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By Gary D. Sprague, Esq. Baker & McKenzie LLP Palo Alto, California
As this article goes to press, those responsible for tax policy around the world are considering what positions their countries will take in their tax treaties with respect to the various options contained in the Multilateral Instrument (MLI) to implement the OECD/G20 BEPS Project recommendations. Since many of the proposed treaty changes are not included in the four “minimum standards” for implementing the BEPS Project, governments have quite a bit of flexibility to pick and choose among various alternatives.
This process is unprecedented, at least in the history of international tax law. The MLI essentially will operate as a parallel agreement to the 3,000-plus bilateral agreements now in place among states. If a state agrees to a treaty change through the MLI, then that MLI provision must be read alongside that state's existing bilateral treaties. More importantly, since the two contracting states to any bilateral agreement must both agree to the change, both contracting states would need to agree to the same proposed change through the MLI for that change to apply to their bilateral treaty. Accordingly, for a taxpayer to understand the terms of any particular bilateral treaty after the adoption of the MLI, the taxpayer must review the original treaty, understand which choices each of the contracting states made as part of the MLI adoption, and then identify those (and only those) possible changes where there is a match between the two countries. If the original treaty did not have English or French as one of its official languages, this comparison also will include considering the effect of a foreign (to the treaty) language amendment to the original text. The OECD reportedly is wrangling with a large spreadsheet to manage all of this.
The OECD expects to host a signing ceremony in June 2017. By then, we would expect the various country positions to become clear. In a notable development, however, the United Kingdom Treasury and HM Revenue & Customs held a public meeting on December 12 to note for the public the HM Treasury and HMRC recommendations to the Government on various MLI choices.
Of particular interest were the recommendations on the proposed revisions to the PE article arising from the BEPS Action 7 final report. As readers undoubtedly recall, the Action 7 final report, Preventing the Artificial Avoidance of Permanent Establishment Status, recommended significant changes to the OECD Model Tax Convention (MTC) permanent establishment article, including (i) expanding the definition of what circumstances create a deemed PE under Article 5(5) to include cases where the dependent person “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise,” (ii) tightening considerably the circumstances under Article 5(4) under which a nonresident enterprise could claim protection from PE status for preparatory or auxiliary activities, and (iii) essentially eliminating a taxpayer's ability to rely on the independent agent rule of Article 5(6) in the case of a related-party agent.
The MLI connects the Article 5(5) deemed PE and Article 5(6) independent agent changes as a single choice; accordingly, a state will need to choose whether to adopt both or neither. The available choices relating to the preparatory or auxiliary exceptions are more complex. The MLI presents three choices: a state may adopt (i) the proposed Article 5(4) changes that will impose a requirement that all specified activity exceptions constitute preparatory or auxiliary activities; (ii) a refined statement of the current MTC text that the specified activity exceptions shall apply regardless of whether the activity is of a preparatory or auxiliary nature, unless the existing treaty expressly states otherwise; or (iii) neither. The choice of adopting neither presumably would have the effect of preserving the debate (in some quarters) of whether the current specified activity exceptions include as an implicit requirement that the activity be of a preparatory or auxiliary character. A separate choice is available whether to select the proposed anti-fragmentation rule to be added to Article 5(4.1), which removes preparatory or auxiliary protection if the nonresident enterprise or a closely related enterprise carries on business activities in the other state either through a PE or under circumstances where the overall activity conducted through the two places is not of a preparatory or auxiliary character, provided that the two business activities “constitute complementary functions that are part of a cohesive business operation.” The effect of the anti-fragmentation clause essentially is to eliminate the ability to rely on the preparatory or auxiliary exception if the group maintains a separate entity in the other state which is engaged in the same line of business.
In the December 12 meeting, HM Treasury and HMRC disclosed their recommendations to the Government to be as follows: (i) to not adopt the changes to the deemed agent PE rule in Article 5(5) to include arrangements where persons are playing the principal role leading to the conclusion of contracts or the changes to the independent agent rule of Article 5(6) to exclude its application to related persons; (ii) to choose neither option regarding the specified activity exceptions, so that the definition of preparatory or auxiliary activities would remain as is in the U.K.’s current treaties; and (iii) to adopt the anti-fragmentation rule in Article 5(4.1).
The reasons given for these recommendations are particularly interesting. HM Treasury and HMRC representatives noted the following:
HM Treasury and HMRC representatives also expressed the thoughtful observation that other jurisdictions may consider it prudent to adopt a cautious approach to the implementation of the changes to the deemed PE standard, on the basis that it would be easier for a country to subsequently amend treaties through the normal review and revision cycle if it is seen over time that the changes are working well in practice, as compared to accepting the proposed change now and endeavouring to change course later and withdraw the proposed rule from treaties newly amended by the MLI.
So let's assume that the Government accepts the recommendation, and the U.K. does not agree to include the “principal role” provision in its treaties. Since any actual change to a bilateral treaty must be accepted by both parties, that decision would preserve the current deemed PE rules in the entire U.K. treaty network, which is one of the most comprehensive in the world. Let's also assume that various other OECD and non-OECD countries do agree to incorporate the new “principal role” standard, which undoubtedly will be the case. This will mean that a group which supplies goods or services into a state from different nonresident suppliers may face significantly different treaty nexus thresholds for those two supplies, even if the dependent person (such as a sales and marketing affiliate) performs the exact same functions toward the market for the two suppliers. Thus, the identical activities could cause a deemed PE to exist in the state for one nonresident supplier, but not for the other.
It is common, of course, for taxpayers to have to navigate through a network of treaties with different provisions. Some treaties include a “services PE,” under which the provision of services through persons present in a state for a period exceeding a certain time threshold can create a PE, even in the absence of a fixed place of business. Treaties based on the U.N. Model may add to the deemed PE definition cases where the dependent person habitually maintains in the state a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the nonresident enterprise. Treaties based on the 1977 version of the OECD MTC may still include a provision allowing the imposition of withholding tax on payments for the use of industrial, commercial or scientific equipment.
This deemed PE difference in the treaty networks of even OECD member states, however, feels different due to the many recent controversies over the meaning and limits of the current “habitually concludes contracts” rule. Time will tell how well tax administrations and national courts will respect the point that the “principal role” standard is a distinctly different legal test than the existing “habitually exercises … an authority to conclude contracts” rule, so that if a state does not include the “principal role” rule in its treaties, the tax administration in the other contracting state cannot simply act as if it had. There have been off-the-record comments in some quarters that the “principal role” rule is meant to accomplish what always had been intended by the “authority to conclude contracts” rule. That is clearly not correct as a matter of legal interpretation of the treaty language (and the accompanying Commentary to the BEPS Action 7 changes). Accordingly, it will be up to the Competent Authorities of the U.K. and any other countries which follow the same path to make sure that this distinction is observed in cross-border trade under their treaties.
Also of interest are the competitive advantages this decision will provide to U.K. exporters. U.K. enterprises presumably are pleased by this decision (if it is adopted by the Government), as it will allow U.K.-based groups to continue to operate commercially efficient sales models which do not involve local country contracting, but which possibly could run afoul of the highly ambiguous “principal role” rule which emerged from Action 7.
Further, this development presents attractive opportunities for non-U.K. groups which wish to preserve efficient trading models, but also desire a European regional sales base. If the choice narrows to establishing in the U.K. or in some other country which has adopted the full panoply of BEPS Action 7 changes, the existence of a treaty network that allows more efficient sales models will be a clear positive inducement to select the United Kingdom. The adoption of mandatory binding arbitration in a number of the U.K. treaties would be an additional sweetener. This decision, therefore, is a material enhancement to the U.K.’s attractiveness as a base for inward investment, and a stimulus for creating the sort of employment that accompanies regional headquarters companies.
Accordingly, from the perspective of maintaining the integrity of the international tax law, the main challenge looming from the existence of divergent PE rules in different treaty networks is to ensure that the various tax administrations, including those which have been chomping at the bit to expand the scope of the PE Article, recognize and apply in practice that in the U.K. and perhaps other treaty networks, whether a nonresident has local nexus under the deemed PE rule must be assessed only according to authorities developed under the more precise “habitually exercises … an authority to conclude contracts” rule.
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