The treaty concept of permanent establishment ('PE') as defined in Article 5 of the OECD Model Tax Convention is put in place to allow states to tax foreign enterprises whenever they carry out a substantial business activity on their territory. It is deemed fair – based on a quid pro quo sentiment – to shift taxing jurisdiction to the source state whenever an enterprise (due to the nature of its activities) fundamentally engages in economic life in the source state. Originating from a bricks and mortar economy, the concept of PE remained almost unchanged over a century. Amazingly, the concept only gave rise to few discussions with tax authorities and, given the numerous tax treaties, proportionally limited case law is also seen to exist. Especially in a MNE context, where it can be assumed that affiliated companies are acting with one another on an arm's length basis, limited appetite has been observed from foreign tax authorities in seeking taxable PE's (as the profit that would be allocable to them would be nil or very small).
However, due to globalisation and the integration of national markets, the PE concept in its current form was recently found to be no longer suited to cope with base erosion and profit shifting ('BEPS') schemes as applied by MNE's. That is why in 2013, the OECD adopted a comprehensive Action Plan to address BEPS. To prevent the use of certain common tax avoidance strategies that have been used to circumvent the existing PE definition, the Action 7 Report recommended changes to the definition of PE. In that context, changes have been made to the definition of 'Agency PE' to tackle so-called commissionaire structures. Furthermore, changes have also been included to prevent MNE's from obtaining tax advantages by fragmenting a cohesive business operation into several small activities, allowing the argument that each has a mere preparatory or auxiliary character that can benefit from the specific exceptions to the PE definition contained in Article 5(4). Although the OECD concluded that these changes to the PE definition did not require substantive modifications to existing rules on attribution of profits to PE, under Article 7 of the OECD Model Tax Convention, three reports have been published to provide additional guidance on how these profit allocation rules will apply to PE's resulting from the changed PE definition.
Undoubtedly, the OECD has done a tremendous job. In less than five years, the OECD has undertaken a substantial renovation of international tax rules. Once these new rules become applicable, it is expected that profits will be reported where the economic activities that generate them are carried out and where value is created.
However, despite the fact that intentions are good, we believe the OECD may have missed the chance to thoroughly revisit international rules regarding the cross border taxation of business profits. It is clear that the OECD has tackled the most obvious tax evasion schemes (see supra), but others remain very much untouched. For a MNE, it is indeed still possible to organise distribution activities (in a method very similar to the commissionaire structure) without triggering a PE. At the same time, the modification of the OECD Model Tax Convention's Article 5 was not preceded by a fundamental review of theories and principles of international law, nor did it originate from a reconsideration of the inherent material or tangible nature of the existing PE concept. Finally, it is assumed by the OECD that the existing rules on the attribution of profits are effective and well known, whereas in practice, local tax authorities tend to either avoid this type of discussion or apply arbitrary or lump-sum profit allocation rules, frequently leading to double taxation and lengthy remedy procedures.
As a result, we are afraid that the BEPS changes to the PE definition will often lead to theoretical improvements of source state taxation only, leading especially to additional compliance burdens at MNE level and leaving tax authorities without substantial extra revenue for local treasuries.
In this respect, we would like to make some practical observations that relate to PE issues in a MNE context, based on some examples.
First, as regards the attribution of profits to PE's, it can be derived from the recent OECD Report(s) that the zero profit approach does not apply per se. At the same time however, it is acknowledged by the OECD that because the PE's profits should be determined as if it were a separate and independent enterprise, no additional profit should be attributable to the PE if the affiliate creating the PE has already received an arm's length remuneration (taking into account the functions it performs and the risks it assumes). Nevertheless, the OECD has complicated this reasoning by referring (often needlessly) to the superfluous concept of 'internal dealing' (see infra). On the other hand, the OECD seems to agree that tax authorities might choose to collect the appropriate amount of additional tax (if any) resulting from the affiliate's activity, by adopting a kind of administratively convenient procedure and thus collecting tax only from the affiliate. Needless to say that this is positive as it will often enhance simplification. That being said, deleting reporting obligations at PE level is not the same as establishing that there is no PE in the source state. In this respect, it should be reiterated that the amount of profits will need to be calculated by reference to the PE's activities. Besides, the existence of a PE may also be relevant for the taxation of employees functionally deployed by the PE (Article 14) and passive income that is connected to the PE (Articles 10-12). The existence of a local presence might also affect the VAT treatment of the supplies performed for, or through the involvement of, the PE and trigger VAT reporting obligations in the PE's country.
To establish the PE's profits, the OECD has chosen for a 'functionally separate entity'-approach. This approach requires taking into account a certain degree of a PE's hypothetical independence (separate from the head office and/or other PEs), whereby assets and risks are to be allocated based on a functional and factual analysis (focusing on 'significant people functions' or 'key entrepreneurial risk taking functions' at the head office as opposed to the PE(s)), including so-called 'internal dealings', which should be priced on an arm's length basis in order to allocate profit to the PE. However, the OECD acknowledges that internal dealings should only be considered for profit attribution purposes provided that they:
- exceed a certain threshold, i.e. a real and identifiable event embedding a transfer of economically significant risks, responsibilities and benefits, and
- are relevant for the functions performed by the PE (vs. other parts), taking into account the assets used and risks assumed (by the PE or other part of the enterprise), in which case they should be assimilated to a comparable provision of services or goods (by sale, license or lease) between independent enterprises.
It is unfortunate however, that the OECD did not take into account potential VAT or other indirect tax implications of these findings. Although most jurisdictions put forward separate concepts for VAT ('fixed establishment') and direct tax ('PE'), practice shows that the lack of clear demarcation between the concepts triggers inconsistencies and misinterpretations. For example, where turnover or costs have to be VAT reported locally by a fixed establishment, but merely accrue to the principal under Article 7, such mismatch often entails unnecessary corrections, both at taxpayer and tax authority level. BEPS could have been a trigger to align the concepts, or at least clear the haze; so far however, the contrary seems to be the case.
Finally, we believe that the digitalisation of the economy proves that the bricks and mortar PE concept is becoming outdated and increasingly obsolete. Source states are missing-out on tax revenue simply because the criterion to establish tax jurisdiction (i.e. the PE concept) is not adapted, let it be that consensus exists regarding the way profit should be allocated to any such taxable presence. Again, a call for a more profound and fundamental review of the international tax rules …