The last years have been characterized by an impressive and global trend for increasing tax transparency led, in particular, by the Organisation for Economic Co-operation and Development (OECD). In this context, the OECD Project against base erosion and profit shifting (BEPS) sets out 15 key actions to reform the international tax framework and ensure that profits are reported where economic activities are carried out and value created.
Given the number of tax treaties in force between the countries willing to implement OECD’s anti-BEPS recommendations, implementing the recommendations of the BEPS Project on a treaty-by-treaty basis would be a lengthy process, requiring more than 3,000 sets of bilateral negotiations.
Conscious of this constraint, the OECD developed in BEPS Action 15 a multilateral instrument (the “MLI”) the purpose of which is to allow interested countries to swiftly amend their tax treaty network. The MLI covers anti-BEPS measures relating to Action 2 (hybrid mismatches), Action 6 (tax treaty abuse), Action 14 (dispute resolution) and Action 7 (artificial avoidance of permanent establishment status).
BEPS Action 7, on which we focus today, is arguably one of the actions of the BEPS Project that could have the biggest impact on Luxembourg financial sector, and more particularly on the insurance and private banking sectors.
BEPS Action 7 – Objective to prevent artificial avoidance of PE status
On 5 October 2015, the OECD issued a final report under BEPS Action 7 in relation to preventing the artificial avoidance of permanent establishment
(PE) status. This report introduces changes to the OECD Model Tax Convention with the purpose of addressing what the OECD considers as strategies used to avoid having a taxable presence in a country under tax treaties.
These changes are expecting to restrict the application of a number of exceptions to the definition of PE to activities that are preparatory or auxiliary nature and to ensure that it is not possible to take advantage of these exceptions by the fragmentation of a cohesive operating business into several small operations. They also address situations where the exception applicable to construction sites is circumvented through the splitting-up contracts between closely related enterprises(1).
However, it is probably another change introduced by BEPS Action 7 in the OECD Model Tax Convention that should be of particular interest for the actors of the Luxembourg financial sector. We refer of course to the provisions related to the role of intermediaries/agents. In this respect, the report includes changes to the rules on dependent and independent agents intended to address commissionnaire and other undisclosed agent arrangements by:
The final report under BEPS Action 7 also confirms that there will be no specific PE threshold for insurance businesses in the OECD Model Tax Convention. Instead, insurance businesses will be treated in the same way as any other industry (unless variations are negotiated in bilateral agreements between specific countries), i.e. they will be subject to the above provisions. Insurers will notice that the report specifically mentions that “As part of the work on Action 7, BEPS concerns related to situations where a large network of exclusive agents is used to sell insurance for a foreign insurer were also examined. It was ultimately concluded, however, that it would be inappropriate to try to address these concerns through a PE rule that would treat insurance differently from other types of businesses (…).”
BEPS Action 15 - the multilateral instrument
The MLI published by the OECD in November 2016 addresses in its Part IV the definition of PE for tax treaty purposes. To do so, the MLI builds up on the recommendations provided in the final report on BEPS Action 7.
Whereas articles 13 to 14 of the MLI provides for rules designed to implement BEPS Action 7 when it comes to activities that are preparatory or auxiliary nature, fragmentation of a cohesive operating business into several small operations or splitting-up of contracts, article 12 of the MLI tackles the perceived artificial avoidance of a PE through commissionaire and simila arrangements via the extension of the scope of depend agent PEs.
Based on article 12 (1) of the MLI, where a person is acting in a Contracting Jurisdiction 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, that enterprise shall be deemed to have a PE in that Contracting Jurisdiction (subject to certain additional conditions). The important change introduced by article 12 (1) of the MLI in this respect concerns the reference to the “principal role leading to the conclusion of contracts” (as opposed to the conclusion of contracts). This addition significantly enhances the scope of activities that could lead to the recognition of a PE.
Article 12 (2) of the MLI provides that the above principles shall not apply where the person acting in a Contracting Jurisdiction on behalf of an enterprise of the other Contracting Jurisdiction carries on business in the first-mentioned Contracting Jurisdiction 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 will not be considered to be an independent agent.
This point is also an important factor on enhancement of the scope of activities that could lead to the recognition of a PE. Based on article 15 (1) of the MLI, 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(2) (50% test).
As a conclusion, under these provisions it would be way easier for countries to claim the existence of a PE of a non-resident enterprise and, therefore, a taxable presence in its jurisdiction (in particular) on the ground of the use of dependent agents.
The next questions to be answered to are therefore how and when provisions the MLI will be implemented (i.e. the conditions and circumstances under which a provision of the MLI, for instance its article 12, can become binding for a given country such as Luxembourg). In a nutshell, the provisions of the MLI should apply with respect to double tax treaties where:
In other words, in case one of the two Contracting States elects not to apply the relevant article of the MLI mentioned above, the corresponding provision of the MLI should not apply in the context of the bilateral relationship between those two Contracting States.
The different countries, including Luxembourg, have thus to position themselves. They were supposed to inform the OECD about the measures they intend to implement by 27 January 2017. The next step of the process is the speed networking event organized in February to allow countries to have bilateral discussions and potentially align their positions. At the date of this article, it is not known yet whether the Grand-Duchy will opt to apply article 12 of the MLI and if it does, if it will opt to apply it to all double tax treaties in force or only part of them.
Potential impact in Luxembourg and next steps
In Luxembourg, the local market being limited, actors of the financial sectors in the Grand-Duchy have been encouraged to find potential for growth in the neighboring Member States of the EU, notably on the ground of the freedom to provide services which is at the core of the European Common Market. Actors of the Luxembourg financial sector, and in particular the life insurance and private banking industries, strongly built on the local expertise and the multilingual capabilities of the Luxembourg workforce to propose their products and services across the EU. To do so, they often use the services of persons, called agents, intermediaries or commissionaires depending on the situations.
Under double tax treaties, this relationship is generally not constitutive of PEs of the Luxembourg resident banks or insurance companies in the relevant foreign countries. However, BEPS Action 7, as taken over by BEPS Action 15, could materially change the landscape as explained above. The recognition of a PE in a foreign taxation does not necessarily mean more taxes to be paid for the taxpayer concerned, but what it does mean for sure is increasing administrative burden taking the form of reporting obligations (to name just one example).
In this context, it is interesting to note that, in the UK, HM Treasury and HMRC officials presented on 16 December 2016 details of the extent to which the UK plans to adopt the changes. The proposals set out the UK Government’s thinking in relation to all of the potential changes included within the MLI. Whilst final decisions will be made by UK Ministers(3), these proposals clearly set out the UK Government’s views and are unlikely to change significantly. Largely, the UK is only proposing the minimal amount of mandatory change required to adhere to the minimum standards and is proposing to bring in very few of the other possible changes. Of the changes not being adopted, most significantly, the UK will largely not implement changes that would expand the definition of PEs (but for anti-fragmentation rules). Article 12 of the MLI should not be implemented by the UK.
As mentioned above, the position of the Grand- Duchy on this matter is not known at this stage. The Finance Minister M. Gramegna however mentioned end of January 2017 two things that are of importance in this regard. The first element is the confirmation of the intention of the Government that all the double tax treaties signed by Luxembourg will (in principle) be impacted by the MLI(4). The second announcement made, is that (unlike the UK) Luxembourg intends to go beyond the minimum standards foreseen by the OECD. M. Gramegna concluded however in saying that the Government had to find the “right balance” for Luxembourg.
It is for sure a crucial point. Considering the position taken by other countries such as the UK, as well as the attachment of Luxembourg to maintain the level playing field in Europe (including post-Brexit), the decision of the Luxembourg Government to implement (or not) certain provisions of the MLI, notably its article 12, and to make (or not) reservations on some of those, is likely to be closely monitored by the market.
1) Profit attribution to PEs and interaction with action points on transfer pricing are not covered by the present article.
2) In any case, a person shall be considered to be closely related to an enterprise if one possesses directly or indirectly more than 50% of the beneficial interest in the other (or, in the case of a company, more than 50% 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% of the beneficial interest (or, in the case of a company, more than 50% 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.
3) There is also a short period of consultation until 10 February 2017.
4) This is however subject to the position of the other Contracting State as detailed above.
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