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By James J. Tobin, Esq.*
Ernst & Young LLP, New York, NY
I just finished reading the OECD Public Discussion Draft on BEPS Action 7: Preventing the Artificial Avoidance of PE Status. From the title of the draft, it was pretty obvious that the OECD's inclination would be that there should be more permanent establishments (PEs) in the world than there are today and that they would view tax as the driver of how business is organized. As a tax guy, that latter part makes me feel important. But when I talk to my clients, I'm always brought back to the reality that the tax tail rarely gets to wag the commercial dog. Perhaps the OECD drafters should talk to more business folks at multinational corporations (MNCs) to get a better appreciation of this reality?
A basic premise of the discussion draft is that the nexus threshold we have all grown up with for determining whether a PE exists is in need of redefinition in the current business environment. The thinking here seems largely driven by a perception of inappropriate results where companies can realize substantial profit in low-tax locations and avoid local PEs in customer or sourcing locations if they manage their presence in those locations to fall below current PE nexus definitions. I can appreciate the policy desire to address such results in the current environment and perhaps there are some instances where a refinement of the rules could be appropriate. However, as is often the case, the "solutions" proposed would potentially transform the tax landscape and in my view would lead to huge controversy and double tax burdens for all but purely local businesses or MNCs that operate with a purely country-based business model — if there still are any such companies surviving in today's global environment.
The discussion draft focuses on seven particular areas dealing with the definition of a PE included in Article 5 of the OECD Model Tax Convention. The seven areas covered are commissionaires, preparatory or auxiliary activities, delivery of goods, purchasing offices, fragmentation of activities, splitting up of contracts, and insurance. Each of these areas is considered in the context of "artificial avoidance" of a PE, as if any time activities in these areas fall below existing PE nexus thresholds, it is because of manipulation to achieve that result. Kind of a presumption of guilt approach, which should be rejected. I would suggest that the discussion should be reframed in its next iteration to eliminate this implicit prejudgment.
By framing the issues in the context of PE abuse, the drafters also have failed to adequately address the original mandate in the initial BEPS report of February 2013, which focused on whether and how the PE threshold should be changed to take into account new business models and makes the point that "questions are being raised as to whether the current rules insure a fair allocation of taxing rights on business profits, especially where the profits from such transactions go untaxed anywhere." This statement did not tip me off that the OECD would mount a much wider attack that would sweep in all cross-border activity regardless of whether and how the cross-border income is being taxed outside of the source country, apparently justified by the presumption that companies structure their businesses primarily to avoid a PE.
So the OECD's first area of focus is commissionnaires. A commissionnaire arrangement is a common law concept that doesn't really exist in the United States and that I equate to an undisclosed agent concept. A local distributor sells in its name for the benefit of an undisclosed principal. It is clear that tax authorities hate this structure and think it should create a PE for the principal. But having challenged such arrangements as creating a PE in several European countries, tax authorities have been quite unsuccessful in convincing the courts that this should be the result – to the contrary, taxpayers have been successful in France, Italy, and Norway in defending against local PE assertions on the basis that the commissionaire was not concluding contracts in the name of its undisclosed principal as would be required for a PE under existing treaty language.
The discussion draft considers this result as fostering tax avoidance – as stated in paragraph 10, "It is clear that in many cases commissionnaire structures and similar arrangements were put in place primarily in order to erode the taxable base of the State where sales took place." No evidence is cited to support why this is so clear nor is there any acknowledgment of MNCs' regional or global business models that limit the local presence, decision-making, and risk of local country sales activities consistent with a low-risk distributor (LRD) model. My transfer pricing colleagues regularly tell me that the margins for an LRD would be similar to those for a commissionnaire. My experience with MNCs choosing between an LRD or commissionnaire model for a local sales subsidiary in their global business model is that they are making that decision based on systems issues, indirect tax issues, U.S. subpart F consequences, and other factors, and not at all based on local PE results. To my mind, an LRD should not result in a deemed PE for its suppliers and neither should a commissionaire. I don't see an abuse and therefore I don't see a reason to change the existing PE threshold. Like many other aspects of the BEPS project, it really comes down to transfer pricing — what is the correct margin for local distribution activities and what are the tax consequences of a business restructuring involving conversion from a local approach to a regional or global business model.
In the category of traps for the unwary, the discussion draft's "solution" for the commissionnaire "problem" (which I don't think exists) goes well beyond commissionnaire arrangements. Four alternative proposals are provided for changes in the formulation of the agency PE standard in Article 5(5) of the OECD Model Tax Convention. All four would lower the PE nexus requirement of "concluding" contracts, replacing that standard with more subjective standards, such as negotiating material elements of contracts or engaging "with specific persons in a way that results in the conclusion of contracts." Very soft concepts that can, and I fear would, be applied inconsistently and in some cases aggressively. These proposals all would bring inevitable controversy on a much wider basis than the commissionnaire area. And nothing in these proposals would limit the target zone to situations "where the profits on such transactions go untaxed anywhere."
Most of the remainder of the discussion draft focuses on the specific activity exemptions of Article 5(4). (I won't comment about the short section of the discussion draft that addresses insurance activities other than to say it is as troubling as the other sections.) That paragraph currently excludes from the definition of a PE five specific categories of activities, which was meant to allow companies to conduct these limited activities without crossing the PE nexus threshold.
The five activities are:
And subparagraph 5(4)(f) provides a further exclusion for any combination of the above activities, provided that the overall activity of the fixed place of business is of a preparatory or auxiliary nature.
The OECD drafters are concerned that these exemptions from PE status create the opportunity for BEPS. Therefore, a number of alternative proposals are made to limit their reach. The most encompassing proposal would require that for any of the individual exemptions above to apply, that individual activity must satisfy the preparatory or auxiliary criteria, so that such requirement would not be limited to the combination of the specific activities as in the current language of paragraph 5(4). It seems to me this would effectively eliminate the PE exemptions for delivery of goods, purchasing, and processing in many cases. Such a change would constitute a dramatic change in policy with respect to these activities, which would result in major increases in compliance costs and administrative burdens. Moreover, the change does not seem to be targeted at what I thought were the real BEPS concerns.
The discussion draft also contains alternative proposals that are focused on specific exemptions to be considered if (hopefully) the proposed broadening of the application of the preparatory or auxiliary requirement is not adopted. The discussion of each of these alternative proposals provides some greater insights into the areas of concern for the drafters regarding each of the activities. With respect to the exemption for delivery of goods, the concern is illustrated in paragraph 18 where the draft puts forth the view that "it is difficult to justify the application of these exceptions where an enterprise maintains a very large warehouse in which a significant number of employees work for the main purpose of delivering goods that the enterprise sells online …". Clearly a very specific fact pattern that is troubling the drafters. Despite the concern being about a very large warehouse with lots of dedicated employees and online sales, the alternative proposal regarding delivery of goods is to eliminate the delivery exception altogether and to limit the maintenance of goods exception to maintenance of goods for storage or display. So if this alternative proposal were adopted, any maintenance of inventory for delivery at all could create a PE. I'm thinking this would mean the end of same day (or same week) delivery? Doesn't seem helpful to global trade. Nor does it seem to be a necessary solution to the perceived problem.
The next activity that causes the OECD drafters concern is purchasing. Again, the example is a bit extreme – a buying team with specialized expertise in an organization where virtually no sales effort is needed so that virtually all of the enterprise's profit is due to its purchasing activities. In that example, the drafters view the purchasing office exception as inappropriate. Therefore, the alternative proposal is to eliminate the PE exception for purchasing activities altogether. To my mind, this is another overkill reaction that would have significant adverse commercial/global trade implications.
The next focus area deals with "fragmentation" of activities – that sounds abusive already. The discussion draft refers to language already in the Commentary to Article 5(4) which states, "An enterprise cannot fragment a cohesive operating business into several small operations in order to argue that each is merely engaged in a preparatory or auxiliary activity." That seems reasonable. The discussion draft is concerned with an enterprise fragmenting activities among separate related companies to achieve this goal and therefore proposes that the activities of related entities – whether resident in a jurisdiction or not — be aggregated if the activities constitute complementary functions that are part of a cohesive business operation. This would deny the PE exception for any of the specific activities of Article 5(4), even if they are clearly preparatory or auxiliary, if there is a related company resident in the country whose activities are considered complementary or part of a cohesive business. As an aside, do these sound like terms that can be clear and consistently applied by all?
Along similar lines, the next area covered by the discussion draft is the "splitting-up of contracts" – again a quite unsympathetic characterization. The focus is on the 12-month exception for construction projects in Article 5(3) (and the 183-day version of this rule in the UN Model treaty). Similar to the fragmentation of activity area above, the concern of the drafters relates to the potential to split contracts in order to satisfy the 12-month test – and the ability to do so with multiple related parties. Alternative objective and subjective tests are proposed. The objective test would aggregate the presence of all related companies working on a project, thus effectively resulting in a PE for all nonresident service providers where there is also a longer term resident company involved on the project. The draft acknowledges "one difficulty" of this approach being that a nonresident entity providing specialists even for a few days would have a PE and suggests that perhaps a minimum period exception such as 30 days could be provided. This would obviously be a huge change from the current state 12-month or 183-day threshold. The second alternative is a subjective anti-abuse test for cases where activities are separated for the principal purpose of avoiding creation of a PE. I worry about the increasing resort to subjective principal purpose type GAAR assertions by tax authorities in many countries. But in this case, a subjective purpose test would be the less problematic of the two alternatives. If I were a paranoid guy, I'd think this was part of a plot by the OECD drafters to lure us into accepting the unacceptable trend toward vague and subjective anti-abuse rules. Certainly it is the first time I have ever thought about favoring a GAAR-type provision.
On the whole, the proposals in the discussion draft, whichever alternatives might be chosen, would increase significantly the number of PEs that would need to be reported and accounted for globally. The proposals would not merely impact income of tax haven entities that are cited as the primary BEPS concern but would impact all MNCs operating globally as well as small businesses expanding into foreign markets through the internet and other means. The worry about the compliance burden is compounded by the fact that there is no discussion in the discussion draft about attribution of profits to the PE other than a passing reference to prior OECD work in that area, which was not at all comprehensive and which in practice is much more uncertain than arm's-length transfer pricing principles for related parties. In principle, it seems clear to me that if the only activity an MNC group has in a country is distribution/sales activity, the only profit that should be taxed in that country is an appropriate profit for that activity, regardless of whether there is a PE, a local subsidiary, or both. But I don't have confidence that the OECD drafters or the local tax authorities in some countries are on the same page with respect to profit attribution. So I would predict more claims of the existence of a PE by source countries, less acceptance of a PE by headquarters countries for purposes of allowing territorial exemption or double tax relief, and more disputes involving both countries and the business enterprise as to the amount of income subject to tax in the PE, all leading inevitably to lots more double taxation.
An important mission of the OECD – the Organization for Economic Cooperation and Development — is to boost investment and trade, an important aspect of which has always been helping minimize trade barriers. Exponential expansion of PE status, increased filing burdens, and consequential double taxation seem like a major barrier to trade to me. I fear that the OECD has forgotten or abandoned its mission. And it sounds like it may be developing a cure for BEPS that is worse than the disease.
This commentary also will appear in the February 2015 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, Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties — U.S. Competent Authority Functions and Proceduresand in Tax Practice Series, see ¶7130, Foreign Persons — Effectively-Connected Income, ¶7160, U.S. Income Tax Treaties.
The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.
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