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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
The publication on May 15, 2015, of a revised Discussion Draft under BEPS Action 7 ("Revised DD") discloses what presumably will be close to the final recommendation of the OECD regarding proposed changes to Article 5(5) of the OECD's Model Tax Convention on Income and on Capital (OECD Model), which sets forth the dependent agent deemed permanent establishment (PE) rule. As such, taxpayers whose current sales entity structures may create deemed PEs under the new standards need to start considering what alternatives they may have.
As a threshold matter, however, the Revised DD does not provide clarity as to what sales-oriented activities indeed will give rise to deemed PEs under the new rule. As originally articulated, the scope of Action 7 was relatively focused. The BEPS Action Plan described the purpose of Action 7 as to:Develop changes to the definition of PE to prevent the artificial avoidance of PE status in relation to BEPS, including through the use of commissionaire arrangements and the specific activity exemptions. Work on these issues will also address related profit attribution issues.
While commissionaires certainly have taken a beating under Action 7, the Action 7 work experienced significant scope creep, so that the proposed rules now cover a range of customer-facing activities which is considerably broader than commissionaire arrangements.
The first Action 7 Discussion Draft ("October 2014 DD") presented for discussion four alternative proposals for revising Article 5(5) of the OECD Model. If required to choose among them, most business commentators had identified Option B as the "least bad" alternative, and the Revised DD indeed presents that option as the final recommendation. The proposed text reads as follows (with additions and deletions shown compared to the current Article 5(5) text):Notwithstanding the provisions of paragraphs 1 and 2, but subject to the provisions of paragraph 6, where a person — other than an agent of an independent status to whom paragraph 6 applies — is acting in a Contracting State on behalf of an enterprise and, in doing so, has, and habitually exercises, in a Contracting State an authority to concludes contracts, or negotiates the material elements of contracts, that are:
a) in the name of the enterprise, or
b) for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or
c) for the provision of services by that enterprise,
that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise, unless the activities of such person are limited to those mentioned in paragraph 4 which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph.1
Subsections b) and c)of this text are intended to describe the commercial consequences of a commissionaire selling arrangement. The element which has the potential to expand the scope of Article 5(5) beyond commissionaire arrangements, and probably has the potential to capture a much larger number of taxpayers, is the inclusion of "negotiates the material elements of contracts" as an action that may trigger deemed PE status for the nonresident supplier.
Assuming that this language will become the final proposal for States to choose whether to incorporate in their treaties, what commercial alternatives do taxpayers have to respond to the new deemed PE definition?
The first response would be to limit the commercial activity of the group's sales and marketing affiliate in the market State to remain below the deemed PE threshold. Essentially, this would involve imposing limits on the authority of market jurisdiction personnel to negotiate the material elements of contracts. Taxpayers here, however, may be caught in a dilemma. Many businesses have sought to streamline contracting by insisting on standard terms with all customers. The point of that contracting model is to not allow local sales personnel to engage in negotiations over contractual terms, material or otherwise. Proposed Commentary issued in the Revised DD, however, provides an example of a business that supplies goods or services from outside the market State solely under standard contracts whose terms the local entity employees are not authorized to vary. In that case, there is no "negotiation" in the normal sense of the word, yet the draft Commentary concludes as follows:The fact that [local entity's] employees cannot vary the terms of the contracts does not mean that there is no negotiation but rather means that the negotiation of the material elements of the contracts is limited to convincing the account holder to accept these standard terms.2
Given that the principal mission of any sales employee is to assist in convincing a customer to purchase the enterprise's goods or services, this proposed Commentary creates quite a danger zone under the new "negotiates the material elements" test for any enterprise that has tried to streamline its contracting processes by insisting on standard contracts.
Newly emerging companies face challenges as well. For those companies, the reduced PE threshold certainly creates an incentive to restrict hiring in market jurisdictions, and to endeavor to rely on personnel located outside the market jurisdiction to provide sales support to local customers. If the newly emerging enterprise seeks to rely on persons travelling into the jurisdiction, however, the enterprise needs to be conscious of the fact that these new rules fall under the deemed PE provisions of Article 5(5), not the "fixed place of business" rule of Article 5(1), meaning that there is no "fixed place of business" element to the definition. Instead, the limiting factor applicable to persons travelling into the jurisdiction is only the requirement that the activity be performed "habitually" in that State. The Revised DD does not propose to revise the substantive guidance of the existing Commentary on the meaning of "habitually." That Commentary provides that whether an activity is "habitual" depends on the nature of the contracts and the business of the principal, and that "[i]t is not possible to lay down a precise frequency test."3
As an alternative to addressing these interpretative issues, a taxpayer may choose to avoid the question altogether by structuring its market country sales activities as a reseller. The Revised DD seems to display a bright green light to taxpayers who wish to move in that direction. The Revised DD contains proposed Commentary that clearly states that the actions of a reseller do not fall within the new PE rules, regardless of the allocation of commercial risks between the supplier and the reseller: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 the transfer of the title to property sold by that 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).4
Accepting this invitation, of course, does not come without costs for any business now operating through a centralized sales model. As a matter of risk management for the enterprise, the group may not want to grant authority to conclude contracts to local sales personnel. This push from the tax law to allow local personnel to agree to contracts will degrade management's ability to manage centrally the enterprise's commercial risk. Requiring enterprises to establish financial systems that support recognizing revenue in every jurisdiction, and then supporting all of the intercompany transactions necessary to document the supply of goods and services to the local entity for resale, runs counter to the constant efficiency improvements that enterprises have sought (and achieved) through centralized sales models. Emerging companies would face the financial cost of establishing the infrastructure necessary to support a reseller arrangement in a market jurisdiction from a very early stage in their international expansion.
Given the financial costs of establishing a reseller structure, many enterprises will be tempted to retain the commercial efficiencies of a centralized sales structure and perhaps even report PEs (or at least reserve for the exposure), if they can become confident that the profit attribution consequences of an Article 5(5) deemed PE are acceptable. The Revised DD reported that a large number of the comments received on the October 2014 DD lamented the absence of guidance on the attribution of profits to PEs. The Revised DD reported the view of many commentators that it made little sense to revise the PE threshold without simultaneously providing guidance on how the existing profit attribution guidance would apply in the case of newly created PEs:A significant number of commentators indicated that more work should have been done on attribution of profit issues and expressed the view that changes to the PE rules should not proceed without further work on how much additional profits would be captured by lowering the PE threshold.5
Despite that pragmatic recommendation from many voices, the Revised DD presents recommended Article 5(5) revisions without the benefit of further work on the profit attribution consequences of those changes. As an explanation of that decision, the Revised DD notes that further work on profit attribution could not "realistically be undertaken before the work on Action 7 and Actions 8-10 has been completed."6 In other words, the conclusion was that further guidance on PE profit attribution needed to await the conclusion of the BEPS/G20 project work on intangibles, risk, and capital. The Revised DD stated:… it has been decided that follow-up work on attribution of profits issues related to Action 7 will be carried on after September 2015 with a view to providing the necessary guidance before the end of 2016, which is the deadline for the negotiation of the multilateral instrument that will implement the results of the work on Action 7.7
There is little doubt that many taxpayers would prefer to retain their centralized sales model with single points of revenue recognition, due to the business and cost efficiencies that such models create and the systems and other costs of implementing a different model. Whether that option will remain viable for businesses must await the work on profit attribution. Since the profit attribution work is meant to be completed before any treaties could be amended to incorporate the new rules, enterprises will have at least some period of time (albeit short) to decide whether to adopt the approach of maintaining their existing centralized sales models, and possibly reporting PEs with an appropriate profit attribution, instead of switching to reseller structures.8
Finally, taxpayers located in some jurisdictions may enjoy the luxury of not having to do anything. To become effective, this new PE definition must be incorporated in a treaty to be ratified by the two relevant States. The work on the Multilateral Instrument is intended to provide a vehicle for as many States as possible to agree to incorporate these rules in their respective treaties. It is certainly conceivable that not all States will agree to amend their treaties. An enterprise that is established in such a State would not need to modify its current centralized sales structure. Any State that decides to reserve on the proposed Article 5(5) revisions thus will achieve a competitive advantage over other States in the competition to attract and support enterprises that wish to establish a centralized sales model based on a supplier enterprise located in that State.
This commentary also will appear in the July 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, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively-Connected Income, ¶7160, U.S. Income Tax Treaties.
8 It would seem that a joint working group comprised of both Working Party 1 and Working Party 6 delegates would be appropriate for this work, as it makes little sense to consider either the PE standard or the profit attribution consequences in isolation from each other.
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