Substance over form: the sine qua non of international tax planning in the age of transparency and BEPS
In October 2015, the Organisation for Economic Co-operation and Development (OECD) issued its report on its BEPS Project titled: OECD/G20 Base Erosion and Profit Shifting Project 2015 Reports. This was accepted by the G20 (Group of 20 largest economies in the world) at its November 2015 meeting in Turkey. In actuality, there were 15 Reports/Actions covering the following areas which were presented that day:
- Action 1: Addressing the Tax Challenges of the Digital Economy
- Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements
- Action 3: Designing Effective Controlled Foreign Company Rules
- Action 4: 2 Limiting Base Erosion Involving Interest Deductions and Other Financial Payments
- Action 5: Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance
- Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances
- Action 7: Preventing the Artificial Avoidance of Permanent Establishment Status
- Actions 8–10: Aligning Transfer Pricing Outcomes with Value Creation
- Action 11: Measuring and Monitoring BEPS
- Action 12: Mandatory Disclosure Rules
- Action 13: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting
- Action 14: Making Dispute Resolution Mechanisms More Effective
- Action 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties
The OECD says BEPS refers to: “tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity. Although some of the schemes used are illegal, most are not. This undermines the fairness and integrity of tax systems because businesses that operate across borders can use BEPS to gain a competitive advantage over enterprises that operate at a domestic level. Moreover, when taxpayers see multinational corporations legally avoiding income tax, it undermines voluntary compliance by all taxpayers.”
Others, like the author, see BEPS as the latest step in a move toward global tax harmonization which began in 1998 when the OECD launched its harmful tax competition report.
The purpose of this two-part article is not to litigate the merit or demerits of the report. It is to focus instead on how the new proposals will change the landscape and the rules for international tax law, wealth and tax planning and legal tax minimization if and once they are implemented.
I have no doubt that at least some of the proposals will be implemented. Irrespective of the extent of their implementation, they will change the international tax law infrastructure. It is interesting to note that I presaged the overall thrust of the proposals set out by the OECD in my January 2014 article in this magazine titled: “Substance over form: How international financial centers can survive in the age of automatic exchange of information and transparency.”
The main focus of this two-part article, then, is to show that in this new world, whether or not anyone likes it, the concept of substance will not only be essential for survival, but more importantly, will be central to complying with the law.
The reports are voluminous and thus all the points cannot be covered by an article of this length. I will thus highlight two of the proposals which require substance and in so doing will define through illustration what that concept entails. In this first part, I focus on the new proposed rules on Permanent Establishments.
The rules on Permanent Establishments
The most profound change which the new proposals call for is in the definition of what constitutes a Permanent Establishment (PE). Double taxation treaties (DTTs) provide that the business profits of a foreign enterprise are taxable in a State only to the extent that the enterprise has in that State a PE to which the profits are attributable. The Model uses a two-prong test to identify a PE, namely:
- Whether the corporation has a fixed place of business within the foreign country as defined under the language of a specific treaty.
- Whether the corporation operates in the foreign country through a dependent agent that habitually exercises the authority to conclude contracts on behalf of the corporation in the target country.
Under the first prong of the PE test outlined above, a corporation must operate in a foreign country through a fixed place of business to create a PE. A fixed place of business has been defined in Article 5 of the Model to include the following types of physical locations:
- Place of management;
- Branch or an office;
- A mine, oil, or gas well, quarry, or any other place where natural resources are extracted.
The Model in Article 5(3) also states that a building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months. However, despite these provisions, the Model includes wide exceptions which allowed for creative tax arbitrage and mitigation strategies to which I shall refer to later in this article.
These exceptions, and for purposes of this article I will call them Article 5(4) exceptions, to differentiate them from the Article 5(5) exceptions stated below, include the:
- use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
- maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
- maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
- maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise;
- 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;
- 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.
Further, an enterprise of a contracting state shall not be deemed to have a PE in the other contracting state merely because it carries on business in that other contracting state through a broker, general commission agent, or any other agent of an independent status. This is conditional only if such persons are acting in the ordinary course of their business.
In the report, these are referred to as commissionnaire arrangements as set out in Article 5(5). However, when the activities of such an agent are devoted wholly or almost wholly on behalf of that enterprise, he/she will not be considered an agent of an independent status within the meaning of this paragraph. This will only be the case if it is shown that the transactions between the agent and the enterprise were not made under arm’s-length conditions.
The analysis to determine whether an agent is working as an independent agent can be determined by examining whether the agent is:
- Acting in the ordinary course of their business.
- Economically independent from the home country corporation that has contracted for their services
- Legally independent from the home country corporation that has contracted for their services.
The report itself notes that “through these sorts of commissionnaire arrangements, a foreign enterprise is able to sell its products in a State without technically having a permanent establishment to which such sales may be attributed for tax purposes and without, therefore, being taxable in that State on the profits derived from such sales.
Since the person that concludes the sales does not own the products that it sells, that person cannot be taxed on the profits derived from such sales and may only be taxed on the remuneration that it receives for its services (usually a commission).”
It goes on to state that a “foreign enterprise that uses a commissionnaire arrangement does not have a permanent establishment because it is able to avoid the application of Art. 5(5) of the OECD Model Tax Convention, to the extent that the contracts concluded by the person acting as a commissionnaire are not binding on the foreign enterprise. Since Art. 5(5) relies on the formal conclusion of contracts in the name of the foreign enterprise, it is possible to avoid the application of that rule by changing the terms of contracts without material changes in the functions performed in a State. Commissionnaire arrangements have been a major preoccupation of tax administrations in many countries, as shown by a number of cases dealing with such arrangements that were litigated in OECD countries. In most of the cases that went to court, the tax administration’s arguments were rejected.”
It further notes that “similar strategies that seek to avoid the application of Art. 5(5) involve situations where contracts which are substantially negotiated in a State are not formally concluded in that State because they are finalised or authorised abroad, or where the person that habitually exercises an authority to conclude contracts constitutes an “independent agent” to which the exception of Art. 5(6) applies even though it is closely related to the foreign enterprise on behalf of which it is acting.”
On this point it adds that “as a matter of policy, where the activities that an intermediary exercises in a country are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, that enterprise should be considered to have a taxable presence in that country unless the intermediary is performing these activities in the course of an independent business.”
The report also addresses the exceptions titled Article 5(4) above and notes that there have been dramatic changes in the way that business is conducted since their introduction as outlined in detail in the report on Action 1. The report goes on to say that depending on the circumstances, activities previously considered to be merely preparatory or auxiliary in nature may correspond to core business activities. In order to ensure that profits derived from core activities performed in a country can be taxed in that country, the PE rules will be modified.
The modification will ensure that each of the exceptions included therein is restricted to activities that are otherwise of a “preparatory or auxiliary” character.
The report noted that BEPS concerns related to Article 5(4) exceptions also arise from what is typically referred to as the “fragmentation of activities.” It points out the ease with which multinational enterprises (MNEs) may alter their structures to obtain tax advantages. In light of this, it is important to clarify that it is not possible to avoid PE status by fragmenting a cohesive operating business into several small operations in order to then argue that each part is merely engaged in preparatory or auxiliary activities that benefit from the Article 5(4) exceptions.
Finally, it noted that the exception which applies to construction sites has given rise to abuses through the practice of splitting-up contracts between closely related enterprises.
It is rules like this and others, mainly the ones on transfer pricing, that allowed American MNEs like Apple Inc, Starbucks Corporation, Amazon, Google and others to minimize their tax obligations legally. The purpose of this article is not to debate the merits or demerits of the behavior of these companies, but I mention this to set the context of what drove the OECD and G20 starting in 2013 to launch this project.
In light of all this, the new proposals call for a change in the definition of what constitutes a PE. The first one deals with ending commissionnaire arrangements exemptions. It requires that where a person is acting in a contracting state (in the context of a DTT) on behalf of an enterprise and in so doing, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without major 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 of that the enterprise has the right to use or;
- For the provision of services by that enterprise, that enterprise shall be deemed to have a permanent establishment in that state in respect of any activities which that person undertakes for the enterprise.
The second change relates to the Article 5(4) exceptions listed above. The proposal is to remove the wording which is highlighted in the exceptions in subparagraphs 5 and 6 and insert the following text after item 6: “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.”
When read together, this means that these exceptions which allow physical locations used for storage and the maintenance of goods etc, not to qualify as PEs, will only apply where the said locations and maintenance of goods are being used for activities that are preparatory or auxiliary in character. This will be different from what happens under the current regime where MNEs are using physical locations which are engaged in these activities to conduct business, while at the same time being allowed to avoid the PE requirements and thus paying taxes in the states where these activities occur and locations are situated.
To avoid MNEs using the new proposals to avoid the PE rules by splitting up activities into many different steps, isolating them into various locations and claiming that each is preparatory in nature, a new anti-fragmentation rule has been proposed. The rule says that the exceptions which are set out in Article 5(4) above shall not apply to a fixed place of business that is used or maintained by an enterprise. However, only 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:
- That place or other place constitutes a PE for the enterprise or the closely related enterprise under the provisions of Article 5; or
- 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. This is provided that the business activities carried on by the two enterprises at the same place, or by the same enterprises or closely related enterprises at the two places, constitute complementary functions that part of a cohesive business operation.
Finally, to address the issue of splitting up contracts to get around Article 5(3) above, the Principal Purposes Test (PPT) rule will be added to the OECD Model Tax Convention as a result of the adoption of the report on Action 6 mentioned earlier to address the BEPS concerns related to such abuses. The report does not give a definition of the test but instead provides a model scenario in the commentary that accompanies the report.
The scenario is not all inclusive and it appears that the report basically will leave it up to individual jurisdictions to use the scenario, which I have set out below, with necessary modifications, to apply the test. The objective is to apply the test to cases where contracts are being split to assess whether or not this is being done simply to take advantage of a treaty benefit or whether or not there is an economic rationale for the split.
RCo is a company resident of State R. It has successfully submitted a bid for the construction of a power plant for SCO, an independent company resident of State S. That construction project is expected to last 22 months. During the negotiation of the contract, the project is divided into two different contracts, each lasting 11 months. The first contract is concluded with RCO and the second contract is concluded with SUBCO, a recently incorporated wholly owned subsidiary of RCO resident of State R.
At the request of SCO, which wanted to ensure that RCO would be contractually liable for the performance of the two contracts, the contractual arrangements are such that RCO is jointly and severally liable with SUBCO for the performance of SUBCO’s contractual obligations under the SUBCO-SCO contract.
In this example, in the absence of other facts and circumstances showing otherwise, it would be reasonable to conclude that one of the principal purposes for the conclusion of the separate contract under which SUBCO agreed to perform part of the construction project was for RCO and SUBCO to each obtain the benefit of the rule in paragraph 3 of Article 5 of the State R-State S tax convention. Granting the benefit of that rule in these circumstances would be contrary to the object and purpose of that paragraph as the time limitation of that paragraph would otherwise be meaningless.
Substance in the context of the PE rules focuses on the physical location where activities occur and the actual facilities which are used to conduct them along with the persons who conduct the activities irrespective of the legal arrangements involved. The concept is now grounded in the idea that where value is created is the nexus for where taxes are to be levied and gimmicks like splitting up contracts to take advantage of the 12-month rule and setting up different entities to argue that each entity is doing a separate activity that is preparatory in nature will no longer apply.
In the second part of the article, I will focus on the proposals related to transfer pricing which will further elucidate the concept of substance.