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Key Issues relating to Key Issues relating to Permanent Establishment Permanent Establishment

9 October 2008 (15:30-17:00) 9 October 2008 (15:30-17:00)

ASATSUMA Akiyuki ASATSUMA Akiyuki

Rikkyo University (Tokyo)Rikkyo University (Tokyo)

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issuesissues

Why we need PE concept?Why we need PE concept?PE & FE (fixed establishment)PE & FE (fixed establishment)Trigger of source taxTrigger of source taxTaxable income & PETaxable income & PEAttribution of profits to a PEAttribution of profits to a PEPE & electronic commercePE & electronic commerceAgent PEAgent PEProfit sharing & PEProfit sharing & PE

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Why we need PE concept? (1)Why we need PE concept? (1)

2 kinds of tax jurisdiction on income2 kinds of tax jurisdiction on income– Residence tax jurisdicionResidence tax jurisdicion– Source tax jurisdictionSource tax jurisdiction

income flowincome flow

Income earner Income earner ----------- payer----------- payer

Residence country Source countryResidence country Source country

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Why we need PE concept? (2)Why we need PE concept? (2)

Sometimes it is said that source of income Sometimes it is said that source of income is “illusion”.is “illusion”.

Certainly, it is “logically” true.Certainly, it is “logically” true.

Income is defined as “income = Income is defined as “income = consumption + net increase of wealth”.consumption + net increase of wealth”.

The definition of income only looks at The definition of income only looks at personal situation. Logically income does personal situation. Logically income does not have geographical attributes.not have geographical attributes.

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Why we need PE concept? (3)Why we need PE concept? (3)

Even though logically income has no Even though logically income has no geographical source, in actual, can we geographical source, in actual, can we abandon a concept of source of income?abandon a concept of source of income?

Can we allocate tax authority only Can we allocate tax authority only according to residence?according to residence?

Can we give up taxing income from real Can we give up taxing income from real estate which is own by foreign person?estate which is own by foreign person?

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Why we need PE concept? (4)Why we need PE concept? (4)

Foreign corp.-----------subsidiary (taxable)Foreign corp.-----------subsidiary (taxable)Foreign corp.-----------branch (non taxable)Foreign corp.-----------branch (non taxable)R-country S-countryR-country S-countryS-country should have tax authority on S-country should have tax authority on domestic source income of foreign domestic source income of foreign residents. However, source tax authority residents. However, source tax authority should not be unlimited because of the should not be unlimited because of the difficulty of tax compliance for foreign difficulty of tax compliance for foreign residents.residents.

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PE & FE (fixed establishment)PE & FE (fixed establishment)

Income tax: PE Income tax: PE

Consumption tax: FEConsumption tax: FE

PE threshold is lower than FE threshold.PE threshold is lower than FE threshold.– A vending machine can be a PE.A vending machine can be a PE.– FE needs human intervention.FE needs human intervention.

PE is taxable only on its net income. FE is PE is taxable only on its net income. FE is taxable on gross sales amount.taxable on gross sales amount.

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Trigger of source tax (1)Trigger of source tax (1)

PE is justification of source tax.PE is justification of source tax.PE is limitation on source tax.PE is limitation on source tax.German type:German type:PE (PE (BetriebsstätteBetriebsstätte) concept is a symbol of ) concept is a symbol of domestic businesses of non-residents. Incdomestic businesses of non-residents. Income attributable to a domestic (German) Pome attributable to a domestic (German) PE is domestic source income and is subjecE is domestic source income and is subject to source taxation according both to domt to source taxation according both to domestic tax law and to tax treaties.estic tax law and to tax treaties.

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Trigger of source tax (2)Trigger of source tax (2)

US type:US type:A non-resident’s domestic (US) business A non-resident’s domestic (US) business yields domestic source income and is yields domestic source income and is subject to US source taxation according to subject to US source taxation according to US domestic tax law. US domestic tax law. However, under tax treaties, US cannot However, under tax treaties, US cannot tax a non-resident’s business income if he tax a non-resident’s business income if he has no PE.has no PE.Domestic business and PE are somewhat Domestic business and PE are somewhat resemble but not equal.resemble but not equal.

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Taxable income & PE (1)Taxable income & PE (1)

Entire income principle (Old US; Japan):Entire income principle (Old US; Japan):If a non-resident has a PE, then all If a non-resident has a PE, then all domestic source income is subject to domestic source income is subject to source taxation at the hand of the PE, source taxation at the hand of the PE, regardless whether the income is derived regardless whether the income is derived by the PE.by the PE.It is called as “force of attraction”.It is called as “force of attraction”.Now US applies “effectively connected Now US applies “effectively connected income” principle, resembled next slide.income” principle, resembled next slide.

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Taxable income & PE (2)Taxable income & PE (2)

Attributed income principle (Germany):Attributed income principle (Germany):Domestic source business income is Domestic source business income is income attributable to a domestic PE. income attributable to a domestic PE. Business income not attributable to a PE Business income not attributable to a PE is not subject to source taxation.is not subject to source taxation.

OECD Model Tax Convention OECD Model Tax Convention §7 (1) §7 (1) adopts this principle.adopts this principle.

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Attribution of profits to a PE (1)Attribution of profits to a PE (1)

““functionally separate entity” approachfunctionally separate entity” approachA PE is a part of a non-resident, does not A PE is a part of a non-resident, does not have legal personality. We do not imagine have legal personality. We do not imagine a contract between my left hand and my a contract between my left hand and my right hand.right hand.However we must “hypothesize” the PE as However we must “hypothesize” the PE as a “distinct and separate enterprise” and a “distinct and separate enterprise” and recognize “dealings” between the PE and recognize “dealings” between the PE and other parts of the non-residents.other parts of the non-residents.

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Attribution of profits to a PE (2)Attribution of profits to a PE (2)

Even if total profits of the non-resident is Even if total profits of the non-resident is 100, the PE’s profits can be more than 100 100, the PE’s profits can be more than 100 if the PE did good jobs and it can also be if the PE did good jobs and it can also be minus if it did bad jobs.minus if it did bad jobs.

We must determine:We must determine:– Functions of activities of the PEFunctions of activities of the PE– Risks attributed to the PERisks attributed to the PE– Assets, obligations and capital of the PEAssets, obligations and capital of the PE

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Attribution of profits to a PE (3)Attribution of profits to a PE (3)

Basically profit attributed to a PE is Basically profit attributed to a PE is determined, referring arm’s length determined, referring arm’s length principle applied to transactions between principle applied to transactions between affiliated companies.affiliated companies.

However the lack of legal personality However the lack of legal personality might raise differences. might raise differences. (ex. Creditworthiness)(ex. Creditworthiness)

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Attribution of profits to a PE (4)Attribution of profits to a PE (4)

Old version of OECD Commentary does Old version of OECD Commentary does not recommend recognizing intra-not recommend recognizing intra-payments of royalties or interests from/to a payments of royalties or interests from/to a PE to/from foreign parts of a non-resident.PE to/from foreign parts of a non-resident.

New version will recommend recognizing New version will recommend recognizing intra-payments.intra-payments.However issues of withholding are blank.However issues of withholding are blank.

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PE & electronic commerce (1)PE & electronic commerce (1)

music download----------------music download---------------- money flow money flow ------------------------------------------ supplier user supplier user Foreign JapanForeign Japan

If the foreign supplier has no PE in Japan, If the foreign supplier has no PE in Japan, then Japan cannot tax the income paid then Japan cannot tax the income paid from Japanese users.from Japanese users.

If the payment is royalty, then Japan can If the payment is royalty, then Japan can tax under some tax treaties.tax under some tax treaties.

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PE & electronic commerce (2)PE & electronic commerce (2)

OECD said that a computer server can be OECD said that a computer server can be a PE. (cf. A vending machine can be a PE)a PE. (cf. A vending machine can be a PE)

However income attributed to the server However income attributed to the server PE would be very small, if not zero.PE would be very small, if not zero.Therefore electronic commerce will give Therefore electronic commerce will give little tax revenue to users’ country (Japan).little tax revenue to users’ country (Japan).

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PE & electronic commerce (3)PE & electronic commerce (3)

PE threshold should be amended?PE threshold should be amended?

We can say that PE threshold should be We can say that PE threshold should be amended if business circumstances are amended if business circumstances are changed. PE is not sacred. PE is a crystal changed. PE is not sacred. PE is a crystal of compromise between countries. PE is of compromise between countries. PE is not genuinely led from logic.not genuinely led from logic.

Electronic commerce can be said as big Electronic commerce can be said as big change.change.

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PE & electronic commerce (4)PE & electronic commerce (4)

However, should users’ country (Japan) However, should users’ country (Japan) have tax authority?have tax authority?PE is an indication of income source.PE is an indication of income source.What is source of income?What is source of income?

Suppliers’ business [PE taxation]:Suppliers’ business [PE taxation]:Japan isn’t location of suppliers’ business.Japan isn’t location of suppliers’ business.

Users’ demand [royalty taxation]:Users’ demand [royalty taxation]:Japan is location of demand.Japan is location of demand.

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PE & electronic commerce (5)PE & electronic commerce (5)

Historically PE taxation has been executed Historically PE taxation has been executed along with an image that geographical along with an image that geographical source of income is located at the place of source of income is located at the place of suppliers’ business.suppliers’ business.If only existence of electronic commerce in If only existence of electronic commerce in Japan can be a PE, tax practices would Japan can be a PE, tax practices would not be workable. For example, we do not not be workable. For example, we do not have expenditure allocation rule in the have expenditure allocation rule in the context of such virtual PE.context of such virtual PE.

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PE & electronic commerce (6)PE & electronic commerce (6)

However, tax treaties allocate source tax However, tax treaties allocate source tax jurisdiction not only looking at suppliers’ jurisdiction not only looking at suppliers’ business, but also payers; for example, business, but also payers; for example, royalty taxation.royalty taxation.It is not ridiculous to claim that also It is not ridiculous to claim that also demand country should have tax authority demand country should have tax authority in contexts of electronic commerce; but PE in contexts of electronic commerce; but PE taxation on electronic commerce would be taxation on electronic commerce would be impractical.impractical.

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Agent PE (1)Agent PE (1)

principal -----------agent-----trading partnerprincipal -----------agent-----trading partner (R (R11 co.) (A co.) (A11) (S) (S11 co.) co.)head office--------branch----trading partner head office--------branch----trading partner (R (R22 co.) (S co.) (S22 co.) co.)R-county S-countryR-county S-countryNot only a branch but also an agent can Not only a branch but also an agent can be a PE, because both Rbe a PE, because both R11 & R & R22 participate participate in S-country’s market through an agent or in S-country’s market through an agent or a branch.a branch.

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Agent PE (2)Agent PE (2)

If AIf A11 is an independent agent, A is an independent agent, A11 does not does not

do Rdo R11’s business but do A’s business but do A11’s own business.’s own business.

If AIf A11 is a dependent agent, A is a dependent agent, A11 can be said can be said

as doing Ras doing R11’s business and can be a PE.’s business and can be a PE.

However, does RHowever, does R11 really do its business in really do its business in

S-country? Certainly S-country provides S-country? Certainly S-country provides market in both cases, but Rmarket in both cases, but R11 physically physically

exists only in R-county.exists only in R-county.

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Agent PE (3)Agent PE (3)

Providing market or demand is non Providing market or demand is non justification for PE taxation. In case of Rjustification for PE taxation. In case of R11, , S-country’s taxing power should be limited S-country’s taxing power should be limited on income attributed to Aon income attributed to A11’s activity.’s activity.

Do we still need agent PE concept?Do we still need agent PE concept?

If AIf A11 is not compensated by R is not compensated by R11 along with along with arm’s length principle because Aarm’s length principle because A11 is is dependent, then dependent, then §§7 (2) increases tax 7 (2) increases tax revenue of S-country.revenue of S-country.

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Agent PE (4)Agent PE (4)

If AIf A11 is compensated along with arm’s is compensated along with arm’s

length principle, do we still apply length principle, do we still apply §§7 (2)?7 (2)?

Some people say that in such cases RSome people say that in such cases R11’s ’s

agent PE would have no income.agent PE would have no income.

OECD concluded that income of AOECD concluded that income of A11 and and

income of Rincome of R11’s agent PE are different.’s agent PE are different.

Does OECD consider providing market as Does OECD consider providing market as base for PE taxation?base for PE taxation?

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Agent PE (5)Agent PE (5)

Germany ItalyGermany ItalyPhilip Morris GmbH---------A-co.----I-co.Philip Morris GmbH---------A-co.----I-co.PMG sold tobacco to I-co.PMG sold tobacco to I-co.A-co. was a member of Philip Morris group A-co. was a member of Philip Morris group and had only acted as liaison of contracts and had only acted as liaison of contracts between PMG and I-co. But A-co. was between PMG and I-co. But A-co. was considered as an agent PE by Italian considered as an agent PE by Italian supreme court.supreme court.Did PMG really do its business in Italy?Did PMG really do its business in Italy?

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Profit sharing & PE (1)Profit sharing & PE (1)

shareholder------------corporationshareholder------------corporationpartner------------------partnershippartner------------------partnershipR-country S-countryR-country S-countryA corporation is a taxable entity. A non-A corporation is a taxable entity. A non-resident shareholder bears tax on dividend resident shareholder bears tax on dividend income.income.A partnership is a transparent entity. A partnership is a transparent entity. However, the partnership is usually seen However, the partnership is usually seen as a PE of a non-resident partner.as a PE of a non-resident partner.

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Profit sharing & PE (2)Profit sharing & PE (2)

silent partner (N-co.) ------ business (J-co.)silent partner (N-co.) ------ business (J-co.)Netherlands JapanNetherlands Japan

J-co. did business and distributed the J-co. did business and distributed the business profits to N-co. but this income is business profits to N-co. but this income is characterized as “other income” (characterized as “other income” (§23§23). J-). J-co. was not considered as a PE of N-co.co. was not considered as a PE of N-co.

However Netherlands did not tax N-co., However Netherlands did not tax N-co., considered as having a PE in Japan!considered as having a PE in Japan!

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Profit sharing & PE (3)Profit sharing & PE (3)

shareholder------------corporationshareholder------------corporationcreditor------------------debtorcreditor------------------debtorpartner------------------partnership partner------------------partnership R-country S-countryR-country S-country

Entity characterizationEntity characterization

Deductibility of paymentDeductibility of payment

Withholding tax or PE recognitionWithholding tax or PE recognition