The measures formulated in this action may substantially promote the option of filing binding ruling requests provided in individual jurisdictions, which is aimed at eliminating taxpayer’s tax risks deriving from the subjective judgement of certain rules and promoting the correct application of law.
In general we can say that the finalized actions address major, important issues and may have substantial impact in the future but action no. 7 is most likely the most significant of all. Not the least because the action contains specific amendments and additions to the text of certain paragraphs of Article 5 of the OECD Model Convention and to the relating Commentaries, which, unlike before (as currently the text in the Model Convention only serves as a recommendation) will have binding force as soon as the multilateral instrument signed by the participating states discussed in detail in BEPS action no. 15 will overwrites the text of the conventions on the avoidance of double taxation. Signing of this multilateral instrument is expected in 2016 already.
Interest in action no. 7 is also demonstrated by the fact that the draft of the action had to be put up for debate twice because a number of significant business players worldwide submitted a huge amount of comments and recommendations to OECD in relation to the changes proposed by this action.
Why is Article 5 of the double tax treaties so important that its amendment triggered such a reaction globally?
Article 5 of the treaties contains the definition of permanent establishment, which determines whether a taxable person having its seat in in a certain country will become a taxable person in another country as a result of the activity it performs in such other country, i.e. it basically regulates whether tax is payable on the activity performed in the other country or not. The importance of this question lies in the fact that in today’s increasingly globalizing world trade a huge volume and number of business transactions are conducted at international level and a very large number of commercial and service companies are present (in one way or another) in a country other than the country of their seat without establishing a subsidiary there. For this reason, it is especially important how these “presences” in another country are treated in international tax law.
The PE rules of treaties and internal regulations have so far determined and will continue to determine the point at which a presence in another country will trigger registration and tax payment obligation. Having regard to relating substantial increase in administrative burdens (registration, requesting of tax number, potential bookkeeping obligation, tax assessment and tax return filing obligation, use of a local tax consultant etc.) and also to the potentially higher tax payment obligation it is no wonder that a company (or group of companies) will strive to avoid PE status of its activity performed in another country.
Article 5 currently in force contains a relatively detailed (perhaps even too detailed) and specifically formulated list, system of conditions and exemptions as to when and which activities create PE status. This detailed regulation has, by now, lead to a large number of (mostly) multinational groups developing structures, which meet the relevant criteria based on a strictly literal interpretation of the rules but, in terms of their actual content, these structures are aimed exclusively at avoiding PE status. For this reason, courts frequently ruled in favour of such groups and against tax authorities because they interpreted the law literally also.
Regarding the nature of the activity, groups engaged in the commercial and service sectors could (can) avoid PE status most easily. This is due to the fact that while, for instance, a manufacturing activity is tied to a certain location and requires substantial assets and labour, in the increasingly digitalized global economy a commercial or service activity can basically be performed from another country without using a significant amount of local assets and labour (if using any at all).
Below we briefly present the most important amendments and additions to the action in a breakdown by topics:
General tightening of activity exemptions (Article 5, paragraph 4)
Paragraph 4 of Article 5 of the treaties contains a detailed list for the exemption of certain activities in the case of which a company can avoid PE status in another country. Such exemption applies if a company only performs certain partial activities in relation to its activity (e.g. warehousing, gathering of information, preparatory or auxiliary activities) in the other country. The purpose of this provision was originally to relieve internationally active groups of unnecessary burdens as long as they did not perform their main income earning activity in the other country.
However, as I explained above, the economy went through a major transition in the meantime. So much so that activities which previously in fact served only auxiliary/preparatory functions or warehousing etc. now are often, mostly in commerce, the main activity of a certain company disguised as an auxiliary/preparatory activity. In the case of an online trading company, for instance, (the likes of which basically did not exist at the time the text of paragraph 4 of Article 5 was originally formulated) it was often enough to have a warehouse in the other country for the company to be able to perform its main activity but, as a warehouse did not qualify as a PE, the company was exempt from the obligation to register and pay taxes.
For this reason, paragraph 4 was amended so that the condition of the activity having a preparatory or auxiliary character was extended to all listed activities (facilities, maintenance of stocks, maintenance of stocks only for processing or the purchasing of goods, collecting information) otherwise the activity creates a permanent establishment. The above-mentioned online trading company will therefore have to prove (based on the new rules) that it does not use the warehouse for carrying out its main activity.
Anti-fragmentation rule (newly added paragraph 4.1 of Article 5)
The anti-fragmentation rules relate closely to (and to a certain extant overlap) the existing activity exemption rules. So much so, that the states which do not agree with the above mentioned amendment of paragraph 4 may reserve the right to continue to apply the current regulation. The new paragraph 4.1 was necessary because activity exemption was a popular means of avoiding PE status by way of fragmenting the activity of a group among a number of companies to smaller sub-activities making sure that individual sub-activities on their own satisfy the exemption rules.
The rules of exemption of the above listed activities do not apply under the new regulation if the activity of a certain enterprise or a “closely related enterprise” (a term newly introduced in the text of the model convention) would qualify as a PE in a certain state or if the activities of two enterprises would aggregately not have preparatory or auxiliary nature, i.e. if the activities of the two enterprises in fact constitute complementary functions that are part of a cohesive business operation. The terms “complementary functions” and “part of a cohesive business operation” are not defined in particular, which is, most likely, due to the above mentioned more general and subjective formulation and therefore, the focus of the underlying content over form.
Dependent agent structures (paragraph 5 of Article 5)
Paragraphs 5 and 6 of Article 5 of the treaties regulate cases in which an enterprise performs its activity in another country through an agent. This is an especially sensitive area of PE status, which has been in the focus of legislator already and which has also given space for major abuse. Based on the current wording of the treaties a typical example is if an agent has the right to conclude contracts in the other country in the name of an enterprise and the agent regularly exercises this right but nonetheless has to be regarded as a so-called dependent agent, unless the agent performs a similar activity for another enterprise, i.e. if it can be regarded as an independent agent.
The activities carried out with representation by these dependent agents only create PE status if certain conditions (discussed in detail in the Commentary to the Model Convention) are fulfilled, for example, if the agent had the right to sign document in the enterprise’s name (which does not create a PE in every case).
Having regard to the fact that from the perspective of whether PE status is created by a dependent agent, the decisive factor was often who has the right to sing contracts and literally who sing contracts (or where for that matter) (irrespective of who negotiates material conditions and where and how these are negotiated are conducted),this PE status rule could also be evaded easily and is in fact evaded frequently by certain groups. This method of PE status avoidance is so popular that many group transformed existing distribution networks into so-called agent structures (applying so-called commissionnaire arrangements, which, on paper, means that the activities of the distributor of a group is stripped down – inventories, receivables, liabilities, contractual rights relating to its clientele are sold to the related party and only agent commission is invoiced to the related party) while the functions and risks of the distributor remain practically unchanged.
In order to prevent avoidance of PE status using dependent agent structures, action no. 7 provides for the amendment of the definition so that it not only includes habitual exercise of an authority to conclude contracts in the name of the enterprise as a condition but provides that the agent “habitually plays a principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are in the name of the enterprise or for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use or for the provision of services by that enterprise.”
Hence, OECD tightens the objective definition of dependent agent by extending and specifying the relevant conditions and at the same time it integrates an expression suitable for open interpretation such as material modification thereby further enhancing the generalization and subjective interpretation of the already mentioned principle of content over form.
Independent agents (paragraph 6 of Article 5)
So far, it did not create PE status if an enterprise carried out is activity through an independent agent, e.g. a general broker in another state. This principle will be maintained in unchanged form under the new rules, however, in order to avoid abuse, the current regulation (that the agent must act in the ordinary course of its business) is extended to include that the agent shall not be considered to be closely related to the enterprise in question (based on the above mentioned newly introduced definition of this term).
Although the text of the new Commentary contains some guidance as to the independence of agents – e.g. that it cannot be regarded independent if it acts to 90 percent for a certain enterprise, in this case also to focus will most likely be on the underlying content of the legal relationship existing between the parties on paper.
The amendments and additions to the PE status rules presented above and the change and extension of the interpretation of these clearly shows that action no. 7 (and consequently, Article 5 of the treaties) focuses on promoting a more general, subjective formulation of texts and judgment based on the underlying, actual content instead of an objective legal treatment of artificial structures (i.e. the literal interpretation of rules), that is on the strengthening of the “content over form” principle.
The possibility of a more subjective judgment helps tax authorities in the fight against tax evasion (as it may promote the identification of artificial structures and thereby protect the domestic tax base). However, it may also generate substantial uncertainty in the future as certain facts, circumstances may have different interpretations and these uncertainties lead to tax risks. In order to avoid tax risk, much more careful preliminary consideration will be required in the future regarding the judgment of PE status. Due to the subjective nature of judgment, the most certain way of avoiding risks in Hungary (and in many other countries) will be the filing of a binding ruling request as the resolutions issued to these requests have binding force.