On 5 October 2015, the Organisation for Economic Co-operation and Development (OECD) released its final report on preventing the artificial avoidance of permanent establishment (PE) status under its Action Plan (Action 7) on Base Erosion and Profit Shifting (BEPS). This report was released in a package that included final reports on all 15 BEPS Actions.

The document, Preventing the Artificial Avoidance of Permanent Establishment Status (the Action 7 Report), aims to develop changes to the PE definition in Article 5 of the OECD Model Tax Convention (the OECD Model) to prevent multinationals from establishing arrangements that the OECD consider to artificially avoid the existence of a PE. The changes to Article 5 revise the established principles of ‘a fixed place of business, ‘a dependent agent’, and ‘an independent agent’ as well as introducing new anti-fragmentation and contract splitting rules.

The revisions to Article 5 of the OECD Model by the Action 7 Report can be categorised as follows –

1. Commissionaire and similar arrangements
2. Specific activity exemptions
3. Anti-fragmentation rules
4. Splitting-up of contracts

1. Commissionaire and similar arrangements

A commissionaire is an arrangement recognised under the European civil law concept of agency. Under civil law, the commissionaire is acting in its own name, but on behalf of and at the risk of a principal company.

Through commissionaire arrangements, a foreign enterprise, acting as the principal, is able to sell in another country, via an affiliate company acting as a commissionaire, without having a PE in that country on the basis that the commissionaire is not concluding contracts in the name of the foreign enterprise.

Commissionaire arrangements are a common feature of tax efficient international business models. However, they have been subject to significant litigation by various tax authorities in recent years, on the basis that they regard such arrangements as artificially avoiding a PE. However, tax authorities have largely been unsuccessful in their efforts.

Similar strategies that seek to limit the application of Article (5)(5) of the OECD Model include arrangements where contracts which are substantially concluded in one country by an affiliate company of another company but those contracts are not formally concluded by that other company in its country of residence, i.e. ‘commission agent’ arrangements. For example, an Italian subsidiary of a company in the UK may substantially conclude contracts in Italy but those contracts are then formally concluded in the UK by the parent company. Under such arrangements, the UK company may assert that it does not have a PE in Italy on the basis that the Italian subsidiary does not have the ‘authority to conclude contracts’ in the name of the UK company which is a key feature of Article (5)(5) for the UK company to be regarded as having a PE in Italy by virtue of the activities of the Italian subsidiary.

As part of the BEPS Action Plan, the OECD, as a matter of policy, sought to ensure that where activities that an intermediary exercises in a country are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, that enterprise should be regarded as having a PE in that country unless the intermediary is performing these activities in the course of an independent business, i.e. acting as an ‘independent agent’.

The Action 7 Report proposes to amend Article 5(5) (commonly referred to as ‘the dependent agent’ paragraph) such that a foreign enterprise will be deemed to have a PE in a country where a person is acting in that country on behalf of the enterprise, and, in doing so, such person 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”. The relevant ‘contracts’ for this purpose are those that are –

1. In the name of the enterprise, or
2. For the transfer of, or right to use, property that the enterprise owns or has the right to use, or
3. For the provision of services by the enterprise.

However, the foregoing activities shall not create a PE for the applicable enterprise if:

1. The activities are limited to the “preparatory or auxiliary” activities described in Article 5(4) of the OECD Model (discussed further in ‘Specific Activity Exemptions’ below); or
2. The activities are carried on by certain ‘independent agents’ under Article 5(6) of the OECD Model (discussed further below)

The phrase “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise” targets situations where the conclusion of a contract directly results from the actions that a person or entity performs in another country on behalf of the enterprise even though, under the relevant law, the contract is not concluded by that person in that country.

The revision to Article 5(5) has the following consequences for commissionaire and commission agent sales models –

1. Commissionaire arrangements will in the future create a PE for the foreign principal enterprise in the country of the commissionaire on the basis that the commissionaire plays the principal role leading to the conclusion of contracts without material modification by the principal enterprise and those contracts are for the transfer of, or right to use, property that the enterprise owns or has the right to use, or for the provision of services by the enterprise.
2. Commission agent arrangements will in the future create a PE for the principal enterprise where the commission agent habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise. For example, a PE is likely to arise where a person solicits and receives (but does not formally finalise) orders which are sent directly to a warehouse from which goods belonging to the enterprise are delivered and where the enterprise routinely approves these transactions.

The Action 7 Report also proposes to amend Article 5(6) of the Model Treaty. Previously, Article 5(6) provided that an enterprise shall not be deemed to have a PE in another country merely because it carries on business in that country 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, i.e. they act as an ‘independent agent’. However, the Action 7 Report proposes to delete the current version of Article 5(6) and replace it with a new Article 5(6) which effectively provides that a person will not be regarded as an independent agent where that person “acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related”. Specific rules are set out in the new Article 5(6) for determining whether the agent and the foreign enterprise are “closely related”.

2. Specific Activity Exemptions

Currently, Article 5(4) of the OECD Model specifically exempts certain activities from creating a PE (‘Specific Activity Exemptions’) where a place of business is used solely for activities listed in that paragraph. When the Specific Activity Exemptions were first introduced, the activities covered by these exceptions were generally considered to be of a preparatory or auxiliary nature. However, the OECD believes that these Specific Activity Exemptions may no longer be preparatory or auxiliary in nature in certain circumstances. In fact, activities previously considered to be merely preparatory or auxiliary in nature may now be regarded as core business activities.

The Action 7 Report proposes to modify the wording of Article 5(4) such that each of the listed exemptions from PE status is restricted to activities that are of a preparatory or auxiliary character or the overall activity of the fixed place of business is of a preparatory or auxiliary character. Through this modification, the OECD aims to prevent what it views as the artificial avoidance of a PE through the use of these exemptions.

The OECD acknowledges that it is often difficult to distinguish between activities which have a preparatory or auxiliary character and those which have not. They purport the decisive criterion to be whether or not the activity of the fixed place of business in itself forms an essential and significant part of the activity of the enterprise as a whole. Each individual case will have to be examined on its own facts and circumstances. In any case, a fixed place of business whose general purpose is one which is identical to the general purpose of the whole enterprise, does not exercise a preparatory or auxiliary activity.

The Action 7 Report also proposes optional wording for Article 5(4) under which the activities listed are not subject to an explicit “preparatory or auxiliary” requirement. This is to address the concern of certain countries that consider the activities listed in Article 5(4) as being intrinsically preparatory or auxiliary in nature and that are of the view that subjecting these activities to such requirement would create greater uncertainty for both tax administrations and taxpayers. The proposed revised commentary on Article 5 also provides that any concern about the inappropriate use of the paragraph 4 exceptions would be addressed by the new anti-fragmentation provision (discussed below).

3. Anti-Fragmentation Rules

The Action 7 Report also proposes to incorporate a new anti-fragmentation rule by adding a new sub-paragraph 4.1 to Article 5. The purpose of an anti-fragmentation rule is to prevent the use of the Specific Activity Exemptions in paragraph 4 to artificially avoid PE status by fragmenting a ‘cohesive operating business’ into several small operations in order to argue that each part is merely engaged in preparatory or auxiliary activities. The OECD takes the view that because of the ease of setting up subsidiaries, the anti-fragmentation rule should to be extended to cases where these places of business belong to closely related enterprises.

The anti-fragmentation rule would work to prevent the preparatory or auxiliary exemptions under Article 5(4) from applying to a fixed place of business maintained by an enterprise, if the same enterprise or closely related enterprise carries on business activities at the same place or another place in the same country and either:

1. The place or other place constitutes a PE, or
2. The overall activity by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places is not preparatory or auxiliary.

Also, the aggregation rule under the new paragraph 4.1 would only apply if the business activities carried on by the two enterprises constitute “complementary functions that are part of a cohesive business operation”.

The proposed Commentary provides that in order for the anti-fragmentation rule to apply, at least one of the places where these activities are exercised must constitute a PE or, if this is not the case, the overall activity resulting from the combination of the relevant activities must go beyond what is merely preparatory or auxiliary.

4. Splitting-up of contracts

The OECD stated in the Action 7 Report that the exception in Article 5(3) of the OECD Model, which applies to construction sites, has given rise to abuses through the practice of splitting-up contracts between closely related enterprises.

The Final Report proposes that the Principal Purpose Test (PPT) rule to be added to the OECD Model under BEPS Action 6 would prevent such abuses. The Final Report further proposes the inclusion of an example in the OECD Commentary to the PPT rule illustrating when it would be considered appropriate to aggregate the time that two related companies worked on a construction project because it is reasonable to conclude that one of the principal purposes of splitting up the contract is to obtain the benefit of the 12 month rule under Article 5(3). For countries that cannot address the issue via their domestic anti-abuse rules, an alternative automatic aggregation rule will also be included in the OECD Commentary as a provision to be used in treaties that would not include the PPT rule or by countries with specific concerns in this area.

Insurance Industry

As part of the work on Action 7, concerns were examined regarding situations where a large network of exclusive agents is used to sell insurance for a foreign insurer. However, it was concluded that it would be inappropriate to try to address these concerns through a PE rule because it would treat insurance differently from other types of businesses and that BEPS concerns in those cases should be addressed through the more general changes to Articles 5(5) and 5(6).

Profit Attribution to PEs

The Action 7 Report also considered whether the existing rules in the OECD Model would be appropriate for determining the profits that would be allocated to PEs resulting from the changes included in the report. The conclusion was that these changes do not require substantive modifications to the existing rules and guidance but that there is a need for some additional guidance on how the Article 7 (Business Profits) rules would apply to PEs resulting from these changes.

The Action 7 Report states that work on attribution of profit issues related to Action 7 could not be done before the work on Action 7 and Actions 8–10 (aligning transfer pricing outcomes with value creation) is completed. Therefore, the Action 7 Report indicates that follow-up work on attribution of profits issues related to Action 7 will continue 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 is intended as a mechanism for implementing the treaty-based recommendations under the BEPS Action Plan.

Implications

The Action 7 Report sets forth specific amendments modifying paragraphs 4, 5 and 6 of Article 5 of the OECD Model, together with proposed Commentary to provide guidance on the new rules.

Once implemented, the Action 7 Report amendments will have implications for how companies operate global businesses going forward as current operating models could create new PEs in other countries for these companies. New PEs would mean additional tax filing obligations, potentially a higher tax burden on companies and increased potential for controversy. Moreover, the issue of profit attribution to these new PEs is an important matter for businesses, and the work on that issue has not yet been completed. The precise timing for the implementation of these changes to the OECD Model is linked to the BEPS Action Plan multilateral instrument taking effect. However, companies would be well advised to assess to assess the impact of the proposed changes now to avoid surprises later.

Colin Smith is a corporate tax partner within EY Industrial, Commercial and Technology tax group. He specialises in providing tax services to Irish listed companies and multinational businesses.

Email: colin.smith@ie.ey.com

Tele: +353 (0) 1 221 2655

Mark Connor is a senior tax manager within EY International tax group. He specialises in the development of international business models and cross border financing.

Email: mark.connor@ie.ey.com

Tele: +353 (0) 1 221 2838