The evolution and rethink of the Permanent Establishment concept as a consequence of BEPS

Formulating Raju Kumaranti-BEPS (Base Erosion and Profit Shifting) measures for cases where companies were deemed to not have a Permanent Establishment (PE) despite substantial business activity, was a key priority for the Organisation for Economic Cooperation and Development (OECD) in its BEPS project.

Recommendations and outcomes from the OECD

Action Plan 7 of the BEPS project, titled “Preventing the Artificial Avoidance of Permanent Establishment Status”, involved significant work by OECD and associated countries to arrive at suitable recommendations.. Action Plan 7 has proposed to revise the PE standard predominantly to prevent the misuse of the following arrangements:

  • Commissionaire and other similar arrangements: Amendments have been proposed in a manner that widen the scope of what would be considered dependent agent activities, while also narrowing down the independent agent exception, such that agents who play a key role in the conclusion of contracts, or in the conclusion of contracts without material modification by the enterprise, or those who provide services to multiple related parties may now result in the formation of PE for the foreign enterprise.
  • Use of preparatory or auxiliary activity exemptions: As per the current practice and language of the treaties, certain activities are objectively exempted from creating a PE on the assumption that such activities are preparatory and auxiliary by their very definition. It is proposed to narrow these exemptions for fixed place of business PE by requiring activities to subjectively pass the test of actually being preparatory or auxiliary in character. For instance, storing and delivering goods to fulfil online sales may not be considered as preparatory or auxiliary activities for the business.
  • Artificial fragmentation of activities: It has been proposed to incorporate a new anti-fragmentation rule to prevent misuse of specific activity exemptions. Under the new rule, it is proposed that a PE may exist if the enterprise or a closely related enterprise carries on business activities at the same location, or different locations in the same country, and such activities constitute complementary functions that are part of a cohesive business operation, and such activities, when combined, exceed what may be considered preparatory or auxiliary.
  • Splitting up of contracts between closely related parties: An automatic rule requiring aggregation of the time spent by closely related enterprises at the same site or project to calculate the threshold, or Principal Purpose Test (PPT) would apply to long-duration construction/installation contracts to avoid artificial avoidance of PE by splitting up of contracts.

Current importance

Besides the criticality of the PE status of foreign corporations for Governments and tax authorities for calculation of tax on business profits, the heightened importance of the consequences of this Action Plan at this point is also attributable to the following:

  • Pace of growth of the digital economy, which exacerbates the possibility of enterprises not having physical presence in another country
  • First signing of the Multilateral Instrument by a group of countries in June 2017, which would commence the process of bilateral tax treaty amendments, including PE-related changes.

India’s response

India has a varied tax treaty policy, and many of its treaties already contain a wider agency PE rule. Essentially, this means that some OECD proposals echo the approach currently followed by the Indian tax authorities and might also result in a positive revenue impact.

However, how India chooses to implement changes in relation to the preparatory/auxiliary test and contract split or applies the anti-fragmentation rules remains to be seen. This is the area likely to affect Engineering, Procurement and Construction (EPC) projects and arrangements, which include activities such as storage, distribution and delivery, the most. Accordingly, it may be relevant for companies to review their operating structures in India to assess the changes that may arise once the recommendations are implemented in tax treaties.

India’s OECD patterned treaties, such as those with Brazil, China and Japan, may stand to be most impacted by the Action Plan 7 recommendations.

Treaty amendments and the Multilateral Instrument

Action Plan 7 recommendations are not a minimum standard that must be adhered to by countries. Accordingly, both the choice and the mode of implementation have been left as an option, and a country that chooses to do so may undertake either of the bilateral or multilateral routes.

The text of the Multilateral Instrument, released in November 2016*, contains the PE-related articles in pursuance of Action Plan 7 that may be incorporated into tax treaties. However, it is also possible for artificial splitting of contracts to also be covered by the PPT clause of a treaty, which is likely to be adopted by India and most countries in terms of their obligations to implement measures of Action Plan 6 dealing with treaty abuse.

PE taxation is an area that may witness action and developments in the near term on account of the Multilateral Instrument, growth of the digital economy and the pace at which BEPS-related changes are being enacted across jurisdiction.

The author is Partner, International Tax Services, EY India


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