Comments on definition of permanent establishment in the OECD Model Tax Convention: October 17, 2003.

On October 17, 2003, Tax Executives Institute filed the following comments with the Organisation of Economic Cooperation and Development of the definition of permanent establishment under the OECD Model Tax Convention. The comments were prepared under the aegis of TEI's European Chapter, whose president is Guy A. Kersch of Pharmacia Enterprises S.A. Contributing material to the preparation of the comments were Peter H. Taylor of Du Pont de Nemours International, Clive M. Baxter of A.P. Moller, Mary Carol Holbert of J.T. International, Mark D. Kuck of Lexmark International Technology S.A., and Hilary A. Robinson of Kodak Ltd.

Tax Executives Institute is the preeminent organization of business tax professionals with 53 chapters in North America and Europe. Our 5,400 members represent approximately 2,800 of the leading corporations in the United States, Canada, and Europe. TEI is a non-profit organization that represents a cross-section of the business community; it is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and governments alike. As a professional association, TEI is firmly committed to maintaining tax systems that work--systems that are administrable and with which taxpayers can comply.

TEI has a chapter in Europe with nearly 200 members and the majority of TEI members work for multinational companies with substantial international operations and sales. Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the various tax laws relating to the operation of business enterprises. Consequently, TEI members have a special interest in the definition of permanent establishment in the OECD Model Tax Convention on Income and on Capital.

The Importance of the OECD Model Treaty In Establishing a Level Playing Field

For 40 years the OECD Model Tax Convention on Income and on Capital (hereinafter referred to as the "Model Treaty" or "Model Convention") has framed the rules by which companies operating in more than one country may be safeguarded against double taxation. The Model Treaty reflects a multinational consensus on the general rules governing the jurisdiction to tax business profits across borders by requiring the finding of a permanent establishment (PE) in the jurisdiction seeking to impose the tax. In promoting the establishment of a global network of bilateral double taxation treaties based on common principles, terms, and structure, the Model Treaty enhances the ability of enterprises to plan efficient and effective marketing routes with confidence that only a single level of tax will apply to their revenues. Thus, the Model Treaty fosters the development of trade and encourages economic growth.

The Model Treaty has a particularly important role to play in cases where the tax conventions signed between the Contracting States contain terms that are not defined in the domestic law of one (or both) of the Contracting States. In these circumstances, the Model Treaty and its Commentary become a guide for interpreting the terms of an existing convention.

According to Paragraph 27 of the Model Treaty's introduction, the Convention seeks, wherever possible, "to specify for each situation a single rule." To permit "efficient implementation of the Model Convention," however, it "was thought necessary to allow for a certain degree of flexibility" to the Contracting States. TEI suggests that this degree of flexibility applies to the selection of the language agreed upon during the negotiation of specific treaties, but not to their subsequent interpretation. Uncertainty in the interpretation of fundamental concepts should be minimized, especially in the critical areas that may involve multiple and potentially significant tax liabilities.

Article 5's Definition Of Permanent Establishment

Article 5 of the Model Treaty defines what constitutes a "permanent establishment" for tax purposes. Under this article, there are two--and only two--ways in which an enterprise may be found to have a PE:

* Paragraph 1 establishes a physical presence test by requiring a "fixed place of business through which the business of an enterprise is wholly or partly carried on." This definition is supplemented by paragraphs providing examples of a PE (a "positive list"), excluded activities (a "negative list"), and certain exceptions for building sites or construction projects.

* Paragraph 5 provides that certain agencies may also create a PE but requires that a person be acting on behalf of an enterprise and have--and habitually exercise--in a Contracting State an authority to conclude contracts in the name of the enterprise, with exceptions for certain activities (such as storage facilities) listed in Paragraph 4 of the Model Treaty.

In addition, subsection (e) of Article 5(4) provides a general exception excluding the maintenance of a place of business for activities of a "preparatory or auxiliary" character.

Stated affirmatively, the interaction of Articles 5(1) and 5(5) demonstrates that a Contracting State acquires taxing jurisdiction over a non-resident entity (NRE) only if that enterprise has--

* a fixed place of business caused either by operation of assets of the NRE located in the Contracting State or the action in that state of individual persons in a paid-employment relationship with the NRE, or

* a dependent agent, which requires the persons, individuals, or companies to act for the NRE in the Contracting State.

TEI believes that the definition of what constitutes a PE set forth in the Model Treaty is appropriate and has served its purpose of establishing the threshold for a taxable presence in a territory. The basic principles contained in Article 5 have been generally well recognized throughout the OECD countries. A 2002 decision by the Italian Supreme Court, however, has created uncertainty concerning the definition of a PE. See Ministry of Finance (Tax Office) v. Philip Morris (GmbH), Corte Suprema di Cassazione, No. 7682/02 (May 25, 2002). (1) In that case, the Italian court delineated five principles, none of which is embodied in the Model Treaty and Commentary:

* The "Multiple PE" Principle: A joint stock company having its legal seat in Italy may take on the role of a multiple PE of foreign companies belonging to the same group and pursuing a common strategy. In this case, in order to determine whether or not the activity carried out by the national company is an auxiliary or preparatory activity, the reconstruction thereof must be global and make reference to the group programme considered as a whole;

* The "Supervision and Control" Principle: The supervision or control of the proper performance of a contract between a resident entity and a non-resident entity cannot be considered as--in principle--auxiliary, within the meaning of Article 5(4) of the Model Treaty;

* The "Mere Participation" Principle: The participation of representatives or officers of a "national structure" in a phase of the conclusion of contracts between a foreign company and another resident entity can fall within the concept of the authority to conclude contracts in the name of the company, even without any power of representation;

* The "Imputation" Principle: The entrusting of the management of business transactions to a "national structure" by a company that is not based in Italy, causes that structure to take on the status of a PE for the purposes of income tax, even if it concerns a certain area of business; and

* The "Substance Over Form" Principle: The verification of the requisites of a PE, including those of dependence and of participation in the conclusion of contracts, must not only be conducted from he formal standpoint, but also--and above all--from a substantial standpoint.

For the reasons set forth below, TEI suggests that the decision runs contrary to the generally accepted understanding of Article 5 and its Commentary. TEI is not concerned here with the facts of the Philip Morris case per se, or with the interpretation of Italian double tax treaties. Rather, we are concerned with the uncertainty that has arisen regarding the scope of the definition of a PE in the OECD Commentary and the generally accepted interpretation of the principles and definitions within the Model Treaty. The Model Treaty forms the basis of hundreds of bilateral treaties that are relied upon in global business and the disruptions caused by uncertainty regarding the PE definition could be extensive. Because the Philip Morris opinion has the potential of eroding the longstanding PE rules and leading to double taxation, TEI urges the OECD to clarify the Commentary of the Model Treaty.

A Fixed Place of Business Cannot Be Imputed Under Article 5(1)

The principal definition of a PE set out in Article 5(1) requires a fixed place of business (FPOB) through which the business of the enterprise is wholly or partly carried on. It is the FPOB of the NRE itself that must exist in the Contracting State, not an FPOB of the local entity. The definition requires a location in the Contracting State that is "fixed," which requires that: there must be a geographical situs; the FPOB must be at the disposal of the NRE (i.e., the NRE can use that location as it wishes in the conduct of its business); and it must be used in the NRE's business with a "certain degree of permanence." Under Article 5(4), even if these conditions are satisfied, a PE will not exist if the activities carried on are "auxiliary or preparatory" in nature.

The business may be carried on through the NRE's own assets or employees, or by persons in an employment relationship with the enterprise (i.e., personnel). (2) The court in Philip Morris, however, apparently confused a subsidiary with a branch. A foreign enterprise and its branch are a single entity; this is not the case, however, with a foreign entity and a subsidiary. TEI submits that a subsidiary cannot be a PE of the NRE under the basic definition of Article 5(1).

A Dependent Agent Is Required To Find a PE Under Article 5(5)

Uncertainty also arises under the dependent agent rule. Paragraph 5 of Article 5 requires a determination whether in the Contracting State there exists a person who has and habitually exercises "an authority to conclude contracts in the name of the enterprise." If the answer is no, then a PE does not exist because there is no dependent agent in the Contracting State; there is no need to delve further into whether the activities of the person are limited to those on the negative list under Paragraph 4. Only where it can be established that a person exists who has and habitually exercises an authority to conclude contracts in the name of the enterprise does the need to consider the other activities of this person arise. If no contracts are concluded, the nature of the person's activities is irrelevant.

In TEI's view, the current threshold definition of a person who concludes contracts on behalf of the enterprise under Paragraph 5 operates as a workable bright-line test for determining a dependent agent PE. The test should be applied to a specific foreign principal and an alleged dependent agent. (3)

A PE Is a Separate Entity, Not A Group, Concept

TEI is concerned by the "multiple PE" principle suggested in the Philip Morris case that, when considering whether an enterprise has a permanent establishment, the "enterprise" should be seen as an entire group of companies. Potentially, this includes multiple legal entities in multiple jurisdictions. In our view, the test of whether a PE arises and the concept of an "enterprise" relates to a single foreign legal entity. In other words, whether an entity has established a PE is made on an entity-by-entity basis, not on a group basis.

The Model Treaty is a means by which double taxation can be avoided in a bilateral situation. Treaties based on the Model Convention achieve a similar goal. The Italian court's consideration of the assets and activities of all group companies based in various jurisdictions is not appropriate under the Model Treaty or the bilateral agreements based on it.

In TEI's view, a multinational group could have several foreign legal entities to be tested for PE purposes, but each test is discrete and must reference both the local legislation and any applicable tax treaty. Once the foreign entity to be tested is identified, it is that entity's assets and activities in the taxing jurisdiction that must be considered. Assets and activities of group members located outside the taxing jurisdiction are irrelevant. Assets and activities of group members inside the taxing jurisdiction are relevant only to the extent that they fall within the dependent agent clause. In other words, nothing in the Model Treaty contemplates attributing business profits to a multiple PE, as found by the Italian Supreme Court.

A Separate Legal Entity Cannot Constitute a "Place of Management" under Article 5(2)

The Philip Morris case highlights the confusion that sometimes surrounds the provision of service activities by a local entity to an affiliated NRE. To be a PE, a non-resident enterprise must have a FPOB in the local jurisdiction. While this place of business is normally established through the use of a branch, office, or similar physical premises in the taxing jurisdiction, it is also clear under Article 5(2) that the maintenance of a "place of management" in a local jurisdiction may constitute a FPOB. The question becomes, "What is a place of management?"

Paragraph 24 of the Commentary distinguishes between activities that have a preparatory and auxiliary character and those that do not. The decisive criterion is whether the activity of the FPOB in itself forms an essential and significant part of the activity of the enterprise as a whole. At a minimum, to constitute a "place of management," any management services must be more than preparatory or auxiliary in character and thus must relate to some essential and significant part of the activity of the business of the foreign enterprise. Paragraph 24 does not, however, contemplate that the fixed place of business of a separate local entity will be imputed to an NRE (thereby causing the NRE to be deemed to have a "fixed place PE" under Article 5(1)), even if the local entity renders significant managerial services to the NRE. As we read the Commentary, Paragraph 24 addresses only the case of a local office and simply elaborates on when the services provided by a local office may qualify as preparatory or auxiliary services.

First and foremost, a PE must be a fixed place of business of the NRE. A FPOB cannot constitute a PE of the NRE unless it is owned, used, or otherwise at the disposal of the NRE and carries out the business of the NRE. Thus, TEI suggests that a "place of management" should not constitute a PE of the non-resident entity where the NRE's business is carried out through a separate local legal entity (such as a subsidiary) that is not at the disposal of the NRE (i.e., no employees of the NRE use the facility).

The issue comes into focus when the local entity undertakes to provide certain services for the NRE. Assume that the services are compensated for on an arm's-length basis. The local entity should not be deemed to constitute a PE of the NRE--regardless of the nature or level of services that it performs--unless the services are such that the subsidiary qualifies as a dependent agent who exercises authority to conclude contracts under Article 5(5).

Paragraph 24 focuses on services provided by a local office of the NRE, not on services provided by a separate local entity. The Paragraph describes certain services that are to be considered preparatory or auxiliary in nature, thereby precluding the local office from constituting a PE of the NRE. Paragraph 24 seemingly states that managerial services (almost by definition) are not considered preparatory or auxiliary. Therefore, if a local office provides managerial services to the NRE, the office will qualify as a PE because the services it is performing cannot be excluded under the preparatory and auxiliary exception. But TEI believes that the references to "local office" in the Commentary denote a local office of the NRE itself, i.e., a branch or division office, not the office of a separate local legal entity.

In Philip Morris, the Italian Supreme Court expanded the meaning of Paragraph 24 by stating that the "entrusting of management of business transactions to a 'national structure' ... causes that structure to take on the status of a PE ... even if it concerns [only] a certain area of business." It also stated that the "supervision or control of the proper performance of a contract ... cannot be considered--in principle--auxiliary." The Italian court failed to distinguish between a local office and a local entity in its reading of Paragraph 24. The court also lowered the bar for the types of services that may create a fixed-place PE rather than qualify for the preparatory and auxiliary exception. The OECD should clarify Paragraph 24 to prevent other courts from following this interpretation. (4)

Article 5(5) Provides A Bright-Line Definition That Should Be Retained

In a situation where a multinational NRE has no personnel in a paid-employment relationship to promote its sales in a Contracting State, it may instead use either the agency services of unrelated individuals, or, more commonly, a separate local company wholly owned by the NRE. This company will normally have an arm's-length contract to provide commission agent, commissionaire, or other preparatory or auxiliary services to a selling company of the NRE in another Contracting State. As previously discussed, Article 5(1) cannot de facto apply; only Article 5(5) is potentially applicable.

Paragraph 5 proceeds on the basis that only persons (including individuals or companies) with the authority to conclude contracts that bind the enterprise under local law can lead to a PE for the enterprise maintaining them. (5) In Philip Morris, however, the Italian court stated that the mere participation of representatives of a "national structure" in the conclusion of contracts between a foreign company and another resident entity can fall within the concept of the authority to conclude contracts in the name of the company, even in the absence of any power of representation. Under this rationale, management functions--no matter how inconsequential or formalistic--can never be considered auxiliary or preparatory under Article 5(4). TEI believes that this "mere participation" principle misinterprets the Model Treaty.

Under Article 5(5), the existence of the authority to conclude contracts should be the determining factor in whether a PE is found to exist. Such power must be real; this may be reflected in form, but it may also be interpreted constructively in cases where substantively the negotiations are handled by the dependent agent and where the non-resident selling company merely rubber-stamps the terms and conditions of the deal negotiated by the dependent agent. (6) Merely being present at the negotiations cannot, in and of itself, be sufficient justification for finding a PE under Paragraph 5. We recommend that the OECD clarify Paragraph 32 of the Commentary on Article 5(5) by including the following sentence:

   The mere attendance at, or
   participation by a person acting
   on behalf of an enterprise
   in, business negotiations of
   the enterprise will not, in and
   of itself, comprise sufficient
   evidence that that person
   has or habitually exercises
   an authority to conclude
   contracts in the name of the
   enterprise.

Furthermore, even where it is found that the agent is exercising authority to conclude contracts, it must still be found that the agent's activities relate to operations that constitute the "business proper of the enterprise" and not those that are "auxiliary and preparatory" in character to support the conclusion that a permanent establishment exists. (7)

Summary of Recommendations

The Philip Morris opinion has the potential of eroding the PE rules and producing double taxation. TEI urges the OECD to clarify the Commentary to the Model Treaty in respect of the following areas.

* Multiple PE Concept. This concept does not exist in the bilateral treaty context. The test of whether a PE arises and the concept of an "enterprise" relates to a single foreign legal entity. In other words, whether an entity has established a PE is made on a one-by-one basis, not on a group basis.

* Supervision and Control of Contracts. The service of "managing the performance of a contract" between the foreign enterprise and a third party--at the request of the foreign enterprise and under direction from the foreign enterprise--does not rise to the level of managing the core business of the foreign enterprise itself. It thus does not create a "place of management" under Article 5(2).

* Mere Participation in Contract Conclusion. Under Article 5(5), the existence of the authority to conclude contracts should be the determining factor in whether a PE is found to exist. Merely being present at the negotiations cannot, in and of itself, be sufficient justification for finding a PE under Paragraph 5. We recommend that OECD clarify Paragraph 32 of the Commentary on Article 5(5) by including the following sentence:

   The mere attendance at, or
   participation by a person acting
   on behalf of an enterprise
   in, business negotiations of
   the enterprise will not, in and
   of itself, comprise sufficient
   evidence that that person
   has or habitually exercises
   an authority to conclude
   contracts in the name of the
   enterprise.

Services and Separate Business Existence.

** Management Services. A PE must be a fixed place of business of the NRE. A FPOB cannot constitute a PE of the NRE unless it is owned, used, or otherwise at the disposal of the NRE and carries out the business of the NRE. Thus, a "place of management" should not constitute a PE of the non-resident entity where a separate local legal entity (such as a subsidiary) that is not placed at the disposal of the NRE (i.e., no employees of the NRE use the facility) performs services for the NRE.

** Non-Management Group-Provided Business Services Must Be Through a FPOB of the NRE. A company forming part of a multinational enterprise that is not carrying out the NRE's management functions cannot create a PE for the NRE--unless such services are carried on through the physical fixed place of business of the NRE. If the services are carried on through the FPOB of the NRE, a PE may exist (but not if the activities are excepted as preparatory or auxiliary under Article 5(4)).

* Logic of Article 5. Absent rewriting and restructuring Article 5, the OECD should consider using a flowchart similar to the attached to aid interpreters of this important but complex Article.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the definition of permanent establishment in the OECD Model Tax Treaty. These comments were prepared under the guidance of TEI's European Chapter, whose president is Guy A. Kersch. If you have any questions about the Institute's views, please contact Mr. Kersch at 352.264.20.448, or Fred F. Murray or Mary L. Fahey of the Institute's legal staff at 1.202.638.5601.

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(1) The case involved the German subsidiary of Philip Morris (a GmbH), which maintained manufacturing operations in Germany but had no place of business in Italy. Two related companies in the Philip Morris group entered into licensing agreements with Italy's state-owned monopoly, AAMS, which called for the payment of certain royalties. The GmbH, along with two other related foreign manufacturing companies, sold tobacco products to AAMS, which distributed cigarettes for retail sale throughout the country. The GmbH and the other two manufacturing affiliates entered into separate contracts with a related Italian firm, Intertaba, under which the local company gathered market information for each manufacturing company and monitored the storage and handling of its products in Italian warehouses. The issue in the case was whether the Italian firm was a PE of the GmbH.

OECD Commentary on Article 5, [paragraph] 10.

Under Article 5(6), if an enterprise carries on business in a Contracting State through a broker, general commission agent, or any other independent agent acting in the ordinary course of its business, the enterprise is not deemed to have established a PE. Paragraph 6 provides an exception, however; it does not set forth another test for the assertion of a PE. Only Paragraphs 1 and 5 are the routes to a finding of a PE. A re-ordering of the paragraphs of Article 5 may be in order to clarify this point.

(4) Paragraph 24 is silent concerning compensation for the services rendered. Transfer pricing rules will generally ensure that the local entity is properly compensated for its services. TEI believes that a subsidiary or associate company cannot create a PE for its parent when the subsidiary receives an arm's-length remuneration for the services its performs.

(5) OECD Commentary on Article 5, [paragraph] 31.

(6) See OECD Commentary on Article 5, [paragraph] 32.

(7) In Philip Morris, the German GmbH was assessed tax on the basis of its entire gross proceeds of its sales to AAMS, without any allowance for deductions. While the Italian court has not ruled on whether this approach is appropriate, the authorities' position highlights another related area of concern: There is a lack of consensus among OECD members on the application of Article 7 of the Model Treaty (relating to the taxation of Business Profits). The OECD is currently reviewing Article 7, issuing a "Discussion Draft on the Attribution of Profits to Permanent Establishments." We encourage the organization to establish a consensus regarding the interpretation and practical application of Article 7. The current situation, as highlighted by the attempt in Philip Morris to attribute an NRE's entire gross proceeds of sale in Italy to a deemed PE, is inappropriate and should be reviewed.