Until a human being changes internally, morals are imposed upon him externally so that it leads to a gradual realization. Similarly, until all the countries/ stakeholders appreciate the long term evil effects of tax evasion, provisions like Base Erosion and Profit Shifting are introduced.

As a follow up to the OECD Base Erosion and Profit Shifting Project ("BEPS") action plans, the Organisation for Economic Co-operation and Development ("OECD") has proposed changes in the Model Tax Convention or the OECD Model Tax Convention ("MTC"). 

Article 5 of the MTC provides for the concept of Permanent Establishment("PE"). In this article, we are discussing the changes proposed in Article 5 of the MTC pursuant to the BEPS Action plan 7i.e. preventing the artificial avoidance of Permanent Establishment status. 

According to Philip Baker Q.C., the concept of PE marks the dividing line for businesses between merely trading with a country and trading in that country; if an enterprise has a PE, its presence in that country is sufficiently substantial that it is trading in the country. In a generic sense, the term PE has been described as a virtual projection of the foreign enterprise of one country on the soil of another country. 

The reasons behind determination of a PE in a Source State is to establish that the enterprise is liable to pay tax on the business profits earned in the source state irrespective of the fact that the enterprise is a resident of another state.Thus, generally, the source state cannot levy tax on business profits of an enterprise unless it is established that that enterprise is performing its functions through a PE located in that state. 

Currently, Article 5 of the MTC provides for determination of a PE. The same is extracted as under:

1. For the purposes of this Convention, the term "permanent establishment" means a fixed place of business through which the business of an enterprise is wholly or partly carried on. 

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. 

3. A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months. 

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 subparagraphs 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.

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.

7. The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other.

Para 1 of Article 5 defines a PE to mean a fixed place of business through which the business of an enterprise is wholly or partially carried on. Para 2 of Article 5 of the MTC provides for an inclusive definition of the term PE and specifically lists out places of business that fall within the meaning of that expression. Thus, all classes of PEs as specified in various clauses of para 2 of Article 5 would be construed as a PE subject to the essential conditions of para  1 of Article 5 being met. Para 3 of Article 5 specifically includes a building site or installation project etc. within the definition of a PE if they exist for a specified minimum period. Likewise, para  4 excludes certain kinds of places from the term PE. Hitherto, many activities were considered as not giving rise to creation of a PE, regardless of the continuity of the operations or other factors which could otherwise create a PE. Likewise, para (5) excludes certain kinds of agents of enterprise, namely, broker, general commission agent or agent of an independent status, by clarifying that if the business is carried on through these persons, the enterprise shall not be deemed to be a PE. However, one exception thereto is carved out, namely, if the activities of such an agent are carried out wholly or almost wholly for the enterprise, or for the enterprise and other enterprises which are controlled by it or have a controlling interest in it or are subject to same common control, then, such an agent will be treated as an agent of an independent status. It means that if the business is carried out with such  kind of agent, the enterprise will be deemed to have a PE in India.

BEPS Proposal

In Action Plan 7 of the BEPS, the G20 countries observed that the definition of PE, as defined under Article 5 in the tax treaties, is used by Multinational Enterprises ("MNE") to circumvent through the loopholes present in the definition of PE especially in situations where PE is considered not to exist. This circumvention leads to shifting of the business profits from the Source State. 

The Report on Action 7 inter-alia addressed the following issues:

  1. Avoidance of PE status through commissionnaire arrangements and similar strategies.
  2. Avoidance of PE status through the specific activity exemptions provided in paragraph 4 of Article 5 of the MTC.
  3. Avoidance of PE status through the splitting up of contracts to take advantage of the exception of paragraph 3 of Article 5

All the proposed changes are explained hereunder:

  1. Avoidance of PE status through commissionnaire arrangements and similar strategies.

A commissionnaire arrangement may be loosely defined as an arrangement through which a person sells products in a given State in its own name but on behalf of a foreign enterprise that is the owner of these products. Through such an arrangement, a foreign enterprise is able to sell its products in a State without having a permanent establishment to which such sales may be attributed for tax purposes; since the person that concludes the sales does not own the products that it sell, it cannot be taxed on the profits derived from such sales and may only be taxed on the remuneration that it receives for its services (usually a commission).

In order to prevent the avoidance of PE status through commissionnaire arrangements and similar strategies, the Report concludes that where the activities that an intermediary exercises in a country are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, that enterprise should be considered to have a taxable presence in that country unless the intermediary is performing these activities in the course of an independent business. This has resulted in changes to Articles 5(5) and 5(6) of the MTC, which are as follows:

5. Notwithstanding the provisions of paragraphs 1 and 2 but subject to the provisions of paragraph 6, where a person − other than an agent of an independent status to whom paragraph 6 applies − is acting in a Contracting State on behalf of an enterprise and has, and habitually exercises, in a Contracting State, an authority to conclude contracts, in doing so, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are 

a) in the name of the enterprise, or 

b) for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or 

c) for the provision of services by that 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 (other than a fixed place of business to which paragraph 4.1 would apply), 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.Paragraph 5 shall not apply where the person acting in a Contracting State on behalf of an enterprise of the other Contracting State carries on business in the first-mentioned State as an independent agent and acts for the enterprise in the ordinary course of that business. Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, that person shall not be considered to be an independent agent within the meaning of this paragraph with respect to any such enterprise.

8. For the purposes of this Article, a person or enterprise is closely related to an enterprise if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same persons or enterprises. In any case, a person or enterprise shall be considered to be closely related to an enterprise if one possesses directly or indirectly more than 50 per cent of the beneficial interest in the other (or, in the case of a company, more than 50 per cent of the aggregate vote and value of the company's shares or of the beneficial equity interest in the company) or if another person or enterprise possesses directly or indirectly more than 50 per cent of the beneficial interest (or, in the case of a company, more than 50 per cent of the aggregate vote and value of the company's shares or of the beneficial equity interest in the company) in the person and the enterprise or in the two enterprises.

The changes made to Article 5(5) and 5(6) by the Report on Action 7 have modified the threshold for the existence of a deemed permanent establishment under Article 5(5). Both the pre-BEPS and post-BEPS versions of Article 5(5) apply only to the extent that a person is "acting on behalf of an enterprise" and provide that the PE that is deemed to exist if the threshold is met is constituted by "any activities which that person undertakes for the enterprise".

Where the conditions of Article 5(5) are met, the permanent establishment exists "to the extent that person acts for the enterprise, i.e. not only to the extent that such a person exercises the authority to conclude contracts in the name of the enterprise but also plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise.

Therefore, the Report on Action 7 has modified the threshold, which may now be met even if a person does not habitually concludes contracts in the name of the enterprise but plays the principal role leading to the conclusion of contracts.

The Report on Action 7 recommends that Article 5(6) be amended to provide that, although a PE will not be deemed to exist under Article 5(5) if the person acting in a Contracting State for the enterpriseis doing so in the ordinary course of its business as an independent agent, a person will not be considered to be an independent agent if it acts "exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related". 

Relevance for India

BEPS seeks to address the artificial avoidance of PE in cases where the conduct of an agent is such that it not only habitually concludes contracts in the name of the enterprise but also plays the principal role leading to the conclusion of contracts. Therefore, whether or not the contract is concluded on the name of foreign enterprise, the conduct of the parties has been given the paramount importance for determination of a PE. 

India follows the 'Common Law' system, where the conduct of the parties is the decisive factor determining the Agency PE. In contrast, under the Civil law, to conclude a contract binding on the principal, the agent needs to disclose the principal to the third party in the process of contracting failing which the concluded contract doesn't bind the principal. 

Therefore, the proposed amendments may not have much relevance from India's perspective as well as other countries following the 'Common Law' concept.

  1. Avoidance of PE status through the specific activity exemptions provided in paragraph 4 of Article 5 of the MTC.

In order to prevent the avoidance of PE status through the specific activity exemptions, the Report concludes that it should not be possible to avoid permanent establishment status by using the exceptions of paragraph 4 of Article 5 of the MTC in the case of activities that are not preparatory or auxiliary or by fragmenting a cohesive operating business into several small operations in order to argue that each party is merely engaged in preparatory or auxiliary activities that benefit from these exceptions. 

This has resulted in changes to Article 5(4) of the MTC to include: a) a "preparatory or auxiliary" condition applicable to all the subparagraphs of Article 5(4) of the MTC; and, b) a new anti-fragmentation rule.  The same are provided hereunder:

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 subparagraphs 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, 

provided that such activity or, in the case of subparagraph f), the overall activity of the fixed place of business, is of a preparatory or auxiliary character. 

4.1 Paragraph 4 shall not apply to a fixed place of business that is used or maintained by an enterprise if the same enterprise or a closely related enterprise carries on business activities at the same place or at another place in the same Contracting State and 

a) that place or other place constitutes a permanent establishment for the enterprise or the closely related enterprise under the provisions of this Article, or

b) the overall activity resulting from the combination of the activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, is not of a preparatory or auxiliary character, 

provided that the business activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, constitute complementary functions that are part of a cohesive business operation.

A pre-requisite for the application of these exceptions is that an enterprise has a fixed place of business through which its business is wholly or partly carried on and which would otherwise constitute a permanent establishment under Article 5(1).

In order to ensure that profits derived from core activities performed in a country can be taxed in that country, Article 5(4) is modified to ensure that each of the exceptions included therein is restricted to activities that are otherwise of a 'preparatory or auxiliary' character.

MNEs may alter their structures to obtain tax advantages, it is important to clarify that it is not possible to avoid PE status by fragmenting a cohesive operating business into several small operations in order to argue that each part is merely engaged in preparatory or auxiliary activities that benefit from the exceptions of Article 5(4). The addition of the anti-fragmentation rule of Article 5(4.1) is to restrict the scope of the exceptions currently found in Article 5(4).

  1. Avoidance of PE status through the splitting up of contracts to take advantage of the exception of paragraph 3 of Article 5

In order to prevent the avoidance of PE status through the splitting up of contracts to take advantage of the exception of paragraph 3 of Article 5, the Report concludes that the Principal Purposes Test rule ("PPT rule") should address the BEPS concerns related to the abusive splitting up of contracts for purposes of that exception. 

In this regard certain examples have been added to the Commentary to MTC on the PPT rule so as to address the splitting-up of contracts issue. These changes do not create a new type of PE; they merely deny, in certain limited cases, the application of the exception of Article 5(3), which applies to an Article 5(1) permanent establishment that is a "building site or construction or installation project" provided that this permanent establishment does not meet the time threshold provided in Article 5(3). In other words, where the exception of Article 5(3) does not apply as a result of the new guidance on the splitting-up of contracts (or as a result of the alternative provision on the splitting-up of contracts that is now included in the Commentary), the enterprise has a permanent establishment under Article 5(1), i.e. a fixed place of business through which its business is wholly or partly carried on.

On 21 November 2017, the OECD Council approved the contents of the 2017 Update to the MTC. The 2017 Update, which was previously approved by the Committee on Fiscal Affairs on 28 September 2017, will be incorporated in a revised version of the MTC that will be published in the next few months. The 2017 Update primarily comprises changes to the MTC that were developed through the OECD/G20 BEPS Project. The introduction to the contents of the 2017 Update describes in detail all of these changes, which inter-alia include, changes to Article 5 of the MTC and its Commentary resulting from the  Report on Action 7 (Preventing the Artificial Avoidance of Permanent Establishment Status) and follow-up work on Action 7.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.