Policy Proposals Business Law Comments on the Public Discussion Draft on BEPS Action 7 (Preventing the Artificial Avoidance of PE Status)
Marlies de Ruiter
Head, Tax Treaties, Transfer Pricing and Financial Transaction Division
Centre for Tax Policy and Administration
Organisation for Economic Co-operation and Development
Comments on the Public Discussion Draft on
BEPS Action 7 (Preventing the Artificial Avoidance of PE Status)
Keidanren hereby submits its comments on the Public Discussion Draft "BEPS Action 7: Preventing the Artificial Avoidance of PE Status)" published by the OECD on October 31, 2014.
We are supportive of an approach to prevent an enterprise from engaging in artificial arrangements to avoid a permanent establishment (PE) status when it is considered, based on the current taxation rules, to have a sufficient taxable nexus in the source country. We also understand that the increasing digitization of the economy has created certain issues that are difficult to solve within the existing framework and made us initiate discussions for the review of the system. Keidanren supports the OECD's efforts for the implementation of BEPS Action 7, which is intended to ensure the prevention of unfair base erosion in source countries, an effective response to the challenges of a digital economy, and fair competitive conditions among companies.
However, the Public Discussion Draft has caused a concern over a possible broadening of the scope of PE and increased taxation in source countries, exceeding its primary objective of addressing the BEPS issues. We consider that it is necessary to review the Draft taking fully into consideration the consistency with the BEPS Action Plan, which states that "these actions are not directly aimed at changing the existing international standards on the allocation of taxing rights on cross-border income."
We believe that the primary aim of Action 7 is to develop measures that focus on the prevention of artificial avoidance of PE status (i.e., a recovery of lost tax revenue). The Draft would go too far if it were intended to generate new tax revenues in source countries by assigning a PE status to activities that are not a PE per se. It is already a common practice in some member countries of the BEPS project to give an expansionary interpretation to PE. As a result, enterprises are faced by unfair double taxation. We would recommend the OECD to develop balanced anti-avoidance measures taking into consideration the situations above.
We found that the Public Discussion Draft does not necessarily provide clear definitions of the words used in the fourteen options (A through N), which are included in the Draft for changes to Article 5 of the OECD Model Tax Convention. Such a lack of clear definitions may allow tax authorities subjective interpretation and arbitrary application of the Article and thereby cause uncertainties for taxpayers. The scope of PE should be defined as clearly as possible because it plays an important role as a threshold that determines whether an enterprise is subject to a country's corporate income taxation or not.
Further, the Public Discussion Draft does not offer any proposal about the profit attribution to a PE. The interpretation of "attributable profits" varies significantly from member state to member state as their domestic law governs the calculation of profits attributable to a PE. While OECD member states have started and are expected to introduce the Authorised OECD Approach (AOA), non-OECD countries are unlikely to do the same, which has created a concern over the proliferation of income calculation approaches that are not consistent with the AOA (e.g., taxation based on deemed profit rates and worldwide taxation). Under these circumstances, the broadening of the scope of PE will automatically result in an increased double taxation. If the OECD/G20 aims to reach a new agreement among member states in respect of the scope of PE, it would be necessary for the purpose of striking a balance to build an appropriate consensus on the calculation of profits attributable to a PE.
Should the Draft be adopted as it is, it will create concern over double taxation. Such a concern could have a significant impact on enterprises' existing business models and consequently may jeopardize cross-border economic exchanges. Accordingly, we expect that in September 2015, when the OECD compiles a final recommendation for Action 7, it would provide, in conjunction with rules governing the attribution of profits to a PE, a new set of clearly-defined measures that focus on the prevention of BEPS and response to the challenges of a digital economy. Further, in order to completely solve disputes over PEs, it would also be necessary to develop measures such as making the mutual agreement procedure (MAP) effective under Action 14 (Dispute Resolution Mechanism).
The following are our comments on specific issues based on the general comments above.
In the Public Discussion Draft, a commissionnaire arrangement is defined as "an arrangement through which a person sells products in a given State in its own name but on behalf of a foreign enterprise that is the owner of these products" (paragraph 6). In addition, the Draft expressed a view that "it is clear that in many cases commissionnaire structures and similar arrangements were put in place primarily in order to erode the taxable base of the State where sales took place," and that "as a matter of policy, where the 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 considered to have a sufficient taxable nexus in that country unless the intermediary is performing these activities in the course of an independent business" (paragraph 10).
However, in our opinion, the view that "it is clear that ...put in place in order to erode the taxable base" is one-sided and does not accurately reflect the actual state of corporations.
First of all, the Public Discussion Draft seems to have some concern about the cases in which a buy-sell distributor is changed to a commissionaire to reduce taxable income to an unreasonably low level (paragraph 7). However, we believe that a change of business structure does not always result in a reduced level of taxable income. Rather, when a buy-sell distributor is engaged in marketing activities facing inventory and other risk factors and suffers from high costs and severe marketing competition, it will be difficult for the distributor to secure a sufficient level of income. In such cases, if local distributors are converted to a commissionnaire and inventory risks and inventory management costs are concentrated on the principal, it may allow the commissionnaire to obtain commission income and stabilize its income stream.
It is unclear what is meant by the phrase "similar arrangements" (paragraph 10). However, it is often the case that an enterprise is initially engaged in direct sales with foreign companies, but later establishes subsidiaries in the foreign countries not as a buy-sell distributor but as an intermediary. This is a normal activity based on a valid business reason and is not intended for "base erosion". In other words, the subsidiary may be merely performing its function, i.e., communicating on a daily basis with clients who are a resident of a distant country according to a request of such clients. Otherwise, the reason why a subsidiary does not act as a buy-sell distributor may be that the subsidiary is not financially capable of taking credit risks associated with sale and purchase transactions. It is not reasonable to view all of these enterprise behaviors as BEPS.
With regard to the change from a buy-sell distributor to a commissionaire, necessary measures have already been taken in the transfer pricing taxation system (Transfer Pricing Guidelines Chapter IX "Transfer Pricing Aspects of Business Restructurings"). If abusive arrangements are one of the reasons for the base erosion, it would be appropriate to resolve the issue in the context of transfer pricing taxation rather than through the expansion of the PE concept, including a review of the appropriateness of the commission level based on the arm's length price (ALP).
(Comments on Proposals)
The Public Discussion Draft offers four options (A through D) for changes to Article 5, paragraph 5 (dependent agent) and paragraph 6 (independent agent) of the Model Tax Convention to deal with the artificial avoidance of PE status through "commissionnaire arrangements and similar strategies." All of these options are designed to strengthen the requirements to be identified as an independent agent. The Draft also provides four (2X2) variations for the changes concerning dependent agent.
That is, to deal with issues arising from the phrase "in the name of," which is found in Art. 5(5) of the current Model Tax Convention, the Draft presents possible approaches that focus on the "subject" of the contracts (transfer of property ownership/provision of services) rather than the authority to conclude contracts, or on the "substance" of the contracts (account and risk). Specifically, the Draft presents two options of "engages with specific persons in a way that results in the conclusion of contracts" or "negotiates the material elements of contracts" to deal with cases where contract negotiations are held but the contract is not concluded.
The following table shows the summary of the previous paragraph:
Focus on Contract Subject
(Transfer of ownership/ Provision of services)
Focus on Contract Substance
(Account and risk)
Engages with specific persons in a way that results in the conclusion of contracts Option A Option C Negotiates the material elements of contracts Option B Option D
We reviewed each option based on the understanding above. As a result, we are not supportive of the options focused on the substance of the contracts (Options C and D), as we believe they may broaden the scope excessively.
Further, the approach that requires "engaging with specific persons in a way that results in the conclusion of contracts" (Option A) is also unacceptable in view of the possibility to lead to expansionary interpretations. If Option A is to be adopted, a person may be regarded as a PE even if he merely gathers information or makes arrangements for appointments with prospective and existing customers. In contrast to Option A, Option B's wording will lead to a lower risk of being recognized as a PE. However, it is ambiguous with respect to the meaning of "material elements of contracts." As mentioned above, we believe that both Options A and B may lead to a subjective or arbitrary application by the tax authorities. We are also concerned that they may impose significant constraints on enterprises' temporary employee transfers to their overseas subsidiaries and seriously undermine business predictability.
According to Article 5, paragraph 6 of the current Model Tax Convention, independent agents are not regarded as a PE. However, in the Public Discussion Draft, a clause "where a person acts exclusively or almost exclusively on behalf of one enterprise or associated enterprises, that person shall not be considered to be an independent agent within the meaning of this paragraph with respect to these enterprises" was added and the requirements were further strengthened.
However, in view of paragraph 38.6 of the current Commentary on Article 5, which states "All the facts and circumstances must be taken into account to determine whether the agent's activities constitute an autonomous business conducted by him in which he bears risk and receives reward through the use of his entrepreneurial skills and knowledge," independent status should not be determined only on the basis of the number of principals that the person acts for.
Preparatory or Auxiliary Activities
A fixed place of business through which the enterprise exercises solely an activity which has a preparatory or auxiliary character, is deemed not to be a permanent establishment because "it is recognized that such a place of business may well contribute to the productivity of the enterprise, but the services it performs are so remote from the actual realization of profits that it is difficult to allocate any profit to the fixed place of business in question" as stated in paragraph 23 of the current Commentary on Article 5.
Accordingly, if any revision needs to be made to Article 5, paragraph 4 of the Model Tax Convention, which provides for exceptions from PE status for preparatory or auxiliary activities, it would be necessary to build an international consensus that the fixed place in question is at least a place of business to which profits can be allocated. Put differently, if it is still difficult to allocate any profit, it would not be necessary to create a new PE category by imposing additional burden on both the tax authorities and taxpayers.
(Comments on Proposals)
The Public Discussion Draft provides Options E through H for the proposed revision of Article 5, paragraph 4 of the Model Tax Convention, describing, in the Executive Summary, that "the fact that some parts of Art. 5(4) do not expressly refer to preparatory or auxiliary activities does not seem to conform with what they consider to be the original purpose of the paragraph, i.e., to cover only preparatory or auxiliary activities." Of the four Options, Option E is intended to clarify that all the activities currently listed in paragraph 4 of Article 5 are subject to the condition of being preparatory or auxiliary.
On the other hand, Options F through H would modify the paragraph on a more targeted basis in the event of Option E being not adopted (paragraph 16). That is, Option F provides for the deletion of the word "delivery" in subparagraphs a) and b) of paragraph 4, for cases, for example, where an enterprise maintains a very large warehouse in which a significant number of employees work for the main purpose of delivering goods that the enterprise sells online (paragraphs 17 through 20).
Option G proposes to delete the reference to "purchasing goods or merchandise" from subparagraph d), to ensure consistency with the AOA, which abolished the provision intended to exempt mere purchases from taxation (paragraphs 21 through 27). Option H provides for the deletion of the entire subparagraph d) and thereby removes the exception for "collecting information," in addition to "purchasing goods or merchandise." As the reason for the deletion of information collection activities, the Draft explained that "some enterprises attempt to disguise what is in reality the collection of information for other enterprises by repackaging the information collected into reports prepared for these enterprises" (paragraph 28).
We have reviewed these proposals based on the "basic concept" stated above and found that there was a logical gap between the concept of Option F, which is seemingly based on a new understanding developed against the background of an increasingly digitized economy (i.e., "online sellers and very large warehouses" are one of the places of business to which business profits are attributable), and the uniform deletion of the word "delivery" from subparagraphs a) and b) of Art. 5(4).
In short, adoption of this Option may result in traditional B2B distribution warehouses and small scale warehouses other than "online sellers and very large warehouses" being regarded as a PE. To begin with, there has not yet been adequate discussion as to the taxation of the digital economy. Under such circumstances, it is far from true to say that there has been a consensus that any types of warehouses (including aforementioned traditional warehouses) should be regarded as a fixed place of business PEs to which profits are attributable, and such a consensus is not referred to in the Public Discussion Draft.
In reality, it is a common business practice for enterprises to use a warehouse located in a foreign country's free trade zone to ship and deliver its products as soon and as effectively as possible in response to its international customers' requests. In this case, the use of a warehouse for delivery is not associated with BEPS as it is not intended to serve the needs of the enterprise/shipper but for the convenience of its customers. If Option F is adopted, it will become necessary to change business models that make use of these traditional warehouses. In addition, if, as a result of the above, the enterprise decides to leave the free trade zone, the country that owns the free trade zone will also suffer a loss. Further, when an enterprise delivers equipment to a foreign construction site, it may be regarded as a PE merely because of the fact of delivery. We believe that the exception for delivery should be retained.
Second, with regard to Option G, we understand the need to ensure the consistency with the AOA that provides for the elimination of the tax exemption for mere purchases. However, we have a fundamental question on how the OECD responds to the fact that the AOA is not adopted by non-OECD countries. Moreover, we do not believe that there has been adequate debate about the question of what amount of profits could be generated from mere purchases. We recommend that very careful consideration should be given to the uniform deletion of the phrase "purchasing goods or merchandise" from Art. 5(4) d).
We disagree with Option H, which provides for the deletion of the entire subparagraph d). As a reason for the deletion, the Draft explains that "some enterprises may disguise what is in reality the collection of information for other enterprises by repackaging the information collected into reports prepared for these enterprises." However, we believe that such extreme cases can be dealt with by disapproving them on an individual basis. Furthermore, information collection activities generate no profits. If Option H is adopted, it may lead to mere representative offices and employees' overseas business trips being regarded as a PE and discourage cross-border economic exchanges.
On the other hand, Option E is to clarify the general understanding that Art. 5(4) is applicable only to activities of a preparatory or auxiliary character. It will still contain the words "delivery," "purchasing goods or merchandise," and "information collection," and we understand that an enterprise will not be regarded as having a permanent establishment unless the place of activity is regarded as a place of business to which business profits are attributable in each individual case. However, a lack of uniform interpretation about the condition of being of a "preparatory or auxiliary" character among member countries will allow tax authorities to apply the condition in a subjective and arbitrary manner, which may consequently cause uncertainties for taxpayers.
We are particularly concerned about the impact on Art. 5(4) c). For example, in response to a request from a foreign resident client, an enterprise sometimes retains its products or merchandise in a warehouse located in the client's premises to allow the client to process the product or process the merchandise. These products or merchandise are called vendor-managed inventory (VMI). In the international trade context, they are primarily observed in the manufacturing industry. Although it is a business structure that is not related to BEPS, it may be regarded to be a PE if, under Option E, it is determined not to be of a preparatory or auxiliary character.
Therefore, if the OECD adopts Option E, it will be critical to provide detailed examples to clarify which activities are deemed to be of a preparatory or auxiliary character and which are not. It would also be necessary to describe in the commentary that, aforementioned establishments, including "traditional and small-scale warehouses" and "VMI warehouses" are of a preparatory or auxiliary character.
For activities of a preparatory or auxiliary character, the Draft also proposes that, to prevent circumvention of Art. 5(4) as a result of fragmentation of activities between associated enterprises, a new paragraph 4.1 should be added, and that the determination of whether an activity is of a preparatory or auxiliary character or not should be made taking into account not only the activities carried on by the same enterprise at different places but also activities carried on by associated enterprises at different places or at the same place (Options I and J). However, the phrase "cohesive business operation" may allow tax authorities to make a subjective and arbitrary interpretation. We believe that abusive cases can be prevented by dealing with them on an individual basis and that a cautious approach should be taken to uniform tightening of rules.
Splitting-up of contracts
The Public Discussion Draft refers to a concern about the splitting-up of contract terms between related parties in order to abuse construction-PE and service-PE provisions in paragraph 3 of Article 5. To deal with the concern, it proposes to adopt either Option K or Option L. The former is an "automatic" rule that would take account of any activities performed by associated enterprises (with certain solutions to possible problems, such as an addition of a minimum period of presence) and the latter is the addition of a new example to the Commentary on the "Principal Purposes Test" (PPT) rule proposed as a result of the work on Action 6. However, as is the case with the fragmentation of activities between related parties, we believe that abusive cases can be prevented by dealing with them on an individual basis.
The Public Discussion Draft does not provide sufficient reason why only the insurance industry, among all other industries, was subjected to a new proposal. We believe that it would be necessary to clarify where problems exist. Unless there is a BEPS concern that is common to all member countries and cannot be ignored, it would be appropriate to follow the approach outlined in paragraph 39 of the current Commentary on Article 5, which states that the decision as to whether or not a provision along these lines should be included in a convention will depend on the factual and legal situation prevailing in the Contracting States concerned. It is at least not desirable to include any insurance-related provisions in a uniform way as in Option M.
As pointed out in the general comments, unreasonable broadening of the scope of PE without international consensus on profits attributable to a PE may result in a further proliferation of double taxation. It is necessary in the first place to disseminate the AOA not only to the OECD member countries but also to non-member countries. At the same time, a uniform guideline should be developed as far as it is possible to provide for a specific formula to calculate profits attributable to a PE, although such a calculation is governed by domestic laws.
Subcommittee on Taxation