By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
It was not so long ago that international tax practitioners would frequently express surprise that despite the fact that the permanent establishment (PE) standard in the Organisation for Economic Co-Operation and Development (OECD) and UN Model Tax Conventions is the fundamental determinant of when a source state may impose net-based taxation on the business income of a nonresident enterprise, there was relatively little judicial interpretation of that standard. That certainly remains true in the United States, as Taisei Insurance1 and the NatWest2 cases are the only reported cases in the last 30 years to deal in detail with the PE standard under a U.S. treaty. Relative to the size of the countries, there tends to be proportionately more reported decisions in the jurisprudence of many of our major trading partners, but it is still surprising that the number of cases is small relative to the significance of the rule in the international tax framework, and the number of controversies which have been generated over the application of the PE standard.
So it is remarkable that in the last 18 months, four European Supreme Courts have rendered decisions on PE issues, three dealing with commissionaire structures and one dealing with a business restructuring. I have commented on the first three in previous commentaries. The most recent is the Supreme Court of Italy's decision in the case of Boston Scientific,3 supporting the taxpayer's position that Boston Scientific's Italian commissionaire ("BS SpA") did not constitute a PE of its Dutch principal ("BSI BV"). Adding this case to the French and Norwegian Supreme Court decisions in Zimmer4 and Dell5, respectively, this is the third case regarding the PE treatment of a civil law commissionaire to reach a European Supreme Court.
Each of the three commissionaire cases has its own peculiarities. The Boston Scientific case is interesting not just for the result, but also for the comprehensive reach of the arguments raised by the tax administration, the "plain meaning" approach the court took to treaty interpretation and to reject the tax administration's arguments, and the fact that this case might not represent the final word on the subject in Italy, despite being a Supreme Court decision.
As in the Zimmer and Dell cases, the decision upholds the taxpayer's contention that the normal operation of a civil law commissionaire does not create a PE under the dependent agent paragraph of Article 5 of the relevant treaty (which, in this case, was the Netherlands-Italy Income Tax Treaty).
The Italian tax authorities made a broader assault on the structure in the Boston Scientific case than did the French or Norwegian authorities in the Zimmer and Dell cases. In those latter cases, the principal argument was that the actions of the commissionaire bound the principal in economic effect, even if not by law. In the Boston Scientific case, the authorities dug deeper into the OECD Commentary for arguments to support their assertions.
The Supreme Court opinion referred extensively to the lower Regional Tax Court opinion, which it upheld. The technical discussion below is taken largely from the Regional Tax Court opinion. The Regional Tax Court addressed three technical issues which frequently arise in PE disputes concerning commissionaires and other sales entities.
First, the tax administration argued that BS SpA constituted a dependent agent with authority to conclude contracts in the name of its principal. Article 5(4) of the Netherlands-Italy treaty provides as follows:
A person acting in one of the States on behalf of an enterprise of the other State-other than an agent of an independent status to whom paragraph 5 applies-is deemed to be a "permanent establishment" in the first State if it has in this State, and habitually exercises, an authority to conclude contracts in the name of the enterprise, unless the activity of said person is limited to the purchase of goods and merchandise for the enterprise.
The tax authorities argued that BS SpA had the power to execute agreements "on behalf" of its principal, despite the treaty language which refers to contracts "in the name of" an enterprise. The tax authorities further argued that the treaty should not be interpreted according to a strict application of the commissionaire law to the treaty terms, but according to a "substance-over-form" approach to treaty interpretation. This argument, that the actions of the commissionaire were "in substance" binding on the principal, is the same line of argument which prevailed at the lower court levels in the Zimmer and Dell cases, but which eventually was reversed in the French and Norwegian Supreme Courts. Following the same analytical approach as the French and Norwegian Supreme Courts, the Regional Tax Court concluded that BS SpA contracted in its own name, and not in the name of its principal, and therefore it was acting on its own behalf.
This is an important conclusion, and has significance beyond the PE area. Taxpayers should take comfort in this decision as standing for the principle that treaty language should be interpreted according to its plain meaning, and not according to a "substance-over-form" approach.
Second, the tax administration argued that the lack of active involvement of BSI BV indicated a grant of contractual authority to BS SpA within the meaning of Article 5(4). Paragraph 32.1 of the OECD Commentary provides as follows:
Also, the phrase "authority to conclude contracts in the name of the enterprise" does not confine the application of the paragraph to an agent who enters into contracts literally in the name of the enterprise; the paragraph applies equally to an agent who concludes contracts which are binding on the enterprise even if those contracts are not actually in the name of the enterprise. Lack of active involvement by an enterprise in transactions may be indicative of a grant of authority to an agent. For example, an agent may be considered to possess actual authority to conclude contracts where he solicits (but does not formally finalise) orders which are sent directly to a warehouse from which goods are delivered and where the foreign enterprise routinely approves the transactions.
The tax authorities noted that BS SpA received orders from customers which were then sent directly to a warehouse from which the goods were delivered, arguing that these facts indicated that BSI BV was not actively involved in the execution of the contracts proposed by BS SpA. The Regional Tax Court did not directly address this contention, apparently considering that this issue was resolved once it had concluded that BS SpA was entering into contracts in its own name, and not operating under a power of attorney granted by and on behalf of BSI BV.
Third, the tax authorities argued that a PE existed because BS SpA carried out activities beyond the ordinary course of its business as a sales commissionaire. The authorities argued that BS SpA should have restricted its activity to the execution of sales contracts, but instead it entered into other commercial arrangements, such as making equipment available to hospitals on lease or bailment, and factoring receivables. The tax authorities argued that a commissionaire could not be authorized to lease property owned by other entities, or factor receivables owned by other entities. As authority for the proposition that these additional activities create a PE, the administration referred to paragraph 38.7 of the Article 5 Commentary, which reads as follows:Persons cannot be said to act in the ordinary course of their own business if, in place of the enterprise, such persons perform activities which, economically, belong to the sphere of the enterprise rather than to that of their own business operations. Where, for example, a commission agent not only sells the goods or merchandise of the enterprise in his own name but also habitually acts, in relation to that enterprise, as a permanent agent having an authority to conclude contracts, he would be deemed in respect of this particular activity to be a permanent establishment, since he is thus acting outside the ordinary course of his own trade or business (namely that of a commission agent), unless his activities are limited to those mentioned at the end of paragraph 5.
As a technical matter, this passage is a commentary on Article 5(6) of the OECD Model, which is the definition of an independent agent. Article 5(6) of the OECD Model provides as follows:6 An 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 an independent status, provided that such persons are acting in the ordinary course of their business.
The last clause of Article 5(6) has always been problematic. Based on the plain meaning of the article, it would seem that the consequences of an agent not operating within the ordinary course of its business would be only that the PE defense offered by the existence of an Article 5(6) independent agent would not be available. It would seem that the absence of an Article 5(6) defense should not then necessarily lead to the conclusion that a PE does exist, unless the elements of an Article 5(5) PE do, in fact, exist, including that the agent holds the requisite contract concluding authority. Instead, the tax authorities here argued that the conduct of activities outside the scope of a commissionaire's responsibilities necessarily creates a PE, apparently under the assumption that it was then not necessary to also demonstrate that the test of Article 5(5) had been met.
The Italian Supreme Court addressed this issue by concluding that the tax administration had not provided any justification why such business activities are contrary to the typical duties of a commissionaire and, therefore, accepted the conclusions of the Regional Tax Court, which had observed that those activities enhanced BS SpA's independent relationship vis-a`-vis BSI BV and, accordingly, could not be used to prove the Italian company's dependence on the Dutch principal. The Regional Tax Court indeed had concluded that the Italian commissionaire had sufficient financial resources so as to be regarded as autonomous in carrying out its marketing activity as a commissionaire.
Effect for the Future
Because this is a decision of the Supreme Court, does that mean that the commissionaire issue is settled in Italy? One would be excused for assuming that such is the case, especially as the Italian tax authorities had been so comprehensive in raising a variety of interpretative arguments to try to make their case.
The major peculiarity of the Boston Scientific case, however, is that it does not necessarily represent a final conclusion on the merits in Italy. In the United States, a case which reaches the Supreme Court normally is positioned such that the Court is able to render a definitive interpretation of law which must be followed by lower courts. In contrast, the Boston Scientific decision was not a final determination on the merits of the interpretative issue, but rather was a procedural decision. Technically, the Court rejected the appeal by the tax authorities against the decision of the Regional Tax Court on the procedural grounds that the General Advocate failed to present the government's arguments with sufficient basis to overturn the lower court's ruling. In a future tax audit of another taxpayer, the tax authorities could try to distinguish the Boston Scientific case on the facts of the new case. The unusual (at least to an American lawyer) aspect of this decision, however, is that the procedural basis of the decision allows the Italian tax administration also to argue the issue again on the legal merits, for this or another taxpayer.
Whether the authorities will do so, of course, remains to be seen. This case is regarded in Italy as an important precedent which is very likely to influence future decisions for other taxpayers which have adopted the commissionaire structure. In this author's view, deference to the Boston Scientific reasoning and conclusion certainly is warranted in future cases, as the Boston Scientific case stands as the most complete judicial analysis so far of the arguments that various tax authorities, inside and outside of Italy, have asserted in attempting to establish that a commissionaire relationship creates a PE. Given the thoroughness of the analysis, it would be somewhat surprising if the authorities indeed endeavored to relitigate the legal issue.
If the Italian Supreme Court does issue a conflicting opinion on the legal issue in some future case, then the unusual Italian procedural remedy for ultimately reaching a uniform interpretation in light of the conflicting decisions might be needed. In that procedure, a special section of the Italian Supreme Court (i.e., the United Section) is requested to reach a conclusive determination.
The question of whether a typical civil law commissionaire constitutes a PE is one of the topics currently being addressed in the OECD project to provide clarifications in the Article 5 Commentary. In the working group's draft report on its deliberations, the working group noted that consensus could not be reached on this issue at the time the draft report was prepared. Despite the procedural aspect of this decision as noted above, the Boston Scientific case represents the most complete discussion by a court so far of the issues around commissionaire structures. Perhaps the OECD delegates will take note of the Regional Tax Court analysis, and find some way to reach consensus based on the reasoning of that court.
This commentary also will appear in the July 2012 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, and Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties - U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶7130, Foreign Persons - Effectively Connected Income, and ¶7160, U.S. Income Tax Treaties.
1 Taisei Fire & Marine Insurance Co. Ltd. v. Comr., 104 T.C. 535 (1995).
2 Nat'l Westminster Bank, PLC v. U.S., 58 Fed. Cl. 491 (2003), aff'd, 512 F.3d 1347 (Fed. Cir. 2008).
3 Italian Supreme Court, Tax Section, n. 3769 of Mar. 9, 2012.
4 Zimmer Limited, CE 31 Mars 2010 N° 304715 and 308525 10 e´me et 9 e´me sous sections re´unies.
5 Borgarting Lagmannsrett, dated 2 March 2011, Dell Products vs. Skatt Øst, ref 10-032855ASD-BORG/03.
6 The corresponding provision in the Netherlands-Italy treaty is Article 5(5), which is essentially identical to Article 5(6) of the OECD Model.
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