Wednesday, February 29, 2012

The OECD Model Treaty: Permanent Establishment, Pt. III

Continuing the look at the OECD Model Treaty's definition of permanent establishment, we find the treaty specifically stating the following are PEs in Article 5, Section 2:

2. The term “permanent establishment” includes especially

a)  a place of management;

b)  a branch;

c)  an office;

d)  a factory;

e)  a workshop, and

f)  a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.

The accompanying commentaries add the following

This paragraph contains a list, by no means exhaustive, of examples, each of which can be regarded, prima facie, as constituting a permanent establishment. As these examples are to be seen against the background of the general definition given in paragraph 1, it is assumed that the Contracting States interpret the terms listed, "a place of management", "a branch", "an office", etc. in such a way that such places of business constitute permanent establishments only if they meet the requirements of paragraph 1.
To practitioners, the list should hardly seem controversial.  These are all common terms used in regular parlance, all of which would denote some level of physical commitment to a jurisdiction such as to allow for a taxing nexus to arise.  

As I previously noted, the commentaries cast a very wide net to encompass most situations that would logically lead to a PE.  In addition, the commentaries add the following regarding the typical length of time necessary to establish a PE:

Since the place of business must be fixed, it also follows that a permanent establishment can be deemed to exist only if the place of business has a certain degree of permanency, i.e. if it is not of a purely temporary nature. A place of business may, however, constitute a permanent establishment even though it exists, in practice, only for a very short period of time because the nature of the business is such that it will only be carried on for that short period of time. It is sometimes difficult to determine whether this is the case. Whilst the practices followed by Member countries have not been consistent in so far as time requirements are concerned, experience has shown that permanent establishments normally have not been considered to exist in situations where a business had been car-ried on in a country through a place of business that was maintained for less than six months (conversely, practice shows that there were many cases where a permanent es-tablishment has been considered to exist where the place of business was maintained for a period longer than six months).
 Also of importance is that the activity conducted does not have to be "productive," meaning the PE does not have to add to the profits of the overall enterprise.  As the commentary notes:

It could perhaps be argued that in the general definition some mention should also be made of the other characteristic of a permanent establishment to which some importance has sometimes been attached in the past, namely that the establishment must have a pro-ductive character, i.e. contribute to the profits of the enterprise. In the present definition this course has not been taken. Within the framework of a well-run business organisation it is surely axiomatic to assume that each part contributes to the productivity of the whole. It does not, of course, follow in every case that because in the wider context of the whole organisation a particular establishment has a "productive character" it is consequently a permanent establishment to which profits can properly be attributed for the purpose of tax in a particular territory (cf. Commentary on paragraph 4).
In the next piece, I'll look at the exemptions to PE.

Sunday, February 26, 2012

Captive Case Law Conclusion: The Harper Test, Part I: What Is Insurance?

If you're interested in forming a captive, or simply learning more, please see this link.

Today, I want to turn to the Harper Test, which states that a captive must comply with the following three factors:

(1) whether the arrangement involves the existence of an “insurance risk”;

(2) whether there was both risk shifting and risk  distribution; and

(3) whether the arrangement was for “insurance” in its commonly accepted sense.

I've already discussed the idea of risk shifting and risk distribution.  For the next few posts, I want to focus on factors 1 and 3, starting with one, that the arrangement involves the existence of an "insurance risk."  

Legally, insurance risk has three factors: an insurable interest, risk shifting and risk distribution and risk of loss.  The following excerpts are from my doctoral dissertation and discuss insurable interest and risk of loss:

The historical roots of this policy [insurable interest] date back to England when maritime insurance was sold to an insured whether or not he had a personal or financial interest in the ship or cargo. This sales practice “caused many pernicious practices, whereby great numbers of ships with their cargoes, [were] either … fraudulently lost or destroyed.”[1]  The second root of the insurable interest doctrine is judicial policy to prevent using insurance for gambling or wagering.[2]  During the 1800s, people purchased life insurance on famous elderly persons as a way to speculate on the time of their death.[3]  This practice displaces the primary purpose of insurance -- to protect the purchaser against unforeseen losses that directly impact his personal or financial interests.[4]  The third root of the insurable interest doctrine is the prevention of waste[5] by preventing non-essential insurance policies (such as those previously mentioned) from being written.

A person has an insurable interest in property “when he or she will derive a pecuniary benefit or advantage from its preservation or will suffer a pecuniary loss or damage from its destruction, termination or injury by the happening of the event insured against.”[6]  The interest can exist in law or equity[7] and can be found in a legal interest that is slight,[8] contingent or beneficial.[9]  In fact, outright ownership or title of ownership is not relevant to the inquiry.[10]  Obviously, courts construe the interest very liberally.[11]  The amount of insurance purchased cannot be disproportionate to the insurable interest or the court will rule the insurance policy is a wagering contract and therefore void against public policy.[12]


The primary purpose of an insurance contract is to transfer risk, which is an unforeseen and uncertain event that is a “disadvantage to the party insured.”[1]  The insured can’t prevent the risk from occurring;[2] it must be accidental[3]  or “fortuitous,” also defined as

‘…an event which so far as the parties to the contract are aware, is dependent on chance.  It must be beyond the power of any human being to bring the event to pass; it may be within the control of third persons; it may even be a past event, such as the loss of a vessel, provided that the fact is unknown to the parties.’[4]

Fortuitous should not be confused with natural degradation or depreciation – which is foreseeable but whose timing may be unpredictable.  In contrast, a fortuitous event is unforeseen and its timing is unknown, thereby impacting the insured when he is less prepared to mitigate the damages.[5]  The unknown or unforeseen element of the fortuity definition is best explained by the three primary fortuity-related defenses insurers offer to challenge an insured’s claim, the first of which is the “known loss” defense, where an insurer will argue the loss had “already occurred or [the insured should have known] the loss already occurred at the time the policy was written.”[6]  The second fortuity related loss defense is the “known risk” defense, where the insured knew the probability of loss was so high as to warrant some type of advance preparation or attempt to avoid the event on the part of the insured.[7]  “Loss in progress” is the third defense, which the insurer will argue when the loss was preceding at the time the insured purchased the insurance contract.[8]  The one common element to all of these defenses is actual or legally impugned knowledge on the part of the insured of the risk actually occurring or having a statistically significant possibility of occurring when he purchases the policy.

[1] 1A Couch on Insurance Section 17.7
[2] Id
[3] Appleman, Section 1.05[2][a]
[4] Appleman, section 1.05[2][b]
[5] Id
[6] Id
[7] Id
[8] Id

[1] Robert H. Jerry II, New Appleman on Insurance Law Library Edition, © 2009 Matthew Bender and Co. Section 1.05
[2] 44 Am. Jur. 2d Insurance Section 934
[3] Appleman, Section 1.05
[4] Id
[5] Id
[6] 44 C.J.S. Insurance Section 318
[7] Id
[8] Id
[9] 44 Am. Jur. 2d Insurance Section 932
[10] Id
[11] 44 C.J.S. Insurance Section 319
[12] 3 Couch on Ins. Section 41:2

Sunday, February 19, 2012

Captive Case Law Conclustion: The Need For A Valid Business Purpose

If you are interested in forming a captive or simply have questions about the industry, please see my website.

In looking at the cases, a few points immediately become apparent.

First, all the captives that were challenged by the IRS were formed because of business necessity.  They are all great examples of the business purpose test outlined in the Frank Lyon case, where has the following factors:
  1. there is a genuine multiple-party transaction
  2. with economic substance that is
  3. compelled or encouraged by business or regulatory realities,
  4. that is imbued with tax-independent considerations, and
  5. that is not shaped solely by tax-avoidance features to which meaningless labels are attached.
Perhaps the best example of this was the Humana case, where the company clearly weighted the need to create a captive against all the alternatives and determined a captive was the best option.  As I previously noted:

Humana was a groundbreaking case because it was the first major victory for a taxpayer in the captive insurance area.   Humana was (and is) a publicly traded health care company.     By the mid-1970s, it was incredibly difficult for the company to find adequate insurance.   The company considered going uninsured but did not have enough funds to withstand a catastrophic risk.   They also considered setting up a reserve, but payments to a reserve fund are not deductible, and the trust fund would not allow Humana to access the third-party insurance market.   A third option was combining with other hospitals in a 5-year pooling arrangement, but Humana did not want to commit to a 5-year program and was unsure about the financial viability of other possible participants.   Finally, the company could set up a captive insurance company – an option which was accepted because

it possessed none of the perceived disadvantages associated with the other options and it would provide a regulated method of insuring risks which would both isolate funds for the settlement of claims and satisfy interested lenders, mortgagees, and securities analysts.  In addition, Option (4) [establishing a captive] would provide access to world reinsurance and excess insurance markets.

Also note that Humana could demonstrate this need before they formed the captive; they had corporate records that clearly outlined and demonstrated the decision making process that led to their creation of a captive.  Corporate minutes were maintained that outlined the research that went into the decision.

Stearns Rogers also shows a clear business purpose.  The following excerpt is from my book:

The plaintiff in Stearns Rogers designed and manufactured “large mining, petroleum and power generation plants.”   In order to bid on projects, the company had to obtain insurance for its own contractors as well as its clients.   Starting in the early 1970s, the company “found it difficult or impossible to obtain from traditional companies the types and huge amounts of coverage needed.”   Therefore the company formed a captive insurance company under the Colorado Captive Insurance Company Act.   In order to gain approval from the Colorado Insurance Commissioner, Stearns Rogers had to demonstrate the company could not find other insurance.   The plaintiff named the company Glendale Insurance Company, which only issued insurance policies for the plaintiff, the plaintiff’s subsidiaries and the plaintiff’s clients.

While there were other issues with captive, their problem was not a lack of business purpose.

The above mentioned Frank Lyon factors should first and foremost,  always be at the forefront of our thinking when putting captives together.

Wednesday, February 15, 2012

The OECD Model Tax treaty; Permanent Establishment, Pt. II

Today I'm going to continue looking at the OECD model tax treaty's definition of permanent establishment.  Let me start with, Article 5, Section 2, which states:

2. The term “permanent establishment” includes especially:
a)  a place of management;
b)  a branch;
c)  an office;
d)  a factory;
e)  a workshop, and
f)  a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.

These are nothing more than specific terms which are used across jurisdictions which "can be regarded, prima facie, as constituting a permanent establishment."  While like most things legal the actual determination will be based on a specific cases facts and circumstances, it goes without saying that the above terms are commonly understood throughout the taxing world. 

Article 5, section three offers the following definition regarding construction sites: " A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months."

The commentaries provide important clarification.  For example:
This paragraph provides expressly that a building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months. Any of those items which does not meet this condition does not of itself constitute a permanent establishment, even if there is within it an installation, for instance an office or a workshop within the meaning of paragraph 2, associated with the construction activity. Where, however, such an office or workshop is used for a number of construction projects and the activities performed therein go beyond those mentioned in paragraph 4, it will be considered a permanent establishment if the conditions of the Article are otherwise met even if none of the projects involve a building site or construction or installation project that lasts more than 12 months.
It's standard practice to have a portable office on the work site.  However, having one does not in and of itself create a PE -- unless that office also manages other work sites.  This will be very difficult to deal with.  My recommendation would be for the parties involved to maintain immaculate records.  There would also need to be extremely strict rules regarding communications, especially with other work sites (if they exist).

Also consider the following:
The term "building site or construction or installation project" includes not only the construction of buildings but also the construction of roads, bridges or canals, the renovation (involving more than mere maintenance or redecoration) of buildings, roads, bridges or canals, the laying of pipe-lines and excavating and dredging. Additionally, the term "installation project" is not restricted to an installation related to a construction project; it also includes the installation of new equipment, such as a complex machine, in an existing building or outdoors.
While the first part of the commentary shouldn't come as a surprise, it's important to note the second part -- name, the installation of equipment.   For companies that sell heavy machinery who also service and install that machinery, this is a very important piece of information.

Finally, consider that under the UN model treaty, the length of time necessary to establish a permanent establishment is lowered to 6 months.


Sunday, February 12, 2012

The IRS' War on Captives; UPS, Pt. III

If you're interesting in forming a captive insurance company, please visit my captive management website.

The following is an excerpt from my book U.S. Captive Insurance Law:

After mentioning the general facts, the appellate court first noted, “It is not perfectly clear on what judicial doctrine the holding rests.”   Next, the court noted that this was essentially a sham transaction case, with the IRS arguing that the court should not respect the transaction, because its only motive was tax avoidance.   The court first outlined the basic concept of the sham transaction doctrine:
This economic-substance doctrine, also called the sham-transaction doctrine, provides that a transaction ceases to merit tax respect when it has no “economic effects other than the creation of tax benefits.” Even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance.
In other words, the plaintiff must prove that there is a legitimate, non-tax business purpose to the transaction in order to avoid the application of the sham-transaction doctrine. 

The appellate court noted that “economic effects” include the creation of genuine obligations enforceable by an unrelated party.   The court noted that a legitimate insurance contract existed between OPL and NUL, which NUL had the right to enforce.   The tax court “dismissed these obligations” because of the reinsurance agreement between NUL and OPL, arguing that NUL was nothing more than a conduit for payment from UPS to OPL.   In addition, UPS actually lost the income, given OPLs separate taxable status.   Finally, the court noted that the tax court was stretching the business purpose doctrine farther than it was intended to go.   The court sided with UPS and remanded the case back to the trial level. 

End excerpt

I previously noted that the UPS appellate decision is incredibly weak.  The above excerpt explains why.  The appellate court completely ignored the assignment of income doctrine, which was fully developed and painstakingly documented by the lower court.  Instead, we see the incredibly weak, "a valid contract was created" argument, followed by the statement this is adequate grounds to uphold the transaction and satisfy the economic substance doctrine.

To put it bluntly, the appellate court has absolutely no idea or concept regarding the economic substance doctrine, which is a two prong test that has both an objective and subjective component.  In addition, many transactions voided by previous courts because they lacked economic substance contained valid contracts.  Either the court knew this and chose to ignore it, or they didn't know it and marched forward.  Either way, their decision is at best laughable.

However. it is also apparent from the lack of true legal justification for their decision, that the appellate court was sending a message: we will not void a captive insurance transaction, period.  As this was the last case brought by by the IRS, it's obvious they got the message.

Wednesday, February 8, 2012

The OECD Model Treaty; Permanent Establishment, Part I

Today, I'm going to move forward and look at the OECD Model Treaty's rules on permanent establishment.  This is important for a simple reason: in order to exert its taxing rights over a transaction or individual, a jurisdiction must either prove the person/business is a resident (which we covered over the last few weeks) or prove the transaction took place within the jurisdiction's borders.  A permanent establishment is where a transaction occurs; hence the determination of a permanent establishment is of vital importance.

Let's start with the basic definition: "For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on."  The commentary adds important, further clarification.
-- the existence of a "place of business", i.e. a facility such as premises or, in certain instances, machinery or equipment;

-- this place of business must be "fixed", i.e. it must be established at a distinct place with a certain degree of permanence;

-- the carrying on of the business of the enterprise through this fixed place of business.
Key to the above ideas is the importance of attachment to the jurisdiction's geography.  The tax authority must be able to point to a place on the map and say with certainty, "economic activity over which we can exert taxing authority occurs at this location."   The length of time the location is established is irrelevant; for example, as soon as the business is formally incorporated it will exist at the address listed in its articles of incorporation.  In addition, the commentary notes that some enterprises only exist for a short period of time, but should still be considered permanent establishments.

The commentary continues:
The term "place of business" covers any premises, facilities or installations used for carrying on the business of the enterprise whether or not they are used exclusively for that purpose. A place of business may also exist where no premises are available or required for carrying on the business of the enterprise and it simply has a certain amount of space at its disposal. It is immaterial whether the premises, facilities or installations are owned or rented by or are otherwise at the disposal of the enterprise. A place of business may thus be constituted by a pitch in a market place, or by a certain permanently used area in a customs depot (e.g. for the storage of dutiable goods). Again the place of business may be situated in the business facilities of another enterprise. This may be the case for instance where the foreign enterprise has at its constant disposal certain premises or a part thereof owned by the other enterprise.
The purpose of the above paragraph is to cover as many situations as possible, and to prevent ultra-technical lawyering from getting around the PE statute.  In short, this is what I personally call a legal "duck test;" if it walks and talks like a PE, it is a PE.  

Over the next few posts, I'll delve deeper into this concept.

Sunday, February 5, 2012

The IRS' War on Captives; UPS, Part II

If you're interested in forming a captive insurance company -- or simply learning more -- please visit my captive management website.

In analyzing UPS’ situation before and after it established the captive, the tax court noted that UPS performed all the work related to the EVCs before and after the transaction:
Before January 1, 1984, petitioner performed all the functions and activities related to the EVC's and was liable for the damage or loss of packages up to their declared value.  After January 1, 1984, petitioner continued to perform all the functions and activities related to EVC's, including billing for and receiving EVC's, and remained liable to shippers whose shipments were damaged or lost while in petitioner's possession.  Petitioner continued to receive shippers' claims for lost or damaged goods, investigate and adjust such claims, and pay such claims out of the EVC revenue that it had collected from shippers.  The difference between petitioner's EVC activity before and after January 1, 1984 was that after that date it remitted the excess of EVC revenues over claims paid, i.e. gross profit, to NUF, which, after subtracting relatively small fronting fees and expenses, paid the remainder to OPL, which was essentially owned by petitioner's shareholders.
The only difference between UPS’ pre- and post-1984 arrangement was the insertion of NUF and OPL into the equation.   However, if that arrangement did not have economic substance, the court would not recognize the arrangement.   Hence, at trial this case’s focus was the objective and subjective substance of the transactions between UPS and NUF and NUF and OPL.

UPS first stated it created the transaction between UPS, NUF and OPL out of concern that the EVCs were insurance for which UPS did not have the requisite state licenses.   As a result, UPS’ business purpose for the transaction was to bring an existing business practice in line with various state laws.  However, for this claim to be valid, UPS would have to demonstrate that it “was motivated by a good faith concern that it was illegal for petitioner to continue to receive the excess value income.”   But UPS never obtained a legal opinion regarding the possible legal status of the ECV program.    In addition, after the program was in place, UPS continued to sell ECV policies to shippers in the same manner as before the transaction was established.   Finally, at trial, UPS did not offer any documentary evidence to back up this assertion.

Other of petitioner’s arguments were proven inaccurate by documentary evidence or testimony at trial.  First, UPS argued that its business purpose for establishing OPL was to create a viable insurance company as a profit center for the company overall.  However, the court noted that there were plenty of ways UPS could capitalize this new venture without diverting excess value premiums to OPL.  UPS also argued its business purpose was to allow the company to raise insurance rates.   But this assertion was proven incorrect by testimony from petitioner’s own witness at trial.   UPS also argued the new arrangement was a form of asset protection – that it lowered UPS’ exposure to risk and therefore protected the company’s core assets.   However, UPS continued to be primarily liable on many aspects of the ECV after the implementation of the captive insurance company.   Therefore, the company was still essentially liable, and its claim was proven incorrect by the facts. 

The court next determined whether the rate charged by UPS for its ECV policy was an arm’s length price.  The service procured an expert named Mr. Kelly to demonstrate that the rates charged for EVCs were higher than would be charged in a competitive market.   To demonstrate this fact, Mr. Kelly noted that OPL had a loss ratio of 33% – meaning the company paid out approximately 33% of premiums received in the form of payment for claims.   Mr. Kelly testified that this rate of profit retention would have driven clients away.   The court also noted that another UPS subsidiary named PIP charged a lower rate (0.125 cents per $100 – about half the ECV rate) for its insurance.  Several other experts backed-up this claim.  Even an expert procured by the petitioner conceded that UPS’ ECV rates were high.   As such, the court determined that the rates charged were not at arm’s length, making the transaction a sham for tax purposes.

Finally, the court noted that the petitioner’s sole purpose for entering in the transaction was lowering its federal tax burden.   The petitioner’s insurance broker prepared an original report stating that UPS could save $16 million in federal taxes the first year the plan was put in effect.   Other documents procured at trial demonstrated that tax reasons were the petitioner’s primary motivation for entering into the transaction.  

For all of the reasons listed, the court ruled that the payments UPS deducted as insurance premiums were not legitimate business deductions.   UPS appealed the decision.

Wednesday, February 1, 2012

The OECD Model Treaty; Residence, Part II

Last week, I looked at the residence provisions of the OECD Model Tax Treaty for individuals.  This week, I'll take a look at the provisions for non-individuals.

Before moving forward, however, it's important to briefly diverge into an area of academic discussion: partnerships, and how the OECD treaty deals with these business entities.  Under Article 1, the treaty applies to "persons who are residents of one or both of the contracting states."  This leads to the question of, "how does the treaty deal with a pass-through entity?"  Is the entity actually a separate company or is the entity a collection of its partners?  If the latter, how do we deal with that?  While this might seem like an academic debate, in reality it's not, as some jurisdictions treat these business entities in a very different manner.  The debate went so far as to have the OECD issue a paper on this topic, titled, "Double Taxation Conventions and the Use of Conduit Companies."  I would highly recommend reading the paper, as it offers some fascinating insights into partnerships the world over and how they are used in complicated business transactions.

All that being said, the word "person" (which is used in the above referenced Article 1 of the treaty) is defined in Article 3, which states, "the term person includes an individual, a company and any other body of persons."  The accompanying commentary adds this:
The definition of the term "person" given in subparagraph a) is not exhaustive and should be read as indicating that the term "person" is used in a very wide sense (cf. especially Articles 1 and 4). The definition explicitly mentions individuals, companies and other bodies of persons. From the meaning assigned to the term "company" by the definition contained in subparagraph b) it follows that, in addition, the term "person" includes any entity that, although not incorporated, is treated as a body corporate for tax purposes. Thus, e.g. a foundation (fondation, Stiftung) may fall within the meaning of the term "person". Partnerships will also be considered to be "persons" either because they fall within the definition of "company" or, where this is not the case, because they constitute other bodies of persons.
In short, after a long debate about partnerships and how to deal with them, we see they are covered by the convention.

That leads us to the question of residence of a non-person, which the treaty deals with thusly (Article 4(3)):
Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident only of the State in which its place of effective management is situated.
The commentary adds this clarification:
As a result of these considerations, the "place of effective management" has been adopted as the preference criterion for persons other than individuals. The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entitys business are in substance made. The place of effective management will ordinarily be the place where the most senior person or group of persons (for example a board of directors) makes its decisions, the place where the actions to be taken by the entity as a whole are determined; however, no definitive rule can be given and all relevant facts and circumstances must be examined to determine the place of effective management. An entity may have more than one place of management, but it can have only one place of effective management at any one time.
There are two possible ways to deal with a business entity: either the entity is a resident of the country where it is incorporated or it's a resident based on its place of effective management.  As the commentary points out, the primary reason the treaty settled on the place of effective management test was some companies with extensive international transportation operations (shipping and air transport companies) would be placed at an extremely advantageous tactical advantage using the place of incorporation test.   As such, the place of management test was adopted.

Finally, residence is usually a non-issue.  The rules are written in such a way as to provide clear guidance and procedures to determine residence with little difficulty.