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.

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.
 

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.