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Permanent Establishment Concept: How to Apply it to Modern Business Operations

OECD/USCIB/BIAC Tax ForumRecent OECD Initiatives in International Taxation: Permanent Establishment and Dispute Settlement

Procedures

The Cosmos ClubWashington, DCJanuary 13, 2005

WDC01/157543

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OECD Work related to the Permanent Establishment

Definition

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OECD work on Permanent Establishments

Since the mid-1990s, there have been different OECD projects related to the PE definition:– OECD set up a Working Group on Permanent establishments in 1994

to deal with practical issues related to the PE definition– Business asked the OECD to clarify the “server-PE” issue– The emergence of e-commerce required the OECD to examine

whether the current treaty rules, including the PE definition, were appropriate for e-commerce

– Business asked for clarification of some of the fundamental aspects of the PE definition following a court decision

– Member countries asked the OECD to consider various alternative treaty rules for the treatment of services

– Member countries asked the OECD to examine issues related to commissionnaire arrangements

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The scope of the OECD work

The interpretation of the current definition:– Work of the Working Group on Permanent establishments– The “server-PE” issue– 2005 clarification of some fundamental aspects of the PE

definition– Part of the work on commissionnaire arrangements (and business

restructuring)

Should the current definition be supplemented or modified? – The work of the Business Profits TAG– Alternative treaty rules for the treatment of services– Part of the work related to commissionnaire arrangements (and

business restructuring)

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2003 update

First results of the work on PE:– Application of the PE definition in the context of E-Commerce – Permanent establishment interpretation issues

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Application of the existing PE definition to e-commerce

Draft released by Working Party 1 in October 1999Comments receivedRevised draft released 3 March 2000More comments receivedWorking Party finalized discussions in September 2000; Committee adopted the changes in December 2000Changes included in the 2003 update

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What has been concluded

A web site alone cannot be a permanent establishment: virtual is not realHosting of a web site by an ISP– not a PE since the server is not “at the disposal” of the

enterprise that owns the web sitePE can exist if the place where the server is located is at the disposal of the non-resident and activities performed there go beyond preparatory or auxiliary

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Permanent establishment interpretation issues

Results of the work of the Working Group on Permanent EstablishmentsBackground report published in May 2003Focusses on practical issues arising from litigation or competent authority workOutput: a number of changes to the Commentary on Article 5 first released in October 2001 (presented at the San Francisco IFA Congress) and finalized at the end of 2002

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The basic PE definition

Article 5(1)“A fixed place of business through which the business of an enterprise is wholly or partly carried on”“place”“place of “business”“fixed” place of business “through which business is carried on”

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“Place”

must be a place of businessmust be “fixed”Is a country a place? Is a city a place? Is a road or a forest a place?Is an office in a building a place?

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“Fixed”

Geographical aspect (new paragraphs 5.1 to 5.4)– Fixed place

Temporal aspect (new paragraphs 6 to 6.2)– Administrative guideline to solve dispute:

• If more than 6 months, PE• If less than 6 months, no PE• Exception for recurrent activities and activities carried on only in one

country

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“through which the business of an enterprise is wholly or partly carried on”

Most difficult part of the definition: relationship between place and taxpayer’s business (new paragraphs 4 to 4.6)– owned or rented by the taxpayer?– legal right?– right to use or simply use?– when is a place at the taxpayer’s disposal?– use of client’s or subsidiary’s place of business?– construction site for a subcontractor?– construction site for a main contractor?

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Construction Sites — Article 5(3)construction site is PE only if it lasts more than 12 monthsdeeming rule or additional condition? [next slide]treatment of subcontractorsgeneral contractor or architect with on-site office?multiple projects?temporary disruptions?

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What is paragraph 5(3)?

Paragraph 5(3):“A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.”

Is this– A deeming rule (deeming a PE to exist when it would not)– An exception to paragraph 5(1)?

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The practical consequences

If it is a deeming rule, there is no need to identify a particular location as long as there is “an installation project” (e.g. a 13-month contract to install equipment in all the German branches of a German bank)

If it is only an exception, the Commentary examples of a construction site PE (e.g. paragraphs 18-20 of the Commentary) illustrates the scope of paragraph 5(1)

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The history of 5(3)

In the 1963 Draft convention, the rule was included in paragraph 5(2):

“2. The term “permanent establishment” includes especially:[…]g) a building site or construction or assembly project which exists

for more than twelve months.”

Paragraph 5(2) is merely illustrative of paragraph 5(1): “such places of business constitute permanent establishments only if they meet the requirements of paragraph 1” (paragraph 12 of the Commentary)

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Why the change in 1977 ?

• It was suggested that the rule, as drafted in the 1963 Draft Convention, simply did not deal with construction sites lasting less than 12 months, which could therefore be considered to be permanent establishments under paragraph 5(1)

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The UN Model

Paragraph 5(3)

3. The term permanent establishment also encompasses:a. A building site, a construction, assembly or installation project or

supervisory activities in connection therewith, but only if such site, project or activities last more than six months;

b. The furnishing of services …

This is clearly a deeming rule and the last part is a condition for the rule to apply

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Preparatory Activities —Article 5(4)

Little substantial clarification of the preparatory or auxiliary activities exception in the 2003 report– use of “or” in paragraph 25– new paragraph 27.1 on places “separated organisationally” for the

purposes of 4 f)

Background report also deals with a case of split-up of storage facilitiesSee also the BP TAG report

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Agency PEs — Article 5(5)

agent deemed to be PE of nonresident if agent acts on behalf of nonresident and habitually exercises authority to conclude contractsnot applicable to agents of independent statusnot applicable if agent’s activities are limited to preparatory activities

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Dependent Agents - Policy Rationale

– the fixed place of business rule alone would enable an enterprise to carry on significant economic activity, indirectly through another person, without triggering a taxable presence

– thus an additional rule is required which ensures that where an enterprise participates significantly in the economic life of a state through an agent a permanent establishment will be deemed to exist

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Agency PEs

2003 clarification dealing with agency permanent establishment:– agent needs not be a resident or have a place of business (amended

paragraph 32)– has and habitually exercises an authority to conclude contracts

(new paragraphs 33.1 and 38.1)– factors indicating independence (new paragraphs 38.2 to 38.7)– when are agents acting outside the ordinary course of their

business? (new paragraph 38.8)

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2005 clarification

As a result of a court decision, Working Party No. 1 was invited by business to expressly confirm in the Commentary some widely-accepted interpretations related to the permanent establishment conceptDiscussion draft released on 12 April 2004Slightly amended in September 2004Will be included in the 2005 update (no other PE changes in the 2005 update)

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Clarification in the 2005 update

3 issues to be clarified– PE determination must be made for each company of a group– Providing management services to another company of the group

does not mean that the company has a PE– Participation in meetings is not enough to conclude that one

exercises an authority to conclude contracts

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2005 clarification

“41.1 […]The determination of the existence of a permanent establishment under the rules of paragraphs 1 or 5 of the Article must, however, be done separately for each company of the group. Thus, the existence in one State of a permanent establishment of one company of the group will not have any relevance as to whether another company of the group has itself a permanent establishment in that State.”

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2005 clarification“42. Whilst premises belonging to a company that is a member of a multinational group can be put at the disposal of another company of the group and may, subject to the other conditions ofArticle 5, constitute a permanent establishment of that other company if the business of that other company is carried on through that place, it is important to distinguish that case from the frequent situation where a company that is a member of a multinational group provides services (e.g. management services)to another company of the group as part of its own business carried on in premises that are not those of that other company and using its own personnel. In that case, the place where those services are provided is not at the disposal of the latter company and it is not the business of that company that is carried on through that place. That place cannot, therefore, be considered to be a permanent establishment of the company to which the services are provided…

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…and (added in September)

…Indeed, the fact that a company’s own activities at a given location may provide an economic benefit to the business of another company does not mean that the latter company carries on its business through that location: clearly, a company that merely purchases parts produced or services supplied by another company in a different country would not have a permanent establishment because of that, even though it may benefit from the manufacturing of these parts or the supplying of these services.”

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2005 clarification“33. […] situation. A person who is authorised to negotiate all elements and details of a contract in a way binding on the enterprise can be said to exercise this authority "in that State", even if the contract is signed by another person in the State inwhich the enterprise is situated or if the first person has not formally been given a power of representation. The mere fact, however, that a person has attended or even participated in negotiations in a State between an enterprise and a client will not be sufficient, by itself, to conclude thatthe person has exercised in that State an authority to conclude contracts in the name of the enterprise. The fact that a person has attended or even participated in such negotiations could, however, be a relevant factor in determining the exact functions performed by that person on behalf of the enterprise. Since […]”

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Are the Current Treaty Rules for Taxing Business Profits

Appropriate for E-commerce ?

Report completed by the TAG in April 2004Report presented to the CFA in June 2004The BP TAG has now completed its mandate

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Table of contents of the Report1. Introduction

2. Description of the current treaty rules for taxing business profits

3. A critical evaluation of the current treaty rules with respect to e-commerce

4. Some alternatives to the current treaty rules for taxing business profits

A. Changes that would not require a fundamentalmodification of the existing rules

B. Changes that would require a fundamental modification of the existing rules

5. Conclusions

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The alternatives that were examined

A. Changes that would not require a fundamentalmodification of the existing rules

• Modification of the permanent establishment definition to exclude activities that do not involve human intervention by dependent agents

• Modification of the permanent establishment definition to provide that a server cannot, in itself, constitute a permanent establishment

• Modification of the permanent establishment definition/interpretation to exclude functions attributable to software when applying the preparatory or auxiliary exception

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The alternatives that were examinedElimination of the existing exceptions in paragraph 4 of Article 5 or making these exceptions subject to the overall condition that they be preparatory or auxiliaryElimination of the exceptions for storage, display or delivery in paragraph 4 of Article 5Modification of the existing rules to add a force-of-attraction rule dealing with e-commerceAdopting supplementary nexus rules for purposes of taxing profits arising from the provision of services

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The alternatives that were examinedB. Changes that would require a fundamental modification of

the existing rules• Adopting rules similar to those concerning taxation of

passive income to allow source taxation of payments related to some forms of e-commerce

• A new nexus: base eroding payments arising in a country

• Replacing separate entity accounting and arm’s length by formulary apportionment of profits of a common group

• Adding a new nexus of “electronic (virtual) permanent establishment”

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Conclusions of the Report

Alternatives for fundamental changes: not appropriate to embark on such changes at this point in timeBUT– need to continue to monitor the effect of the new business models

on tax revenues– existing international rules for taxing business profits have some

shortcomings some of which could be addressed through changes based on some of the more restricted alternatives

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Current work related to the permanent establishment definition

Working Party no. 1 is also carrying on other work related to the permanent establishment definition which could result in further changes in a subsequent update:– the application of tax treaties to services;– work on corporate restructuring, which includes the examination of

commissionaire arrangements; – “subcontractor who subcontracts all aspects of a construction

contract” (while that change was included in the first draft of the 2003 update that was released in October 2001, it was pulled out at the request of one country that wanted to have it reconsidered);

– another proposal that was pulled out of the 2003 update following comments received from business representatives, was to add a new paragraph 38.7 on the assumption of entrepreneurial risk as a distinguishing feature of the independent agent (that proposal will be reviewed as part of the work on corporate restructuring).

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Case 1 - Consulting ServicesScenario 1

– Consulting is headquartered in Country X. It has wholly-owned subsidiaries located in a number of countries around the world including SubA, SubB, SubC located respectively in Countries A, B, and C.

– Consulting enters into a contract with Customer, which is also headquartered in Country X, to provide consulting services related to the installation of a new customer relationship management (CRM) system. The contract indicates that in addition to services provided in Country X, consulting will provide services to customer affiliates in Countries A, B and C either itself or by contracting the work to Consulting’s subsidiaries in these countries.

– Consulting chooses to subcontract the non-Country X work to its subsidiaries and pays its subsidiaries an arm’s length fee based on the cost plus method.

– The project takes a total of 12 months.

Does Consulting have PEs in countries A, B, and/or C?

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Case 1 - Consulting ServicesScenario 2

– Same as scenario 1, except that the nature of the project requires that Consulting send its owns employees to Countries A, B, and C.

– Consulting’s employees will be working at the premises of Customer and will not normally use the premises of Consulting affiliates.

– The employees will remain on the job at Customer premises for the duration of the project --12 months -- but may travel for personal reasons back to Country X periodically.

– Customer controls access to its premises and requests that Consulting employees work under direction of Customer employees.

Does Consulting have a PE in countries A, B, or C?

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Case 1 - Consulting Services

Scenario 3

Same as scenario 2, except that:

– Scenario 3a: Consulting’s employees are provided badges by Customer that allow 7 by 24 access to Customer facilities

– Scenario 3b: Consulting’s employees stay on the job for more than 12 months

Does Consulting have a PE in Countries A, B, and/or C?

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Case 1- Consulting Services

Scenario 4

– Consulting engages in a huge contract and engages the services of unrelated Subconsulting for its special expertise. Employees of both Consulting and Subconsulting work at the premises of Customer for more than 12 months under conditions similar to Scenario 3a

Does consulting have a PE in countries A, B, and/or C? Does Subconsulting? Would the answers change if Subconsulting is a wholly owned subsidiary of Consulting?

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Case 2 - FactsC is a UK corporation and the parent of a multinational group of affiliated corporations. FP is an unrelated US corporation and the parent of a multinational group of affiliated corporations. C and its subsidiaries manufacture various components that are incorporated into the finished products that FP and its subsidiaries manufacture. C has a US subsidiary (“C-US”) that employs engineers and salesmen to negotiate specifications for, and market, C components to FP. The actual components that the C group sells to the FP group are manufactured by C’s subsidiary in China (“C-China”) and sold to FP’s subsidiary in China (“FP-China”). C and C-China do not engage in any business activity in the US.

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Case 2C

FP-China

UKUS

C-US FPspecifications

USChina

C-Chinacomponents

payment

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Case 2 - Questions1. Do the activities of C-US cause C or C-China to have a dependent

agent in the US?2. If C-US were otherwise a buy-sell distributor or manufacturer,

would negotiating for its affiliates be treated as not in the ordinary course of its business?

3. If C-US were not engaged in any other business, could it bear sufficient entrepreneurial risk to be economically and legally independent of its affiliates?

4. If C-US does not actually sign contracts with FP, could C-US nevertheless be deemed to be habitually concluding contracts on behalf of C or C-China?

5. Would the answer be different if C-US can calculate the price per good by formulas set by C and then finalize the terms of sale from C-China to FP-China?

6. Is C-US providing services as part of its own business carried on in premises that are not those of C or C-China?

7. If C were to send its own employees to the US instead of relying on employees of C-US, would the result be different?

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Case 3 - FactsX group is a multinational group that manufactures and sells products around the world under the X brand. P is the parent ofthe X group and the owner of the world-wide rights to the X brand. S is a subsidiary of P. P is organized and operates solely in Country A, and S is organized and operates solely in Country B. S manufactures and sells products in Country B under the X brand. In response to certain quality control issues, S has asked P to send some P employees to oversee its operations. In addition, P has determined that quality control issues at S are adversely affecting the X brand. S provides these P employees with an office from which to work. S will compensate P for the salariesof the P employees. The P employees are expected to remain at S for a period of six months.

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Case 3

P

S

Country A

employees Country B

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Case 3 - Questions1. Does P have a fixed place of business in country B (i.e., are S’s premises

at the disposal of P)?2. Would the answer be different if S did not provide P’s employees with

an office?3. Would the answer be different if the activities of P’s employees are

limited to those that S has requested?4. Is the business of P being carried on at the premises of S?5. Would the answer be different if P initiated the assignment of its

employees to protect the X name, rather than S requesting the assignment of the employees?

6. Would the answer be different if P seconded the employees?7. Would the answer be different if S had multiple facilities and P’s

employees spent only a limited amount of time at each facility?8. Would the answer depend on the amount of time that the employees of S

were at P’s facility?

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Case 4 - Electronic Software Distribution

Scenario 1

– US software developer (USCO) develops and distributes standard software electronically via internet download

– Local subsidiary (LOCO) is established in Country X and performsadvertising services in Country X for USCO for a fee.

– Customers are in Country X– Software is downloaded from a server located in the US– A separate server also located in the US maintains the order

management and transaction software

Does USCO have a PE in Country X?

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Case 4 - Electronic Software Distribution

Scenario 2

Same as scenario 1, except that the download server(s) is located in Country X.– Subcase 1: USCO rents download servers from unrelated data farm co

(located in Country X) that owns and maintains the servers and the facility in which they are located (in Country X) and charges USCO a fee

– Subcase 2: Same as subcase 1, except the server lease agreement is between LOCO and unrelated co.

Does USCO have a PE in Country X?– In Subcase 1? – In Subcase 2?

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Case 4 - Electronic Software Distribution

Scenario 3

Same as scenario 2, except both the download server and the transaction server are located in Country X. USCO provides the software and programming to unrelated co (in Country X) that in turn loads the software onto its own servers (in Country X) and provides the hosting service. USCO has the hosting contract with unrelated co.

Does USCO have a PE in Country X?

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Case 4 - Electronic Software Distribution

Scenario 4

Same as scenario 3, except that USCO rents the servers from unrelated co (as opposed to using a hosting service).

Does USCO have a PE in Country X?

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Case 4 - Electronic Software Distribution

Scenario 5

Same as scenario 3, except that the servers are owned and maintained by LOCO (in Country X), which provides a hosting service to USCO. USCO pays LOCO a fee to cover its costs plus provide LOCO with aprofit similar to that earned by unrelated co in scenario 3.

Does USCO have a PE in Country X?

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Case 4 - Electronic Software Distribution

Scenario 6

Same as scenario 5 except that USCO owns or rents the servers located on the premises of LOCO (in Country X) and pays LOCO a fee to maintain them and to follow specific instructions as to how the server usage is performed.

Does USCO have a PE in Country X?

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Case 4 - Electronic Software Distribution

Scenario 7

Same as scenario 6, except that LOCO also has a staff responsible for pricing decisions in Country X and determines pricing policy anduploads the pricing information onto the servers that USCO owns or leases in Country X.

Does USCO have a PE in Country X? Could USCO have 2 PEs from both the servers and the activities of LOCO?

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Case 5 - FactsThe Olympiad is held for three weeks in Country X. Rental Co. leases certain equipment to LOC (the local Olympics organizing committee) to be used at the Olympiad. Charitable Co. donates the use of certain equipment to LOC to be used at the Olympiad in exchange for recognition as a sponsor. Broadcast Co. brings certain equipment and personnel into Country X to broadcast events at the Olympiad to viewers in Country Y. Broadcast Co. sells advertising that is to be included in the broadcast of theOlympiad. LOC contracts with Security Co. to send employees to review the security arrangements and advise on deficiencies. Each of Rental Co., Charitable Co., Broadcast Co. and Security Co. is organized in Country Y and conducts no business in country X except as described herein.

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Case 5 - Questions1. Does the Olympiad constitute a place of business for

Rental Co., Charitable Co., Broadcast Co., or Security Co.?

2. Would the conclusion with respect to Security Co. be different if Security Co. had employees on the ground providing security services during the Olympiad?

3. If so, does that place of business have the requisite degree of permanency with respect to the business of Rental Co., Charitable Co., Broadcast Co., or Security Co. have a PE in Country X?

4. Would the conclusion with respect to the place of business of Rental Co., Broadcast Co., or Security Co. be different if each of these enterprises were created solely for the duration of the Olympiad and solely to perform functions with respect to the Olympiad?

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Case 6 - FactsI is a citizen of Country X and the president of P. I is also the president of S, a subsidiary of P. P is organized as a Country X corporation and conducts business solely in Country X; S is organized as a Country Y corporation and conducts business solely in Country Y. I visits S for two weeks each year; otherwise, I participates in the management of S from his office at P. S directly compensates I for the services that I renders to S. S sells product that it purchases from P.

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Case 6 - Questions1. Does S have a place of business (e.g., a place of

management) in country X?2. Would the answer be different if I were not an employee

of P but instead maintained an office in his home and worked from that home office?

3. Would the answer be different if S paid P for I’sservices, such that P provides services to S with its own personnel as part of its own business carried on in premises that are not those of S?

4. Would the answer be different if S’s Board were to adopt a resolution that explicitly prohibited I from signing any contracts while in country X?

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Case 6

P

( I )

Country X

Country Y

S