(OECD Model Convention, Article 5, paragraph 4)
Adv LLM thesis
submitted by
Ekaterina Shachneva
in fulfilment of the requirements of the
'Advanced Master of Laws in International Tax Law'
degree at the University of Amsterdam
supervised by
Dr Joanna Wheeler
PERSONAL STATEMENT
Regarding the Adv LLM Thesis submitted to satisfy the requirements of the 'Advanced Master of Laws in International Tax Law' degree:
1. I hereby certify (a) that this is an original work that has been entirely prepared and written by myself without any assistance, (b) that this thesis does not contain any materials from other sources unless these sources have been clearly identified in footnotes, and (c) that all quotations and paraphrases have been properly marked as such while full attribution has been made to the authors thereof. I accept that any violation of this certification will result in my expulsion from the Adv LLM Program or in a revocation of my Adv LLM degree. I also accept that in case of such a violation professional organizations in my home country and in countries where I may work as a tax professional, are informed of this violation.
2. I hereby authorize the University of Amsterdam and IBFD to place my thesis, of which I retain the copyright, in its library or other repository for the use of visitors to and/or staff of said library or other repository. Access shall include, but not be limited to, the hard copy of the thesis and its digital format. 3. In articles that I may publish on the basis of my Adv LLM Thesis, I will include the following statement in a footnote to the article’s title or to the author’s name:
“This article is based on the Adv LLM thesis the author submitted in fulfilment of the requirements of the 'Advanced Master of Laws in International Tax Law' degree at the University of Amsterdam.”
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Ekaterina Shachneva
Table of Contents
Table of Contents ... III
List of Abbreviations used ... V
Executive Summary ... VI
Main Findings ... VII
1.
Introduction ... 1
1.1. Permanent establishment as a fundamental tax principle ... 1
1.2. Business models: now and then ... 2
1.2.1. Centralization of functions and risks ... 2
1.2.1.1. Contract manufacturing ... 3
1.2.1.2. Limited-risk distribution ... 3
1.2.2. Integration ... 4
1.2.3. Digitalization ... 4
1.3. Why is change needed? ... 5
1.3.1. Taxation of routine profits is no longer enough ... 5
1.3.2. Economic presence raises questions ... 5
1.3.3. New paradigm to tax digital business ... 6
2.
Action 7 – preparatory or auxiliary activities ... 7
2.1. Goals and controversies ... 7
2.2. Business fights back ... 8
2.2.1. Option E ………..10
2.2.2. Option F ………..11
2.2.3. Options G and H ... 12
2.2.3.1. Purchasing office ... 12
2.2.3.2. Collection of information ... 13
2.3. New Commentaries for Article 5.4 ... 14
2.3.1. Warehouse for delivery ... 15
2.3.2. Purchasing office ... 15
2.3.3. Collection of information ... 15
2.4. “Preparatory & auxiliary” activities – in search of clarity... 15
2.4.1. Realization of profits/ creation of value ... 15
2.4.2. Essential and significant part ... 16
3.
Action 7 - the anti-fragmentation rule ... 16
3.1. Pre-BEPS ... 16
3.2. BEPS ... 17
3.2.1. Options I and J ... 18
3.2.2. Scope of Article 5.4.1 ... 19
3.3. What rule rules? ... 19
3.3.1. Interrelation with Article 5.4 ... 19
3.3.2. How revolutionary is the new anti-fragmentation clause? ... 21
4.
Issues with application of anti-fragmentation rule ... 21
4.1. Taxation of MNE profits – separate entity approach ... 21
4.1.1. The arm’s length principle (ALP) ... 21
4.1.1.1. Why do one-sided methods not bring desired results? ... 22
4.1.3. Why is profit split method different?... 24
4.2. Can anti-fragmentation go beyond “preparatory or auxiliary” activities? ... 24
5.
Multilateral Instrument ... 25
6.
Pillar 1 (“BEPS 2.0”) ... 25
6.1. Assessment of Action 7 ... 25 6.2. New nexus ... 267.
Сonclusions ... 27
8.
Appendix 1 ... 29
9.
Appendix 2 ... 30
10.
Appendix 3 ... 31
11.
Bibliography ... 32
List of Abbreviations used
ALP Arm’s length principle, arm’s length price
BEPS Base Erosion Profit Shifting
DD Public Discussion Draft BEPS Action 7: preventing the artificial avoidance of PE status
MC Model Tax Convention (OECD)
MLI Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base
Erosion and Profit Shifting
MNE Multinational enterprise
OECD The Organisation for Economic Co-operation and Development
PE Permanent establishment
PSM Profit split method
PWC PriceWaterhouseCoopers
RDD Revised Public Discussion Draft BEPS Action 7: preventing the artificial avoidance of
PE status
TNMM Transactional net margin method
Executive Summary
The purpose of this thesis is to analyse changes introduced by BEPS Action 7 for activity exemptions of Article 5.4 of the MC. The use of activity exemptions is connected with taxation of return on fixed assets (routine profits) and allows taxpayers not to create a taxable presence in a host country. Taxation of return on digital assets (residual profits) has not been widely and openly discussed up until 2018 when the new nexus (Amount A) was introduced by the OECD as part of its Pillar 1 initiative. This work will also discuss how the underlying principles of the Amount A may affect the activity exemptions and what these principles might have in common with the new anti-fragmentation rule that is now part of Article 5.4.
In pre-BEPS times companies operated with understanding that they may use a list of exemptions as “per se” exemptions. This turned to be a convenient route and many MNEs found themselves in favorable situations where part of the return on investment in traditional assets (like warehousing) was not subject to source taxation. With time, such reliance on Article 5.4 led to aggressive tax planning by MNEs and enabled them to benefit from a lack of substantial taxation in the source country. BEPS Action 7 introduced an overall “preparatory/ auxiliary” condition to apply to the list of activities in Article 5.4. As a result, the OECD removed the bright-line test and it seemed like created more ambiguity around the application of this paragraph.
However, the OECD also introduced the anti-fragmentation rule that would most certainly rule out the application of Article 5.4 for large multinationals in countries where they already carry business via some form of established presence. The rule is a new condition for the use of Article 5.4, and it analyses all activities of MNE in a source state as if it were one single unit although activities may be carried out by several resident and non-resident entities. If a group already has some presence in a jurisdiction (for example, a subsidiary), its activities will be aggregated with activities of a non-resident related enterprise in this jurisdiction for anti-fragmentation analysis. If it is determined that tested activities constitute complementary parts of cohesive business operation, then MNE will not be able to rely on activity exemptions but will have to register new PE in a country of source.
Despite taking a first step towards treating MNE as a single enterprise by introducing a “preparatory/ auxiliary” analysis of aggregated activities, for profit attribution the OECD chose to remain in the domain of a separate entity approach - a firmly embedded pillar of legal and tax systems around the world. This approach was reversed in preparation of rules for taxation of residual profits – Pillar 1 Amount A will tax MNE’s non-routine profits if there is a significant and sustained engagement with the jurisdiction. The tax base will be determined based on consolidated financial statements with no attribution of residual profits on a separate entity basis.
While attribution of profits of PEs created as a result of the anti-fragmentation analysis will be performed on ALP basis, there is what seems to be a change in OECD recommendations as to the choice of transfer pricing methods to be applied in this situation – it advises to take into account the level of integration of activities that is usually possible with the use of two-sided methods, such as profit split. In its sense, profit split remains an ALP method, but it is close to the profit apportionment that has been introduced under the Pillar 1 Amount A proposal.
This thesis concludes on a note that although it was not an intention of BEPS Action 7, its outcome (in form of new anti-fragmentation rule) may play a role in the future alignment of routine and residual profits taxation. The OECD may consider extending the application of anti-fragmentation rule beyond the activities of preparatory/ auxiliary character thus taking further steps towards unitary (consolidated) taxation of MNEs that has been proposed under Pillar 1. In the author’s view, future application of activity exemptions will be limited and will have to account for the fact that sustained non-physical engagement with a jurisdiction established under Pillar 1 Amount A will most likely prevent MNEs from relying on these exemptions.
Main Findings
A thorough analysis of recent OECD initiatives – BEPS Action 7 and Pillar 1 (Amount A) – has shown that although it may not be immediately evident, these proposals to change existing tax rules may be well aligned to create a modern system of international business taxation, with activity exemptions of Article 5 of the Model tax convention being part of this system albeit with some necessary modifications.
Pillar 1 and its Amount A target taxation of MNE’s residual (non-routine) profits and look at a multinational group as if it were a single entity doing business in many foreign jurisdictions. Pillar 1 will require multinational enterprises to perform a detailed segmentation of their financials to understand the geographical reach of MNE’s sales. The submission of such information will identify countries where MNE’s sales are significant (or exceed a certain threshold).
OECD Commentary on Article 5.4 defines “preparatory or auxiliary” activities as those that are “so remote from the actual realisation of profits that it is difficult to allocate any profit to the fixed place of business in question” and thus deem it to be a permanent establishment. However, if sales are a form of such actual realisation of profits, then “Amount A” reporting documentation will shed the light on those fixed places that were wrongly treated as carrying out “preparatory or auxiliary” activities and existed in parallel with ongoing sales to or in the jurisdiction. Unregistered “preparatory or auxiliary” presence in a source state is hardly sustainable when there is a sales element that already creates a strong economic link between MNE and a source (market) state. On top of that, the new anti-fragmentation rule will allow the tax administrations to aggregate activities of all fixed places of MNE’s closely related enterprises in one state and to determine if they perform complementary functions that are part of cohesive business operation. If that holds true, such fixed places will be treated as PEs. Although the anti-fragmentation analysis is performed as if all fixed places represent one single enterprise, a permanent establishment will be recognized on a separate entity basis as before.
Many multinationals argue that registration of numerous PEs in one state will create an unjustified administrative reporting burden while the profits attributed to newly formed PEs will be minimal. This is arguable as, firstly, new guidance on the Attribution of profits to permanent establishments advises to take into account the level of integration of operations when determining profits attributable to such PEs. That could be an indication that the OECD is leaning towards two-sided transfer pricing methods (such as profit split method that offers a solution for highly integrated operations) instead of keeping up with one-sided methods that rely heavily on comparables from independent parties. In practice, two-sided methods are methods for apportioning profits, and hence close to formulary apportionment. Formulary apportionment is also the basis for calculation of Amount A.
Secondly, it is likely that once Pillar 1 is implemented the OECD will extend the idea of simplified reporting and registration-based mechanisms (such as a “one-stop shop”) beyond taxation of non-routine profits. Under “Amount A” proposal tax on residual profits will be paid via one designated entity. It will simplify things to a great extent if both parts of income tax – on routine and non-routine profits – will be payable by one entity or PE. If this happens, we will most likely see a gradual move towards unitary (consolidated) taxation of global firms regardless of the type of profits (routine or residual) they earn in each state. Such a form of taxation has been explored earlier by the European Commission with its CCCTB proposal. Overall, technicalities of rules on how to tax profits of multinational groups remain work in progress. However, several fundamental changes like anti-fragmentation rule have already found their way into MLI, despite many difficulties mainly of political character.
1. Introduction
The following analysis will look at activities of preparatory or auxiliary character as described in paragraph 4 Article 5 of the OECD Model (Article 5.4). Activities listed in this Article work as exemptions1
in a way that in general (but subject to several caveats) they do not create a permanent establishment and do not allow taxation of business income derived from such activities at source. The policy developments with respect to activity exemptions will be traced for the period of the last twenty years with an attempt to give a prediction of their future existence in light of BEPS project and Pillar One initiative.
Further, next sections in most part limit the examination of Article 5.4 application to consumer facing business sector. Most recently, the OECD has delineated consumer facing as “businesses that generate revenues from selling goods or services, whether directly or indirectly, to consumers”2:
“This is a broad set of businesses that includes traditional businesses that have
been disrupted to a lesser degree by digitalisation, e.g. businesses that
manufacture physical products, sell those products through physical distribution
channels and support sales with less sophisticated marketing methods such as
television and banner advertising. However, there is an increasing use by these
businesses of digital technologies to more heavily interact and engage with their
customer base. That could be through building more sustained relationships with
individual customers, through more targeted marketing and branding, and
through the collection and exploitation of individual customer data.”
3Amazon is one of the best-known examples of consumer facing business. It seeks to be Earth’s most customer-centric company4. As at 31 March 2020 Amazon is number 4 in Global Top 100 companies
ranking (PWC) and is number 1 in Consumer services sector5. The way this US-based group organized
its European operations in pre-BEPS times raised a lot of questions from tax administrations along with public unrest and what many believed prompted OECD to take a tougher position on taxing multibillion operations of global MNEs6.
1.1. Permanent establishment as a fundamental tax principle
The model tax convention (the MC) aims to allocate the right to tax income from international business activities between the residence and the source states. When MNE operates through a separately incorporated subsidiary company, the subsidiary is treated as a separate enterprise and its business profits are taxed by the source state. Where MNE operates abroad through an office or a branch which
1 Exceptions or exclusions. Used interchangeably hereinafter;
2 OECD (2020), Statement by the OECD/ G20 Inclusive Framework on BEPS on the Two-Pillar Approach to
Address the Tax Challenges Arising from the Digitalisation of the Economy – January 2020, OECD/G20 Inclusive Framework on BEPS, OECD, Paris. www.oecd.org/tax/beps/statement-by-the-oecd-g20-inclusive-framework-on-beps-january-2020.pdf , page 10, paragraph 19;
3 Ibid.
4 AMAZON.COM, INC. Form 10-K for the FY2019, page 3
https://s2.q4cdn.com/299287126/files/doc_financials/2020/ar/2019-Annual-Report.pdf
5 Other consumer services companies on this list include such MNEs as Alibaba, Walmart, Nestle, Procter &
Gamble, Home Depot and many others;
6 While this goes beyond the scope of current analysis, it is notable that Amazon’s global income tax provision
for FY2019 tripled since FY2017 (from US$769M to US$2,374M). Source: consolidated statements of operations @ https://s2.q4cdn.com/299287126/files/doc_financials/2020/ar/2019-Annual-Report.pdf , page 38
is not separately incorporated, the MC uses the concept of a permanent establishment (PE). The concept of PE is a threshold that separates residence and source taxing powers. Typically, the source state only gets to tax business profit to the extent there is a PE (fixed place of business) in that state and in so much as the profits are attributable to the PE in accordance with Article 7 of the MC. PE taxation at source goes hand in hand with the separate entity approach7 and the arm’s length
principle (ALP): the profits that are attributable to the permanent establishment are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise, taking into account the functions performed, assets used and risks assumed8. The separate entity approach and the ALP are the two basic principles that existed pre-BEPS
times. They are time-tested rules of the current international corporate tax framework. As it will be shown in subsequent sections, these policy principles have very likely become the limits of the current system and the PE threshold.
1.2. Business models: now and then
In the past MNEs mostly operated in physical markets and through established presence in multiple jurisdictions (“bricks and mortar” economy). As explained by Jeffery Kadet in his BEPS Primer, when businesses began expanding internationally after World War II, overseas manufacturing and other operations were better conducted on a stand-alone basis, with each operating subsidiary having its own management team locally directing sales, operations, finance, and other functions9. It was common for
the MNE to have its own fully integrated local subsidiary in every country where presence was established10. Such structuring was dictated by several factors, including slow communications,
currency exchange rules, customs duties, and relatively high transportation costs.
Amazon model is a refined form of the traditional mail order business model. The sale of a wide range of products and services to customers constitutes the most important segment of Amazon’s business11.
This is not a new business model that arose in the context of digitalization12 - the physical goods continue
to be delivered in the traditional way (for example, by parcel post as was the case with the catalogue mail order business)13. Activities of a digitalised reseller are like those of a traditional reseller: both
require the sourcing of products/suppliers; the receipt and storage of products to sell; and the use of warehouse facilities in which to keep inventory14. But new “add-ons” to the existing traditional models,
mainly centralization, digitalization and high levels of integration enabled business to become truly global and highly mobile and as a result gain a dramatic competitive advantage over domestic business15.
1.2.1. Centralization of functions and risks
In economic terms MNE is a single firm operating under unified direction, but legally it consists of many affiliates forming a corporate group16. Gradually, the previous stand-alone and independently operated
subsidiaries have given a way to the centrally managed supply chains. New business structures rely
7 According to Article 7.2 of the MC (2017) for the purposes of profit attribution PE is hypothesized to be a distinct
and separate enterprise;
8 MC (2017), Article 7.2;
9 BEPS: A Primer on Where It Came From and Where It’s Going by Jeffery M. Kadet, Tax Notes, February 15,
2016, page 793;
10 OECD (2014), Addressing the Tax Challenges of the Digital Economy, OECD/ G20 Base Erosion and Profit
Shifting Project, OECD Publishing. http://dx.doi.org/10.1787/9789264218789-en , page 119;
11 Supra note 4, page 19;
12 Unlike Google or Netflix business models;
13 Taxation of the Digital Economy: “Quick Fixes” or Long-Term Solution? by Georg Kofler, Gunter Mayr and
Christoph Schlager, European Taxation, December 2017;
14 OECD/ G20 Base Erosion and Profit Shifting Project, Tax Challenges Arising from Digitalisation – Interim Report
2018, Inclusive Framework on BEPS, page 63 https://www.oecd.org/tax/tax-challenges-arising-from-digitalisation-interim-report-9789264293083-en.htm ;
15 Consider the story of Amazon competing with a local bookseller or Booking.com competing with a travel agent
next door;
on centralization of functions and integration of operations to the extent that was not possible in “bricks and mortar” times. A typical example of such structure is shown in Appendix 1.
The key difference between “new” and “old” is that fully-fledged manufacturers and distributors representing MNEs in host (or source) states are being replaced with contract manufacturers, limited-risk distributors and commissionaire agents. Such replacement results in re-allocation of limited-risk and functions within the group with further effect on intra-group (transfer) pricing arrangements. As a rule, new structures include a principal (or central) company to centralise key functions and risks in one location that is usually a low-tax jurisdiction (for example, Luxembourg for Amazon European operations). Also, the ownership of valuable intellectual property usually resides with the central company. The central company operates its business by entering into contractual arrangements with group entities and branches in host states for the manufacturing, R&D and sales and marketing activities17. Although activities in source state are business-driven, from the MNE point of view there is
little to no key entrepreneurial risk attached to functions carried out there. So even though these subsidiaries or PEs will be taxable in their jurisdiction on the profits attributable to services/ assistance they provide to the central company, the amount they earn is limited.
Two examples below illustrate this change in risk and function allocation. 1.2.1.1. Contract manufacturing
Starting in the mid-1980s, some MNEs began moving portions of their domestic manufacturing to Asia and, in particular, to China, a country that at the time severely restricted levels of foreign ownership and mandated the form that investments must take. Legal and practical difficulties prevented MNEs from owning and controlling manufacturing operations in China and MNEs were forced to accept uncontrolled contract manufacturing arrangements18. Contract manufacturing limits the income attributable to
manufacturing operations by restricting the manufacturer’s local income to “costs plus mark-up”. The principal company assumes ownership of the raw materials and responsibility for quality, credit and marketing risks19. Because the manufacturer does not own the product it is working on, its profit has
been essentially reduced to getting a fee for services20. The profit from sales of the product remains
with the principal company.
At the same time Article 5.4(c) of the MC allows the principal company to have non-taxable presence in source state for the purposes of “maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise”.
1.2.1.2. Limited-risk distribution
In “bricks and mortar” times distributors usually acted in a capacity of a fully-fledged distributor who purchased manufactured goods and sold them further to unrelated local customers bearing the inventory risk and the credit risk. The new global business models tend to favour limited-risk distributors which contractually relinquish this type of risks to the principal company21. An MNE may structure local sales,
product support, warehousing, and other distribution functions through service companies to avoid taxation on sales income in the countries where customers are located. For example, in Amazon case consumers conclude a mail order contract with its company in Luxembourg but the actual delivery is then made by one of Amazon’s logistics centres located in different European countries.
17 The impact of BEPS Action 7 on operating models by Joost Vreeswijk and Ai-Leen Tan, E&Y,
https://www.internationaltaxreview.com/article/b1f7nd98s8sqff/the-impact-of-beps-action-7-on-operating-models ;
18 Supra note 9, page 796;
19 Is Transfer Pricing Worth Salvaging? by Lee A. Sheppard in Tax Notes, July 30, 2012, page 470; 20 Ibid.;
Conveniently, Article 5.4 (a) and (b) of the MC allow the principal company to have non-taxable presence in source state if the former maintains there a fixed place and/ or a stock of goods
solely for the purpose
of storage, display or delivery.
As a result of changes described above new complex structures allow multinationals to avoid taxation of sales income in the countries where customers are located. For example. the company filings for FY2012 showed Amazon's main UK company paid just £3.2m in corporation tax on sales of £320m. However, the Seattle-based group told investors its 2012 UK sales were £4.2bn22.
Amazon: All the strategic functions for our business in Europe [including the UK]
are based in Luxembourg. That could be our retail business, our third-party
business, our transportation teams, our customer service, HR, finance. UK staff
only offered "support" to these activities.
23This is important from a tax perspective, since, with regard to direct sales, only the company’s residence state is entitled to tax the enterprise’s profits, unless a PE exists in the other state. Centralization of business coupled with straightforward use of activity exemptions played significant role in boosting multinationals’ worldwide sales without corresponding increase in tax accruals in source (market) states. And even when such multinationals recognized their taxable presence in non-residence states, application of existing transfer pricing rules permitted allocation of minimal profits to newly created subsidiaries and PEs since technically speaking their contribution to the sales process was adding little value.
This issue was recognized by the OECD and addressed in its Action 1 final report with an indication that minimisation of the income allocable to functions, assets and risks in market (source) jurisdictions leads to reduced economic returns and income shift into low-tax environments24.
1.2.2. Integration
Integrated global supply chains are a common thing for large MNEs. Integration allows a group of companies to operate more as a single global firm and consequently to maximise opportunities and to earn more profits than what it could have earned working with independent contractors. Successful multinational groups exist because of the advantages and synergies that come from combining economic activities on a large scale and in different locations25. Still, the “separate entity”
approach and the widespread application of traditional transaction transfer pricing methods26 (those that
rely on comparable prices as used by independent parties) do not allow to account for such additional profits that may be generated by MNE as a result of integration. These advantages cannot be attributed to a single company, but to the whole global entity.
1.2.3. Digitalization
Digitalisation of various processes has made it easier to offer goods and services to customers all over the world without setting up a “physical” permanent establishment or subsidiary. Digitalisation has greatly reduced communication costs, allowing businesses to quickly reach a global base of suppliers,
22 Fresh questions for Amazon over pittance it pays in tax by Ian Griffiths and Simon Bowers, 16th May 2013
https://www.theguardian.com/technology/2013/may/15/amazon-tax-bill-new-questions ;
23 Ibid., Amazon representation in front of the UK public accounts committee; 24 Supra note 10, page 103;
25 Supra note 16, page 1;
users or customers and to establish user networks across different jurisdictions through websites, online platforms and mobile applications27.
The implications of digitalization are such that MNEs can choose at will the location of central functions by for example setting up a principal company in a jurisdiction which is neither the country where the ultimate consumer resides nor the country where the ultimate parent company is resident28.
Already this has prompted many countries to claim that the missing tax base is in fact effectively connected to their jurisdiction and therefore they would like to assert a share in the MNE’s revenue. 1.3. Why is change needed?
1.3.1. Taxation of routine profits is no longer enough
Corporate income tax is by its nature a tax on return on country-specific investment29. This investment
can take the form of a permanent establishment or a foreign subsidiary. In the age of “bricks and mortar” economy for a company to be able to enter a new market, to grow and to make sales there significant investments in traditional (or physical) assets were of no question30. Therefore, it is of no surprise the
traditional PE definition primarily relies on a fixed place of business as a prerequisite for the business income to be taxed at source31. Business income derived by a company represents a return on
investments previously made by it in a specific jurisdiction (also commonly known as return on tangible capital). This type of business income is often termed as “routine profits”. Subsequently, corporate tax on PE income is a means of taxation of such profits by that specific jurisdiction.
The difficulty came when in order to successfully grow their investments in other jurisdictions companies started employing intangible (digital) assets along with the use of tangible ones. Return on intangible capital (commonly known as “residual or non-routine profits”) could not be factored in source taxation that relied on traditional PE concept. So, whereas in “bricks and mortar” times return of MNE on investment in other jurisdiction was predominantly represented by return on tangible capital, in digital era it is a combination of tangible and intangible capital invested in another country. As an example of the latter, consider the business model of Amazon with its investments in both traditional (warehousing) and in digital (online) assets.
1.3.2. Economic presence raises questions
As noted by Schön, traditional “bricks and mortar” investment in foreign countries will become more and more a thing of the past, as more companies dedicate intangible investment to individual country-specific markets in order to get better customer access, offer tailor-made solutions, develop brands and so on32.
Centralization and digitalization (through reliance upon intangible assets) have allowed companies to move from “physical” (fixed) to “economic” presence rather easily. The difference between these two types of presence is that the latter one allows MNE to maintain a sustained and significant involvement in the economy of a market jurisdiction without creating a taxable presence there. In this situation routine
27 Supra note 14, page 28;
28 Schön, Wolfgang, Ten Questions About Why and How to Tax the Digitalized Economy (December 21, 2017).
Working Paper of the Max Planck Institute for Tax Law and Public Finance No. 2017-11, Available at SSRN: https://ssrn.com/abstract=3091496 or http://dx.doi.org/10.2139/ssrn.3091496
29 Schön, Wolfgang, One Answer to Why and How to Tax the Digitalized Economy (June 25, 2019). Working Paper
of the Max Planck Institute for Tax Law and Public Finance No. 2019-10, Available at SSRN: https://ssrn.com/abstract=3409783 or http://dx.doi.org/10.2139/ssrn.3409783
30 Consider, for example, a setup of a fully-fledged sales enterprise in a country other than a state of residence; 31 MC (2017) Article 5 “the term “permanent establishment” means a fixed place of business through which the
business of an enterprise is wholly or partly carried on”.
profits in source (market) states are minimal with a bulk of profits residing with the principal company33.
This is clearly seen when comparing a traditional reseller (a bookstore) that would generally operate and serve a customer base within a single jurisdiction or in a limited number of jurisdictions with a digitalised reseller who sells the goods online and directly reaches customers globally34. A digitalised
reseller receives orders from customers via its online platform, where requests may be placed from any foreign jurisdiction where a reseller need not maintain retail stores. It will still require warehousing facilities and employees that work to fulfil orders. But a “warehousing” element in this simplified chain was for a long time protected by one of the activity exemptions of Article 5.4. The consequences are that a firm such as Amazon could sell into a country, even through a website in the local language, without needing the kind of physical presence that amounts to a `permanent establishment. Hence, under current rules Amazon can declare low or no profits in countries where it enjoys very substantial sales, which gives it a very significant advantage over local retailers. This is what may be called a phenomenon of digital times where in the absence of physical presence the MNE is able to build up a very strong economic link with the jurisdiction and the benefits of this genuine economic presence go virtually untaxed.
1.3.3. New paradigm to tax digital business
From the example above it is obvious that application of the existing corporate tax rules to the digital economy has led to a misalignment between the place where the profits are taxed and the place where economic substance of business is. The important task is to consider what factors (value drivers) influence profitability of business and ultimately drive a firm’s success in each market35. To address this
issue the OECD proclaimed that profits should be taxed where economic activity generating such profits is performed and where value is created36. Schön reasons that at the level of the OECD there seems
to be agreement that the notion of “value creation” shall be the guiding light in the search for a new balance of international taxing rights37.
“Change is going to happen, but we need to know the direction. The challenge is
we need to plan for the next 80 years. Need to think far ahead into the future.”
Sol Picciotto, BEPS Monitoring Group
The following sections will look more closely at BEPS Action 7 that was developed to fight tax avoidance (in part relating to activity exemptions) and will touch upon Pillar 1 (Amount A), a far-reaching proposal that pursues a wider goal of (partially) re-allocating taxing rights between jurisdictions on a global scale. While Action 7 targets avoidance schemes implemented by MNEs to minimize source taxation of returns on tangible assets, Pillar I and Amount A look at possible ways to tax returns on intangible assets. Action 7 proposals try to retain connection with existing international tax system (with one notable exception of a new anti-fragmentation rule that is being discussed in detail below) while Pillar 1 takes a bold approach by suggesting to tax MNE as a single enterprise (moving away from a “separate entity” approach) with application of formulas and profit splits38.
33 See section 1.2.1 for the definition of a “principal” company; 34 Supra note 14, page 63;
35 In the vast majority of cases such factors will be people, assets and sales; 36 Supra note 10, page 3, Foreword;
37 Supra note 29, page 6;
38 Although there are views that the new taxing right “Amount A” is only a necessary complement to the existing,
consensus-based international taxation rules. See, for instance, Comments from NERA Economic Consulting (Paris, France) on Public Consultation document – Secretariat Proposal for a “Unified Approach” under Pillar One;
2. Action 7 – preparatory or auxiliary activities
In July 2013, the OECD rolled out its Action Plan on Base Erosion and Profit Shifting (the “Action Plan”)39
that contained 15 Actions to tackle tax avoidance and abusive tax planning. It followed the OECD February 2013 report “Addressing Base Erosion and Profit Shifting” (the “BEPS Report”). BEPS relates chiefly to instances where the interaction of different tax rules leads to double non-taxation or less than single taxation. Due to gaps caused by the interaction of different tax systems, and in some cases because of the application of bilateral tax treaties, income from cross-border activities may go untaxed anywhere or be only unduly lowly taxed40. The Economist called the BEPS project “the biggest shake-up of multinational taxation since the basics of the current framework were put in place in the 1920s”41.
The purpose of this section is to identify circumstances where activity exemptions may lead to BEPS, to describe the steps proposed by the OECD and business community to limit BEPS exposure when activity exemptions are relied on and to conclude whether Action 7 served its role in closing the gaps that were used to exploit elements of rules set out in Article 5.4.
2.1. Goals and controversies
The BEPS Report and the Action Plan both recognized that the definition of a permanent establishment had to be changed to restore source taxation:
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 substantial physical
presence or a dependent agent)
42.
The starting point of Action 7 was to “develop changes to the definition of PE to prevent the artificial avoidance of PE status in relation to BEPS, including through the use of commissionaire arrangements and the specific activity exemptions”43. The changes were thought to be introduced by updating the PE
definition that was already in Article 5 of the MC and not by changing the existing international standards on the allocation of taxing rights on cross-border income. The working hypothesis was and remained of a permanent establishment as a fixed place of business through which the business of an enterprise was wholly or partly carried on. At this stage the issue of what creates taxable presence (other than a fixed place of business or dependent agent) in light of new digital economy was not dealt with.
In order to propose changes and to draft Action 7 the OECD faced a task to describe the strategies that could result in artificial avoidance of permanent establishment status. In 2013 only one strategy was clearly identified as leading to BEPS and that was agency PE arrangements. The OECD briefly mentioned the issue of fragmentation but did not develop on it44. To continue it invited all interested
parties to submit their comments as to what structures could lead to PE threshold abuse45. Only one
39 OECD (2013), Action Plan on Base Erosion and Profit Shifting, OECD Publishing.
http://dx.doi.org/10.1787/9789264202719-en
40 Ibid, page 12;
41 New rules, same old paradigm, the Economist, October 10th 2015
https://www.economist.com/business/2015/10/10/new-rules-same-old-paradigm
42 BEPS Action 7: Preventing the Artificial Avoidance of PE Status, public discussion draft, page 9 paragraph 1
http://www.oecd.org/ctp/treaties/discussion-draft-action-7-prevent-artificial-avoidance-pe-status.htm
43 Ibid.;
44 Supra note 39 , page 19
45 OECD invites interested parties to identify strategies that allegedly result in the artificial avoidance of PE
Status, October 22 2013 http://www.oecd.org/ctp/treaties/identifying-strategies-artificial-avoidance-permanent-establishment-status.htm
submission was released by the OECD in response to that request46.
The Action 7 first discussion draft (the “DD”) was prepared by the Focus Group on the Artificial Avoidance of PE Status (the “Focus Group”) and released on 31 October 2014. The OECD specifically noted that the views laid down in the DD did not represent a consensus opinion and were presented to facilitate discussion. The Draft received an overwhelming response – more than 800 pages of comments were published by OECD. But as noted by Sol Picciotto, the coordinator of the BEPS Monitoring Group, “It is notable that out of almost one hundred comments received, it seems that only four were not from tax advisers, industry associations, or specific MNEs, all parties with a vested interest in minimising change from the status quo”47. There were very few submissions from independent commentators.
Such dominance of business and advisory representatives set the tone for future discussions at the OECD where a great deal of resistance to any kind of change was demonstrated. As pointed out by the BIAC Tax Committee “the current PE rules have worked well for the past fifty years, in that they provide a level of certainty and stability which has encouraged business to engage in long-term cross-border trade and investment.”48 On many occasions such comments ignore the fact that the increasing
complexity of business and its changing nature most probably should trigger a corrective wave in regulations. Anti-abuse measures cannot serve as one decision for all problems, the principal regulations need to be in line with business practices too.
The DD proposed to modify the activity exemptions list: the main targets included warehouses, purchasing offices, and offices used to collect information. One over-arching preparatory and auxiliary requirement for all the exemptions listed in paragraph 4 was drafted by the Focus Group as an alternative. This was initially considered by many as setting new PE boundaries.
BASF: With some of the proposed changes (especially the changes as regards the
currently exempted activities) doing business in the source state creates a PE
rather as a general rule than as an exception, even for legitimate business
transactions
49.
On the other hand, there were opposing views suggesting a more ambitious approach should be adopted, that would “entail a reconsideration not only of paragraphs 4, 5 and 6 of article 5, but also paragraph 7, and of its relationship to article 9”50.
2.2. Business fights back
The overall reaction of stakeholders could be characterized as the Action 7 proposal being “controversial” and “debatable”. Business and advisors were worried the proposed options draw indeed a picture of a changed understanding of a fair allocation of taxing rights between the source state and the state of residency and the issues expressed could be grouped as follows:
(i) Lower PE threshold – the proposed rules go far beyond those problems that had to be addressed in light of BEPS. The DD did not sufficiently distinguish between BEPS and the
46 OECD publishes one comment received on strategies that allegedly result in the artificial avoidance of PE
Status, January 20th 2014 https://www.taxlive.nl/nl/documenten/nieuws/oecd-publishes-one-comment-received-on-strategies-that-allegedly-result-in-the-artificial-avoidance-of-pe-status/
47 BEPS Action 7, Comments received on Revised Discussion Draft, 15 June 2015,
https://www.oecd.org/tax/treaties/public-comments-revised-beps-action-7-prevent-artificial-avoidance-pe-status.pdf page 29;
48 BEPS Action 7, Comments received on public Discussion Draft, 10 January 2015,
http://www.oecd.org/ctp/treaties/public-comments-action-7-prevent-artificial-avoidance-pe-status.htm, page 102;
49 Ibid, page 79; 50 Ibid, page 89;
allocation of taxing rights between the source state and the residence state51. Where a
taxpayer was appropriately taxed in the state of residence with no taxation in the state of source, it was typically not a matter of BEPS but a question of allocating taxing rights52. A
change in the balance between source and residence taxation was perceived as a highly undesired consequence of proposed changes.
Business considered it of utmost importance not to lower the PE threshold for players engaged in non-abusive transactions53. A distinction should be drawn between situations
that constitute an artificial or abusive exclusion from the existence of a permanent establishment and situations in which, it is considered that the existing rules are not suitable for ensuring taxation of business income in the location in which its value is created or in which the corresponding activities are carried out54.
(ii) A dramatic increase in a number of permanent establishments was expected as a result of the lower PE threshold – again, this would not effectively solve BEPS concerns but would rather increase the burden for multinationals in connection with registration, bookkeeping or filing of tax returns and additional costs connected with these obligations.. Companies in fact treated the activity exemptions list in Article 5.4 as a mechanism to mitigate administrative costs, a cost saving planning technique that works especially well when activity exemptions are treated as “per se” exemptions. As posed by one speaker during the Public Consultation meeting “why is the OECD calling into question the delivery exception as it is enjoyed by all businesses” instead of just addressing a narrow case (Amazon) it had in mind.55
Several commentators went further and argued that compliance costs in relation to a PE were so significant that when coupled with increased uncertainty in this area they were likely to have a negative impact on cross border trade56. Decisions to limit PE exposure will
reduce the global footprint of a business, which would impact local employment and investment57. This is a consequence that developing countries strive to avoid and for that
reason should call on the OECD to postpone implementation of changes that will create such an effect. But if changes to the PE Article help to achieve a level playing field then the multinationals will not have to choose a country with the lowest reporting and PE running costs, they simply will not matter that much if one universal set of rules is applied.
The argument about multiple PEs endangering the future of global trade was best addressed by Schön: “the decision where to invest is not excessively distorted by taxation at the point in time when the directors of a company have to decide on an investment. If they expect a certain amount of return on the investment, they will accept a regular corporate income tax on this return as well. If they decide upon higher investment in a country, they will accept a larger part of the overall profit to be allocated to this country58”
.
Issues of VAT registration and customs implications were also mentioned as being part of a complex registration procedure that a multinational will have to undertake if its activities lead to
51 Supra note 48, page 136; 52 Ibid.;
53 Ibid, page 138; 54 Ibid, page 18;
55 BEPS Action 7 Public Consultation meeting - Prevent the Artificial Avoidance of PE Status (Second Session),
https://www.youtube.com/watch?v=efnIjCZ2Dd8&t=4871s , @54’
56 Supra note 48, page 137; 57 Ibid, page 103;
58 W. Schön, International Tax Coordination for a Second-Best World (Part III), 2 World Tax J. (2010), Journals
a PE59.
(iii) Implementing lower thresholds for PE concept will place greater emphasis on profit attribution, a complex and controversial topic.
In the view of business and its representatives activities mentioned in Article 5.4 normally are not by themselves income generating. Therefore, it will be quite difficult to allocate income to such a PE and disputes in this area are likely to increase significantly60. Business
insisted that the creation of a permanent establishment definition to which in the end very little, if any profit can be allocated makes no sense. However, in the course of discussions no one provided any calculation as to how minimal such profit could be.
In the view of the business community, the discussion should not be just with respect to the recognition of a PE but also to what extent profits/ losses are attributed to the PE. In many cases countries are quick to assert a PE but are unwilling to accept expenses and/ or losses properly attributable to such a PE.
(iv) the final matter is intertwined with the previous two – business predicted a rise in conflicting claims of tax jurisdictions, allocation disputes and double taxation. As noted earlier, for a great number of MNEs the exceptions in Article 5.4 facilitated less administration and cost by enabling a relatively simple and consistent approach to the determination of whether a PE exists. Companies report that whenever they are considered to have a PE, there is the inevitable dispute on how much income should be attributed to that PE. On many occasions this results in long litigations and high costs61.
The analysis below will attempt to understand whether these were well-grounded concerns or rather arguments made to postpone any change in a concept that had been developed almost a century ago. With respect to activity exemptions the DD proposed several options, namely:
2.2.1. Option E
This Option would make all the activities currently listed in paragraph 4 of Article 5 subject to the condition of being preparatory or auxiliary.
This Option went in direct contradiction with the work carried on in 2011-2013 that concluded that activity exemptions of paragraph 4 were automatic exemptions62. The conclusions that were reached by the
OECD at that earlier point helped to establish a bright line test that business was happy to apply. By putting a “per se” label on a list of exemptions the OECD took much of ambiguity away from this issue. Option E increases reliance on the definition of the terms “auxiliary” and “preparatory” and places great weight on these terms. It also leaves considerable room for subjectivity. Certain activities that were previously considered to be preparatory or auxiliary are now increasingly significant components of businesses. Putting a dividing line between “significant” and “preparatory/ auxiliary” may prove to be a hard task.
The Model does not provide any definition for “preparatory or auxiliary” terms and their interpretation is usually guided by the Commentaries that for obvious reasons cannot provide examples for all industries and situations.
59 Supra note 48, page 103; 60 Ibid, page 139;
61 Ibid.;
62 Interpretation and application of Article 5 (Permanent Establishment) of the OECD Model Tax Convention,
Revised public discussion draft of October 19th, 2012, page 24
Although several commentators understood the principled intentions of the OECD in proposing the preparatory and auxiliary override, they thought the time and the project limitations would not make it possible to implement such proposal consistently.63 The business community suggested another way
to deal with this issue: leave paragraph 4 as it is and provide for a PE exception unless the tax authority can show that the activity is not of a preparatory or auxiliary nature64. What the OECD latercalled a
“rebuttable presumption” option.
On the other hand, the OECD was prepared for a trade-off – the exemptions could be kept as “per se” exemptions if several of them (delivery, purchasing office and data collection) would be removed. However, during the public consultation meeting several participants noted that if they were to choose between Option E and its alternatives, they would have chosen Option E as the least harmful one. 2.2.2. Option F
This Option targeted the “delivery” exemption. The Draft suggested deleting the “delivery” exemption from sub-paragraphs (a) and (b). This was an option to consider if option E would not find enough support with the Member States.
The proposed new version would read:
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;
A specific example was provided by the OECD describing a very large warehouse in which a significant number of employees work for the main purpose of delivering goods that the enterprise sells online65.
According to the OECD, formal reliance on exemptions (a) and (b) could lead to a no PE situation. Although never mentioned during public consultations, the case was presumably copied from the Amazon business structure.
Another example is of many MNEs that sell hard and soft products and provide various services through internet platforms and for that reason maintain extensive local operations to provide both customer support and quick delivery of physical products. These local activities are so much a part of the core business being conducted that such MNEs will have a PE (or a dependent agent PE) in many host countries. These local activities are not in any way preparatory or auxiliary to the overall business activity of the enterprise66.
Nevertheless, Option E raised a lot of debate during the Public consultation meeting. Many asked how it was possible to have storage without a delivery and found it difficult to understand the purpose of having the exception for storage when deleting the exception for delivery. The mere existence of such
63 Supra note 48, page 113 64 Ibid., page 139
65 Supra note 42, page 16, paragraph 18;
66 The BEPS Monitoring Group, Comments on the Public Discussion Draft on Additional guidance on attribution
of profits to permanent establishments, page 4
a concern leads to the question Why would an enterprise want to store and deliver in a host country? As these are elements of trade that by no definition can be of preparatory and auxiliary character. Business did acknowledge that it was becoming increasingly important to have warehouses in close proximity to where the demand is to be able to serve clients in a fast and cost-efficient manner. Having a warehouse for storage without the possibility of delivery makes little sense and would have significant consequences for their business operations67.
The exclusion for warehouses, such as Amazon's distribution centres, is contained in the double taxation treaty the UK negotiated with Luxembourg in 196668. Amazon.co.uk is registered to a Luxembourg
company, Amazon Europe Holding Technologies SCS, and the site runs off the group's servers in Ireland69. The situation is that a warehouse of itself is not a permanent establishment. An internet-based
business, where essentially the website and servers are based outside the UK, is also not a UK permanent establishment. Strictly speaking, there are no rules in pre-BEPS times that would allow the UK to tax such income as a source country.
From the perspective of an independent observer the situation around the delivery exemption may look awkward – it seems that business confirms it uses stock and warehouse facilities to make sales in host countries but at the same time goes in denial when asked to admit that such operations as storage and delivery may no longer be treated as preparatory and auxiliary under such circumstances. This approach was described by the BEPS Monitoring Group as MNEs trying to “undervalue for source countries the value that is truly created within their borders”.70
2.2.3. Options G and H
These options applied to purchasing offices and the collection of information. Like option F, these were alternative options to consider if option E would not find enough support with the Member States. Option G provided for the removal of purchasing of goods exception:
4. Notwithstanding the preceding provisions of this Article, the term "permanent
establishment" shall be deemed not to include:
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;
Option H would eliminate entire subparagraph (d). 2.2.3.1. Purchasing office
One of the reasons why the OECD came out with idea to remove the purchasing office exception is its connection with what used to be paragraph 5 of Article 7 of the OECD MC. The paragraph was included in 1963 and removed in 2010.
67 Supra note 48, page 140;
68 Luxembourg - United Kingdom Income and Capital Tax Treaty (1967) (as amended through 2009),
Article V.3;
69 Supra note 22;
5. No profits shall be attributed to a permanent establishment by reason of the
mere purchase by that permanent establishment of goods or merchandise for the
enterprise
71.
It seemed logical to put Articles 5 and 7 in line as by removing paragraph 5 of Article 7 the OECD opened the room to the idea that attribution of profits was possible in case of mere purchase deeming it to be one of the functions of the enterprise that could be properly remunerated. The position of the OECD was there should be no limit to the attribution of profits to the PE in such cases, apart from the limit imposed by the operation of the arm’s length principle72.
The BIAC Tax Committee admitted that a purchasing function would contribute to profit or loss, however, the issue was that such a contribution would not be enough to justify the creation of a PE73. Taking
BIAC’s vested interest with business one could argue quite the opposite – what if such a contribution was enough to create a PE? No data were provided to support any of the positions.
The problem of how profits should be calculated in the case of a permanent establishment which merely purchases goods for its group was red flagged and could not be overlooked.
One of the examples provided by the OECD described a purchasing office located in State S where several manufacturing plants operated. Both the office and plants were part of one group. The purchasing office received discounts based on the volume purchased from the plants. Such discounts reduced the taxable profit of the manufacturing units and went untaxed in State S as the purchasing office activity was also covered by the activity exemption74. While one commentator to the
Draft thought it could be a legitimate example of abuse, such abuse was thought to be better addressed with a transfer pricing rule75.
But the general reaction to this Option was that in most cases the purchasing of materials will not, by itself, generate profit; thus, if the purchasing exception was eliminated there would still be very little to gain by taxing those profits76.
The business community also suggested that removal of the purchasing office exception will have an adverse effect on many developing countries as such exceptions can also boost the local economy by attracting foreign buyers to make purchases from local sellers77. As stated by BIAC “simpler solutions
for abusive cases should be pursued and exception for purchasing should be retained”.78
2.2.3.2. Collection of information
In today’s world information is key. MNEs make their decisions on market entry, product launch, and advertising campaigns from the information they receive either by doing their own data mining or from obtaining research from third parties. To say that in the former cases collection of information is preparatory or auxiliary may seem to be an overstatement as what companies obtain as a result of their search serves as a base for many other business decisions made by MNEs.
71 MC (2008) Article 7(5);
72 The 2008 Report on Attribution of Profits to Permanent Establishments, 17th July 2008, paragraph 57; 73 Supra note 48, page 115, paragraph 64;
74 Supra note 42, page 18, paragraph 26, example 1; 75 Supra note 48, page 83;
76 Ibid.;
77 Ibid, page 142;
Example 1: Consider the case of an Italian ice-cream company collecting
information about customer preferences in ice-cream in the Netherlands. Based
on the information obtained the company decides to start with the launch of their
high-priced “luxury” series of ice-cream via a distribution chain in the Netherlands.
Later, the company realizes (again, based on the information collected) that a dire
mistake was made in collecting information at the initial stage. This mistake
triggered a wrongful allocation of resources and after all led to the negative
perception of the brand by the customers in the Netherlands
79.
Is it possible to say that in this case collection of information was so remote from profit generating activities of a company that no profits (or loss) should be attributed to it? Or does this act of collection of information contributes to the overall profitability of an enterprise and need to be rewarded?
Raw data by itself has limited value. Value is usually created by the processing and interpretation of the data. It could be that the “collection of information” exception triggers a greater PE risk if conclusions are drawn based on the analysis of all the functions performed by all the members of MNE group as a whole and not on a separate entity basis. For example, an affiliate selling goods in State S may also be collecting, reviewing and analysing information about a possibility of launching a new product and communicate the results of such work to the head office of the group located in State P where the decision is made. Will such a situation create a PE risk for the head office?
For example, one of the commentators from the banking industry suggested that if option H is followed the mere provision of assistance by an affiliate in connection with due diligence or credit review in a country where a prospective borrower conducts significant operations could be treated as giving rise to a PE even though in his opinion such activity was clearly of a preparatory or auxiliary character and the affiliate providing the assistance did not play any role in decisions regarding whether and on what terms to extend credit80. However, the conclusion reached by the commentator is debatable as it may seem
that such information is what drives credit department work. The absence of such information could lead to a high risk that the banking institution would be unwilling to take.
2.3. New Commentaries for Article 5.4
The Action 7 revised Discussion Draft (the “RDD”) came out in May 2015 with a conclusion that Option E was preferable to Options F, G and H. Art. 5.4 of the MC was expected to be modified so that each of the exceptions included in that paragraph would be restricted to the activities of a “preparatory or auxiliary” character only. The OECD underscored the importance of providing additional guidance in the Commentaries, primarily through examples, concerning the meaning of the phrase “preparatory or auxiliary”81. The RDD contained seven pages of revised and extended Commentaries. Later that text
(with a couple of non-essential additional remarks82) replaced the Commentary on Article 5.4
(2014->2017).
In the revised Commentaries the OECD confirmed its reliance on a fixed place of business as the only valid nexus to determine whether the activities listed in Art. 5.4 can be treated as exceptions. The OECD reiterated several times in the text that paragraph 4 was irrelevant without a fixed place of business
79 This case is based on the example given by Giammarco Cottani during his UvA-IBFD LLM lecture on Transfer
Pricing Aspects of Business Restructurings on February 24, 2020;
80 Supra note 48, page 74;
81 BEPS Action 7: Preventing the Artificial Avoidance of PE Status, revised public discussion draft, page 22,
paragraph 31;
maintained in the source state83. This was not surprising as the work on Action 7 did not include any
revisions of Art. 5.1 where the general definition of a PE is provided. The list of exceptions initially was written in a way that evolved around a fixed place of business. For the purpose of preventing BEPS the RDD intention was to reverse the previous interpretation issues and to close the gaps through a stricter rule and a lower threshold.
2.3.1. Warehouse for delivery
Keeping in mind the earlier example of a very large warehouse the RDD concluded “it is unlikely that an activity that requires a significant proportion of the assets or employees of the enterprise could be considered as having an auxiliary character”84. The soft tone of the “unlikely” may (rather mistakenly)
lead to a conclusion that it is also possible in some cases. However, when describing the delivery exemption, the RDD directly said that if the enterprise sells online to customers then in such a case the exceptions will not apply to the warehouse if the storage and delivery activities are performed there85.
The RDD also clarified that maintenance of a warehouse for the delivery of spare parts where such delivery is part of after-sales activities may not be treated as “preparatory or auxiliary”.
2.3.2. Purchasing office
For the purchasing office exception, the examples provided in the RDD were simpler and much more straightforward than those given by the DD86 (see above for discussion of Option G). In addition, the
RDD noted that such exception will typically not apply in the case of a fixed place of business used for the purchase of goods or merchandise where the overall activity of the enterprise consists in selling these goods87.
2.3.3. Collection of information
The OECD dealt with this exception in a somewhat old-fashioned way assuming that in the digital age companies may still opt to establish offices solely to collect information to decide “whether and how to carry on its core business activities in a state”88. In this case such an office will not be treated as a PE.
2.4. “Preparatory & auxiliary” activities – in search of clarity
With the PE concept being a threshold, it is inevitable that its practical application will raise issues. The practical application of a threshold that is based on the rules that are not clear and not well understood may raise twice as many issues if not more than that. The question of what the OECD and the business mean by preparatory/ auxiliary activities remains open for discussion even though the work on Action 7 was finalized several years ago.
2.4.1. Realization of profits/ creation of value
The OECD did not amend the definition of “preparatory or auxiliary” activities neither in the final Action 7 report nor in the revised Commentaries to Article 5.4. The central idea remains that such activities may contribute to the productivity of the enterprise, but they are so remote from the actual realization of profits that it is difficult to allocate any profit to them 89.
Fundamentally, sales are connected with realization of profits – unless a company can sell its product in the market, no revenue can be generated, and no value can be created for the shareholder.
83 For example, the OECD Model Commentaries (2017), Article 5.4, paragraph 69, line 3 84 Supra note 81, paragraph 60, line 7
85 Ibid., paragraph 62, line 3
86 Ibid., paragraph 68, examples 1 and 2 87 Ibid., paragraph 68, line 2
88 Ibid., paragraph 69, line 2
