Policy Proposals Business Law Comments on the Revised Discussion Draft on BEPS Action 7 (Preventing the Artificial Avoidance of PE Status)
Marlies de Ruiter
Head, Tax Treaties, Transfer Pricing and Financial Transactions Division
Centre for Tax Policy and Administration
Organisation for Economic Co-operation and Development
Keidanren hereby submits its comments on the Revised Discussion Draft "BEPS Action 7: Preventing the Artificial Avoidance of PE Status" published by the OECD on May 15, 2015.
Keidanren supports the OECD's work to implement Base Erosion and Profit Shifting (BEPS) Action 7, in principle. Our position is based on the perspective of preventing a source country's tax base from being wrongfully eroded, addressing the digital economy, and ensuring a level playing field for companies, as we stated in our January comment letter.
Furthermore, we appreciate the fact that this Revised Discussion Draft has narrowed down the proposals compared to the October 2014 discussion draft, has reflected Keidanren's comments to some extent, and has specifically stated in various sections that consideration had been given to taxpayers' opinions in the narrowing-down process, enhancing transparency in the OECD's discussion processes.
In terms of specific individual items, though, this Revised Discussion Draft still has many issues that need to be solved. It is true that preventing a source country's tax base from being wrongfully eroded is important, but the importance does not justify either the scope of permanent establishments (PEs) being set more broadly than is warranted by that end, or PE status being determined based on more substantive criteria. These changes would create an extremely high risk of double taxation. From that perspective, it is of high importance to make the definition and threshold of PEs as objective and clear as possible. In view of this, we present below our comments on the proposed changes to the provisions of the OECD Model Tax Convention and to the Commentary thereon on a subject-by-subject basis.
2. Commissionnaire Arrangements
First of all, the reality is not that all commissionnaire arrangements and similar strategies are put in place to erode the taxable base, as we stated in our January comment letter. Also, even if a commissionnaire were to be regarded as a PE, profits attributable to the PE would presumably be extremely limited. Hence, the reasonable approach is not to expand the PE concept, but to try to resolve the matter in the context of transfer pricing taxation, including by checking as a first step whether commission income is appropriate compared to the arm's length price. Of the Options A to D proposed in the October 2014 discussion draft, Option B has been chosen in this Revised Discussion Draft—one that is the least harmful of the four but is not positively agreed upon either. We are strongly concerned about the increasing possibility that transactions unrelated to BEPS may be readily regarded as PEs in the future. From that perspective, we state our opinions below of the proposed changes to the Commentary on paragraph 5 of Article 5 of the OECD Model Tax Convention.
Although the paragraph states "if the enterprise is not directly or indirectly affected by the action performed by that person," it is not clear how the term "indirectly affected" should be construed. We request that the term be clearly defined.
As the subject and limit of the phrase "negotiates the material elements of contracts" are unclear, tax administrations may interpret the phrase arbitrarily. The Commentary should clearly state, at least, that the word "negotiates" in the aforementioned phrase does not include an intermediary merely communicating the terms and conditions of the contract or the needs of the customer, head office, or other parties. Additionally, each country should be aware that neither of the following two types of agreements fall under the definition of "concludes contracts" or "negotiates the material elements of contracts": agreement to enter into negotiations of a contract; and agreement reached as part of the routine process under the master (long-term) contract (e.g., agreement which does not need to be negotiated to change the price as long as it is within the expected price range that has been roughly set in the master contract concerning the long-term supply of the product whose price tends to fluctuate depending on the market prices of the raw materials).
The illustrative example given in this paragraph may lead to the misinterpretation that informing the account holder of the standard terms of contracts on behalf of RCO in itself constitutes "negotiate." Whether having engaged in a negotiation or not needs to be carefully determined taking into account the relevant facts. In the case of the aforementioned example, the determination should be predicated on whether SCO's employee has convinced the account holder to accept the standard terms of contracts.
The phrase "in a way binding on the enterprise" in the current text of the Commentary should be maintained, from the perspective of preventing undue determination of PE status and limiting the contracts subjected to the determination process.
3. Independent Agents
In principle, independent agent status should be determined based on the nature of the agent, in other words, whether the agent conducts business in which he or she bears risk, based on his or her skills, knowledge, experience, and other assets. We thus basically believe that no amendments should be made to paragraph 6 of Article 5.
We, however, should make comments on amendments to the provisions of paragraph 6, which this Revised Discussion Draft proposes. The new provisions of paragraph 6 read, "Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is connected, that person shall not be considered to be an independent agent . . . with respect to any such enterprise." As the threshold for connected enterprises, it is proposed that a person should be considered to be connected to an enterprise if one possesses "at least 50 percent" of the beneficial interests, etc., in the other. We request that this threshold be changed to "more than 50 percent" because a 50-50 joint ownership with another entity cannot be regarded as having control over the enterprise in question.
As for the criterion for exclusivity, paragraph 38.7 of the Commentary provides that, when "the sales that an agent concludes for enterprises to which it is not connected represent less than 10 percent of all the sales that it concludes as an agent acting for other enterprises," the agent should be viewed as acting exclusively or almost exclusively. However, the basis for this criterion is unclear.
4. Preparatory or Auxiliary Activities
We appreciate to some degree the adoption of Option E, rather than Options F and G under which the word "delivery" would be uniformly removed from subparagraphs a) and b) of paragraph 4 of Article 5. Still, care should be taken to ensure that these proposed amendments to the provisions on preparatory or auxiliary activities do not lead to substantial changes in the current treatment of fixed places of business that are used to conduct the activities listed in subparagraphs a) to d) of paragraph 4 of Article 5 and that have hitherto been deemed not to constitute PEs. To that end, we request that the definition of preparatory or auxiliary activities be clarified and augmented by more examples.
Paragraphs 21.1, 21.2
We welcome the guidance on the significance of preparatory or auxiliary activities. Paragraphs 21.1 and 21.2 state that the decisive criterion as to whether activities have a preparatory or auxiliary character is whether the activities constitute "the essential and significant part of the activity of the enterprise as a whole". Under the Option B, it is vital to decide whether the activities are preparatory or auxiliary activities or not, and it is important more than ever before to make a case-by-case basis judgment about what constitutes "the essential and significant part of the activity of the enterprise as a whole" which varies significantly depending on industries. For example, we believe that a warehouse used by a manufacturer for delivering its products to customers does not basically influence the conditions of competition for companies, and thus does not constitute "the essential and significant part of the activity". Additionally, throughout paragraph 21.2, what we consider important is the sentence that reads, "It is unlikely that an activity that requires a significant proportion of the assets or employees of the enterprise could be considered as having an auxiliary character." This specifically suggests that, when determining whether an activity has an auxiliary character, attention should be paid to the "proportion" the activity accounts for in the enterprise's assets or employees, rather than simply to the fact that the size of the fixed place of business in question (e.g., a warehouse) is large. We request that the reason for this reference to "proportion" be explained more clearly in paragraph 21.2.
The paragraph states, "Whether the activity . . . has a preparatory or auxiliary character will have to be determined in the light of factors that include the size of the facilities used for that purpose and the overall business activity of the enterprise." However, from the perspective of ensuring consistency with paragraph 21.2, it may be more appropriate to refer to the "proportionate size" of the facilities relative to the asset and employee composition of the entire enterprise, rather than to the "size" of the facilities. When considering the overall business activity of an enterprise, the position of the fixed place of business in question within the enterprise's entire supply chain needs to be taken into account as well. Moreover, we request that the Commentary add examples of cases that fall under the definition of preparatory or auxiliary activities in relation to subparagraph a) of paragraph 4 of Article 5, with "delivery" in the manufacturing sector in mind. Such examples will be useful in combination with the examples already given concerning cases that do not fall under the definition of preparatory or auxiliary activities in relation to subparagraphs b) and c) of the same paragraph.
The paragraph provides that, "where . . . that enterprise is allowed unlimited access to a separate part of the warehouse for the purpose of inspecting and maintaining the goods or merchandise stored therein," a permanent establishment is deemed to exist unless these activities constitute preparatory or auxiliary activities. We request that what "unlimited access" means be explained in more detail.
With regard to the phrase "for the purpose of storage, display or delivery" that has been deleted from the current text of this paragraph, we do not see any particular need to delete the phrase and thus request that it be maintained (and the same be done for paragraph 22 as well).
Moreover, consideration should be given to vendor-managed inventory (VMI) contracts that are unique to the manufacturing sector, as we pointed out in our January comment letter. Under a VMI contract, accommodating a request from the foreign-domiciled client, the enterprise places its own goods or merchandise in a warehouse located within the client's factory so that the client can process such goods or merchandise there. We reemphasize that no VMI contracts are entered into with the intention of avoiding taxes, that none of such contracts are related to BEPS, and hence that they should not be regarded as PEs. Although the proposed amendments to the Commentary can be construed as meaning that VMI warehouses do not in principle constitute PEs, we request that steps be taken to ensure a consistent approach among countries.
The paragraph states that "it will typically not apply in the case of a fixed place of business used for the purchase of goods or merchandise where the overall activity of the enterprise consists in selling these goods." This sentence indicates that purchasing activities do not constitute preparatory or auxiliary activities. However, whether a purchasing function constitutes a PE should be determined on a case-by-case basis, from the standpoint of whether the function forms an essential and significant part of the activity of the enterprise, including whether it bears risk, because even for the companies which sell goods they procure, the important point of business activities may be the development and acquisition of potential customers rather than the procurement activities in some cases.
5. Anti-fragmentation Rule
There remains a question as to the effectiveness of the new paragraph 4.1 that is proposed to be added to Article 5. This is because it is sufficient for abusive arrangements with no legitimate business reason to be dealt with on a case-by-case basis in the first place. Also, PEs to which this paragraph would apply are expected to have very little profits attributable thereto.
In the event that the matter proceeds as proposed in this Revised Discussion Draft, the term "cohesive business operation" should be more clearly defined or explained through illustrative examples in the Commentary, as the term leaves large room for interpretation. Particular consideration should be paid to enterprise groups operating globally in which, presumably, a group firm is often engaged in a business activity that is connected to that of another group firm but unrelated to BEPS. It is no easy task for such a group to, whenever an arrangement is made, grasp each and every connection between individual business activities and determine whether some of them constitute a cohesive business operation. Another concern is that an activity deemed to have a preparatory or auxiliary character under paragraph 4 of Article 5 may nevertheless be unduly regarded as being linked to a connected enterprise's activity and be determined to be a PE. That would make determinations under paragraph 4 meaningless. We also fear that temporary activities conducted by an employee seconded to a firm in an emerging country or elsewhere may be regarded as a PE. To prevent these from materializing, the Commentary should contain a clear statement to the effect that paragraph 4.1 applies only to abusive arrangements made for the purpose of tax avoidance.
Additionally, the sentence "it applies equally where an enterprise of one State uses or maintains a fixed place of business in that same State" in the second bullet point of example B in paragraph 30.3 of the Commentary should be deleted, because this would substantially expand the current PE concept.
6. Splitting-Up of Contracts
Viewing different contracts as the splitting of one contract and thereby as an abuse of the tax treaty should be limited to exceptional cases. If each country were to regard contracts differing in their business purposes, responsibilities, parties, and other elements as a series of contracts and levy taxes, the scope of entities regarded as PEs would drastically expand, resulting in the increased risk of double taxation. The types of transactions that do not raise BEPS concerns should continue to be treated in the same way as before.
Many multinational enterprises organize their group companies by function in order to allocate roles within the group and enhance the efficiency of business activities. Take enterprises engaging in the plant construction business, for example. Their installation and construction operations, among others, are often spun off into separate subsidiary companies with the primary aim of assigning personnel optimally according to the expertise and skills of individual employees and workers. This kind of allocation of roles is necessary and commercially rational. Suppose that the parent company concludes a contract, subcontracts it to the subsidiary companies which install machines and construct buildings, and conducts supervision activity at a construction site. If the activity of the parent company were to be regarded as a connected activity and automatically added to the activities conducted by the subsidiaries, those subsidiaries could constitute PEs, and the efficiency of business management would be spoiled.
In another case, suppose that separate companies (e.g. a parent company and its subsidiary) have respectively been awarded a contract as a result of their individual sales activities. In a case like this in which each of the companies has submitted a bid for a separate contract to begin with, they, as bidders, have no power to negotiate the terms and conditions of the contracts, and thus clearly have no intention of avoiding taxes. It is not appropriate to consider whether their activities fall within the definition of "connected activities" in this situation.
Paragraph 18.2 therefore needs to explicitly state that a determination of connected activities should be predicated on the intention of abusing the tax treaty from the beginning. Additionally, we have a concern that the phrase "the nature of the work involved under the different contracts" is vague and would be interpreted broadly without paying due attention to the different kind of activities conducted by each connected person. The factor "whether the nature of the work involved under the different contracts is the same or similar" should be replaced by "whether associated enterprises perform similar activities."
7. Attribution of Profits Issues
The number of countries adopting the authorized OECD approach has not increased to date. If, under such circumstances, the OECD proceeds with its work on the redefinition of the PE concept alone, the risk of double taxation will increase. We understand that follow-up work on attribution of profits issues will be carried on after September of this year for the purpose of providing the necessary guidance before the end of 2016, the deadline for the negotiation of the multilateral instrument. That work must culminate in the development of uniform guidelines that will apply to all the countries participating in the BEPS Project.
The final recommendations for BEPS Action 7 are scheduled to be issued this September. Needless to say, the current practices in determining PE status must not be changed in any way until the multilateral instrument is implemented or a bilateral tax treaty is concluded or revised by the relevant countries. It is our strong hope that effective dispute resolution mechanisms will be presented that will be instrumental in avoiding double taxation arising from the determination of PE status.
Subcommittee on Taxation