Articles 12 to 15 - Artificial Avoidance of Permanent Establishment (PE) Status

 

Tax treaties generally provide that the business profits of a foreign enterprise are taxable in a State only to the extent that the enterprise has in that State a permanent establishment (PE) to which the profits are attributable. The definition of PE included in tax treaties is therefore crucial in determining whether a non-resident enterprise must pay income tax in another State.

 

The Action 7 Final Report includes the changes that will be made to the definition of PE in Article 5 of the OECD Model Tax Convention, which is widely used as the basis for negotiating tax treaties, as a result of the work on Action 7 of the BEPS Action Plan.

 

 

 

 

Those changes mentioned in the preceding paragraph are:

  • Artificial Avoidance of Permanent Establishment Status through Commissionnaire Arrangements and Similar Strategies [Article 12, the MLI]
  • Artificial Avoidance of Permanent Establishment Status through the Specific Activity Exemptions [Article 13, the MLI]
  • splitting-up contracts between closely related enterprises [Article 14, the MLI]

 

Structure and Contents of Articles 12 to 15 of the Multilateral Instrument (the MLI)

 

Article 12

Article 13

Article 14

Article 15

Artificial Avoidance of Permanent Establishment Status through Commissionnaire Arrangements and Similar Strategies

Artificial Avoidance of Permanent Establishment Status through the Specific Activity Exemptions

Splitting-up of Contracts

Definition of a Person Closely Related to an Enterprise

 

 

 

 

Operative Clauses

Operative Clauses

Operative Clauses

Operative Clauses

Article 12(1) and Article 12(2)

Article 13(1)

A party may choose to apply Option A, Option B, or apply neither Option

Article 14(1)

Article 15(1)

 

Article 13(2), (3), and (4)

 

 

 

 

 

 

Compatibility Clauses

Compatibility Clauses

Compatibility Clauses

Compatibility Clauses

Article 12(3)(a)

Article 12(3)(b)

Article 13(5)(a)

Article 13(5)(b)

Article 14(2)

 

 

 

 

 

Reservation Clauses

Reservation Clauses

Reservation Clauses

Reservation Clauses

Article 12(4)

Article 13(6)

Article 14(3)

Article 15(2)

 

 

 

 

Notification Clauses

Notification Clauses

Notification Clauses

Notification Clauses

Article 12(5)

Article 13(7) and (8)

Article 14(4)

(Not applicable)

 

 

 

Article 13 - Artificial Avoidance of Permanent Establishment Status through the Specific Activity Exemptions

 

 

Article 13(1) of the MLI provides three options that a contracting jurisdiction may choose to apply Option A under Article 13(2), or Option B under Article 13(3), or neither Option. Article 13(4) of the MLI replicates Article 5(4) and Article 5(4.1) of the Model Tax Convention, which specifically closes gaps that existed with respect to the avoidance of PE status.

 

Specific Activity Exceptions

 

The 2015 Final Report under Action 7 included changes to prevent the exploitation of the specific exceptions to the PE definition provided for by Article 5(4) of the OECD Model Tax Convention (2014), an issue which is particularly relevant in the case of digitalised businesses. These changes were incorporated into Article 5(4) as part of the 2017 Update of the OECD Model Tax Convention, which is set out below:

 

2014 OECD Model Tax Convention – Article 5(4)

2017 update on OECD Model Tax Convention – Article 5(4)

4. Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include:

(a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;

(b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;

(c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;

(d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;

(e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;

(f) the maintenance of a fixed place of business solely for any combination of activities mentioned in sub-paragraphs (a) to (e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.

 

4. Notwithstanding the preceding provisions of this Article, the term "permanent establishment" shall be deemed not to include: 

a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; 

b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; 

c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; 

d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise; 

e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity;

f) the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) to e), 

provided that such activity or, in the case of subparagraph f), the overall activity of the fixed place of business, is of a preparatory or auxiliary character.

 

4.1 Paragraph 4 shall not apply to a fixed place of business that is used or maintained by an enterprise if the same enterprise or a closely related enterprise carries on business activities at the same place or at another place in the same Contracting State and

a) that place or other place constitutes a permanent establishment for the enterprise or the closely related enterprise under the provisions of this Article, or

b) the overall activity resulting from the combination of the activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, is not of a preparatory or auxiliary character,

provided that the business activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, constitute complementary functions that are part of a cohesive business operation.

 

 

 

The provisions of  Paragraph 4 of Article 5 was redrafted by removing the phrase "of a preparatory or auxiliary character" from sub-paragraph (e). This is to ensure that all the sub-paragraphs of Article 5(4) are subject to a "preparatory or auxiliary character" condition.

 

Paragraph 4.1 of Article 5 of the 2017 version of the Model Tax Convention has incorporated a new anti-fragmentation rule, which, as provided under page 39 of the Final Report, is aimed to restrict the scope of Article 5(4) to activities having a "preparatory and auxiliary" character because, in the absence of that rule, it would be relatively easy to use closely connected enterprises in order to segregate activities which, when taken together, go beyond that threshold.

 

 

 

 

 

Article 14 - Splitting Up of Contracts

 

Article 5(3) of the Model Tax Convention, which is one of the exceptions to the PE status under Article 5(1), provides that "A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months."

 

The 12-month threshold has given rise to abuse because enterprises can divide the contracts up into several parts, each covering a period less than 12-month and attributing to a different company, which is owned by the same person. In this regard, Article 14(1) of the MLI is aimed to close the loophole, as set out below:

 

1. For the sole purpose of determining whether the period (or periods) referred to in a provision of a Covered Tax Agreement that stipulates a period (or periods) of time after which specific projects or activities shall constitute a permanent establishment has been exceeded:

a) where an enterprise of a Contracting Jurisdiction carries on activities in the other Contracting Jurisdiction at a place that constitutes a building site, construction project, installation project or other specific project identified in the relevant provision of the Covered Tax Agreement, or carries on supervisory or consultancy activities in connection with such a place, in the case of a provision of a Covered Tax Agreement that refers to such activities, and these activities are carried on during one or more periods of time that, in the aggregate, exceed 30 days without exceeding the period or periods referred to in the relevant provision of the Covered Tax Agreement; and

b) where connected activities are carried on in that other Contracting Jurisdiction at (or, where the relevant provision of the Covered Tax Agreement applies to supervisory or consultancy activities, in connection with) the same building site, construction or installation project, or other place identified in the relevant provision of the Covered Tax Agreement during different periods of time, each exceeding 30 days, by one or more enterprises closely related to the first-mentioned enterprise,

these different periods of time shall be added to the aggregate period of time during which the first-mentioned enterprise has carried on activities at that building site, construction or installation project, or other place identified in the relevant provision of the Covered Tax Agreement.

 

 

 

 

Article 12 – Artificial Avoidance of Permanent Establishment Status through Commissionnaire Arrangements and Similar Strategies

 

Article 12(1) and Article 12(2) of the MLI replicate the contexts of Article 5(5) and Article 5(6) of the 2017 update of the Model Tax Convention. 

 

In many cases, commissionaire arrangements and similar strategies were put in place primarily in order to erode the taxable base of the contracting state where sales took place. Changes to the wording of Article 5(5) and 5(6) are therefore needed in order to address such strategies.

 

The 2017 update on Model Tax Convention has incorporated the recommendation of the 2015 Final Report under Action 7 of the BEPS package, which expands the scope of the activities of the a person acting in a contracting state for an enterprise to cover the activity that plays a principal role leading to the conclusion of contracts and the supply of services and intangible properties. Such commissionaire arrangements trigger a taxable presence in the state with respect to the activities which that person performs for the enterprise. Consequently that enterprise shall be deemed to have a PE in that state in respect of the activities which that person undertakes on its behalf, unless those activities fall under the scope of specific activity exception mentioned in paragraph 4 of Article 5 which, if done through a fixed place of business, would not make this fixed place of business a PE under the provision of that paragraph.

 

A comparison between the 2014 Model Tax Convention and the 2017 update of the Model Tax Convention is given below:

 

2014 OECD Model Tax Convention – Article 5(5)

2017 update on OECD Model Tax Convention – Article 5(5)

5. Notwithstanding the provisions of paragraphs 1 and 2, where a person - other than an agent of an independent status to whom paragraph 6 applies - is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the 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.

 

5. Notwithstanding the provisions of paragraphs 1 and 2 but subject to the provisions of paragraph 6, where a person is acting in a Contracting State on behalf of an enterprise and, in doing so, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts 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 (other than a fixed place of business to which paragraph 4.1 would apply), would not make this fixed place of business a permanent establishment under the provisions of that paragraph.

 

 

Similarly, the 2017 update of the Model Tax Convention redefines that the activities performed by an independent agent do not include those performed by a closely connected person.

2014 OECD Model Tax Convention – Article 5(6)

2017 update on OECD Model Tax Convention – Article 5(6)

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.

6. Paragraph 5 shall not apply where the person acting in a Contracting State on behalf of an enterprise of the other Contracting State carries on business in the first-mentioned State as an independent agent and acts for the enterprise in the ordinary course of that business. Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, that person shall not be considered to be an independent agent within the meaning of this paragraph with respect to any such enterprise.

 

 

 

 

Article 15 - Definition of a Person Closely Related to an Enterprise

 

1. For the purposes of the provisions of a Covered Tax Agreement that are modified by paragraph 2 of Article 12 (Artificial Avoidance of Permanent Establishment Status through Commissionnaire Arrangements and Similar Strategies), paragraph 4 of Article 13 (Artificial Avoidance of Permanent Establishment Status through the Specific Activity Exemptions), or paragraph 1 of Article 14 (Splitting-up of Contracts), a person is closely related to an enterprise if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same persons or enterprises.  In any case, a person shall be considered to be closely related to an enterprise if one possesses directly or indirectly more than 50 percent of the beneficial interest in the other (or, in the case of a company, more than 50 percent of the aggregate vote and value of the company's shares or of the beneficial equity interest in the company) or if another person possesses directly or indirectly more than 50 percent of the beneficial interest (or, in the case of a company, more than 50 percent of the aggregate vote and value of the company's shares or of the beneficial equity interest in the company) in the person and the enterprise.

 

Allocation of Right to Impose Taxes between jurisdictions

 

The residence jurisdiction that imposes tax on worldwide income is subject to the exclusion by the source jurisdiction, in which income is derived by the P.E. set up in the source jurisdiction by an enterprise of the residence jurisdiction. The source jurisdiction is in turn subject to the specific exceptions of the source jurisdiction, by way of which the right to impose taxes is allocated back to the residence jurisdiction. Set out below is the Diagram showing the relations between residence jurisdiction and the source jurisdiction that limits the scope of residence jurisdiction. [read]

 

Set out below is the summary of the exceptions to the permanent establishment, including the limitation of scope on those exceptions.

2017 update on Model Tax Convention

Residence jurisdiction has the right to tax?

the Multilateral Instrument

Residence jurisdiction has the right to tax?

Article 5(3) – building site or installation project lasting for less than 12 months in source contracting state

Yes, residence jurisdiction has the right to tax.

Article 14 – Splitting-up contracts to avoid the 12-month threshold not allowed

No, it imposes a tax avoidance to the source jurisdiction. The right to tax is allocated to the source jurisdiction

Article 5(4) – Specific activity exceptions

Yes, as above.

Article 13(2) replicates Article 5(4).

 

Article 5(4.1) – Exempted activities carried on by closely related enterprises constitute P.E.

Yes, it provides an exception to the specific activities. The tax right is allocated to the source jurisdiction

Article 13(4) replicates Article 5(4.1).

 

Article 5(5) – If a person plays a principal role leading to contract conclusion, the enterprise is deemed to have a P.E. 

No, the right to tax is allocated to the source jurisdiction. 

Article 12(1) replicates Article 5(5).

 

Article 5(6) – Independent agent

Yes

Article 12(2) replicates Article 5(6).

 

Article 5(8) – Defining closely related enterprise

 

Article 15(1) replicates Article 5(8).

 

 

 

 

Concluding comment

 

Articles 12 to 15 of the MLI incorporate the contexts from the corresponding Articles of the 2017 Model Tax Convention, which were updated on the recommendations made in the 2015 Final Report under Action 7 of the OECD BEPS package.  

 

Paragraph 3 of Article 5 (duration of construction activities and installation projects), paragraph 4 of Article 5 (specific activity exceptions), paragraph 5 of Article 5 (commissionaire arrangements) and paragraph 6 of Article 5 (independent agent) of the 2017 Model Tax Convention, taken together, provide the exceptions to the PE status under paragraph 1 and 2 of Article 5. Those paragraphs were redrafted in order to prevent abuses of Article 5 of the 2014 Model Tax Convention, which had been used as references for concluding tax treaties before the BEPS package came into operation.