OECD proposes changes to be incorporated in the 2017 update to the OECD Model Tax Treaty
The Organisation for Economic Co-operation and Development (OECD) on 11 July 2017 released the draft contents of the update to the OECD Model Tax Convention (the 2017 update).
Among a number of other proposals, the 2017 update contains changes to the Commentary on the definition of permanent establishment (PE) in Article 5, which are the result of not only the final report on Base Erosion and Profit Shifting (BEPS) Action 7, but also of work carried by the OECD since 2011.
The draft 2017 Commentary to the OECD Model to Article 5 contains a number of changes that are intended to clarify the interpretation of the term ”PE” on a number of issues that have been a subject matter of controversy in India before tax authorities as well as courts. These amendments include:
- The meaning of “at the disposal of” in Article 5(1), clarifying that this will depend on the enterprise that has the effective power to use that location, as well as the extent of the presence of the enterprise at that location, and the activities that it performs there, providing examples in that respect.
- An individual home office PE, clarifying that even though part of the business of an enterprise may be carried on at an individual’s home office, that should not lead to the automatic conclusion that that location is at the disposal of that enterprise simply because that location is used by an individual (e.g., an employee) who works for the enterprise, and that it will depend on the facts and circumstances of each case, providing examples in that respect.
- Circumstances under which cross-border deputation/secondment of personnel as well as sub-contracting arrangements could give rise to PE.
- Situations when a PE could arise when activities are carried out exclusively in another country even for a limited duration or when activities are recurring in nature.
The Commentary to Article 5 notes that some of these changes were intended to clarify the interpretation of this article and, as such, should be taken into account for the purposes of the interpretation and application of tax treaties concluded before the 2017 update because they reflect the consensus of the OECD member countries as to the proper interpretation of existing provisions and their application to specific situations.
The proposed changes may have a significant impact on business and taxpayers might need to assess the impact of these changes on the existing and future operating models as well as on their positions in controversy/litigation.
OECD releases 2017 TP guidelines
OCED released the 2017 edition of Transfer Pricing (TP) Guidelines on 10 July 2017 for Multinational Enterprise and Tax Administrations. The 2017 edition mainly reflects changes resulting from the BEPS project.
The 2017 TP guidelines seek to ensure that the TP rules secure outcomes that see operational profits allocated to the economic activities which generate them. To achieve this objective, the revised guidelines require careful delineation of the actual transaction between the associated enterprises by analyzing the contractual relations between the parties in combination with the conduct of the parties. The conduct will supplement or replace the contractual arrangements if the contracts are incomplete or are not supported by the conduct. When combined with the proper application of pricing methods in a way that prevents the allocation of profits to locations where no contributions are made to these profits, it may lead to the allocation of profits to the enterprises that conduct the corresponding business activities. In circumstances where the transaction between associated enterprises lacks commercial rationality, the guidance continues to authorize the disregarding of the arrangement for TP purposes. The revised guidance includes two important clarifications relating to risks and intangibles: (1) risks contractually assumed by a party that cannot in fact exercise meaningful and specifically defined control over the risks or does not have the financial capacity to assume the risks will be allocated to the party that does exercise such control and does have the financial capacity to assume the risks and (2) for intangibles, the guidance clarifies that legal ownership alone does not necessarily generate a right to all (or indeed any) of the return that is generated by the exploitation of the intangible. The group companies performing important functions, controlling economically significant risks and contributing assets, as determined through the accurate delineation of the actual transaction, will be entitled to an appropriate return reflecting the value of their contributions. Finally, the guidance ensures that pricing methods allocate profits to the most important economic activities. It will no longer be possible to allocate the synergistic benefits of operating as a group to members other than the ones contributing to such synergistic benefits.
Since the revised guidance seeks to clarify the application of the arm’s length principles, it is expected to have an immediate effect on taxpayers, and tax authorities may rely on them during on-going/upcoming audits for past years as well. Taxpayers need to review the impact of the revised guidance on their existing TP policies and consider changes, if necessary, as well as consider the need to build adequate defense in case of challenges for past years.
Australian Federal Court lays down principles for setting transfer price of the related party loans
The case law deals with a fact pattern involving a financing structure under which a US subsidiary of an Australian operating company of a US MNE group, borrowed US$2.5b from unrelated parties in the US market at a 2.5% rate of interest and onward lent it to the Australian operating company on an unsecured basis at 9%. The Court observed that the Australian Taxation Office’s (ATO) challenge was purely on the TP issue of whether the arm’s length interest rate can be 9%, which the ATO alleged was more than arm’s length. The ATO did not seek to invoke GAAR, nor was there a question on the application of the Australian thin capitalization rules.
The taxpayer’s main argument was that since the loan was unsecured and without any covenants, the lender carried a much higher risk and accordingly sought to justify a 9% interest rate as arm’s length. According to the Court, since in an uncontrolled scenario no commercial lender would be willing to lend to a hypothetical borrower having the credit worthiness and characteristics of the taxpayer without any security, the commercial and financial relations were non-arm’s length and the interest rate needs to be determined after hypothetically imposing arm’s length terms and conditions in the loan agreement. In the present case, it was reasonable to assume that in an arm’s length scenario, the MNE parent would have provided additional security/guarantee and/or required covenants to be included in an unsecured loan agreement, which would have resulted in a reduced interest rate. While applying the independent assumptions in TP laws, relevant attributes of the broader corporate group to which the taxpayer is a member should be considered. Accordingly, the Australian operating company should not be treated as a standalone/orphan company that is wholly independent of the corporate group to which it belongs.
This is an important TP decision for both intra-group financing and other related party arrangements. This decision shows that TP disputes do not involve just an evaluation of the pricing of related party arrangements but also a thorough analysis of the nature of the property involved to determine precisely what needs to be priced. This involves consideration of complex contractual questions and evidentiary issues.
France Tax Tribunals rules that advertising services rendered by Google France do not create PE under the Ireland–France treaty
An Ireland company (Ire Co) a subsidiary of the US Group Inc., sold an online advertising service named “AdWords,” correlated with the search engine. Ire Co entered into an agreement with its France affiliate (French Co) for assisting and advising the French customers of Ire Co. As per the French tax authorities, Ire Co should have been taxed in France to the extent it carried on business in France through French Co. Accordingly, the French tax authority made tax adjustments in the hands of Ire Co in respect of corporate income tax, withholding tax, VAT, minimum business tax and business value added tax as a result of online advertising of the advertisements ordered by French customers.
The French tribunal held that French Co did not constitute a PE as per the France–Ireland tax treaty, as it could not legally bind Ire Co. The employees of French Co could not carry out the online advertising of the advertisements ordered by the French customers. Any sales made by French Co had to be confirmed by Ire Co. Further, Ire Co did not have any tangible fixed assets under its control in France in order to carry on its activity.
This decision may be leveraged for a similar case pending before the Bangalore Tribunal on the taxability of income under the “AdWords” program. As per the Indian tax authorities,
Indian Company (I Co) constitutes a dependent agency PE (DAPE) of Ire Co in India and its income is taxable under the India–Ireland tax treaty as business income. The decision of the Bangalore tribunal is awaited.
It may, however, be noted that the French Government recently published a press release dated 7 August 2017 detailing the position of the Government with respect to the taxation of the digital economy. The key points of the Government’s positions, inter alia, include taxing profits that are realized in France, reassessing the taxable base of foreign companies, bringing tax harmonization in order to eliminate variations of national legislations that allow tax evasion, ending tax competition between member states of the European Union and supporting the idea of a specific tax treatment of the digital economy, in particular through the notion of “digital tax presence.” Thus, MNEs that have a virtual presence should carefully revisit their business models.
The author is Partner, International Tax Services, EY India