Tax Policy Bulletin
OECD releases revised base erosion
and profit shifting proposals on
permanent establishments
19 May 2015
In brief
The OECD has released its revised proposals on the Permanent Establishment (PE) rules in Article 5 of
the OECD Model Tax Treaty. The earlier OECD proposals, which set out alternative approaches to a
number of significant PE issues, have been replaced by a set of definitive proposals which are largely
focused on expanding the scope of the dependent agent rule (including narrowing the scope of the
independent agent rule) and narrowing the scope of the specific activity PE exemptions. An important
element of the package is a proposed anti-fragmentation rule intended to prevent abuse of the PE rules
by segregating activities across associated entities. Taken together, the proposed rules will clearly
expand the scope of existing PE rules.
In detail
On Friday 15 May the OECD
released revised proposals for
changes to the threshold PE rule
in Art 5 of the OECD Model.
The new proposals update the
earlier OECD discussion draft
on artificial avoidance of PE
status from October 2014 by
replacing the possible options
canvassed at that time with
specific recommendations on
each of the various PE rules
areas where change is proposed.
The BEPS discussion on the PE
rules has, to date, involved
proposals for changes to the PE
rules in six areas. The newly
issued package deals with all of
these, except for the specific
insurance proposals which have
been dropped. This discussion
draft helpfully makes a clear
statement that nothing in the
proposals is intended to reflect
the views of the OECD or the
participating countries on the
interpretation of the OECD
Model’s current provisions.
However, in our experience, tax
authority practice is not always
so constrained.
Dependent agent rule
The most significant change is
the proposed tightening of the
dependent agent rule in Art 5(5)
of the OECD Model. This is
intended to deal with
commissionaire and similar
arrangements, though it will
have an appreciably wider
impact in practice. The OECD
has explained that the policy
basis of the rule change is that
where the activities that an
intermediary (i.e., agent)
exercises are intended to result
in the regular conclusion of
contracts to be performed by a
foreign enterprise, that foreign
enterprise should be considered
to have a taxable nexus in that
country unless that
intermediary is performing
these activities in the course of
an independent business. In the
earlier PE paper of October
2014, four options had been
proposed for re-writing the
dependent agent rule in line
with this objective. These
options are now narrowed to a
single proposal. The new test
applies where an agent acting on
behalf of an enterprise
habitually “concludes contracts,
or negotiates the material
elements of contracts” that are
in the name of that enterprise,
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Tax Policy Bulletin
or that, broadly, relate to property of
that enterprise or which are for the
provision of services by that
enterprise. (The full expression of this
test is that 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.)
Observation: the change in
emphasis in the dependent agent rule
from a legally binding test to one in
which the substance of the agent’s role
in the overall arrangements is now
much more important follows from
one of the major themes of BEPS as a
whole, namely to replace, or at least
supplement, the legal analysis with a
substance-based approach. As with
all substance-based tests, the key
practical difficulty will relate to where
the line is drawn in any particular
case, a matter which the OECD
attempts to resolve with a new
Commentary on this rule (see further
below).
Recognising that the dependent agent
rule does not apply if the agent
concerned qualifies as an
“independent agent” under the terms
of Art 5(6), the October 2014
discussion draft included a proposal
to introduce significant restrictions to
the terms of that exemption. The new
discussion draft notes that there have
been strong objections to the
proposed narrowing of the
independent agent exception but it
has nonetheless been decided to
proceed with this proposal. The
proposal retains the current position
under which the exemption applies if
the relevant agent carries on business
as an independent agent and acts for
the foreign principal in the ordinary
course of that business. However,
there is an important rider introduced
by the proposed change. This states
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that where an agent acts exclusively or
almost exclusively for one or more
enterprises to which it is connected,
the agent shall not be considered to be
an independent agent for the purposes
of the exemption. The proposal has
been modified from the earlier
October 2014 proposals in that the
concept of “associated enterprises”
which has to date been used in the
expression of the independent agent
test is to be replaced by a connected
parties concept - based, broadly, on
vote and value of a company’s shares
or on de facto control. The OECD also
clarified that the test in Art 5(6)
should not automatically exclude an
agent acting exclusively for one
unrelated principal or a number of
principals connected with each other
(which the previous proposals from
October 2014 would have done).
Observation: This modification
should be welcomed in the case of
unrelated principals. However, we
consider the logic should be extended.
In our view, the independent agent
test should generally and as a matter
of principle be directed at whether the
agent is in any particular case carrying
on the business of the principal or
whether the business of the agent has
merged with that of the principal. On
this basis, the focus should be on the
nature of the agent’s activities, not the
relationship between agent and
principal (i.e., whether or not
connected). The OECD seems to
recognise this point in its explanation
of the test but for reasons which are
not explained it retains the absolute
bar on the ability of an agent to act in
the capacity of an independent agent
where it acts exclusively or almost
exclusively on behalf of connected
parties. In the absence of further
explanation, this discrimination
against connected parties seems hard
to justify. We also remain concerned
with the level of clarity in the
explanation of what it is to be an
independent agent. As the proposed
guidance in the Commentary now
stands, there is a great deal of
emphasis on looking at the relevant
facts and circumstances in any
particular case, yet the tests to apply
in any such case are far from clear.
The existing guidance is in some
respects pared back under these new
proposals, making the tests even more
subjective and uncertain than they are
currently. Finally, in relation to the
revised connected party test, this is
intended to be narrower than the
existing “associated enterprises” test
yet the benefits of the modified test
seem diluted by the inclusion of the
more subjective test of control which
is based on “all the relevant facts and
circumstances”.
The OECD discussion draft also
includes proposed new text to revamp
the relevant Commentary in the
OECD Model on the dependent and
independent agent tests. This is
clearly necessary given the
introduction into the terms of Art 5 of
new concepts (e.g., “negotiates the
material elements of contracts”). The
new guidance explains that a contract
can be concluded without any active
negotiation (e.g., where an agent
accepts an offer by a third party to
enter into a standard contract with the
principal or where the agent’s role is
limited to convincing the customer to
accept a standardized contract). It
also clarifies that the meaning of the
phrase “material elements of
contracts” may vary depending on the
nature of the contract concerned but
would typically include the
determination of the parties between
which the contract will be concluded
as well as the price, nature and
quantity of the goods or services to
which the contract applies. It is stated
that the phrase must be interpreted in
the light of the object and purpose of
the dependent agent test, and that the
test applies to a person who acts as the
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salesforce of the enterprise and, in
doing so, makes or accepts contractual
offers even if standard contracts are
used for that purpose.
Observation: The new test is very
likely to have an impact on existing
business processes and arrangements
and the concepts (such as what it
means to “negotiate” and the range of
“material elements” of a contract) will
need to be further explored - for
example, what range of activities will
constitute “accepting” a contract? It
will also be important to appraise the
interaction of on-line and local
physical activity by agents to
understand where the line is drawn.
In designing the test to hit
commissionaire arrangements, the
discussion draft explains that the
revised dependent agent test applies
not only to contracts that create rights
and obligations that are legally
enforceable between the enterprise on
behalf of which the person is acting
and the third parties with which these
contracts are concluded, but also to
contracts that create obligations that
will effectively be performed by such
enterprise rather than by the person
contractually obliged to do so,
meaning that it will of course also
need to be understood how far this
notion of “effective performance”
goes.
An important question raised by the
earlier October 2014 proposals was
how far the BEPS PE proposals are
intended to hit distributor - and
similar - arrangements. This point
has been cleared up by the latest
proposals. The discussion draft now
clarifies that these PE changes are not
intended to address BEPS concerns
relating to the transfer of risks
between related parties through lowrisk distributor arrangements as this
issue is best addressed through the
BEPS work on Action 9 (Risk and
Capital). From a technical
perspective, the paper seems to
confirm that such distributors should
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not be caught by the revised tests
discussed above because, assuming
title in any goods passes to the
distributor in the relevant
arrangements, they are selling their
own property and not acting on behalf
of another enterprise, meaning that
they should not be caught by the
dependent agent test.
Specific activity exemptions
It has been clear for some time that
the OECD wishes to restrict the
existing specific activity exemptions
which allow certain activities to take
place in a state without triggering the
threshold PE rule. As a result, there
has been extensive discussion of - and
various options proposed for - those
specific activity exemptions
(contained in Art 5(4) of the OECD
Model). Rejecting the alternative
options to amend the terms of certain
individual exemptions, the OECD now
proposes to restrict all of the
exemptions in Art 5(4) to activities
that are of a “preparatory or auxiliary”
character. It also proposes additional
Commentary to clarify the meaning of
that phrase. There is also now an
accompanying Commentary to the
rule to explain the meaning of the key
concepts: the proposed Commentary
text states that preparatory activity is
generally carried on during a
relatively short period in
contemplation of the essential and
significant part of the activity of the
enterprise as a whole. An activity that
has an auxiliary character, on the
other hand, generally corresponds to
an activity that is carried on to
support, without being part of, the
essential and significant part of the
activity of the enterprise as a whole.
The proposed Commentary includes
some fairly pointed comments on
large warehouses used for storage and
delivery in the context of an on-line
business failing the preparatory or
auxiliary test. These comments seem
unusually specific and a little out of
step with the normal approach
adopted in the Commentary.
Some particularly controversial
proposals to address the situation
where activities are being fragmented
between related parties were also
included in the package of PE
measures released in October 2014.
As the OECD’s discussion draft
acknowledges, the vast majority of
commentators expressed strong
objections to the alternatives put
forward. However, the OECD has
nonetheless decided to proceed with
the anti-fragmentation rule, under
which the preparatory or auxiliary
exemption of Art 5(4) will not be
available if, broadly, there is an
existing PE of the enterprise
concerned or an affiliate, or there is
no such PE but the overall activity
resulting from the combination of the
activities of those connected
enterprises is not of a preparatory or
auxiliary character. For the rule to
apply, it must also be the case that the
combined business activities
represent “complementary functions
that are part of a cohesive business
operation”. Two examples are
proposed for inclusion in the
Commentary to illustrate the
operation of this rule.
Observation: We remain concerned
that this anti-fragmentation rule will
be difficult to operate in practice.
Also, in our view, business needs
materially more explanation of the
scope of what falls within the notion
of “complementary functions that are
part of a cohesive business operation”
than is provided by the two short
examples proposed for inclusion in
the Commentary. In relation to the
second example given, the antifragmentation rule is illustrated by
reference to a situation where an
affiliate is a business enterprise
resident in the source country
concerned. The implication is that if,
for example, a parent in Country A has
an operating subsidiary in Country B,
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any supplemental parent activity in
Country B (related to the subsidiary’s
business) will be considered to give
rise to income attributable to a PE in
Country B.
Splitting up of contracts
Alternative measures to deal with the
artificial splitting up of contracts to
circumvent the 12 month
“construction site” PE rule (which also
covers installation projects) were also
included in the original proposals to
address BEPS concerns. The OECD
now proposes that the addition of an
example in the Commentary on the
application of the principal purpose
test (from the work on treaty abuse in
Action 6) is the way to deal
appropriately with the issue. The
example proposed indicates that an
attempt to split a 22 month
construction project into two 11
month contracts involving related
parties where the arrangement is
designed to exploit the terms of the 12
month exemption will not be
respected. The Commentary would
include an optional automatic rule
(which aggregates contracts for
connected activities by related parties
at the same site) for states that wish to
deal expressly with the issue.
Insurance
Two options were originally proposed
to expand the PE test in the insurance
sector. These insurance sectorspecific proposals have now been
dropped. For those in the insurance
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sector, this news will be welcome but
is unlikely to be an end to the matter.
In practice, it is likely to mean that
those tax authorities known to have
concerns relating to cases where a
large network of exclusive local agents
is used to sell insurance for a foreign
insurer will have to pursue them by
other means - specifically, under the
more general changes proposed for
the tightening of the dependent agent
rule.
Issues relating to the attribution
of profits
The discussion draft does not provide
any new guidance on the associated
PE profit attribution issues but
acknowledges the need to provide
additional guidance on the attribution
of profits, particularly outside the
financial sector, and to take account of
other work in progress on intangibles,
risk and capital. The discussion draft
therefore proposes to continue work
in this area after September 2015 but
with a view to provide the necessary
guidance by the end of 2016, which is
the deadline for negotiation of the
multilateral instrument that will
implement the results of the work on
Action 7.
Observation: Further guidance on
the operation of the attribution rules
is clearly necessary and we certainly
support that work on clarifying the
operation of Art 7 in the context of the
expansion of the PE rules in Art 5.
However, what this program of work
on the attribution rules means is that
a vital and integral part of the overall
PE package will now be off the radar
as the PE threshold measures are
finalised over the remainder of 2015.
Given that a very common taxpayer
concern has been about a multitude of
PEs created in circumstances where
there is no additional profit at stake
beyond that produced by existing
transfer pricing methodologies, this
seems to give no further opportunity
to test or explore that concern.
The takeaway
These definitive proposals are largely
focused on expanding the scope of the
dependent agent rule (including
narrowing the scope of the
independent agent rule) and
narrowing the scope of the specific
activity PE exemptions. An important
element of the package is a proposed
anti-fragmentation rule intended to
prevent abuse of the PE rules by
segregating activities across
associated entities. Taken together,
the proposed rules will clearly expand
the scope of existing PE rules.
Interested parties are requested to
provide comments - which the OECD
requests be kept as short as possible on these revised proposals by 12 June
2015. The proposals are then to be
discussed by the OECD’s Working
Party 1 in late June, when they will be
asked to finalise the changes to the
OECD Model Treaty.
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Let’s talk
If you’d like to discuss these issues further please call your usual PwC contact or one of the following:
Richard Collier, London
+44 207 212 3395
[email protected]
Steve Nauheim, Washington
+1 (202) 414 1524
[email protected]
David Ernick, Washington
+1 (202) 414 1491
[email protected]
Ulf Andreson, Frankfurt
+49 69 9585-3551
[email protected]
Jerome Monsenego, Stockholm
+46 10 2133483
[email protected]
Mike Gaffney, New York
+1 (646) 471 7135
[email protected]
David Swenson, Washington
+1 (202) 414 4650
[email protected]
Alex Voloshko, Boston
+1 (617) 530-4512
[email protected]
Alenka Turnsek, London
+44 20 7213 5045
[email protected]
Phil Greenfield, London
+44 207 212 6047
[email protected]
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