The OECD Model Treaty, Business Profits and Transfer Pricing

One of the key benefits to international transactions is the ability to utilize a network of inter-related corporate entities to shift profits to lower tax regions.  In tax vernacular, this is  referred to as transfer pricing.  While a complete discussion of this discipline is far beyond the scope of this post, it's important to understand the OECD model treaty grants broad authority to taxing authorities to recast the economic terms of a transaction to better reflect arms-length principles.

The granting of authority starts in paragraph 2 of Section 7:

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.

This section ties directly into Section 9, which is titled "Associated Enterprises," and states the following:

1. Where

a)  an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

b)  the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,

and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

The granting of authority is developed and explained over several sections of the commentary.

1.) The starting place for the analysis is the company's books and records.  Paragraph 12 of the commentary to section 7 states:  In the great majority of cases, trading accounts of the permanent establishment -- which are commonly available if only because a well-run business organisation is normally concerned to know what is the profitability of its various branches -- will be used by the taxation authorities concerned to ascertain the profit properly attributable to that establishment.

2.) However, the taxing authority does not have to take these accounts at face value.  Paragraph 12.1 of the commentary to section 7 states: However, where trading accounts are based on internal agreements that reflect purely artificial arrangements instead of the real economic functions of the different parts of the enterprise, these agreements should simply be ignored and the accounts corrected accordingly.

3.) The related commentaries give the taxing authorities broad authority to re-write internal accounts if they do not reflect economic reality.  Paragraph 2 of the commentary to section nine states: "This paragraph provides that the taxation authorities of a Contracting State may, for the purpose of calculating tax liabilities of associated enterprises, re-write the accounts of the enterprises if, as a result of the special relations between the enterprises, the accounts do not show the true taxable profits arising in that State."

So, the taxing authority will start by looking at the company's records.  If these appear to be fine, then the analysis stops there.  But if there's a problem, they can dig deeper and if warranted completely rewrite the transactions if the original terms to not reflect "economic reality."

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

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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.

The OECD Model Treaty; Permanent Establishment Exceptions

Not only does the OCED model treaty provide an in-depth explanation of what a PE is, there is also a section that outlines what a PE isn't  Here is the section in its entirety:

4. Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include:

a)  the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;

b)  the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;

c)  the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;

d)  the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise;

e)  the 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;

f)  the maintenance of a fixed place of business solely for any combination of activities mentioned in sub-paragraphs 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.

All of these classifications have one element in common: they are either preparatory (they occur before the "main activity") or auxiliary (they are not the primary activity that is occurring at a particular location).

The classic example is section "c," where goods are held for further processioning.  Here, the company is typically importing raw materials into a jurisdiction for the purpose of manufacturing a product in that jurisdiction, with the intention of converting the imported material into another product.  Counting the storage facility as a permanent establishment would create a compliance burden on the importer, and would most likely hinder the development of world trade.

Sections a and b can be seen in combination; they occur where a company has a store that displays or presents goods to the public and/or stores the same.  What is absent from this definition is the selling of goods through the location; once that occurs, a PE clearly exists because then there would be "a fixed place of business through which the business of an enterprise is wholly or partly carried on."

It's also important to remember the differences between the above mentioned activities and a permanent establishment, which the commentary explains thusly:

It is often difficult to distinguish between activities which have a preparatory or auxiliary character and those which have not. The decisive criterion is whether or not the activity of the fixed place of business in itself forms an essential and significant part of the activity of the enterprise as a whole. Each individual case will have to be examined on its own merits. In any case, a fixed place of business whose general purpose is one which is identical to the general purpose of the whole enterprise, does not exercise a preparatory or auxiliary activity. Where, for example, the servicing of patents and know-how is the purpose of an enterprise, a fixed place of business of such enterprise exercising such an activity cannot get the benefits of subparagraph e). A fixed place of business which has the function of managing an enterprise or even only a part of an enterprise or of a group of the concern cannot be regarded as doing a preparatory or auxiliary activity, for such a managerial activity exceeds this level. If enterprises with international ramifications establish a so-called "management office" in States in which they maintain subsidiaries, permanent establishments, agents or licensees, such office having supervisory and coordinating functions for all departments of the enterprise located within the region concerned, a permanent establishment will normally be deemed to exist, because the management office may be regarded as an office within the meaning of paragraph 2. Where a big international concern has delegated all management functions to its regional management offices so that the functions of the head office of the concern are restricted to general supervision (so-called polycentric enterprises), the regional management offices even have to be regarded as a "place of management" within the meaning of subparagraph a) of paragraph 2. The function of managing an enterprise, even if it only covers a certain area of the operations of the concern, constitutes an essential part of the business operations of the enterprise and therefore can in no way be regarded as an activity which has a preparatory or auxiliary character within the meaning of subparagraph e) of paragraph 4.

The above examples all contain professional individuals performing a certain amount of management or professional activities that contribute -- even in a small way -- to the overall enterprise as a whole.  In contrast, the exceptions are more about storing, preparing and or displaying "things."  

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.

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.

 

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.

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.  

The OECD Model Tax Treaty; Residence, Part I

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Article 1 of the OECD treaty states, "This Convention shall apply to persons who are residents of one or both of the Contracting States.."  As such, for a person to claim treaty benefits, they must be residents.  Today, I'll focus on residence for individuals, which is covered in Article four of the treaty:

Article 1, Section 4 states, 

For the purposes of this Convention, the term “resident of a Contracting State” means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.

The above paragraph has several key points as noted in the accompanying commentary.  "The definition refers to the concept of residence adopted in the domestic law."  Put another way, the model treaty melds with the existing domestic law to create a hybrid concept.  Second, "the definition aims at covering the various forms of personal attachment to a State which, in the domestic taxation laws, form the basis of comprehensive liability."  What the treaty is looking for is some outward, easily documented manifestation of an individual's presence in the state.  Also note, this definition does not extend to companies that are taxed in a jurisdiction simply because of their business done in the state.

In the event a person is a resident of both contracting states, the treaty has a comprehensive list of "tie-breaking" provisions:

a)  he shall be deemed to be a resident only of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident only of the State with which his personal and economic relations are closer (centre of vital interests);

b)  if the State in which he has his centre of vital interests cannot be determined, or if he has not a permanent home available to him in either State, he shall be deemed to be a resident only of the State in which he has an habitual abode;

c)  if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident only of the State of which he is a national

d)  if he is a national of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

The criteria start with an easily understood concept: where is the individual's physical home?  If only one exists, the investigation stops.  If there are two homes, then we need to determine where his "center of vital interests" exists -- where he has his closest community.  Here we look at where he has friends, which community he more actively participates in etc... 

The preceding two points are typically where most inquiries stop.  However,  in the event it's difficult to determine, we next look to a "habitual abode."  Habitual abode refers more to the length of time an individual stays in a particular location, regardless of the type of residence (which could even be a hotel).  Finally, if that test doesn't work, we look to nationality and then an agreement between the countries.

In reality, most inquiries are easily handled under these rules.  Typically it stops at at section (a).  

Next, we'll talk about residence for business entities.

 

An Overview of the OECD Tax Treaty: Some Background

Assume that company XYZ -- which is domiciled in the US -- wants to sell goods to Germany.   While this looks like a great idea on paper it may wind up being counter-productive.  Why?  Because the transaction may be subject to double taxation.  The US taxes income of its residents on a world wide basis -- meaning that wherever in the world you earn money, if you're a US citizen you have to pay US tax on the earnings.  In addition, Germany will also tax the transaction because it occurs within its geographic borders.  So, if the US company sells a good in Germany, it will pay both a US tax and a German tax on the transaction, making this a possibly money losing proposition. 

Thankfully, this problem of double taxation has long been recognized as a possible impediment to world trade and various parties have sought to prevent its effects from happening.  In fact, one of the goals of the original League of Nations was to establish international tax norms (this is where the phrase "permanent establishment" was originally developed).  This task eventually fell to the OECD, who issued their first tax treaty in 1963 largely in reaction to the post WWII increase in international trade.  This treaty was revised in 1977 and again 1992 when it was released in loose-leaf form, allowing for periodic updates and revisions. The UN issued its model treaty in 1979, which was based on the OECD model, but which was more oriented towards capital importers rather than capital exporters.  The US issued their first model treaty in 1977, which was replaced in 1981 and again in 1996.

There is a tremendous amount of overlap between the treaties, with the following difference: The US treaty has a "savings clause" which simply means the US reserves the right to continue to tax its "residents" on a world wide basis.  The UN Treaty is considered more beneficial to countries that are capital importers.  But aside from these differences, the overlap between all three treaties is profound.  Going forward, I'll be using the OECD model treaty as the basis for the analysis, while throwing in some points from the US and UN as needed.

The avoidance of double taxation is a primary reason why countries sign double tax treaties.  There are many others.  First, treaties allocate the right tax between jurisdictions -- they essentially say, "country A can tax X and country B and tax Y."  Second, tax treaties create certainty.  When I'm looking at a possible international transaction, my first question is, "does a tax treaty exist between the two countries."  If it does, there are already a number of assumptions I can make about the overall environment.  Additionally, because of the large number of treaties already in effect, the underlying concepts of these treaties (who can tax what when) have already filtered down into the national structures of most if not all countries.  Finally, all of the preceding points have promoted international trade because we have a better idea of what we can expect when money and business involves two or more jurisdictions. 

There is one more point to mention before moving forward: in order to levy a tax, a "nexus" must exist.  According to Dictionary.com, a nexus is "a means of connection; tie; link."  There are two ways to establish a taxing nexus: residency and through a permanent establishment.  Next time, we'll start with an explanation of residency under the OECD tax treaty.