The Organisation for Economic Co-operation and Development (OECD) on May 15, 2015, released a revised discussion draft pursuant to Action 7 (preventing the artificial avoidance of PE* status) under the base erosion and profit shifting (BEPS) project.
The OECD has requested that comments be sent by June 12, 2015. No public consultation is planned for this revised discussion draft.
Read the revised discussion draft [PDF 315 KB] under BEPS Action 7.
The following KPMG report provides initial impressions and observations about the revised discussion draft.
Action 7 of the BEPS Action Plan calls for the development of:
…changes to the definition of PE to prevent the avoidance of PE status in relation to BEPS through the use of commissionaire arrangements and the specific activity exemptions.
The revised discussion draft describes proposals for amending Article 5 of the OECD Model Treaty chosen from the 14 options described in the original discussion draft. These proposals relate to four specific concerns with current Article 5:
The revised discussion draft states that although it includes specific proposals, it does not yet represent a consensus. Nonetheless, the revised draft does seem to reduce significantly the range of issues still under discussion. Like the original discussion draft, the revised discussion draft does not contain any specific rules applicable to electronic commerce.
The revised discussion draft also notes that any amendments to the definition of a PE in Article 5 must consider how the amendments would interact with the attribution of profits to a PE under Article 7 of the OECD Model Treaty. However, such work would need to take into account the results and proposals of the BEPS action dealing with transfer pricing—in particular the work regarding transfer pricing issues related to intangibles, risk, and capital. Accordingly, the follow-up work on attribution of profits issues related to Action 7 will be carried on after September 2015, with necessary guidance to be issued before the end of 2016.
Under existing paragraph 5 of Article 5, the activities of a person may create a permanent establishment (PE) for an enterprise only if the person “habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise.” BEPS Action 7 addresses two aspects of this provision.
The proposal adopted in the revised discussion draft is the narrower of the two alternatives suggested in the original discussion draft. As further explained in the commentary, this suggested change appears to be only a clarification, or at most a modest expansion, of the existing language of paragraph 5.
Paragraph 6 of Article 5 contains an exception to paragraph 5 under which a nonresident enterprise is not considered to have a PE 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.
The revised discussion draft would provide that an agent will never qualify for the independent agent exception if it operates exclusively or almost exclusively on behalf of one or more “connected” enterprises. For these purposes, whether two companies are “connected” generally would be determined under a 50% vote-and- value test; however, a Contracting State could also treat two persons as connected if, based on the facts and circumstances, one controls the other or both are under the control of the same persons or enterprises. Also, the accompanying Commentary suggests that an agent that concludes less than 10% of its sales for unrelated persons should be considered to be acting “exclusively or almost exclusively” for connected enterprises.
The revised discussion draft contains a narrower revision to the independent agent exception than the option contained in the original discussion draft in two respects. First, it permits an agent that acts on behalf of a single unrelated party to qualify as independent. Second, the concept of “connected” persons is narrower than the concept of “associated enterprises” contained in the original discussion draft.
Paragraph 4 of Article 5 of the OECD Model Treaty contains exemptions from PE status for preparatory and auxiliary activities. Subparagraphs 4(a) through (d) list specific activities that do not create a PE, while subparagraph 4(e) provides an exemption for any other activities that are of a preparatory or auxiliary nature.
The revised discussion draft proposes adopting Option E from the original discussion draft, which requires that each of the specific activities stated in existing subparagraphs 4(a) through (d) be preparatory and auxiliary in nature in order for the activity to not create a PE. Since existing subparagraphs 4(e) and (f) already provide for an exemption for any activity or combination of activities to the extent they are “of a preparatory and auxiliary character,” the new requirement that each specific activity or the overall activity must be preparatory and auxiliary would have the practical effect of eliminating the exemptions that are now provided for in subparagraphs 4(a) through (d).
This proposal will serve to add a facts-and-circumstances-based standard to the existing PE safe harbors. Such a proposal will inject a great deal of uncertainty to PE determinations and may lead to significantly more assertions of PEs and associated disputes. For example, paragraph 22 of the proposed commentary would provide for the possible existence of a PE when a taxpayer maintains a large warehouse with a significant number of employees.
The revised discussion draft also proposes adding an expansive anti-fragmentation rule as new paragraph 4.1 of Article 5. Under the proposal, the activities of two connected enterprises occurring at the same or different places could be aggregated to determine if such activities go beyond the preparatory or auxiliary standard— even if neither of the connected enterprises maintains a fixed place of business that constitutes a PE, provided the activities carried on by the two enterprises constitute complementary functions that are part of a cohesive business enterprise. Similarly, the activities of a single enterprise at two or more locations could be combined to create a PE. This proposal is the same as Option J of the original discussion draft, except that it uses the concept of “connected” enterprises, rather than the broader concept of “associated” enterprises
The splitting of contracts among related entities in order to avoid the PE threshold is a concern for building, construction, and installation projects. It also is a concern in the case of treaties that contain a “service PE” provision. The revised discussion draft proposes adding an example to the Commentary on the principal purpose test proposed as part of Action 6. This example would demonstrate a factual situation when a 22-month construction project is broken into two separate contracts between two separate but related entities, each lasting 11 months for a principal purpose of which was to obtain the benefit of paragraph 3 of Article 5. The Commentary concludes that such an arrangement would be contrary to the object and purpose of the rule.
For Contracting States that do not include a principal purpose test in their treaties, the revised discussion draft recommends including an automatic rule dealing with the splitting of contracts among connected enterprises within the Commentary to Article 5 as stated in Option K of the original discussion draft.
The revised discussion draft proposes that no specific rule for insurance enterprises is to be added to Article 5 (Option N of the original discussion draft). Hence, whether an insurance enterprise’s use of agents in a State creates a PE would be determined under the general rules of paragraphs 5 and 6.
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