3.3.2.3 Art. 5 OECD MTC: Permanent establishment

Introduction

The concept of permanent establishment as defined in art. 5 OECD MTC is particularly important to determine whether the source state has the right to tax corporate profits. It thus fulfils a threshold function in the levying of profit tax on cross-border business activities. The fact that certain threshold requirements must be met contributes to the practical workability of the criterion. If the right to tax is allocated to the source state via art. 7 OECD MTC, the state of residence must provide for a reduction to avoid double taxation.

A permanent establishment is a fixed place of business through which the business of an enterprise is wholly or partly carried on. The concept of permanent establishment may include, for instance, a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.1 Where certain auxiliary or preparatory activities are involved, a permanent establishment is generally not considered to be present. If a permanent business establishment is present within the territory of the source state, the source state will be attributed taxing rights.2

According to the OECD Commentary, the elements to be tested in order to conclude whether or not there is a permanent establishment are, in summary, the following:

As follows from the above, the permanent establishment concept is based on the idea of having a physical presence in a country. This starting point does not seem to match with the globalized and digitalised economy.8

Anti-fragmentation rule & closely related enterprise

In some circumstances, a form of a group approach is applied to conclude whether or not a permanent establishment is involved. For example, art. 5, par. 4.1, OECD MTC contains an anti-fragmentation rule. In order to assess whether there is a permanent establishment, the activities of a closely related enterprise should also be taken into account. This applies to determining whether activities are to be regarded as auxiliary or preparatory. After all, by breaking down the business activities into small parts, it could be argued that each activity, viewed in isolation, is only of an auxiliary or preparatory nature. For such activities, the OECD MTC provides an exception to the permanent establishment concept.9

The anti-fragmentation rule provides that the exclusion for auxiliary activities – which would not constitute a permanent establishment – does not apply in certain circumstances. This requires an enterprise to use or maintain a fixed place of business through which the same enterprise or a closely related enterprise carries on business activities in the same or another location within the same state. Next, a permanent establishment (in respect of business activities which do not of themselves qualify as permanent establishments) may exist if at least one of the places where the business activities are carried on is autonomously classified as a permanent establishment (even if it is in fact a permanent establishment belonging to an entity in the same state).10 A permanent establishment may also be deemed to exist where, as a result of the combination of activities, the overall activity is not of a preparatory or auxiliary character. Both exceptions are subject to the condition that the business activities carried on by the enterprise (or two enterprises) in the same place (or in the two places) constitute complementary functions forming part of a cohesive business operation.11

According to the BEPS monitoring group, the anti-fragmentation rule only applies to activities that are preparatory or auxiliary to sales activities, which makes the scope of the provision very limited.12 It would seem that neither the final BEPS report on Action 7,13 nor the OECD MTC Commentary provides any basis for limiting the anti-fragmentation rule to sales activities. Preparatory activities could, for instance, also include training activities.14

Art. 5, par. 8, OECD MTC is relevant for determining whether there is a closely related enterprise15 within the meaning of the anti-fragmentation rule. An enterprise is closely related with another enterprise if one controls the other (e.g., a parent company and a subsidiary).16 In addition, a closely related enterprise exists if both are controlled by the same person or enterprise (e.g., two sister companies). In order to determine whether control exists, all relevant facts and circumstances must be taken into account. The close relationship, as referred to in art. 5, par. 8, OECD MTC, is presumed to exist if one enterprise directly or indirectly holds more than 50% of the beneficial interest in the other. A close relationship is likewise assumed if more than 50% of the beneficial interest is directly or indirectly held by a third entity (for instance, the common parent company). To answer the question whether there is a closely related enterprise or not, the possession of more than 50% of the total number of votes and the value of the shares of the entity or of the beneficial interest in the capital of the entity are considered.

An example of the elaboration of the anti-fragmentation rule given by the OECD17 is the situation in which trading company Parent R, established in state R, uses a warehouse in state S (see figure 3.1). The use of a warehouse for the storage of goods does not, in principle, constitute a permanent establishment.18 In addition, the wholly owned subsidiary of Parent R located in state S, Subsidiary S, has a store in state S. In this store, Subsidiary S sells products acquired from Parent R. To obtain these products, an employee of Subsidiary S goes to the warehouse of Parent R. In this case, due to the application of the anti-fragmentation rule, the warehouse of Parent R in state S is considered a permanent establishment. After all, Parent R and Subsidiary S are closely related enterprises. In addition, according to the OECD Commentary, the store of Subsidiary S constitutes a permanent establishment of the entity (even if that permanent establishment is located in the same state as the entity itself).19 Finally, the business activities carried out by Parent R and Subsidiary S embody complementary functions which are part of a cohesive business operation. By taking into account the activities of Subsidiary S in state S, the conclusion is that in this case the activities of Parent R in state S constitute a permanent establishment. After all, by assessing these activities as being related, there is no longer any question of an activity of an auxiliary or preparatory character.20

The concept of a closely related enterprise raises the question whether the activities of a closely related enterprise in another treaty country (or a non-treaty country) can (or must) also be taken into account in concluding whether or not there is a permanent establishment. In the example given earlier, this question would arise, for instance, if the store is part of the activities of a sister company of Parent R, with the sister company being located in state X. In that case both the tax treaty between state R and state S and the tax treaty between state X and state S are relevant. The involvement of three countries means there is a triangular situation. Tax treaties are in principle bilateral,21 which would make it impossible to take into account the activities of an entity in a non-Contracting State in determining whether the activities are of such a magnitude as to constitute a permanent establishment. However, it could be argued that in view of the purpose of the anti-fragmentation rule – i.e., to prevent tax avoidance – it is relevant to take into account such activities. After all, the fragmentation of activities within a group is not limited by national borders. Also, the objectives of the OECD MTC – to avoid double taxation in order to stimulate cross-border activities, without creating opportunities for non-taxation or reduced taxation through tax avoidance – offer a starting point to argue that not just two countries should be considered. Unfortunately, the OECD Commentary is inconclusive on this point, but seems to imply a bilateral scope of application.22

The permanent establishment provision applies a group approach for application of the anti-fragmentation rule in order to prevent abuse. The closely related enterprise concept applies here, a concept that is only used for the application of the permanent establishment provision. The anti-fragmentation rule seems to contribute to the objective of the OECD MTC to prevent tax avoidance. In this context, the question is whether the concept of a closely related enterprise should have a multilateral scope of application because of the purpose of the OECD MTC. It should also be noted that fragmentation arrangements are not necessarily set up with a tax avoidance objective in mind. Such arrangements may be fully business-driven, involving highly specialised enterprises responsible for a particular part of the value chain.23 Since art. 5 OECD MTC does not require an assessment of tax avoidance, situations which can be explained by sound business reasons and are thus not aimed at tax avoidance may also fall within the scope of the provision.

Dependent agent & closely related enterprise

A second form of a group approach for the application of the permanent establishment provision concerns the dependent agent provisions.24 Here too, the concept of a closely related enterprise is relevant. Even if the requirements of a permanent establishment are not met, a permanent establishment may still exist in the case of a dependent agent. A dependent agent – a natural person or legal entity – acts on behalf of the foreign company. In that capacity, a dependent agent concludes contracts on behalf of the enterprise, or plays an important role in the conclusion of contracts that are entered into on a fairly routine basis by the enterprise without any substantial changes.

An independent agent, in principle, does not have a permanent establishment risk. The Convention provision of the independent agent refers to the concept of a closely related enterprise. If a person acts solely or almost solely for one or more enterprises with which it is closely related, that person is not considered to be an independent agent in relation to those enterprises.25

As with the anti-fragmentation rule, the introduction of the concept of closely related enterprise in the provision seems to contribute to the prevention of tax avoidance. In this context, however, similar to the anti-fragmentation rule it could be argued that in order to effectively counteract tax avoidance, the concept of closely related enterprise should have a multilateral scope of application.

Splitting of contracts & closely related enterprise

The concept of closely related enterprise is potentially relevant for the provision that applies to building sites, construction or installation projects. In that case, for this provision, too, a variant of a group approach is used. Under art. 5, par. 3, OECD MTC, a permanent establishment in principle only exists if such activities last longer than twelve months. The twelve-month test should be applied per project or activity. The OECD Commentary indicates that the twelve-month test has given rise to abuse. By splitting contracts and having them performed by different entities in a group, the permanent establishment status could easily be circumvented. The OECD Commentary contains a model provision that specifically addresses the splitting of contracts.26 When applying such a provision, the connected27building, construction or installation work of closely related enterprises should also be considered to determine whether a permanent establishment exists. In other words, a ‘substance over form’ approach is applied with a view to combatting tax avoidance. This provision again raises the question whether – in order to be an effective instrument against tax avoidance – there should be a multilateral scope of application for the concept of closely related enterprise for situations involving three or more countries.28

Group company with controlling interest

Art. 5, par. 7, OECD MTC explicitly provides that the fact that a group company has control over another group company does not mean that the subsidiary is automatically a permanent establishment of the parent company. This provision confirms that a subsidiary is a legally independent entity for tax purposes.29 In essence, the provision safeguards the independent status that an entity has under national tax law and under treaty application.30 The provision was added to the OECD MTC following the Italian Philip Morris case.31 In this case, the Italian Court of Cassation ruled that an Italian group company could be considered to be a permanent establishment of other companies within the group.

Art. 5, par. 7, OECD MTC clarifies that the mere fact that the activities of a subsidiary are managed by the parent company does not mean that the subsidiary is a permanent establishment for the parent company.32 However, activities carried out by a parent company in the state of the subsidiary can lead to a permanent establishment within the meaning of art. 5 OECD MTC.33 It thus remains possible that as a result of additional circumstances the affiliated company meets the permanent establishment requirements.34 This contributes to an equal treatment. After all, if an unrelated company would carry out such activities, this could also lead to the conclusion that a permanent establishment exists.35

The OECD Commentary stresses that a separate assessment should be made for different entities of a multinational group. If an entity has a permanent establishment in one state, this does not affect the answer to the question whether another group entity has a permanent establishment in that state on its own.36 The question is how these principles can be reconciled with the anti-fragmentation rule discussed above. The parts of the OECD Commentary on this subject matter have been modified to a very limited extent37 as part of the 2017 update of the OECD MTC, with no attention paid to the introduction of the anti-fragmentation rule.

It is also striking that the concept of control within the meaning of art. 5, par. 7, OECD MTC is not further defined.38 This could lead to different interpretations in different countries. The term to control means that there must be the right or the actual power to substantially influence another entity.39 Arnold indicates that control could be defined as having at least 50% of the voting rights of an entity. However, such a ‘simple’ interpretation could lead to abuse. Therefore, Arnold argues that a broader test is required, including a rule to make sure taxpayers cannot fragment the ownership among related entities.40 The term to control could also be interpreted much more broadly and could exist without the presence of a parent-subsidiary relationship. This may be the case when there is an obligation to comply with private law agreements.41

The provision as included in art. 5, par. 7, OECD MTC is mainly incorporated for clarification purposes. In essence, the provision aims at eliminating possible double taxation, by preventing discussions on the answer to the question whether there is a permanent establishment if there is a controlling interest of one group company over the other group company. The provision is thus in line with one of the objectives of the OECD MTC, i.e., the prevention of double taxation.