1. How does a PE Analysis work after BEPS Action 7?
Tax treaties generally provide that the business profits of a foreign enterprise are taxable in a country only to the extent that the enterprise has a permanent establishment (“PE”) in that country to which the profits are attributable. Such a PE is formed when certain criteria listed under the tax treaties are met.
BEPS Action 7 was developed by the Organization for Economic Cooperation and Development (“OECD”) and G-20 to review the existing PE definition contained in the tax treaties because of unintended use of certain tax avoidance strategies commonly employed to circumvent the current PE definition.
However, in an attempt to close the loopholes of the existing PE definition, Action 7, inadvertently, also lowers the threshold for the classification of the local business activities of a foreign enterprise as a PE of such enterprise.
2. Did you know that the “zero-sum” game is over?
The “zero-sum approach” or the “single taxpayer approach”, as discussed by the OECD in its 2010 report on ‘Attribution of Profits to Permanent Establishments’ suggests that after an arm’s length remuneration has been provided to a dependent agent (as per the arm’s length principle enshrined in transfer pricing), no further remuneration needs to be awarded to the dependent agent PE.
However, after BEPS Action 7, these concepts do not appear to hold true anymore. Governments around the world are adopting diverse interpretations of Article 7 to attribute additional profit to the local operations of foreign enterprises. This is seen in, among others, two particular ways:
A.HOW DOES THE “AGENT = AGENT+” CONCEPT WORK?
The new language proposed by BEPS Action 7 states that a PE is formed by the actions of the local agent if the agent is seen to habitually play the principal role, leading to conclusion of contracts between the end customer and the foreign enterprise. This change is aimed to target situations (that were not addressed by the existing definition) where the local agent has been given full authority to negotiate with customers but where the contract at the end (which remains a mere formality at this point) is signed by the foreign enterprise.
However, the explanation provided under BEPS Action 7 allows for a much wider interpretation to be adopted. For example, the tax authorities in the jurisdiction of the agent could treat the inter- action of the local sales agent with the end customer as essential in generating income for the foreign enterprise, thereby labelling its activities as “playing the principal role” leading to formation of a PE.
B.HOW ARE GOVERNMENTS USING THE “STEPPING STONE” CONCEPT TO BROADEN TAX BASE?
A number of countries following the UN Model Double Taxation Avoidance Agreement follow the principle of focus on ‘source state taxation’ when it comes to attributing profits to a PE of a foreign enterprise. This means that when a foreign enterprise is said to have a PE in another country, a major portion of income that the foreign enterprise earns from carrying on activities (of similar kind as carried on by the PE) in that other country, whether or not through that PE is exposed to taxation as income of the PE. Such intention of allocation of additional profits to the PE also appears to come out of the wording of the final report on BEPS Action 7, which suggests that formation of a PE could be a stepping stone to attribution of (additional) income earned by the foreign enterprise in the country of the PE to the PE.
3. When does the MLI with the new PE definition kick in?
The multilateral instrument (“MLI”) seeks to implement a global standard for double tax avoidance treaties between countries signing and ratifying the MLI. However, the MLI proposes an elective approach for this purpose i.e. countries signing the MLI can make reservations on the application of certain articles contained in the MLI to their treaties covered by the MLI.
Thus, if a country makes a reservation on the definition of the PE in a covered tax agreement in the MLI, the old definition will continue to apply in respect of the treaties of that country. Only if two countries simultaneously accept (and ratify in their domestic law) the new definition of PE, it will become applicable to these countries.
4. TPA’s approach for PE self-assessment – process steps
The following chart presents, on one side, an illustration of the steps involved in conducting a PE analysis based on the new BEPS Action 7, and on the other side, the process steps to be taken for such analysis. Please note that the following decision tree only refers to the definition of a dependent agent PE. Similar decision trees are also available to assess the formation of physical PE and project PE.