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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
On October 12, 2011, the Organisation for Economic Co-operation and Development (OECD) released "Interpretation and Application of Article 5 (Permanent Establishment) of the OECD Model Tax Convention," a public discussion draft of proposed additions to, and revisions and clarifications of, the Commentary on Article 5 of the OECD Model Tax Convention ("OECD Model Convention"). The proposals were prepared by a subgroup of Working Party 1 (WP1) on Tax Conventions and Related Questions, and cover a wide range of interpretative issues arising under the definition of "permanent establishment" (PE) in Article 5. The WP1 subgroup tackled many of the most vexing issues that have given rise to controversies under the PE definition in recent years. While on some topics it seems apparent that the subgroup has not yet been able to reach a consensus on possible clarifications, in other areas the discussion draft has proposed some very useful and thoughtful clarifications of the existing text.
This commentary will address the proposed revisions in the discussion draft that deal with the issue of whether a PE could be constituted through subcontractor arrangements. On this topic, the discussion draft makes it clear that an enterprise that conducts its business through subcontractors will not, solely by virtue of such a relationship, have a PE, unless the work of the enterprise is performed at a fixed place of business in the source jurisdiction that is at the disposal of the enterprise for reasons other than the mere fact that the subcontractors are performing the work there.
The most notorious example of a PE being found due to the use of a subcontractor is the case of Offshore Accommodation Service AB v. Government of Norway, decided by the Norwegian Supreme Court in 2001.1 In that case, the entity responsible for maintaining a housing rig for use at a North Sea oil well site in Norwegian territorial waters entered into a management services agreement with a Swedish entity, Brostroms Rederi AB ("Brostroms"), to man and operate the rig. Brostroms then entered into a services agreement with the taxpayer, the Swedish company Offshore Accommodations Service AB ("Offshore"), to provide certain services on the rig, including catering services. Offshore then subcontracted the performance of the catering services to a Norwegian company, Chalk Catering AS ("Chalk"). Offshore did not deploy any of its personnel on the rig, and had real economic risk under the contracts, as it received a set fee from Brostroms but paid a cost-plus fee to Chalk.
The Norwegian tax authorities argued that Offshore was subject to tax in Norway on the basis that it was carrying on an activity on the Norwegian continental shelf for more than 30 days, per Art. 21(2) and (3) of the Nordic treaty. That Article deals with activities conducted in connection with hydrocarbon exploitation. The taxpayer argued the absence of a tax nexus on the basis that the taxpayer did not physically perform any services on the rig. The court disagreed, finding that physical presence was not required because of language in the OECD Commentary interpreting Art. 5(3) dealing with construction sites, which provided that in a case where a general contractor had subcontracted part of the work to other enterprises, the time period spent by the subcontractor must be considered as time spent by the general contractor on the project.2 In a remarkable extension of the view that the OECD Commentary is ambulatory, and thus can be applied to interpret the text of treaties negotiated before the particular Commentary language was adopted, the Norwegian Supreme Court made reference to a proposed change to the Commentary that had not even been adopted or published by the OECD at the time the case was heard, much less during the taxable years at issue, but which the Norwegian tax administration testified had been favorably considered by delegates from most OECD countries during internal OECD discussions.3
It is hard to accept the analysis or result of Offshore Accommodation as appropriate guidance for applying the normal "basic rule" PE standard of Art. 5(1). Perhaps one might sleep better at night by concluding that the precedential value of Offshore Accommodation should be limited to interpreting Article 21 of the Nordic treaty, dealing with activities on the continental shelf. That Article has no parallel in the OECD Model Convention. Article 21 of the Nordic treaty simply states that a PE is deemed to exist if the taxpayer "carries on activities" offshore in a contracting state for a period or periods exceeding in the aggregate 30 days in any 12-month period. Thus, Article 21 does not require a "fixed place of business" to exist as is the requirement in paragraph 1 of Article 5, nor does it require the existence of a "construction site or construction or installation project" as provided in paragraph 3 of Article 5. Accordingly, this case could be regarded as a fraternal affair among the Nordics as they decide how to equitably divide the good fortune of having found petroleum within their territorial borders.
Even if one did not think that the case would have direct application outside of the Norwegian continental shelf (i.e., "onshore"), the Norwegian Supreme Court's reference to the Article 5(3) Commentary for analytical support is troubling. The question at issue was whether Offshore had established nexus by way of doing business in Norway sufficient to allow Norway to tax its profits. The Commentary text the ourt referred to relates to the question of how long a general contractor should be regarded as present at a construction site, in order to apply the 12-month rule of Art. 5(3), which is a very different issue from whether nexus (doing business in Norway) exists in the first place.
Due to the Offshore Accommodation case as well as the increase in creative PE theories being proposed to find taxable nexus of an enterprise operating outside the jurisdiction on the basis that it engaged the services of an associated enterprise operating in the source state, taxpayers have sought clarification as to when, if ever, the use of a contractor to perform business activities can create a PE for the principal under the basic rules of Art. 5(1). The Offshore Accommodation facts formed the basis for one of the case studies on PEs addressed by the branch reports prepared for the 2009 International Fiscal Association (IFA) Congress in connection with the session on the definition of a PE.4 As the context for the analyses by the branch reports was the general rule of Art. 5(1), not the special rule of Art. 21 in the Nordic treaty, the case study thus had metastasized from the context of the special rules dealing with activities on the Norwegian continental shelf to a question of the general principle of tax nexus under the OECD Model Convention.
Some of the debate over this issue has been caused by uncertainty over the significance of certain long-standing language in paragraph 10 of the Article 5 Commentary. That paragraph interprets the requirement that the enterprise "carry on business" through the place which might constitute a PE. The Commentary provides that an enterprise carries on business through its "personnel," which is defined as including "employees and other persons receiving instructions from the enterprise (e.g., dependent agents)."5 Given that the Norwegian Supreme Court made the unwarranted leap from a rule that describes how to measure a time period to the conclusion that an enterprise had taxable nexus, some taxpayers had worried that the reference in paragraph 10 supported the conclusion that "carrying on business" through a dependent agent also meant that the enterprise maintained a fixed place at the dependent agent's place of business. This essentially was the issue raised by the IFA example.
The OECD discussion draft provides some useful clarifications on this point, although there is still some fine-tuning to be done. The discussion draft proposes to add a new paragraph 10.1 to follow the potentially troublesome existing paragraph 10 (discussed immediately above), as follows:An enterprise may also carry on its business through subcontractors, acting alone or together with employees of the enterprise. In that case, a permanent establishment will only exist for the enterprise if the other conditions of Article 5 are met. In the context of paragraph 1, that will require that these subcontractors perform the work of the enterprise at a fixed place of business that is at the disposal of the enterprise for reasons other than the mere fact that these subcontractors perform such work at that location… .
Proposed new paragraph 10.1 then provides an example of such a PE where an enterprise owns a small hotel and rents out the hotel's rooms through the internet, but subcontracts the on-site operation of the hotel to a company that is remunerated on a cost-plus basis. While neither the proposed text nor the accompanying explanation in the discussion draft expressly describes the reasoning, the conclusion that the hotel owner has a PE in this case must be based on the conclusion that the hotel property constitutes a fixed place of business of the property owner, with the final constitutive element of a PE, namely that the enterprise carries on business through that fixed place, being supplied by the activities of the contractor.
This proposed addition is a useful clarification to separate analytically the question of whether an enterprise maintains a fixed place, in distinction to whether that enterprise carries on its business, in whole or in part, through that fixed base. The two requirements are independent, and each must be met for a basic rule PE to arise (plus, those activities cannot be preparatory or auxiliary within the scope of Art. 5(4)). Engaging a contractor to perform useful, or even critical, activities that are essential inputs to the principal's business does not, in itself, give rise to a fixed place of business at the contractor location if that location is not otherwise at the disposal of the enterprise. The proposed Article 10.1 Commentary now makes that clear.
For any particular case involving contractors, the PE analysis then would turn to whether the enterprise did indeed have a fixed place separate and apart from the fact that it had engaged the contractor.
Turning to the issue of whether a "fixed place" indeed exists, the WP1 subgroup seems to have spent a fair bit of time struggling with clarifications to Commentary language which currently provides that a "fixed place" may exist if the enterprise has premises "at the disposal of the enterprise."6 The proposed clarifications here are not as precise as those dealing with the circumstances in which an enterprise is carrying on business, as discussed above. In general, the discussion draft provides two examples of circumstances under which a place of business may be regarded as being at the disposal of an enterprise, namely: (1) where the enterprise has an exclusive legal right to use a particular location which is used only for carrying on that enterprise's own business activities; and (2) where an enterprise performs business activities on a continuous and regular basis during an extended period of time at a location that belongs to another enterprise or that is used by a number of enterprises. Further discussion of the discussion draft's approach to this topic will need to wait for another commentary in this series. I suspect that business commentators on the discussion draft will want to suggest revisions or enhancements to this language to create more clarity as to when an enterprise may engage local contractors without fear of creating a PE. At a minimum, it would be useful to add an example to the Commentary to provide a parallel to the hotel example, and describe circumstances when engaging a subcontractor does not cause the enterprise to have premises at its disposal at the contractor's location.
The WP1 subgroup has clearly made good progress on many important issues. It is also clear that many difficult interpretative issues remain, which perhaps are not susceptible to clarification in the Commentary. Some of these other issues covered (or avoided) addressed in the discussion draft will be addressed in future commentaries in this series.7
This commentary also will appear in the January 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 Case 327/2001 (4/4/01).
2 Art. 5 Commentary, ¶19.
3 The proposed Commentary change, which was under discussion within the OECD back in 2001, would have amended the reference to a subcontractor as described in the text to include cases where the general contractor had subcontracted "all or" part of the project to the subcontractor. Ironically, that change is now being proposed to be adopted in the discussion draft just released, along with important clarifications regarding the meaning of that new wording.
4 The OECD PE report draws heavily on examples developed at the 2009 IFA Congress.
5 Art. 5 Commentary, ¶10.
6 Art. 5 Commentary, ¶4.
7 Public comments on the discussion draft are invited by Feb. 12, 2012.
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