The OECD Model Treaty; Business Profits

For the last few weeks, I've been talking about the OECD Model Treaty and how it deals with permanent establishments (see here, here, here, here, here and here) .  Today, we'll explain why all of this talk has been so important, as we'll discuss the idea of business profits, and how the treaty deals with them.  The following italicized paragraphs are from section 7 of the OECD Treaty dealing with business profits:

1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.

2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.

3. In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.

There is hardly anything in the above statements that is controversial.  It simply states that if a business has a permanent establishment within a jurisdiction, that jurisdiction can levy taxes on the PE to the extent of the profits which are attributable to that country.  In addition, the PE may deduct the expenses that the PE incurs to promote their business.

The opening commentary to this section makes three interesting and oft-debated points.

1.) By expressly stating the PE rule, the treaty is creating a situation that will lead to increased evasion.  For example, a company will deliberately attribute income to a PE established in a low tax country, precisely for the reason that the country has a low tax rate.  For example, Apple is doing this very thing in its tax strategy.

2.) While this is true, the above system's primary benefit -- namely, ease of administration -- outweighs that burden.  Put another way, "Much more importance is attached to the desirability of interfering as little as possible with existing business organization and of refraining from inflicting demands for information on foreign enterprises which are unnecessarily onerous." (from the OECD Model Treaty Commentaries)

3.) This does not mean that fiscal authorities shouldn't be looking for tax evasion; it does mean there should be a balance between investigation and vigilance on one side and a pro-business attitude on the other.

I'll be looking in more detail and the business profit rules in the following posts.

The OECD Model Tax Treaty: Permanent Establishment and Agents, Pt. II

Last week we looked at dependent agents and their ability on the treaty to create a permanent establishment for an enterprise.  Today I'll be looking at independent agents, which do not lead to the determination of a permanent establishment for tax purposes and hence do not create a tax presence.

The commentaries provide this general definition to begin the discussion:

37. A person will come within the scope of paragraph 6, i.e. he will not constitute a permanent establishment of the enterprise on whose behalf he acts only if

a) he is independent of the enterprise both legally and economically, and

b) he acts in the ordinary course of his business when acting on behalf of the enterprise.

The above definition is very similar to the definition of an independent agent under agency law.  In general, under common law rules, the following factors are used to determine whether or not an agent is independent or dependent, and thereby creating some kind of liability.

1.) The extent of control the agent
2.) Is the agent employed in a distinct line of business
3.) The kind of work done and whether or not the work is usually done by an agent
4.) The skill of the agent
5.) Does the agent supply the tools of the craft
6.) The length of time of employment
7.) The method of payment
8.) Is the work part of the regular business of the "employer."
9.) Do the parties of the relationship believe they are creating an independent or dependent agency status

The OECD commentary adds this clarification:

Whether a person is independent of the enterprise represented depends on the extent of the obligations which this person has vis-a-vis the enterprise. Where the person's com-mercial activities for the enterprise are subject to detailed instructions or to comprehensive control by it, such person cannot be regarded as independent of the enterprise. Another important criterion will be whether the entrepreneurial risk has to be borne by the person or by the enterprise the person represents.

You'll note that it is very similar to the 10 points made above, especially in relation to the control the principal has over the agent.  The more control, the more likely the agent is a permanent establishment for the client. 

The OECD Model Tax Treaty; Agents, Pt. I

If you have further questions about international tax issues, please contact me via SKYPE under the name bonddad.  You can also see my website to the righ.

The permanent establishment section in the OECD Model Tax Treaty is a remarkably complete section; it anticipates the work-arounds that most attorney's would consider to avoid PE status.  Case in point: the agent rules.

Remember that a permanent establishment is "a fixed place of business through which the business of an enterprise is wholly or partly carried out.  In seeing that definition, an attorney would start to think," what if, instead of a bricks and mortar establishment, we contract with a person?"  Well, the treaty has that covered as well.  

5. Notwithstanding the provisions of paragraphs 1 and 2, where a person —other than an agent of an independent status to whom paragraph 6 applies —is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the 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, unless the activities of such person are limited to those mentioned in paragraph 4 which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph.


6. An enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

The above two paragraphs are great examples of good treaty drafting, as they anticipate the intended side-stepping that a lawyer would engage in.  

The primary, in country activity that that treaty is looking for is the ability to conclude contracts; in the words of the commentaries:

Persons whose activities may create a permanent establishment for the enterprise are so-called dependent agents i.e. persons, whether or not employees of the enterprise, who are not independent agents falling under paragraph 6. Such persons may be either indi-viduals or companies and need not be residents of, nor have a place of business in, the State in which they act for the enterprise. It would not have been in the interest of interna-tional economic relations to provide that the maintenance of any dependent person would lead to a permanent establishment for the enterprise. Such treatment is to be limited to persons who in view of the scope of their authority or the nature of their activity involve the enterprise to a particular extent in business activities in the State concerned. Therefore, paragraph 5 proceeds on the basis that only persons having the authority to conclude contracts can lead to a permanent establishment for the enterprise maintaining them.

In trying to determine the appropriate level of activity within a state to apply PE status, the drafters had to find some type of balance; they concluded that the ability to habitually conclude contracts in the country was a strong enough fact to demonstrate a companies intent to avail themselves of the benefits and burdens of a particular jurisdiction.

I'll add more detail to this concept in the next post.