The concept of what constitutes a permanent establishment (“PE”) and ultimately whether there is a taxable presence, is an issue frequently faced by international organisations and tax practitioners alike. Unfortunately, there is no easy answer. Typically, interested parties will rely on the OECD commentary to article 5. While this is only commentary, it provides insight into the spirit and intention of what the model treaty intends to capture. Given that the vast majority of treaties negotiated by sophisticated jurisdictions tend to follow the OECD framework, this commentary can be persuasive.

The challenge now though is that in light of the BEPS project and roll out of its recommendations, there is renewed uncertainty as to when a PE will be triggered. The position is made all the more challenging by the recent Swedish case, Dunlop Tyres.

Dunlop Case

Dunlop Tyres, a German tax resident company, was held to have a Swedish PE. The well-known Dunlop group had a company engaged in the development of tyre inflation software systems to unconnected car manufacturers. As part of its development process, on an annual basis, Dunlop sent some of its German based employees to Sweden to test developed software and gather data on how its product performed in the inclement Nordic environment. This testing period lasted approximately three to four months per annum.

While it was accepted by all parties that the research undertaken in Sweden was for the purposes of testing and data collection, there was a divergence in opinion as to whether the nature of the work could be considered “preparatory or auxiliary in nature”.

In order to arrive at its decision, the Swedish court considered the overall business and how integral the work undertaken was overall. The court held that the work undertaken in Sweden, which was performed by the same people and using the same procedures as when the activities were performed in Germany, to be a significant driver in the overall generation of corporate profit. It was felt that it was difficult to delineate between the Swedish activities and those undertaken in Germany.

Additionally, the court considered the nature of the activities performed in Sweden and the context in which this occurred. It was felt that the testing of the product in the cold Swedish environment was crucial in the development of the underlying product. This was evident from the fact that Dunlop had tested its products in this manner for each of the previous ten years.

The learning from this ruling is that the concept of “preparatory or auxiliary in nature” needs to be considered in a renewed light. It is no longer adequate to endeavour to argue that the period is of such a short duration that a PE cannot be triggered. A greater understanding of the business process is required and the importance (if any) of the stages in the product lifecycle. While the Dunlop case does not carry any legal weight in the Irish courts, the movement to an understanding of business operations and value drivers, is likely to be a focus which courts will move to.

BEPS

A second wave of change is coming in the form of BEPS. Action 7 considered the definition of what constitutes a PE. The recommendations and proposed changes have now been published. These will have a significant impact on what we theretofore have considered a PE and how organisations have been structured.

The fundamentals of what will constitute a PE remain unchanged. A taxable presence will continue to arise if a company is carrying on a business through a fixed place of business.

There are two significant amendments proposed to the rule. The first being the operation of agents and commissionaire structures, while the second revolves around the scope of the PE exclusion rules. There is an optional anti-fragmentation rule that jurisdictions can sign up to which will further increase the risk of creating a PE.

Agents and Commissionaire arrangements

The current rules indicate that an agent will only create a PE where they habitually conclude contracts in the name of the enterprise, and the agent is not legally and economically independent from the principal. To manage this potential PE issue, typically organisations ensured that the signing of contracts was undertaken in the enterprises home territory. Consequently, it was arguable that the sale was concluded in the home territory and taxable solely in that jurisdiction.

The proposed changes indicate that if the agent undertakes a significant portion of the work and no material changes are made in the home territory other than signing the contract, a PE could be considered to arise in the foreign jurisdiction. The new commentary also includes provisions to capture situations where the contracts are concluded in the agent’s name, but using the principles IP or goods. The bar on what will constitute independence has been raised. Consideration will need to be given to whether the agents business is largely or wholly dependent on business derived from the principal. If this is the position, the agent will no longer be considered independent.

Permanent establishment exclusion rules

Current rules allow a blanket exclusion of certain operations such as warehouses, procurement offices or information collection. These scenarios are considered to be non-value adding and or a preparatory nature. Where an activity can be captured under one of these exemptions, the organisations are not considered to have permanent establishments.

The proposed changes will limit the scope of the exclusions. This is due to the extension of the “preparatory and ancillary test” from a section in its own right to cover the entire exceptions category. The proposed revised test is grounded in the concept that the activity must be of a short-term duration (preparatory), and not being an essential and significant part of the activity (ancillary). This is a significant limitation to the activities which will be able to avail of the PE exemption.

The proposed new commentary gives an example of a distribution warehouse for an online retailer. Under the current rules, the warehouse would not be considered a permanent establishment as it typically falls within the scope of the exclusion contained in most tax treaties. However, under the new provisions, the warehouse would be considered a permanent establishment as it is not considered to be temporary and that the distribution of said products would be perceived as essential to the business.

Anti-fragmentation rule

The optional anti-fragmentation rule permits a jurisdiction to group a number of operations in the same jurisdiction performed by closely related parties in order to determine that there is a PE. This is in order to combat the use of multiple subsidiaries in an endeavor to avoid a PE. However, this is limited to a certain extent by the inclusion of a clause requiring these complementary functions to be part of a cohesive business operation that is not of a preparatory or ancillary nature as described above.

An extension of this rule covering timelines is also included to address the concerns of connected enterprises taking shorter contracts in succession to avoid creating permanent establishments. This requires groups to take a holistic view of their operations in any single country to ensure that they do not inadvertently create a PE.

When does this come into effect

The OECD’s published Multilateral Instrument enables countries to quickly implement the changes to bilateral treaties proposed by the BEPS project. At the official June 2017 signing ceremony, 68 countries signed up to it, Ireland inclusive. More countries have subsequently followed suit.

One hundred and three jurisdictions participated in the BEPS project. If implemented, the Instrument could result in more than 2,000 treaties being amended. This would equate to more than two thirds of the world’s double taxation agreements. While the proposed changes have the potential for significant change, it would be preferable if there was widespread adoption. At least if this were to occur, it would ensure consistency and certainty for businesses and tax authorities.

With a renewed zeal to increase tax base, what is certain is that the concept of PE will come under renewed focus by tax authorities. Tax functions, be they internal or external, need to have an understanding of organisations, how they operate and the jurisdictions in which functions (e.g. sales, development etc.) are performed. A more detailed understanding will help in assessing if a potential tax issue arises by virtue of this new approach to PE’s. Proactivity as opposed to reactivity is required in order to manage risk and this potential new challenge.

Cormac Kelleher is the international tax partner with Mazars Ireland, with a particular focus on inward investment.

Email: ckelleher@mazars.ie