BEPS Action 7 - Preventing the Artificial Avoidance of Permanent Establishment Status
BEPS Action 7 provides a review of the definition of a permanent establishment. This is needed because generally tax treaties provide that profits of a foreign enterprise are taxable in a state only when it has a permanent establishment to which the profits are attributable. The definition of what a permanent establishment is becomes crucial to determine if a non-resident enterprise is liable to pay tax or not.
Tax avoidance strategies could be created to circumvent the definition as was used in the OECD Model Tax Convention of 2014. By replacing distributors with commissionaire arrangements profits could be shifted out of countries where actual sales took place.
Also with the digital economy becoming more and more important (see BEPS Action 1) there was another reason to review the definition and the exceptions to that definition of a permanent establishment.
BEPS Action 7 recommends the changes to be made to the definition of a permanent establishment in the OECD Model Tax Convention. Three different avoidance strategies are targeted with the updated definition:
- Artificial avoidance of permanent establishment status through commissionaire arrangements and similar strategies
- Artificial avoidance of permanent establishment status through the specific exceptions of the OECD Model Tax Convention
- Other strategies for the artificial avoidance of permanent establishment status
Artificial avoidance of permanent establishment status through commissionaire arrangements and similar strategies
A commissionaire arrangement is an arrangement where a person sells products or services in a country on behalf of a foreign company. The seller does not own the products and/or services it sells. Because of this characteristic the seller cannot be taxed on the revenue of the sales, but only on its income which is sales commission. The foreign enterprise does not pay taxes on the revenues in a commissionaire arrangement in the country where it effectively sells its products and/or services, but only in its home country.
To address this – and similar strategies – changes have been made to the OECD Model Tax Convention. The definition now includes that persons acting in a contracting state 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, and these contracts are
- in the name of the enterprise, or
- for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or
- for the provision of services by that enterprise,
that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise.
The changed definition now sets the activities of sales agents acting foremost on behalf of the company equally the same as distributors for the permanent establishment determination. Based on the characteristics, being the facts and circumstances, of the relation between the sales agent and the enterprise the sales agent is deemed not to be independent of the enterprise in its doings. On the contrary those sales organizations that act for their own account or those that act on behalf of multiple different companies (from different groups) do not fall in the scope of the definition. These kind of sales agents are deemed to be independent from the company they represent.
Artificial avoidance of permanent establishment status through the specific exceptions of the OECD Model Tax Convention
The OECD Model Tax Conventions includes a list of exceptions (the specific activity exemptions) based on which a permanent establishment is not deemed to exist if the place of business is used solely for activities included in the exceptions.
The exceptions are:
- The use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
- The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
- The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
- The maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise;
- The maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity not listed above, provided that this activity has a preparatory or auxiliary character;
- The maintenance of a fixed place of business solely for any combination of activities mentioned above, provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.
Preparatory or auxiliary activities are those activities not being of an essential part of the business. Splitting up such activities in smaller parts or in other words fragmenting them to make them seem not essential parts of the business is taken care of with the anti-fragmentation rule.
The anti-fragmentation rule looks at the cohesive business operation. It prevents that functions are separated in a state so each of them individually would be regarded as an exception whereas the complete business operation in the state would be characterized as a permanent establishment.
Other strategies for the artificial avoidance of permanent establishment status
The work on BEPS Action 7 has identified two more strategies that are used to avoid permanent establishment status. The first is the splitting up of contracts and the second is the situation where a large network of exclusive agents is used to sell insurance for a foreign insurer.
The splitting up of contracts in shorter timeframes to avoid a permanent establishment has effectively been addressed in BEPS Action 6 with the application of the Principal Purposes Test (PPT) rule that has been added to the OECD Model Tax Convention.
For the situation around insurance agents it has been concluded that it would be inappropriate to address these concerns through a permanent establishment rule that would treat insurance differently from other types of businesses. These situations should be covered under the general changes as agreed in this BEPS Action 7.
Effects of BEPS Action 7
The OECD has recognized some gaps in the OECD Model Tax Convention and has used BEPS Action 7 to repair these. The changes made to the Convention result in a more sophisticated approach to permanent establishments. The changes include a more holistic approach where a closer look is being given to the character of a relation between a foreign representative of an enterprise and also to the whole of the business activities instead of isolated parts. These combined result in a more effective prevention of avoiding permanent establishment status.