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 Complete Captive Case Law History Through UPS

Since the last quarter of last year, I've been chronicling the case law history of captive insurance.  Before I move into the safe harbor Revenue Rulings and subsequent PLRs, I wanted to stop and assemble the work in one place.  So, on the right side of my blog, you'll see a section titled "The Captive Cases in Chronological Order" which has links to the various articles.


In the future, if you have any questions on the captive cases, please feel free to drop by and brush up on your knowledge. 

Captive Case Law Conclusions: The Harper Test and Corporate Substance

If you're interested in forming a captive, or simply want to learn more about the topic, please see this website.

The third prong of the Harper Test is "whether the arrangement was for “insurance” in its commonly accepted sense."  The case provides further guidance in this paragraph:

Rampart was both organized and operated as an insurance company. It was regulated by the Insurance Registry of Hong Kong. The adequacy of Rampart's capitalization is not in dispute. The premiums charged by Rampart to its affiliates, as well as to its shippers, were the result of arm's-length transactions. The policies issued by Rampart were valid and binding. In sum, such policies were insurance policies, and the arrangements between the Harper domestic subsidiaries and Rampart constituted insurance, in the commonly accepted sense.

Several other cases have added clarification to this definition.  From the Ocean Drilling Case: 

Several factors contribute to recognizing Mentor as a valid insurance company. The parties that insured with Mentor, both plaintiff and unrelated parties, truly faced hazards. Events such as hurricanes and accidents were real possibilities and could result in losses to the insured parties. The business underwritten by Mentor was understood to be insurance provided by Mentor. Insurance contracts were written and premiums were paid. Unrelated parties purchased reinsurance from Mentor. Unrelated parties co-insured a portion of the direct insurance Mentor wrote for plaintiff. Unrelated parties reinsured policies that Mentor wrote for plaintiff. Premiums charged to plaintiff and unrelated parties were based on the commercial rates in London. The validity of claims was established before payments were made on them. Claims were paid from funds of Mentor that were maintained separately from plaintiff's funds. Mentor's capitalization was adequate, and the policies it entered into were valid and binding. Mentor's business operations were separate from plaintiff's.  Cumulatively, these facts indicate that Mentor's existence as an insurance company was valid and not a sham.

From the Malone Case:

Eastland was adequately capitalized according to Bermuda's insurance law. The record establishes that Eastland was formed for legitimate business purposes. We have found that Eastland operated in the same manner as other insurance companies. It established reserve accounts, paid claimed losses only after the validity of those claims had been established, and was profitable, much in accordance with industry standards. The policies into which it entered were valid and binding. All of these factors cumulatively indicate that Eastland was a valid insurance company.
.....
As discussed above, Eastland was both organized and operated as a valid insurance company and was not a sham corporation. It was regulated by the authorities of Bermuda, and its capitalization was adequate under Bermuda law. The insurance agreements between Malone & Hyde and Northwestern and the reinsurance agreements between Northwestern and Eastland were the result of arm's-length negotiations and were properly evidenced by written policies and endorsements. The reinsurance policies issued by Eastland were valid and binding. Eastland operated as a separate and viable entity, financially capable of meeting its obligations. In sum, the arrangements among Malone & Hyde, its subsidiaries, Northwestern, and Eastland constituted insurance in the commonly accepted sense.

Several elements stand out in the above excerpts;

1.) The importance of adequate capital.  A captive is a stand-alone insurance company.  Central to this idea is the importance of the ability to pay claims and, to do that, it must have money.  An under-capitalized captive will create a red flag.

2.) Forming the captive for a legitimate business purpose.  If there is one key takeaway from looking at the case law history, it's that a captive -- first and foremost -- is about risk.  That must be clearly demonstrated from the beginning of the transaction.  If someone says, "we need to find a business purpose for the captive," they're missing the point.  

3.) The importance of valid insurance policies.  An insurance policy is a contract between the insured and the insurer.  The existence of a policy indicates there are two parties, each with enforceable rights under the contract. 

4.) The importance of being subject to a regulator: while I understand the reason for this, I personally think it's a bit of a misnomer for this simple reason: practically every jurisdiction has some kind of regulatory authority 

Let me add a few other points which I think are worth mentioning, all of which revolve around the idea of corporate substance.  On an ongoing basis, it's imperative to demonstrate the captive is a separate, viable entity.  There are many ways to do this, but I believe the best method is to regularly hold and document company meetings.  Most statutory codes for corporations have a detailed set of rules and requirements for annual meetings (here is a link to Delaware's corporate code on shareholder meetings to give you an idea for what's involved).  The reason for these meetings is simple: to discuss important matters related to the corporation and formulate a direction for the company.  In doing this, the board of directors demonstrates the captive is indeed a separate and viable business entity. 

In addition, there is the concept of alter ego, which is defined by the law.com law dictionary as, "a corporation, organization or other entity set up to provide a legal shield for the person actually controlling the operation."  The best way to think about this concept is that an individual uses the corporation not as a separate, viable company, but instead utilizes the corporation to essentially act as or for the individual with the benefit of limited liability.  This is something we most definitely want to avoid.  According to AMJUR, here are the factors the court will look at to determine if an alter ego exists:

In determining whether to pierce corporation veil, courts will consider whether there was (1) majority ownership and pervasive control of the affairs of the corporation, (2) thin capitalization, (3) nonobservance of corporate formalities or absence of corporate records, (4) no payment of dividends, (5) nonfunctioning of officers and directors, (6) insolvency of the corporation at the time of the litigated transaction, (7) siphoning of corporate funds or intermingling of corporate and personal funds by the dominant shareholder(s), (8) use of the corporation for transactions of the dominant shareholder(s), (9) use of the corporation in promoting fraud, 1 (10) the authorized diversion of an entity's funds, (11) failure to issue stock ownership, (12) ownership of the entity by one person or one family, (13) the use of the same address for the individual and entity, (14) concealment of the entity's ownership, (15) attempts to segregate liabilities to the corporation, (16) whether there was a failure to collect paid-in capital, (17) employment of the same attorneys and employees, (18) use of the entity as a subterfuge in an illegal transaction, (19) formation and use of entity to transfer to it the existing liability of another person or entity, and (20) the failure to maintain
arm's length relationship between related entities.

Taking the above in combination with the third Harper fact, we see the need to make sure the captive operates as a separate and stand alone insurance company.