A Permanent Establishment (PE) risk review is an integral component of a global Tax Risk Framework, increasing in importance with issuance of the OECD Base Erosion and Profit Shifting (BEPS) Action Plan. The PE risk review should be monitored on a recurring basis against the backdrop of current and future developments. The OECD and UN Model Conventions, with related Commentaries, provide insight into the development and current state of international PE guidelines. The Conventions provide a useful framework to document specific PE criteria, and exceptions thereto, for risk analysis.
Action 6 (Prevent Treaty Abuse) of the BEPS Action Plan states that the definition of PE must be updated to prevent abuses. Action 7 (Prevent the artificial avoidance of PE status) provides additional PE initiatives. Actions 6 and 7 are designed to implemented by September 2014 and September 2015, respectively. It will be paramount to note any changes in the “preparatory or auxiliary” exception. A link to the BEPS Action Plan is hereby provided for reference: http://www.oecd.org/ctp/BEPSActionPlan.pdf
Article 5 of the OECD Model Convention provides an outline for PE determination, including a “fixed place of business” standard, building site or installation project criteria, the “preparatory or auxiliary character” exception, dependent agent rules and further exceptions for activities of an independent agent and related entities. The OECD Model Convention can be accessed at: http://www.oecd.org/tax/treaties/oecdmtcavailableproducts.htm
The OECD Commentaries are required reading to fully comprehend the history, and intended meaning, of Article 5. Paragraph 2 of the Commentary provides an outline for determination of a “fixed place of business,” consisting of (i) the existence of a “place of business,” (ii) this place of business must be “fixed,” and (iii) the carrying on of the business through this fixed place of business. Paragraph 24 of the Commentary states that , for application of the “fixed place of business” rule, “the decisive criterion is whether or not the activity of the fixed place of business in itself forms an essential and significant part of the activity of the enterprise as a whole.” Paragraph 33 further provides that “the authority to conclude contracts must cover contracts relating to operations which constitute the business proper of the enterprise.”
The attached reference provides access to the UN Model Convention, Letter from India (13 Aug 2012), revised commentary on existing Article 5 and definition of PE for comprehensive understanding of the current PE Article. The UN Model Convention contains an Introduction, Part One (including the Articles), and Part Two with Commentaries. Paragraph 20 of the Commentaries states that the Commentaries on the Articles are regarded as part of the UN Model Convention, along with the Articles themselves. Most importantly, Part Two cites differences of the UN and OECD Model Conventions, such as the UN inclusion of a services standard, exceeding 183 days in any 12-month period, that is not within the OECD guidelines. http://www.un.org/esa/ffd/tax/unmodel.htm
Best Practice ideas for outlining PE risk include:
Documenting potential significant PE risks by legal entity, with specific reference to the PE attribute that attracts such risk, such as a fixed place of business or dependent agent.
- Outlining availability of the preparatory or auxiliary character exception for potential risks.
- Inclusion of objective and subjective evidence that provides defense for a potential PE determination, including wording from the applicable Convention and Commentaries.
- Tools available to reduce double taxation upon determination of a PE, such as the Mutual Agreement Procedure (MAP).
The above Best Practices should be combined with Best Practice ideas in former posts:
- 14 April PE Risks: Best Practices for Awareness & Planning
- 14 July: PwC PE survey: Trends & Challenges
PE determination is increasing in importance in today’s changing tax world, thus a detailed risk matrix is essential to determine current potential risk areas, as well as provide valuable information to assess proposed changes by the OECD and/or UN.