New PE Language for BEPS Scales Back Earlier Drafts

Through tweaks to the Model Tax Convention, the OECD believes its work on profit shifting will stem elaborate structures, such as commissionaire arrangements, used by large multinationals to avoid the creation of a permanent establishment.

The Organization for Economic Cooperation and Development, however, responded to concerns from taxpayers by narrowing the definition of “dependent agent,” greatly limiting the situations in which a person who negotiates contracts for an enterprise would create a PE.

As in previous drafts, the report on Action 7 doesn’t call for a so-called virtual or digital PE— determined not by facilities or employees but by online activity—as OECD official say it is unfeasible in today’s economy, although such situations could call for the use of a value-added tax.

Pascal Saint-Amans, the OECD’s tax policy director, used the example of a company that uses thousands of people in a country to negotiate advertising contracts, but then has an Irish entity sign them.

“The game is over,” Saint-Amans said during a news conference Oct. 2. “And you may have noticed that a number of these companies have already anticipated and said, ‘yes, indeed, the game is over.’ ”

A permanent establishment is a taxable presence in a country where a multinational entity is not incorporated.

‘Principal Role.’

The new, finalized language says a PE exists if a person acting on behalf of a multinational enterprise “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise”—whereas the previous draft referred to one who “negotiates the material elements of contracts.”

The change drew praise from U.S. officials who said the previous language could lead to confusion. “We are pleased that dependent agent aspects of the PE are tighter than they had been in earlier drafts,” Robert Stack, U.S. deputy assistant Treasury secretary for international tax affairs, told Bloomberg BNA.

It also specifies that such a person’s actions must “go beyond the mere promotion or advertising” of the services or goods being offered.

The guidance further explains the new language is meant to supplement existing laws requiring contracts, which may allow a contract to be signed in a jurisdiction other than where it was negotiated and concluded.

“The phrase must be interpreted in the light of the object and purpose” of the section, “which is to cover cases where the activities that a person exercises in a state are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, i.e. where that person acts as the sales force of the enterprise,” the report states.

Again, the guidance draws a distinction between involving the conclusion of a contract, and the promotion of services or goods.

“It does not apply, however, where a person merely promotes and markets goods or services of an enterprise in a way that does not directly result in the conclusion of contracts,” it states. As in previous drafts, however, a permanent establishment may exist even in situations where the people working on behalf of the enterprise have no power to alter or negotiate the terms of contracts—as long as they’re involved in concluding them.

Possible Confusion

“They made it clear that the principal role is the person that’s doing the convincing,” said Alex Postma of EY LLP. “That narrows it down quite a bit.”

It will still likely require tax administrations to parse the difference between concluding a contract and merely promoting or advertising services.

“All of this is very next door to each other. When are you promoting and when are you convincing?” Postma said. “At least it’s more defined than what we had before, under the previous draft.”

Others expressed puzzlement at the change.

While drawing some praise from some, the new dependent agent definition drew puzzlement from others.

“This is still going to leave a lot of questions about where the cutoff point is,” said Richard Collier of PricewaterhouseCoopers UK. “What is the ‘principal role?’ What does it mean, ‘concluded without material modification?’”

Collier added that this definition was being unveiled in the final report, without an opportunity for public comment or consultation.

Barbara Angus of EY said the guidance gives taxpayers a much better sense of what to prepare for from tax administrations, as this standard is used in practice.

“It’s a little bit more for the taxpayer to use as guidelines, and a little bit more information for them to expect in terms of what a tax administration would be looking at down the road,” she said.

Specific Activity Exemptions

As in previous drafts, the new language would scale back several exemptions to the PE rules—specifying that they apply only when they can be classified as performing a “preparatory or auxiliary” function. Those include facilities for storage, display, information collection, and purchasing.

However, the finalized language also includes a new paragraph allowing countries to, as with the status quo, declare some or all of these activities to be “intrinsically” preparatory and auxiliary, and thus automatically receiving an exemption from PE requirements.

The report states that countries taking this view can use another section of the new language, relating to the fragmentation of activities, to address base erosion concerns related to the use of the auxiliary and preparatory exemptions.

That section, along with a section on the “splitting-up” of contracts, is largely unchanged from previous drafts.

“The OECD seems to be communicating that they believe that countries have a common objective here, but have different approaches,” Angus said. “It’s communicating alternative approaches for addressing it. Presumably at some point, that would be a point of negotiation in a bilateral treaty discussion.”

The Next Step

OECD officials acknowledged that the document had little to say about how income should be allocated once a PE has been determined.

Marlies de Ruiter, the head of the OECD’s division on tax treaties, said that work will likely be completed by the end of 2016, to be included in the so-called multilateral instrument to be used to change existing bilateral tax treaties to comply with the new language.

Because the terms of PEs are normally set out in tax treaties, the change in language will not have an immediate effect, but will be implemented either through future bilateral agreements, or through a possible multilateral instrument.

The finalized language includes a new paragraph noting that it would not necessarily be true that, in a case where a PE was determined to exist due to the conclusion of a contract, all of the profits attributed to that contract would be allocated to the state with the PE. The profit should be allocated with recognition of the entire enterprise, in accordance with Article 7 of the Model Tax Convention.

Otherwise, it notes that work on the allocation issue will continue.

“Realistically, however, work on attribution of profit issues related to Action 7 could not be undertaken before the work on Action 7,” as well as Actions 8-10, which relate to transfer pricing and the allocation of risk.

Many practitioners and officials said the work on profit allocation may be as important as the definition of PE itself.

“The true effect of the changes in the PE rules will not be known until the further work on the attribution of profits to permanent establishments is done, and only then will the U.S. be able to determine whether or not to reserve on changes to the OECD Model with respect to PE,” Stack said.

“It may be that’s where the rubber really hits the road,” said Manal Corwin of KPMG LLP.

The Digital Economy

More broadly, Pascal said the OECD, while nixing the idea of a virtual PE for now, will continue to look at the online marketplace as it develops.

“We still don’t know,” Saint-Amans said. “We’re still in the disruption phase. There are things happening and we don’t know where they will land. So let’s not give up work here, let’s monitor what’s going to happen.”

Saint-Amans noted, however, that in situations where a virtual PE might apply, a country would still be entitled to collect VAT under its new guidelines, which are contained in its report for Action 1, on the digital economy.

As with previous reports, the finalized VAT guidelines call for the tax to be collected at the place of destination—and, if that is not easily determined, at the consumer’s usual place of residence. Despite protests from small online vendors and hobbyists who said such a collection could be onerous, the guidance does not specifically advocate for a threshold exemption, although it does note that as an option.

Otherwise, Action 1 contains few recommendations, as OECD officials say they found it unfeasible to craft rules specifically pertaining to online commerce.

“The digital economy is the economy itself,” Saint-Amans said.

The BEPS proposals will be presented to the G-20 on Oct. 8.