OECD: "permanent establishment" definition should be changed to prevent profit shifting by companies

The Paris-based body is currently working on a single set of international tax rules which would prevent multinational companies from artificially shifting profits to low-tax jurisdictions. It is now seeking feedback on a discussion draft, which deals with point seven of its "action plan" on the prevention of base erosion and profit shifting (BEPS) (26-page / 144KB PDF). The discussion draft considers the need to update the double tax treaty definition of permanent establishment (PE) in order to prevent artificial profit shifting. The OECD is particularly interested in whether its proposals could lead to unintended effects or create possible tax avoidance risks.

"Nowadays it is possible to be heavily involved in the economic life of another country, e.g. by doing business with customers located in that country via the internet, without having a taxable presence therein (such as a substantial physical presence or a dependent agent)," the OECD said in its discussion draft.

"In an era where non-resident taxpayers can derive substantial profits from transactions with customers located in another country, questions are being raised as to whether the current rules ensure a fair allocation of taxing rights on business profits, especially where the profits from such transactions go untaxed anywhere," it said.

BEPS refers to mechanisms through which businesses can deliberately transfer profits from a high tax jurisdiction to one with a lower rate of tax. In July 2013, the OECD set out 15 "actions" to address the practice and set deadlines for implementation. It published its first recommendations in September and is expected to complete the work by the end of next year. Tax treaties are negotiated by countries with other countries to prevent double taxation when individuals and businesses operate in more than one country. Tax treaties are usually based on a 'model' tax convention produced by the OECD.

In its discussion draft, the OECD said that current rules on agency and the definition of permanent establishment in double tax treaties allowed contracts for the sale of goods belonging to a foreign company to be negotiated and concluded in another by a local subsidiary, without the profits from those sales being taxable to the same extent as they would have been if the sales were made by a distributor. This had resulted in some firms replacing traditional distribution agreements with "commissionaire arrangements", allowing profits to be shifted from the country where the sales took place without any particular changes to the firm's presence in that country.

The existing rules also allowed companies to "artificially fragment" their operations among multiple 'group' companies, allowing them to qualify from the exceptions to permanent establishment rules for "preparatory and auxiliary" activities available in some jurisdictions, the OECD said. The OECD's recent report on the potential tax challenges posed by "digital" businesses had also highlighted issues of relevance to permanent establishment rules, it said.

"Certain activities that were previously considered to be preparatory or auxiliary may be increasingly significant components of businesses in the digital economy," the OECD said. "The definition of permanent establishment may need to be modified to address circumstances in which artificial arrangements relating to the sales of goods or services in a multinational group effectively result in the conclusion of contracts, such that the sales should be treated as if they had been made by that company."

In its report, the OECD provided four alternative forms of wording for tax treaties that it said would give effect to its policy that a company should be considered to have "sufficient taxable nexus" in a country if the work of its intermediary was intended to result in the regular conclusion of the foreign company's contracts. All of these options would strengthen the requirement that the intermediary be "independent".

It also recommended "targeted changes" to the exception contained in the OECD Model Tax Convention for preparatory or auxiliary activities, for example by making all the exempted activities subject to the condition that they be preparatory or auxiliary. It could also introduce new rules that would take account not only of the activities carried on by the same enterprise at different places but also those carried on by associated enterprises at different places or the same place; or introduce a new "general anti-abuse rule", according to the discussion draft.

"Both of these proposed changes are 'tidying-up' rules which would ensure that the substance matches form," said corporate tax expert Heather Self of Pinsent Masons, the law firm behind Out-Law.com. "Commissionaire arrangements cannot be used for tax avoidance in the UK anyway, as our rules on agency are different."

The UK has been a strong supporter of the OECD's work on BEPS. George Osborne, the UK's chancellor of the exchequer, told the Conservative Party conference in October that he would "lead the world" by introducing anti-avoidance measures.

"It is understandable that the UK is pushing for these changes to ensure that it gets its 'fair share' of tax when overseas multinationals are making significant sales in the UK. But the impact could be unexpected - any change will be reciprocal, and the UK could lose more than it gains since other countries will want to levy additional tax on UK companies trading there. The government may need to be careful what it wishes for," she said.

The OECD invites comments by 9 January on its discussion draft.  A public consultation meeting will be held in Paris on 21 January . The OECD is due to publish its tax treaty measures to prevent the artificial avoidance of permanent establishment status by September 2015.