Permanent Establishment Status

The author has authorized the publication of the following article in Tax Notes International.

 

 

Multilateral Instrument: The Application of Specific Activity Exemption Article to Covered Tax Agreements

 

1. Introduction

 

Action 7 - 2015 Final Report under the OECD/G20 BEPS Action Plan, titled “Preventing the Artificial Avoidance of Permanent Establishment Status” (the Action 7 Final Report), addresses the issue of artificial avoidance of permanent establishment (PE) status, and that includes a review of the definition to prevent the use of certain common tax avoidance strategies that are currently adopted to circumvent the existing PE definition. Those strategies result in shifting profits out of the country where the sales took place without a substantive change in the functions performed in that country, including (i) the use of commissionaire arrangement to replace subsidiaries that traditionally acted as distributors, (ii) the splitting-up of contracts, and (iii) the exploitation of the specific exceptions to the PE definition provided for by Article 5(4) of the 2014 OECD Model Tax Convention (the MTC), an issue which is particularly relevant in the digital economy.

 

The Action 7 Final Report introduced the changes made to the definition of PE in Article 5 of the OECD Model Tax Convention, which are used as the basis for tax treaties negotiations. The changes are also incorporated in the multilateral instrument (the MLI), which operates alongside the existing tax treaties by modifying the application of the tax treaty provisions. Specifically, article 13 of the MLI – the Artificial Avoidance of PE Status through the Specific Activity Exemption – has been drafted to address some of the concerns the Action 7 final report identified.

 

2. Article 5(4) of the Model Tax Convention

 

The provisions of Article 5(4) of the Model Tax Convention (the MTC), which deals with the specific activity exceptions, was redrafted by removing the phrase "of a preparatory or auxiliary character" from sub-paragraph (e) under paragraph 4. This is to ensure that all the sub-paragraphs of Article 5(4) are subject to a "preparatory or auxiliary character" condition. In contrast to the recommended changes to the aforesaid condition, the policy makers of some countries consider that some of the activities referred to under subparagraphs from (a) to (d) in paragraph 4 are intrinsically preparatory or auxiliary and, in order to provide greater certainty for both tax administrations and taxpayers, take the view that these activities should not be subject to the condition that they be of a preparatory or auxiliary character, any concern about the inappropriate use of these exceptions being addressed through the new fragmentation rule under paragraph 4.1, which is added to the 2017 Model Tax Convention. See the anti-fragmentation rule in Table 1 below.

 

2.1. Policy choice

 

The prevention of artificial avoidance of permanent establishment status including the specific activity exception article does not come under the scope of the BEPS minimum standards. [1] Accordingly, the contracting jurisdictions that share different views on the preparatory or auxiliary condition are free to choose whether they should adopt the 2014 or 2017 version of the MTC, with respect to paragraph 4 of Article 5. A comparison of the two versions of Article 5(4) is set out in Table 1 below:

 

Table 1 - Text Structure of the Specific Activity Exception Article

 

2014 Model Tax Convention		2017 Model Tax Convention
4. Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include:		4. Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include:
a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise;		a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise;
e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any activity not listed in subparagraphs a) to d), provided that this activity has a preparatory or auxiliary character, or		e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity;
f) the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) to e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.		f) the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) to e),
		provided that such activity or, in the case of subparagraph f), the overall activity of the fixed place of business, is of a preparatory or auxiliary character.
		4.1 Paragraph 4 shall not apply to a fixed place of business that is used or maintained by an enterprise if the same enterprise or a closely related enterprise carries on business activities at the same place or at another place in the same Contracting State and a) that place or other place constitutes a permanent establishment for the enterprise or the closely related enterprise under the provisions of this Article, or b) the overall activity resulting from the combination of the activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, is not of a preparatory or auxiliary character, provided that the business activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, constitute complementary functions that are part of a cohesive business operation.

 

2.2. The anti-fragmentation rule

 

Paragraph 4.1 of Article 5 of the 2017 MTC, as provided under page 39 of the Action 7 Final Report, is aimed to restrict the scope of Article 5(4) to activities having a "preparatory and auxiliary" character because, in the absence of that rule, it would be relatively easy to use closely connected enterprises in order to segregate activities which, when taken together, go beyond that threshold. Paragraph 4.1 of Article 5 applies to two types of cases, as set out below:

 

• First, it applies where the non-resident has a PE in the source country, whether the non-resident directly sets up the PE or it uses closely related entities to set up the PE in the source country. The tax authority in the source country needs to determine whether the activities of the non-resident enterprises give rise to one or more PE's in the country under Article 5(4.1).
• Second, it applies where the non-resident enterprise has no pre-existing PE in the source country but the combined activities by the non-resident and closely related non-resident enterprises result in a cohesive business operation that is not merely preparatory or auxiliary in nature. In such a case, a determination will need to be made as to whether the activities of the enterprises give rise to one or more PEs in the source country under Article 5(4.1).

 

3. Article 13 of the MLI

 

Article 13 of the MLI replicates the contexts of the Article 5 of the 2014 MTC and 2017 MTC.

 

Article 13(1) provides that “a Party may choose to apply paragraph 2 (Option A) or paragraph 3 (Option B) or to apply neither Option.” Article 13(2) corresponds to Article 5(4) of the 2017 Model Tax Convention while Article 13(3) corresponds to Article 5(4) of the 2014 Model Tax Convention, as set out in Table 2 below. Article 13(4) corresponds to article 5(4.1) of the 2017 model tax convention.

 

Table 2 – Corresponding paragraphs of the specific activity exception article between the MLI and the two versions of the MTC’s

MLI	2017 Model Tax Convention (per Table 1)	MLI	2014 Model Tax Convention (per Table 1)
Article 13	Article 5	Article 13	Article 5
(2)(a)	4(a) to (d)	(3)(a)	4(a) to (d)
(2)(b)	4(e)	(3)(b)	4(e)
(2)(c)	4(f)	(3)(c)	4(f)
(4)	4.1	N/A	N/A

 

4. Legal Structure of Article 13

 

The legal structure of Article 13 of the MLI shows the logic how different provisions are related to one another. See Table 3 below:

 

Operative clause	Article 13(1)			The new anti-fragmentation rule Article 13(4)
	Option A Article 13(2)	Option B Article 13(3)	Neither Option A nor Option B
Compatibility clause	Article 13(5); (a) Paragraph 2 [Option A] or 3 [Option B] shall apply in place of the relevant parts of provisions of a Covered Tax Agreement that list specific activities that are deemed not to constitute a permanent establishment even if the activity is carried on through a fixed place of business (or provisions of a Covered Tax Agreement that operate in a comparable manner).			Article 13(5); (b) Paragraph 4 shall apply to provisions of a CTA (as they may be modified by paragraph 2 or 3) that list specific activities that are deemed not to constitute a PE even if the activity is carried on through a fixed place of business (or provisions of a Covered Tax Agreement that operate in a comparable manner).
Reservation	Article 13(6)(b); Reserve right for article 13(2) not to apply to its CTAs			Article 13(6)(c); Reserve right for article 13(4) not to apply to the CTAs
Notification clause	Article 13(7); A Party choosing an Option under Article 13(1) gives notification of choice of Option, including list of CTAs containing a provision described under paragraph 5(a), as well as article and paragraph number of such provision. An Option shall apply with respect to a provision of a Covered Tax Agreement only where all Contracting Jurisdictions have chosen to apply the same Option and have made such a notification with respect to that provision.			Article 13(8); A Party making no reservation under (6)(a) or (6)(c), and not choosing to apply Article 13(1) give notification whether each CTA contains provision described under paragraph 5(a), article and paragraph number of such provision. Paragraph 4 shall apply with respect to a provision of a CTA only where all Contracting Jurisdictions have made a notification with respect to that provision under this paragraph or paragraph 7.

 

4.1. Compatibility clause of Article 13

• Paragraph 5(a) of Article 13 modify the application of paragraph 2 [Option A] or 3 [Option B] to the CTAs respectively, subject to any reservations made under Article 13(6)(b).
• Paragraph 5(b) of Article 13 modifies the application of paragraph 4 to the CTAs, subject to any reservations made under Article 13(6)(c).

 

4.2. Reservations

• Article 13(6)(a) provides that a Party may reserve the right for the entire Article 13 not to apply to its CTAs.
• Article 13(6)(b) provides that a Party may reserve its right for paragraph 2 [Option A] not to apply to its Covered Tax Agreements that explicitly state that a list of specific activities shall be deemed not to constitute a permanent establishment only if each of the activities is of a preparatory or auxiliary character;
• Article 13(6)(c) provides that a Party may reserve the right for paragraph 4 not to apply to its Covered Tax Agreements

 

4.3. Notification

Notification is required in the following circumstances:

• where a jurisdiction nominates a covered tax agreement at the time of signing the MLI or depositing its instrument of ratification to the OECD Depositary, or includes any additional CTA after becoming a party to the MLI;
• where a party reserves its right for an article or a provision of an article not to apply to its CTAs;
• where a party wishes to give legal effect to the Article or the provision of an Article that it has chosen.

 

5. Application of Article 13 to CTAs - Country Survey

 

As of 19^th Dec 2019, there are 35 countries/jurisdictions that have confirmed their MLI positions by the deposit of Instrument of Ratification with the OECD Depositary. Amongst them, 14 contracting jurisdictions have chosen to adopt Option A under Article 13(2), 6 adopted Option B under Article 13(3), and 15 chosen neither Option.

 

Table 4 – It shows the MLI positions of selected contracting jurisdictions as per information from the MLI database - Matrix of Options and Reservations, which the Depositary has maintained pursuant to Article 39 of the MLI.

 

Jurisdiction	Entry-into-force	Article 13
		Paragraph 6 (Reservations)			Paragraph 7 (Notification)
		a	b	c
Australia	2019-01-01		Y		A
India	2019-10-01				A
Japan	2019-01-01				A
New Zealand	2018-10-01				A
France	2019-01-01				B
Ireland	2019-05-01				B
Luxembourg	2019-08-01			Y	B
Singapore	2019-04-01			Y	B
Canada	2019-12-01	Y
Finland	2019-06-01	Y
United Kingdom	2018-10-01

 

Pursuant to Article 13(6)(a), Canada and Finland have opted out of the entire Article 13. Pursuant to Article 13(7), Australia, India, Japan, and New Zealand have given notification that they adopt option A under Article 13(2), France Ireland, Singapore, and Luxembourg have chosen to adopt Option B under Article 13(3), while the United Kingdom has chosen neither option.

 

5.1. Contracting Jurisdictions That Adopt Option A under Article 13(2)

 

a) Notification

 

From the Australian perspective, the Australia-India CTA, and the Australia-Japan CTA have made the same choice for Option A under Article 13(2) and given matched notifications respectively under Article 13(7). Therefore, Article 13(2) [Option A] shall apply in place of the relevant part of the provision of the CTAs.

 

Similarly, Option A under Article 13(2) shall apply in place of the relevant parts of the provisions of a CTA that list specific activities that are deemed not to constitute a PE even if the activity is carried on through a fixed place of business, with respect to the India-Japan CTA, the India-New Zealand CTA, and with respect to the Japan-New Zealand CTA. See Option A in Table 5 below:

 

Table 5 - Option A matrix

 

	Australia	India	Japan	New Zealand
Australia		Y	Y	N
India	Y		Y	Y
Japan	Y	Y		Y
New Zealand	N	Y	Y

 

b) Reservation

 

Pursuant to Article 13(6)(b), Australia has reserved its right for Option A under Article 13(2) not to apply to its CTA with New Zealand, which falls within the scope of the reservation. Subparagraphs (e) and (f), both of which are at odds with the relevant parts in Option A in the application of the preparatory or auxiliary condition, of paragraph 4 of Article 5 of the Australia-New Zealand CTA was reproduced below: -

a) to d) {as per Table 1}

e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;

f) the maintenance of a fixed place of business solely for any combination of activities mentioned in sub-paragraphs a) to e) of this paragraph,

provided that such activities are, in relation to the enterprise, of a preparatory or auxiliary character.

 

Australia has also reserved the right for Article 13(2) not to apply to its CTA with respect to the Australia-Finland CTA, and the Australia-South Africa CTA. [2]

 

5.2. Contracting Jurisdictions That Adopt Option B under Article 13(3)

 

Notification and reservation

 

From the Singapore perspective, Option B shall apply in place of the relevant part of the provisions of the Singapore-France CTA, Singapore-Ireland CTA, and the Singapore-Luxembourg CTA where both parties to the paired CTA have made a matching notification, pursuant to Article 13(7).

 

Article 13 does not provide that a contracting jurisdiction can reserve its right for Option B not to apply to the CTAs, pursuant to Article 28(1), which explicitly lists the provisions for which a party can make a reservation.

 

5.3. Contracting Jurisdictions That Adopt Neither Option

 

Notification and reservation

 

As noted in Table 4, in respect of the CTA between United Kingdom and Australia, Australia adopts Article 13(2) [Option A] while the UK adopts neither Option A nor Option B. Therefore, Article 13(2) shall not apply on ground of an asymmetrical choice of options. The same holds for the UK-India CTA, the UK-Japan CTA, and the UK-New Zealand CTA. In respect of the CTA between the United Kingdom and Ireland, Ireland adopts Article 13(3) [Option B] while the UK adopts neither Option A nor B. Therefore, Article 13(3) shall not apply on ground of an asymmetrical choice of options. The same holds for the UK-France, the UK-Luxembourg and UK-Singapore CTAs.

 

It is also noted that Canada, Finland, and the UK have chosen neither Option A nor B. However, both Canada and Finland have reserved the rights under Article 13(6)(a) for the entire Article 13 not to apply to their CTAs. Therefore, the provisions of the permanent establishment article in the UK-Canada CTA and the UK-Finland CTA shall operate not being subject to any modification by the MLI.

 

6. Anti-Fragmentation provision

 

6.1. Article 13(4) – A United Kingdom perspective

 

Article 13(4) operates independently from Article 13(1), subject to the reservation made and the requirement for notification.

 

6.1.1. Notifications

 

From the United Kingdom perspective, both Australia and the United Kingdom have chosen to apply the anti-fragmentation rule under Article 13(4) to the provisions of the CTAs pursuant to Article 13(5)(b), and given notification to the OECD Depositary pursuant to Article 13(8). Therefore, Article 13(4) shall apply to the UK-Australia CTA. [3] As per Table 4, the United Kingdom has concluded CTAs with the contracting jurisdictions including India, Japan, New Zealand, France, and Ireland. As noted, both the UK and all of the aforesaid contracting jurisdictions have given notification for the adoption of the anti-fragmentation rules. Therefore, Article 13(4) shall apply in the absence of any reservations made. [4]

 

6.1.2. Reservations under Article 13(6)(a) and Article 13(6)(c)

 

In respect of the CTA between Canada and the United Kingdom, the CTA between Finland and the United Kingdom, Article 13 shall not apply because Canada and Finland have respectively reserved the right for the entire Article 13 not to apply to the CTAs, pursuant to Article 13(6)(a).

 

Both Luxembourg and Singapore reserve the right for Article 13(4) not to apply to the CTAs pursuant to Article 13(6)(c). Therefore, from the UK perspective, Article 13(4) shall not apply to the UK-Luxembourg CTA and the UK-Singapore CTA.

 

6.1.3. Principle of Reciprocity

 

It is noted that in respect of the UK-Luxembourg CTA, one Party has made reservation under Article 13(6)(c) and the other Party does not. Yet Article 13(4) shall not apply to the UK-Luxembourg CTA. The same holds for the UK-Singapore CTA. To illustrate the legal point, it is useful to take a look at paragraph 3 of article 28 (Reservations) of the MLI, which replicates Articles 21(1)(a) and (b) of the Vienna Convention on the Law of Treaties (1969). Article 28(3) reads:

“Unless explicitly provided otherwise in the relevant provisions of this Convention [the MLI], a reservation made in accordance with paragraph 1 or 2 (of Article 28) shall:

a) Modify for the reserving party in its relations with another party the provisions of this Convention to which the reservation relates and to the extent of such reservation; and

b) Modify those provisions to the same extent for the other Party in its relations with the reserving Party.”

 

Article 28(3) contains two principles. First, unless explicitly provided otherwise, a reservation is made on a unilateral basis will not only have effect on the CTA between the reserving party and the other party, but also have effect on other CTAs that the reserving party has nominated in accordance with paragraph (1)(a) of article 2 (Interpretation of Terms) or paragraph 5 of article 29 (Notifications). The main exception to this rule is that a reservation to apply the arbitration articles under Part VI of the MLI requires acceptance under article 28, paragraph 2 of the MLI. Second, unless explicitly provided otherwise, a reservation is reciprocal between the Parties to the MLI with respect to the application of an Article or a provision of the Article of the MLI to existing CTAs. That is, it does not work only one way, but works both ways. In general, a reservation shall apply symmetrically.

 

6.1.4. Withdrawal or replacement of reservation

 

However, Article 13(4) shall apply to the UK-Luxembourg [or Singapore] CTA if Luxembourg [or Singapore] is later to withdraw its 13(6)(c) reservation pursuant to article 28(9), which reads that “[a]ny Party which has made a reservation in accordance with paragraph 1 or 2 (of Article 28) may at any time withdraw it or replace it with a more limited reservation by means of a notification addressed to the Depositary”. Note that the United Kingdom is not permitted to make additional reservation to bring it in line with Luxembourg [or Singapore], except for the situation described under paragraph 5 of article 29 – Notifications. [5] Likewise, Luxembourg [or Singapore] cannot replace the 13(6)(c) reservation with the full reservation under Article 13(6)(a). Article 28 of the MLI only works in one direction in making changes to the scope of the reservation. The reason is that by withdrawing a reservation or replacing it with one that is more limited in scope, a Party will be moving closer to the full adoption of the MLI, and not moving away from it.

 

6.2. Article 13(4) – A non-UK perspective

 

Notification and reservation

 

From the France perspective, Article 13(4) shall apply to the France-Ireland CTA where both parties have made the same choice and given the notification pursuant to Article 13(8). Article 13(4) also applies to the France-UK CTA for the same reason.

 

From the Singapore perspective, Article 13(4) shall not apply to the Singapore-Luxembourg CTA because both parties reserve the right for Article 13(4) not to apply to the Singapore-Luxembourg CTA. Article 13(4) shall not apply to the Singapore-France CTA, the Singapore-Ireland CTA, and the Singapore-UK CTA either as asymmetrical choices exist between the Parties to the respective CTAs.

 

Table 6 – Matrix of Article 13(4) extracted from Table 4

 

	France	Ireland	Luxembourg	Singapore	The U.K.
France	-		N	N
Ireland		-	N	N
Luxembourg	N	N	-	N	N
Singapore	N	N	N	-	N
The U.K.			N	N	-

N = representing reservation made under Article 13(6)(c)

 

7. Conclusion

 

From the policy perspective, certainty and clarity are of great concern to tax administrations and taxpayers alike in matters of international taxation. How contracting jurisdictions allocate the respective taxing rights certainly falls under the scope of certainty. Yet the allocation of taxing rights depends very much on how PE status is defined. How a PE status is defined among others depends on how specific activity exception is determined. The determination of specific activity exception in turn depends on whether the preparatory or auxiliary condition needs to be taken into consideration. If yes, then one must determine (i) whether a specific activity is of preparatory or auxiliary character; and (ii) whether a combination of specific activities constitutes complementary functions that are parts of a cohesive business operation that is not merely preparatory or auxiliary in nature. Adding an important element to uncertainty regarding the allocation of taxing rights, the ever-evolving world of information and communication technology has continued to exert influence on existing business model and process, and that will alter the view which people share in considering whether or not an activity has a preparatory or auxiliary character. The status quo is that contracting jurisdictions sharing different views on the aforesaid issues cannot reach a consensus on them. Therefore, the MLI article on the artificial avoidance of PE status with respect to specific activity exception includes options or alternative provisions giving rise to different outcomes.

 

From a technical perspective, Article 13 provides for three alternative options under Article 13(1), and three opt-out provisions (reservations) under Article 13(6). A party is permitted to withdraw a reservation or replace it with one that is more limited in scope, but cannot shift its position in the opposite direction with respect to pre-existing CTAs after confirming its initial position. As exemplified in this article, an opt-in provision and an alternative provision have something in common as the application of these two types of options is subject to any reservations made. But there are differences between the two. An opt-in provision applies only if both parties make a matched notification. Thus, the adoption of an opt-in provision gives rise to the same outcome as it must be applied symmetrically. In contrast, the adoption of an alternative provision may result in different outcomes as it can be applied asymmetrically.

 

 

Dr. Alfred Chan

China Tax & Investment Consultants Ltd

www.china-tax.net

2019-12-17