foreign Persons -- Effectively-Connected Income, and ¶7160, U.S. Income Tax Treaties.
2 OECD (2015), Preventing the Artificial Avoidance of Permanent Establishment Status, Action 7 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. http://dx.doi.org/10.1787/9789264241220-en.
6 Compare Chastain v. Belmont, 43 C.2d 45, 53 (1954) (ambiguous consignment contract was interpreted as a contract for sale (i.e., reseller agreement)) and Hacker Pipe & Supply Co. v. Chapman Valve Mfg. Co., 17 C.A.2d 265, 267 (1936) (an exclusive agency contract conferring the right to sell goods was treated as a bona fide agency agreement).
7 Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605-45 ("Principal Agent Considerations"). Note that Accounting Standards Update (ASU) No. 2014-09 will amend the Codification by creating a new Topic 606 ("Revenue from Contracts"). ASU No. 2015-14 and ASU No. 2016-08 further amended new ASC 606 as a result of the joint efforts of the FASB and the International Accounting Standards Board (IASB). The new ASC 606, specifically ASC 606-10-55-36 through 606-10-55-40 ("Principal Agent Considerations"), will supersede current ASC 605-45 for annual reporting periods beginning after December 15, 2017, for public filers and beginning after December 15, 2018, for other filers on a rolling, yearly basis.
8 A convergence of International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Practices (U.S. GAAP) on this issue, of course, would reduce the potential inconsistencies. Note that Topic 606 represents a converged standard for revenue recognition that mirrors the IASB's guidance in IFRS 15 ("Revenue from Contracts with Customers"). As a result of the joint project between the FASB and IASB, any amendments to Topic 606 will be reflected in the final IFRS 15 standard. ASC 606 and IFRS 15, and the amendments to such guidance provided by the FASB and IASB, respectively, remain converged as of the issuance of ASU No. 2016-08 in March 2016.
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