Permanent Establishment Risks: A New World Order?
By Tom Lickess, Director, International Tax
How Did We Get Here?
In recent years, the tax affairs of multinational corporations have come under increased scrutiny from tax authorities and the public. Their cross-border tax dealings — such as last year’s significant Pfizer-Allergan merger — are making front page news around the world.
So-called corporate inversions and other corporate activities resulting in tax-efficient outcomes typically involve a high level of technical detail. They are also inevitably accompanied by statements from the multinational(s) involved that such corporate and operational structuring complies with the tax laws in each jurisdiction of operation. Popular public sentiment however now appears to support the line that such activities are not within “the spirit” of the law. Fair or not, prevailing public opinion is that any entity which is perceived as not paying its “fair share” of corporate tax is somehow operating on the edges of reasonable expectation.
Influential global bodies like the Organization for Economic Cooperation and Development (OECD) have also targeted perceived multinational corporate tax avoidance through programs like the Base Erosion and Profit Shifting (BEPS) project. At a basic level, these and related country-specific initiatives target the perceived avoidance of permanent establishment (PE) and egregious transfer pricing practices. The initiatives are directed towards multinationals shifting their tax presence and taxable income to low tax jurisdictions so that they are not being taxed on profits where economic activity is performed and value created.
What Has Changed?
Certain jurisdictions have already passed specific and general anti-avoidance legislation in response to this perceived tax-base erosion. For example, the UK rewrote its transfer pricing rules in 2010, and in April 2015 it introduced a diverted-profits tax. Australia has also implemented new, stricter transfer pricing legislation, and in January 2016 strengthened its general anti-avoidance laws to include a specific multinational anti-avoidance component with 100% penalties.
Other jurisdictions have also amended their specific anti-avoidance provisions to counteract corporate tax arrangements which seek to avoid PE or result in a mismatch between the economic substance and tax outcome of a transaction.
It’s simply a matter of time before other countries follow suit and implement specific multinational anti-avoidance laws. In late 2015, the OECD released the final raft of their BEPS recommendations. The result is a package of 15 action items providing a framework for use by governments in addressing tax avoidance in its various forms.
One of the principle measures in the BEPS recommendations is Action 7, titled “Preventing the Artificial Avoidance of Permanent Establishment Status.” Action 7 will update the definition of PE as defined in Article 5 of the OECD Model Tax Convention. Under the existing provisions: “Where a person — other than [independent] agent — is acting on behalf of an enterprise and has, and habitually exercises … authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State.”
Action 7 expands this “deemed agency” PE threshold to include situations where a person “habitually plays a principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise.”
In plain English, if someone (an “agent”) in another country drafts an agreement with another party and sends that agreement to your home-country headquarters for execution, then a PE may be triggered regardless of whether the agent operates independently of your organization and is in business for themselves.
Action 7 tightens the “independent agent” threshold to clarify that an agent would not be considered “independent” where it acts “exclusively or almost exclusively” for a third party.
In addition, Action 7 expands the activity of the intermediary beyond contracting “in the name of the enterprise” to now include contracts “for the transfer of, or the granting of the right to use, property or the provision of services.” This change is specifically directed towards the use of local commissionaires where the agent acts in its own name, with no legal arrangement between the customer and the (offshore) principal. For example, if you hire a third-party agent in another country to sign a contract with another third party in that country — for example to sign a lease for a warehouse — that signature could under Action 7 trigger a PE.
Action 7 will also amend the “fixed place of business” PE rule. Under this rule, a PE exists where a non-resident has a fixed place of operations through which the business of an enterprise is carried on. These provisions are currently subject to specific activity exemptions in cases where the activities are “preparatory or auxiliary to an entity’s main business,” such as using the fixed place for storage or display purposes. In light of modern commercial operations — which include storing intellectual property “in the cloud” and transferring that property electronically across borders — Article 7 proposes amending the “fixed place of business” exclusions to ensure that all exemptions are subject to a general override that the overall activity of the fixed place of business must be preparatory or auxiliary in nature. Clearly, this will make the exemption more difficult to apply in practice. For example, certain marketing activities under previous guidance might have been deemed “auxiliary” and therefore exempt. Those same activities could now trigger a PE under Action 7, since Action 7 accounts for the ease of cross-border electronic commerce and could tie the activities more directly to revenue generation.
As an additional measure, the new BEPS PE guidance contains an “anti-fragmentation rule.” This rule targets groups that artificially separate their activities to manufacture PE exemptions. In short, the anti-fragmentation seeks to determine if a fixed place of business exists in a jurisdiction by taking into account the all the activities — including those that make up the various operations of a business — conducted by closely related entities within that jurisdiction.
What Does This Mean for Me and My Business Operations?
In the face of heightened public perception and a raft of new and proposed legislative changes directed towards perceived corporate tax avoidance, multinationals are increasingly proactive about protecting their bottom lines and reputations. Many are working with tax authorities from a number of jurisdictions to unwind certain historic global tax structures and cease operations perceived as aggressive. Generally speaking, multinationals have accepted the requirement for fully transparent disclosure of cross-border related-party transactions, including documenting those transactions and conducting country-by-country reporting. These global organizations have little appetite for expensive, intrusive and reputation-damaging litigation.
But multinationals of all sizes should be mindful that revenue authorities are not solely focusing on the world’s largest organizations, as recent press might suggest. Tax authorities now have deep experience reviewing cases of perceived tax avoidance. They have greater resources, and are backed by more stringent tax anti-avoidance laws and powers. As a result, they have the capacity and appetite to focus on the cross-border activities of small-to-medium enterprises, along with the larger multinationals. They are aware that many of these small-to-medium taxpayers have experienced rapid cross-border growth in recent years. Businesses in this situation often do not have the time or resources to devote to documenting their cross-border related-party transactions, and may have fallen foul of PE rules.
Companies should also be aware that taxpayers often bear the evidentiary burden in tax disputes. The new OECD transfer pricing rules prescribe that without adequate documentation, a taxpayer cannot have a reasonably arguable position. Equitable or otherwise, tax officers are well aware that small-to-medium entity taxpayers often do not have the financial resources to defend positions against tax-authority review.
What this means is that for all taxpayers operating globally, there is an imperative to:
- Review your historic offshore operations from a PE risk perspective;
- Adequately consider the tax risks associated with future cross-border expansion;
- Fully document your related-party cross-border transactions and structures.
Given the new world order in international tax, the risk of tax-authority review and challenge in respect of cross-border operations has never been greater.