BEPS recommendation: Lower thresholds for permanent establishments may impact MNEs going global
At the request of the G20, OECD published its Action Plan on addressing ‘base erosion and profit shifting’ (BEPS) in July 2013, wherein it identified 15 actions on BEPS for future work, intending to carry out fundamental changes to the international tax standards. Amongst other, Action 7 deals with ‘preventing artificial avoidance of PE status’ on which two discussion drafts have been released so far.
In an era where non-resident taxpayers can derive substantial profits from transactions with customers located in another country, concerns are raised as to whether the current permanent establishment (PE)rules ensure a fair allocation of taxing rights on business profits, especially where the profits from such transactions go untaxed anywhere.
Action 7 focuses on re-evaluation of the existing treaty definition of PE in order to prevent artificial avoidance of PE status through use of abusive arrangements resulting in BEPS including issues in digital economy. Action 7 has identified the following focus areas of work viz; (i) Commissionaire arrangements and similar strategies, (ii) Specific activity exemptions and Fragmentation of activities, (iii) Splitting up of contract, (iv)Insurance, and (v) Profit attribution.
The revised discussion draft on Action 7, released in May 2015, recommends options for addressing BEPS concerns in relation with the above focus areas. The options appear to lower the PE threshold and tighten the exceptions to PE status set forth in Article 5 of the OECD Model Convention (MC) and its Commentary.
Commissionaire arrangements and similar strategies – Changes are recommended in Article 5(5) and Article 5(6) of the OECD MC on Agency PE. As per the proposal, anenterprise is deemed to have a PE when a person acting on behalf of the enterprise habitually concludes contracts or negotiates material elements of contracts. Further, a more stringent definition of independent agent under Article 5(6) is proposed to include agents working for connected enterprises.Though the changes are proposed in view of commissionaire arrangements and similar strategies, its impact can be far reaching to encompass many other arrangements e.g. where agent is soliciting/ receiving orders, online distribution arrangements etc. which were hitherto outside the purview of Agency PE.
Specific activity exemptions and fragmentation of activities -The original purpose of PE exemptions under Article 5(4) is to cover only preparatory or auxiliary activities. It is noted that an automatic application of the exemption for activities listed in Article 5(4)may give rise to BEPS since such activitiesmay have significance in certain businesses. Accordingly, the revised discussion draftproposes to clarify in the treaty itself that the exceptions listed out therein are applicable only upon the activity being preparatory or auxiliary in nature. Further, a new anti-fragmentation rule is proposed wherein the exemption will be denied if the activities of all the connected enterprise combined together do not amount to preparatory and auxiliary activity but results into cohesive business operation. The above proposals will result in a strict application of the PE exemption rule under Article 5(4) impacting the increasingly globalised and digitised businesses.
Splitting up of contracts – Action 7 seeks to check artificial splitting up of contracts between group entities to avoid meeting of time threshold in case of construction/ installation contracts. It is proposed to use a general anti abuse rule based on the “principal purpose test” or to incorporate an automatic rule for aggregation of time spent by each connected enterprise to determine the threshold in certain scenarios.
Action 7 seeks to address BEPS concerns by broadening the rules of creation of PE. The proposals are likely to have an impact on genuine/ bona-fidetransactions also. It may be noted that Indian treaties already contain lower PE thresholds giving more taxation rights to the source state for taxing business profits.In 2008, India had reserved its positions (as a non-member) on the OECD MC and Commentary. Some of the India positions are comparable to the BEPS proposals.Broadly, BEPS proposals can be seen to be in same spirit as India’s tax treaty policy and PE enforcement trends in India.In terms of Indian multinationals which have a presence abroad, these recommendationsif crystalized increase the exposure of doing business in overseas jurisdictions e.g. foreign sales personnel, warehouses/ delivery offices, e-trade, affiliates doing complimentary functions may create taxable presence overseas. This will result in increased compliances, risk of double taxation and taxations costs in source jurisdiction.
All the G20 and OECD members have their interests on the BEPS final reports releasing on 5 October 2015. In terms of Action 7, the final recommendations will need to be implemented either by renegotiation ofthe existing tax treaties or by way of multilateral instrument as recommended under Action 15. There is no doubt on India’s commitment with the BEPS project being a G20 member, however, it needs to be seen how Indian Government will implement the final proposals.
Multinationals in India or doing business in India may consider proactivelyassessing the impact of Action 7 recommendations on its existing or future business arrangements to take appropriate measures at an early stage.
