PERMANENT ESTABLISHMENT AS A SEPARATE
PERSON UNDER TAX TREATIES — A MULTI-EDGED
SWORD
THESIS — UNIVERSITY OF AMSTERDAM (UvA) - IBFD
(INTERNATIONAL BUREAU OF FISCAL DOCUMENTATION)
Submitted by: Mehul Saboo
Student Id No: 11367210
TABLE OF CONTENTS
A. List of Abbreviations……… 3
B. Introduction……….. 4
C. Chapter I —Triangular Cases………. 6
1. Introductory Remarks………... 6
2. PE Triangular case………... 6
3. Consequences Arising from the PE Triangular Case……… 7 3.1. State S………... 7 3.2. State PE………... 8 3.3. State R………... 8 3.4. Overall Outcome………... 9 D. Chapter II — Potential Solutions……… 11
1. Introductory Remarks………... 11
2. The Non-Discrimination Principle………... 11
2.1. Application of Article 24(3) ……….. 11 2.2. Analysis of Article 24(3) ……….. 13 2.3. Conclusion………... 17
3. PE as a Separate Person and Residence Concept under Tax Treaties………… 18 3.1. Introductory Remarks……… 18 3.2. Assessment and Analysis of the Proposed Recommendation……… 21 3.3. Final Remarks……….... 28 3.4. Multi-Edged Solution……… 29 4. Conclusion………... 37
E. Chapter III — Entering the Future……… 38
1. Introductory Remarks………... 38
2. Proposed Draft of the OECD
MC……….
38 3. Drawbacks of Absolute Independence of a PE with Counter
Arguments…….
3.1. Treaty Shopping and Tax Avoidance Considerations……… 46 3.2. Other Drawbacks………... 52 4. Conclusion………... 54 F. Conclusions………... 55 G. Bibliography………... 57 A. LIST OF ABBREVIATIONS
ALP : Arm’s Length Price
AOA : Authorized OECD Approach BEPS : Base Erosion and Profit Shifting CIT : Corporate Income Tax
CFC : Controlled Foreign Companies
DTAA : Double Tax Avoidance Agreement or Tax Treaty
HO : Head Office
OECD : Organization for Economic Co-operation and Development OECD MC : Model Tax Convention on Income and Capital (2014) LOB : Limitation on Benefit
PE : Permanent Establishment PPT : Principle Purpose Test
POEM : Place of Effective Management State R : State where Taxpayer is a resident
State S : State of Source i.e. the State where the income is derived from State PE : State where the Permanent Establishment (PE) exists
TP : Transfer Pricing US : United States WHT : Withholding Tax
B. INTRODUCTION
International juridical double taxation is generally defined as the imposition of comparable taxes in two (or more) States on the same taxpayer in respect of the same subject matter for identical periods and it is one of the main purpose of the OECD MC1 to provide relief from
it.2 Majority of the States try to alleviate the problem of international juridical double taxation
by concluding DTAA’s which are usually based on the OECD MC and are bilateral in nature i.e. the DTAA is binding only between the two contracting States involved. However, the effectiveness of bilateral DTAA in alleviating international juridical double taxation gets diluted when more than two contracting States are involved which are typically known to be triangular cases.
Involvement of more than two contracting States can occur when a person (say, company) resident in one State has a permanent establishment (PE) in another State and receives passive income3 from a resident of a third State which is attributable to the PE. Such a
situation where passive income from the third State is attributable to the PE is the common most identified triangular case and would form the also be the core topic of discussion in this thesis.4 Due to the involvement of more than two contracting States, the potential for multiple
level taxation on the same income by different States increases which would be detrimental for taxpayers and also against the main principle of the OECD MC of alleviating international juridical double taxation.
1 All references to the OECD Model Tax Convention on Income and Capital (OECD MC) are to the 2014 version, unless otherwise specified.
2 OECD (2014), Model Tax Convention on Income and Capital version 2014, OECD publishing, paragraph 1-3 of Introduction.
3 Passive income for the purposes of this thesis means interest under Article 11 “Interest” of the OECD MC.
The OECD has acknowledged the problems of triangular cases when the first OECD MC was drafted in 19635, but it does not provide any general or consistent solution to solve the issues
emerging from triangular cases6. Given the increasing importance of this topic and often
occurring PE triangular cases, this thesis at Chapter II recommends PE to be treated as a separate person and residence concept under the tax treaties entitled to claim complete treaty benefits just like a company/separate legal entity to eliminate the issues emerging from triangular cases.
Treating PE as a separate person and residence concept (i.e. absolute independence) under tax treaties would not only eliminate the issues arising under triangular cases but also act as a multi-edged solution as will be seen in Chapter II. In particular, it would align the different methodologies adopted by the OECD in Transfer Pricing (TP) with regards to determining the ALP between associated enterprise (company) and PE. Further, Chapter III of the thesis recognizes the need of a paradigm shift in the OECD MC for implementing the recommendation of absolute independence of a PE and accordingly proposes a draft version of the OECD MC on an experimental basis incorporating the same.
Every action has an equal and opposite reaction (Newton’s 3rd Law of Motion) and treating
PE as a separate person under the tax treaties is no exception to this principle. Implementing absolute independence of a PE under the OECD MC would lead to certain drawbacks particularly with regards to avoidance of taxes generally referred as “treaty shopping”.7
Finally the thesis enters into its final phase by analyzing these drawbacks and suggests some potential measures and counter arguments to overcome them, for the proposed recommendation of absolute independence to function effectively.
5 H. Pijl, 'The Epic of Gilgamesh, or the Noise of the Profession' (2011) 65 Bulletin for International Taxation 606.
6 OECD Committee on Fiscal Affairs, Issues in International Taxation, Four Related Studies, Triangular Cases, (OECD 1992), paragraph 2.
C. CHAPTER I — TRIANGULAR CASES8
1. Introductory Remarks:
Triangular cases can occur in many circumstances inter alia PE triangular cases, dual resident triangular cases, reverse dual triangular cases9 etc. However, the scope of this Chapter will be
limited only to PE triangular cases wherein, passive income from third State is received by resident of a contracting State which is attributable to a PE in another State. Further, the discussion in this Chapter is based on the primary assumption that all the States involved in the PE triangular case have concluded bilaterally between themselves a DTAA based on the OECD MC.10
2. PE Triangular Case:
A PE triangular cases requires the following events to happen:11 (i) Income from dividends or
interest is derived from a source in State S; (ii) Such income is received by a PE in State P; (iii) The PE depends on an enterprise resident in State R. The same can be better illustrated
with the aid of a hypothetical example and graphical representation.
E.g. Assume, a company (HO) resident in State R has a PE in State PE. The only income which the company earns is interest income of $100 which is sourced in State S. The 8 The contents of this chapter are primarily based on, E. Fett, chapter 2: PE Triangular Cases and Specific Categories of Income in Triangular Cases and Chapter 3: Double Taxation Relief in the Residence State in Triangular Cases -The application of Bilateral Income Tax Treaties in Multilateral Situations (IBFD 2014), Online Books IBFD. However, specific references are mentioned as and when required in this Chapter.
9 E. Fett, Chapter 1: Introduction in Triangular Cases – The application of Bilateral Income Tax Treaties in Multilateral Situations (IBFD 2014), Section 1.1
10 Further assumptions would be specifically mentioned as and when required in this Chapter.
company incurs no expenses and this interest income is attributable to its PE. The withholding tax (WHT) rate specified in R-S treaty on interest income is 10% on the gross amount of payment. Further, State PE levies tax at a rate of 10% under its domestic laws on the profits attributable to the PE and State R levies CIT tax at a rate of 15%. The graphical representation of the same is as under: 12
State R: CIT @ 15% State PE:
Tax @ 10% on PE Profits in
Accordance with Article 7 of R-PE treaty
3. Consequences Arising from the PE Triangular Case:
3.1 State S:
Tax treaties are applicable to persons who are residents of one or both of the contracting State.13 Under the current international tax framework, a PE is not considered as a separate
person eligible for treaty benefits but only a part of the enterprise to which it belongs. Accordingly, State S is obliged to the apply the provisions of R-S treaty and the provisions of PE-S treaty does not apply in the present case.14 Since R-S treaty is based on the OECD
MC15, Article 11 would be applicable as it specifically deals with interest.
12 E. Fett, Chapter 3: Double Taxation Relief in the Residence State in Triangular Cases -The application of Bilateral Income Tax Treaties in Multilateral Situations (IBFD 2014), Online Books IBFD, Section 3.2.2.1.
13 Article 1 of the OECD MC reads as follows: “This Convention shall apply to persons who are residents of one or both the Contracting States.”
14 J. F Avery Jones & C. Bobbett, Triangular Treaty Problems: A Summary of the Discussion in Seminar E at the IFA Congress in London, 53 Bulletin, International Fiscal Docn., pp 16-20 (1999), Journals IBFD, Section II, page 17.
15 See assumption mentioned in section 1 of Chapter I.
HO State S: Interest payment $100 WHT under R-S treaty: 10% PE
On a perusal of paragraph 216 and paragraph 517 of Article 11 of the R-S treaty, the
contracting State where the interest arises would be eligible to levy tax (usually a WHT) but the taxes levied shall not exceed 10% of the gross amount of interest. In the given example, State S is the State of source where interest arises and therefore would levy a maximum WHT of $1018 on the interest payment made to the company resident in State R in accordance with
Article 11 of the R-S treaty.
3.2 State PE:
As mentioned in section 3.1 above, PE is not considered as a separate person but is only a part of the enterprise, therefore the PE-S or the R-S treaty would not apply in State PE. The interest of $100 is attributable to the PE and therefore the provisions of the R-PE treaty must be applied by the PE State. Article 11 “Interest” of the R-PE treaty will not apply in the present example as the interest does not arise in the PE State for the purposes of Article 11. Rather, paragraph 1 of Article 7 “Business Profits”19 of the R-PE treaty will be applicable
directly as the interest attributable to the PE would be considered as business profits in State PE.
The provision of Article 7 would even apply indirectly as an outcome of paragraph 2 of Article 21 “Other Income”20 of the R-PE treaty. Further assuming, that State PE does not
provide any double tax relief under paragraph 3 of Article 24 “Non-Discrimination”21 of the
16 Article 11(2) of the OECD MC reads as follows: “However, interest arising in a Contracting State may also be taxed in that State according to the laws of that State, but if the beneficial owner of the interest is a resident of the other Contracting State, the tax so charged shall not exceed 10 per cent of the gross amount of the interest. (…)” (Emphasis Added).
17 Article 11(5) of the OECD MC reads as follows: “Interest shall be deemed to arise in a Contracting State when the payer is a resident of that State. Where, however, the person paying the interest, whether he is a resident of a Contracting State or not, has in a Contracting State a permanent establishment in connection with which the indebtedness on which the interest is paid was incurred, and such interest is borne by such permanent establishment, then such interest shall be deemed to arise in the State in which the permanent establishment is situated.”
18 WHT is calculated as follows: $100 * 10% = $10.
19 Article 7(1) of the OECD MC reads as follows: “Profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment (…) may be taxed in that other State.” (Emphasis Added)
20 Article 21(2) of the OECD MC reads as follows: “The provisions of paragraph 1 shall not apply to income (…) if the recipient of such income, being a resident of a Contracting State, carries on business in the other Contracting State through a permanent establishment situated therein and the right or property in respect of which the income is paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply.” (Emphasis Added)
R-PE treaty, State PE would levy tax of $1022 on the profit attributable to the PE (being
interest) in accordance with Article 7 of the R-PE treaty.
3.3 State R:
State R is obligated to apply the provisions of both R-S and R-PE treaty. The interest is being taxed first in the form of WHT levied by State S under the R-S treaty and again in PE State as profits attributable to the PE under the R-PE treaty. State R is also entitled to levy taxation on the interest income under Article 11 “Interest” of the R-S treaty and therefore the same interest income is taxed thrice (i.e. all the three States involved in the PE triangular case). State R, being the resident State is obliged to provide relief from double taxation (triple taxation in this example) on the interest income under the R-S as well as R-PE treaty. The quantum of relief of double taxation will depend on the methodology which State R adopts under its tax treaties. Assuming, State R adopts Article 23A “Exemption Method” for eliminating double taxation, the effect would be that, under paragraph 1 of Article 23A23 of
the R-PE treaty, State R would exempt the profits attributable to the PE (i.e. the interest income) and would not levy any taxation.
Further, in accordance with paragraph 2 of Article 23A24 of the R-S treaty, State R would also
be obliged to provide a credit for the taxes withheld in State S on interest income. However, the amount of credit would be lower of (i) foreign taxes paid or (ii) domestic tax levied on the foreign income. Since, interest is attributable to PE and State R exempts the PE profits, State R will not be able to provide sufficient credit for the taxes levied in State S due of lack of taxable income in State R.25,26
22 Tax is calculated as follows: $100 * 10% = $10.
23Article 23A(1) of the OECD MC reads as follows: “Where a resident of a Contracting State derives income or owns capital which, in accordance with the provisions of this Convention, may be taxed in the other Contracting State, the first-mentioned State shall, (…), exempt such income or capital from tax.” (Emphasis Added)
24Article 23A(2) of the OECD MC reads as follows: “Where a resident of a Contracting State derives items of income which, in accordance with the provisions of Articles 10 and 11, may be taxed in the other Contracting State, the first-mentioned State shall allow as a deduction from the tax on the income of that resident an amount equal to the tax paid in that other State. Such deduction shall not, however, exceed that part of the tax, as computed before the deduction is given, which is attributable to such items of income derived from that other State.”
25 The credit is limited to the lower of (i) foreign taxes paid (i.e. $10 in State S) or (ii) domestic tax levied on the foreign income (i.e. $0, since interest is attributable to the PE and State R exempts the PE profits altogether). Therefore, lower of the two would be $0. See also, supra note 6, paragraph 17 and 36.
The obligation on the resident State to provide dual relief in PE triangular cases i.e. providing a credit for WHT levied in source State as well exempting PE profits was addressed in two cases in the Netherlands, one 200227 and the other in 200728. In both these cases it was held
that, Netherlands being the resident State is not obliged to provide a credit for the WHT levied in source State in addition to exempting the PE profits in PE triangular cases. Thus, granting of dual relief was denied by the Supreme Court of the Netherlands.
3.4 Overall Outcome:
In a bilateral situation, exempting certain income or providing a credit in the residence State ensures relief from juridical double taxation. However, in a multilateral situation, such as PE triangular case, unrelieved double taxation should be considered to occur only if the overall tax burden imposed on a person in relation to a particular item of income is higher than the highest applicable tax rates in each of the (three) States that seek to impose tax.29 Therefore,
based on this definition, if the overall tax burden in the above example is more than 15% (being the highest tax rate in each of the three States involved) then there would be unrelieved juridical double taxation. This can be demonstrated with the following table:
Interest Income $100
Tax levied by State R (See sub-section 3.3 above) —
Tax levied by State PE (see sub-section 3.2 above) $10
Tax levied by State S (See sub-section 3.1 above) $10 Overall Tax Imposed in the PE triangular case on Interest Income $20 or 20% Highest applicable tax rate in each of the three States involved (i.e. State R) 15% Unrelieved Juridical Double Taxation $5 or 5% Thus, it can be seen from the above table that, there is incidence of unrelieved juridical double taxation to extent of $5 or 5% in a PE triangular case.
However, it is not always necessary that in a PE triangular case there would be unrelieved juridical double taxation, for example, if State R would have levied CIT at a rate of 30% instead of 15% in the above example then, the overall tax imposed in relation to the interest 27 NL:HR, BNB 2002/184, dated 8th February 2002, also available at Tax Treaty Case Laws IBFD.
28 NL:HR, BNB 2007/230, dated 11th May 2007, also available at Tax Treaty Case Laws IBFD.
income (i.e. 20% or $20) would have been lower to the highest applicable tax rate in the three States involved and there would be no incidence of unrelieved juridical taxation.30
There would also be no incidence of unrelieved juridical double taxation if State PE provides relief under Article 24(3) “Non-Discrimination” of the R-PE treaty for the WHT taxes levied in State S31 and the same is acknowledged by the OECD.32 This incidence where no
unrelieved juridical double taxation exists is also consistent with the analysis and conclusion derived by E.Fett.33 Nevertheless, the effectiveness of Article 24(3) is discussed further in
Chapter II.
D. CHAPTER II — POTENTIAL SOLUTIONS
1. Introductory Remarks:
As seen in Chapter I above, unrelieved juridical double taxation will continue to exist in a PE triangular case unless, the sum of the tax imposed in the source and PE States is lower than the tax imposed in the residence State or the PE State provides relief under Article 24(3) “Non-Discrimination” of the R-PE treaty. This Chapter analyzes the effectiveness of Article 24(3) in alleviating unrelieved juridical double taxation in PE triangular case and in addition recommends treating PE as a separate person and residence concept under tax treaties entitled for complete treaty benefits as a better solution. The Chapter further, discusses that, treating PE as a separate person not only solves the issues emerging from the PE triangular cases but also other cross border issues, particularly in TP.
2. The Non-Discrimination principle:
2.1 Application of Article 24(3):
In a PE triangular case, where the same income is taxed in the source as well as PE States the OECD addresses that, the onus of alleviating unrelieved juridical double taxation can take 30 F.A Garcia Prats “Triangular cases and residence as a basis of alleviating International Double taxation. Rethinking the Subjective Scope of Double Tax Treaties, Intertax, page 473-491, foot note 30.
31 See supra note 12, section 3.2.2.2.
32 See supra note 6, paragraph 18.
place only in the PE State.34 Continuing with the same example (refer section 2 of Chapter I),
PE is not considered as a separate person under tax treaties, therefore PE-S treaty is not applicable.35 However, R-PE treaty is applicable in the present example36 and accordingly,
State PE is required to fulfill its obligation under Article 24(3) “Non-Discrimination” of the R-PE treaty which reads as follows:
“(3) The taxation on a permanent establishment which an enterprise of a Contracting State has in the other Contracting State shall not be less favourably levied in that other State than the taxation levied on enterprises of that other State
carrying on the same activities (…)”. (Emphasis Added)
From the quoted paragraph above, the taxation of the PE shall not be less favorably levied in the PE State in comparison with the taxation levied on its own (i.e. PE State) resident enterprises carrying on the same activities.37,38 Alternatively, the tax burden levied on the PE
should be at par with the tax burden levied on the resident enterprise carrying on the same activities in the PE State, however differential tax treatment would be permitted as long as it does not produce a less favourable result for the PE.39
Therefore, if State PE provides a relief for the taxes levied in State S for its own resident enterprises under the PE-S treaty for eliminating double taxation40, then it will also be obliged
to provide the same extent of relief even to the residents of State R having a PE in the PE State under Article 24(3) “Non-Discrimination” article of the R-PE treaty.41 Application of
Article 24(3) can be illustrated by further assuming in the example mentioned in Chapter I that, State S could levy a WHT of 10% under the PE-S treaty on interest derived by a comparable resident enterprise of State PE and State PE adopts credit method for eliminating double taxation under the PE-S treaty. The overall outcome after applying these changes would be as follows:
34 See supra note 6, paragraph 18.
35 See supra note 13.
36 See Section 3.2 of Chapter I.
37 Commentary to Article 24 “Non-Discrimination” of the OECD MC, paragraph 35 and 37.
38 See supra note 30, foot note. 41, where it is mentioned that “it is not necessary to compare PE with resident companies which are subsidiaries of foreign parent company.”
39 See supra note 37, paragraph 34.
40 K. van Raad, The 1992 OECD Model Treaty: Triangular Cases, European Taxation (1993), pp 298-301, foot note. 1.
Interest Income $100 Tax levied by State R (PE profits are exempt) — Tax levied by State PE (-) Relief under Article 24(3) of R-PE treaty $042
Tax levied by State S $10
Overall Tax Imposed in the PE triangular case on Interest Income $10 or 10% Highest applicable tax rate in each the three States involved (i.e. State R) 15%
Unrelieved Juridical Double Taxation
-As can be seen, if State PE provides relief for the WHT levied in State S, then the overall tax imposed in the PE triangular case would be lower than the highest applicable tax rate in each of the three States involved thereby, leading to no unrelieved juridical double taxation.
2.2 Analysis of Article 24(3):
The OECD address that the objective of Article 24(3) is to eliminate all discrimination in the treatment of PE in comparison with resident enterprises belonging to the same sector of activities.43 It was seen in section 2.1 that, there would be no incidence of unrelieved juridical
double taxation if Article 24(3) was applied by the PE State. However, experience has shown that, the substance of the principle of Article 24(3) has been a topic of debate and has led to wide differences of opinion with regards to the implication of this principle.44 “The
application of Non-Discrimination clause does not solve completely the extra-double taxation raised in a triangular case”45 and some of the issues encompassing the principle of
Article 24(3) are discussed as under:
i) Dependability on Comparable Resident Enterprise:
a) Article 24(3) is dependent on whether the comparable resident enterprise is itself entitled to relief under PE-S treaty. Therefore, in PE triangular case, a resident of State R will be entitled to relief under Article 24(3) of the R-PE treaty only if a comparable resident enterprise of State PE derives income from State S and is eligible to a relief under the PE-S treaty. In my view, this dependability on comparable resident enterprise, is inconsistent with 42 $10 (Tax levied by State PE before to any relief) – $10 (Relief under Article 24(3) of the R-PE treaty since, comparable resident enterprise in State PE would also be entitled to same relief under the PE-S treaty) = $0 (Overall outcome of tax burden in State PE).
43 See supra note 37.
44 See supra note 37, paragraph 39.
the principle of legal certainty. The outcome of law should be certain and not conditional or dependent upon whether a comparable resident enterprise in the PE State is or is not eligible for relief under the PE-S treaty for a resident of State R to claim the benefit of Article 24(3) of the R-PE treaty.
Further, to be eligible for relief under the PE-S treaty, a comparable resident enterprise must fulfill these three basic conditions:46“(i) it must be a resident of State PE for the purposes of
PE-S treaty, (ii) it must derive income from State S to which the PE-S treaty applies and (iii) it must be eligible for relief provision under the PE-S treaty.” There could arise a situation
where, State S is prevented from imposing any taxation on the income under the provision of the PE-S treaty if that income is derived by a resident of State PE.47
Thus, in this situation State PE will not be obliged to provide any double tax relief to its own residents under the PE-S treaty as there is no incidence of double taxation. If this be the case, then under Article 24(3) of the R-PE treaty in a PE triangular case, the resident of State R will also not be eligible for any relief as the comparable resident enterprise itself is not eligible for any relief, leading to unrelieved juridical double taxation.48
b) The outcome from (a) above continues to persist even when State PE provides a domestic exemption for a foreign source income (say, interest income) to its own residents. In this case, State PE would not be obliged to provide any relief under the PE-S treaty due to lack of domestic tax base on foreign income.49 Consequently, due to the domestic exemption
of income in State PE, a resident of State R in a PE triangular case would not be entitled to any relief under Article 24(3) of the R-PE treaty as the comparable resident enterprise in State PE would not be eligible for the same under the PE-S treaty.
c) Application of Article 24(3) under the PE-S treaty when the comparable resident enterprise is an individual or a company does not raise issues with regards to the applicability 46 E. Fett, Chapter 4: The PE State and the Non-Discrimination Principle in Triangular Cases -The application of Bilateral Income Tax Treaties in Multilateral Situations (IBFD 2014), Online Books IBFD, Section 4.3.3.2.
47 Ibid, foot note 259.
48 See supra note 46.
49 Assume that, the method of relief adopted by the State PE for eliminating double taxation under the PE-S treaty is the credit method. Since, income is domestically exempt in State PE, the domestic taxes levied on the foreign source income would be NIL and State PE would not be obliged to provide any credit for the taxes levied by the source State. Also see supra note. 25.
of the PE-S treaty. However, applicability of PE-S treaty gets complex when the comparable resident enterprise is a partnership which is transparent for tax purposes, as they are not eligible for treaty benefits because of not satisfying the criteria of residence.50 This can be
illustrated with the help of an example:51
Assume a PE belonging to a transparent partnership (formed in State R) is compared, for the purposes of Article 24(3), to a similar transparent partnership which is formed in the PE State but has all its partner’s resident outside the PE State. In such a situation, the non-residents partners will be eligible to claim the treaty benefits in their respective State of residence and the comparable enterprise to which PE is being compared would not be entitled to any relief under the PE-S treaty. Consequently, the resident in State R would not be entitled to any benefit from Article 24(3) of the R-PE treaty in a PE triangular case.
d) The outcome of Article 24(3) may also get distorted due to the presence of a LOB clause under the PE-S treaty. “An LOB clause restricts the availability of treaty benefits by
providing that such benefits are only available is certain conditions are satisfied.”52 In a PE
triangular case, if the comparable resident entity in State PE is not able to satisfy the conditions of LOB clause then it would not be eligible to claim any relief under the PE-S treaty. Consequently, no relief would be allowed to the resident in State R under Article 24(3) of the R-PE treaty.
ii) Continuity of Unrelieved Juridical Double Taxation:
Even in the case where State PE provides relief to the PE under Article 24(3) of the R-PE treaty, there could arise a situation where unrelieved juridical double taxation still exists. This can be illustrated with the same example mentioned in section 2 of Chapter I above, by making the following alterations:53 (i) State S now levies WHT at a rate of 15% instead of
10% on interest income under Article 11 of the R-S treaty, (ii) Under the PE-S treaty, State S could levy WHT at a rate of 10% on interest income derived by comparable resident enterprise of State PE and State PE adopts credit method for eliminating double taxation 50 Paragraph 5 of Commentary to Article 1 “Persons Covered” of the OECD MC.
51 See supra note 46, section 4.3.4.1.
52 Supra note 46, section 4.3.4.2.
under the PE-S treaty, (iii) The PE State imposes tax a rate of 20% on the profits attributable to the PE before providing any relief. The graphical representation of the same is as under: State R:
CIT @ 15% but exempts PE profits State PE:
Tax @ 20% on PE Profits in accordance with Article 7 of R-PE treaty
The overall outcome after incorporating the above alterations would be as follows:
Interest Income $100
Tax levied by State R (PE profits are exempt) — Tax levied by State PE (-) Relief under Article 24(3) of R-PE treaty $1054
Tax levied by State S under R-S treaty $15
Overall Tax Imposed in the PE triangular case on Interest Income $25 or 25% Highest applicable tax rate in each the three States involved (i.e. State PE) 20% Unrelieved Juridical Double Taxation $5 or 5% The problem of unrelieved juridical double taxation continues to exist as State PE is not obliged to provide a relief under Article 24(3) of the R-PE treaty more than what it would have provided to its own resident. The OECD also confirms this view by expressing that Article 24 “Non-Discrimination” is not intended to provide foreign nationals, non-residents, enterprise of other States with a tax treatment that is better than that of the nationals, residents or domestic enterprises owned or controlled by residents.55 Therefore, in the present example,
State PE will provide a credit to its residents only to the extent of 10% under the PE-S treaty and the resident of State R in a PE triangular case would be entitled to relief under Article 24(3) of the R-PE treaty to the same extent.
iii) Inconsistency in application of Article 24(3):
54 $20 (Tax levied by State PE before any relief) – $10 (Relief available under Article 24(3) of the R-PE treaty since, a hypothetical comparable resident enterprise in State PE would be entitled to relief only to the extent of 10% under the terms of PE-S treaty) = $10 (Overall outcome of tax burden in State PE).
55 See supra note 37, paragraph 3.
HO State S:
Interest payment $100 WHT under R-S treaty: 15%, under PE-S treaty: 10%
The OECD addresses that, the interpretation of the Article 24(3) has been applied differently among different States and not all States recognize the underlying principles of granting a tax credit under their domestic laws.56 The OECD further mentions that, States such as Ireland
and the United Kingdom does not grant credit under the Non-Discrimination article except in certain circumstances for example branches of foreign banks.57
G. Zhai also expresses the same view and mentions that, different States have interpreted the applicability of Article 24(3) differently and the practices adopted by them also vary considerably.58 G. Zhai further expresses that “even if some countries do think that they have
such obligation under this provision, the scope of the obligation gives rise to further disputes.”59
With the objective of bringing uniformity in the application of Article 24(3) among States, the OECD recommends an alternative version which reads as follows:
"When a permanent establishment in a Contracting State of an enterprise of the other Contracting State receives dividends or interest from a third State and the holding or debt-claim in respect of which the dividends or interest are paid is effectively connected with that permanent establishment, the first-mentioned State shall grant a tax credit in respect of the tax paid in the third State on the dividends or interest, as the case may be, by applying the rate of tax provided in the convention with respect to taxes on income and capital between the State of which the enterprise is a resident and the third State. However, the amount of the credit shall not exceed the amount that an enterprise that is a resident of the first-mentioned State can claim under that State's convention on income and capital with the third State." 60
Even with adoption of this alternative version of Article 24(3) by States, there could still arise a situation where unrelieved juridical double taxation exists as the amount of relief which the
56 See supra note 6, paragraph 30-34.
57 Ibid.
58 G. Zhai, Triangular Cases Involving Income Attribution to PE’s, 53 Tax Notes International 12, pp. 1105-1123 (2009), page no. 1106.
59 Ibid.
PE State is obliged to grant would not exceed the amount which a comparable resident enterprise in State PE would be entitled to and the same was seen in point (ii) of section 2.2 above.
2.3 Conclusion:
The OECD promotes the applicability of Article 24 “Non-Discrimination” as a solution to eliminate the problems arising in a PE triangular case61 but as can be seen above the
Non-Discrimination principle is encompassed with several issues and may not be as effective in solving PE triangular cases as claimed by the OECD. Article 24(3) of the OECD MC is incoherent and lacks conceptual structure.62 In my view, eliminating one segment of the PE
triangular case and converting it into a bilateral situation would be a more promising solution to solve the issues emerging under the PE triangular case, as will be seen below.
3. PE as a Separate Person and Residence Concept under Tax Treaties:
3.1 Introductory Remarks:
Majority of the DTAAs concluded are bilateral in nature having effect between the two contracting States63 and follows the principle of reciprocity i.e. interchanging of rights,
benefits, concessions or advantages with each other.64 Generally, DTAA concluded between
the contracting State are based on the OECD MC65 which follows the concept of ‘State of
Residence’ and ‘State of Source’.66
61 See supra note 6, paragraph 60.
62 K. van Raad, Non-discrimination in International Tax Law, Deventer: Kluwer (1986), page no. 255 and K. van Raad, “Non-Discrimination in Taxation of Cross-Border Income under the OECD Model and EC Treaty Rules – A Concise Comparison and Assessment”, in: A Tax Globalist (Amsterdam IBFD Publication, 2005), pp. 129-143, at page no. 129.
63 B. Kosters “Triangular Cases in Tax Treaties”, Asia-Pacific Tax Bulletin (2009), pp 372-377, page no. 372, Section 1.
64 O. Dorr, Kirsten Schmalenbach (eds), Vienna Convention on the Law of Treaties (Springer-Verlag Berlin Heidelberg 2011), page no. 437.
65 S. Yong, Triangular Treaty Cases: Putting Permanent Establishment in Their Proper Place, 63 Bulletin International Taxation. 3, pp 152-164 (2010), Journals IBFD, page no. 152, Section 1.
The OECD MC provides as a rule, the exclusive taxing rights to the State of residence67(i.e.
taxing world-wide income) and the resident State is also obliged to eliminate juridical double taxation for income that may get taxed in the State of source or situs with or without any limitation.68 The two main reasons why PE triangular case arise are (i) the bilateral nature of
tax treaties particularly categorizing the States into residence and source under OECD MC69,
as two more States can claim to be the State of source for a particular source of income70 (ii)
treating PE as source concept under the OECD MC.
Adding to the observation of Jack Sasseville,71 in my view, if bilateral nature of tax treaties
on one hand is the venom causing PE triangular cases then on the other hand it is also the anti-venom for eliminating the issues of a PE triangular case. By deleting one segment of the PE triangular case and re-converting it into a bilateral situation could alleviate the issues of PE triangular cases. One way this can be achieved is by treating PE as a separate person under tax treaties entitled to complete treaty benefits (like a separate legal entity) which would allow the direct application of the PE-S treaty. In other words, considering PE as a residence concept under tax treaties rather than a source concept. This can be illustrated as follows:
Continuing with the example mentioned in point (ii) of section 2.2 of Chapter II above and by making the following alterations (i) PE is treated as a separate person under all the DTAA involved and it satisfies the threshold for residence under Article 4 “Resident” (ii) State PE adopts the credit method for relieving double taxation, the graphical representation and overall outcome would be as follows:
State PE: CIT @ 20%
67 Ibid, paragraph 19 of introduction.
68 Ibid, paragraph 25 of introduction.
69 J. Sasseville, The Role of Tax Treaties in the 21st Century (2002), 56 Bulletin for International Taxation, page no.
246-247.
70 In the example mentioned in section 2 of Chapter I, State S levies WHT on interest income under the R-S treaty and State PE also levies tax on the profits attributable to the PE being interest income under the R-PE treaty. Thus, both State S and State PE claim to be the State of source for the same interest income.
71 See supra note 69.
State S:
Interest payment $100 WHT under PE-S treaty: 10%
Interest Income $100
Tax levied by State S under PE-S treaty $10 Tax levied by State PE before any credit under the PE-S treaty (x) $20 Relief under Article 23(B) of PE-S treaty (y) $1072
Total Tax imposed in State PE (x – y) $10
Unrelieved Juridical Double Taxation —
By treating PE as a separate person under tax treaties, State PE enters into the shoes of resident State and State S being the State of source is obliged to apply the provisions of PE-S treaty directly.73 State R would no more be able to claim taxing rights over the interest
income as PE is considered as a separate person under tax treaties entitled to complete treaty benefits and accordingly the R-S treaty would no longer be applicable in the present situation. Deleting this segment of State R converts the PE triangular structure into bilateral by allowing direct application of the PE-S treaty and as can be seen from above, eliminating juridical double taxation is more effective in a bilateral situation.74
R. Vann also supports the direct application of PE-S treaty in a PE triangular case and writes in relation to the Crown Forest Industries case75 as follows:
“It is not self-evident that the Canadian (source country) tax rate on royalties received by the US business (i.e. US PE) should be determined by the treaty between Canada and a country which very likely would collect no tax on the income (i.e. residence State), rather than the treaty with the country which would collect tax on
72 Credit available under Article 23B of the PE-S treaty would be lower of (i) foreign taxes paid (i.e. $10 WHT in State S), or (ii) domestic taxes levied on foreign income (i.e. $20 in State PE before any credit). Therefore, the entire WHT levied by State S would be allowed as a credit in State PE i.e. $10
73 See supra note 16 and 17.
74 See supra note 66.
75 CA: SCC, 22nd June 1995, Crown Forest Industries v. Canada, (1995) 2 S.C.R. 802, also available at Tax Treaty Case
the income and so can provide relief for the third-country tax.”76
(Emphasis Added)
The OECD recognizes that, the main reason for difficulty in the application of Article 24(3) “Non-Discrimination” is the actual nature of the PE, which is not a separate legal entity but only a part of an enterprise77 and had itself recommended the proposition of treating PE as a
resident in State PE on an equal footing with the enterprises of State PE as a solution to solve the issues of a PE triangular case.78 Therefore, it can be said that the proposition of treating
PE as separate person and residence concept under tax treaties and consequently allowing the direct application of PE-S treaty in a PE triangular case has not gone unnoticed by the OECD. However, the feasibility of this proposition is further assessed and analyzed in the next section.
3.2 Assessment and Analysis of the Proposed Recommendation:
i) Liability to tax on worldwide income:
Under the OECD MC, a person who is resident in one or both of the contracting State is eligible for claiming treaty benefits.79 The term resident of a contracting State is defined
under paragraph 1 of Article 4 of the OECD MC which reads as follows:80
“For the purposes of this Convention, the term "resident of a Contracting State" means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature (….) This term, however, does not include any person who is liable to tax in that
State in respect only of income from sources in that State or capital situated therein.” (Emphasis Added)
76 R. Vann, “Liable to Tax” and Company Residence under Tax Treaties in G. Maisto (ed.), Residence of Companies under Tax Treaties and EC Law, pp. 197-271 (IBFD 2006), Section 7.4.1.3. The words between the parenthesis are added by E. Fett, see, E. Fett, Chapter 5: Limitation of the Source State’s Taxing Rights in Triangular Cases – The Application of Bilateral Income Tax Treaties in Multilateral Situations, (IBFD 2014), Online Books IBFD, section 5.2.2.2.
77 See supra note 37, paragraph 39.
78 See supra note 6, paragraph 42-45.
79 See supra note 13.
One of the key criteria in determining whether a person is a resident of a State is ‘liability to tax’ under the laws of that State by reason of the various connecting factors. The term ‘liable to tax’ means a comprehensive or full liability to tax81 not only on the income having a source
in that State but also on foreign income. In other words, comprehensive tax liability on the worldwide income of the person under consideration. This can be confirmed by the last sentence of the above quoted paragraph and the Commentary to Article 4 “Resident” also mentions that, a person is not considered as a resident of a State, even though he is considered a resident according to the domestic law of the State, but is subject only to taxation limited to the income from sources in that State.82
Therefore, if a person satisfies the conditions of comprehensive tax liability in State due to one of the connecting factor (see above) then, that person would be considered a resident in that State. Whether PE can satisfy these conditions under the current framework of OECD MC will now be checked. Paragraph 1 of Article 5 “Permanent Establishment” of the OECD MC defines PE as follows:
“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.”
The OECD Commentary recognizes the presence of several limbs for satisfaction of the above definition which are as follows: the enterprise must have a place of business; the place of business must be fixed83 and the enterprise must carry on its business through this fixed
place.84 Once these conditions are satisfied and the existence of PE is confirmed in that State,
the next step is to ascertain the profits attributable to the PE due to its economic attachment with the PE State in accordance with Article 7 “Business Profits” of the OECD MC.
81 Paragraph 3 and 8 of Commentary to Article 4 “Resident” of the OECD MC.
82 Paragraph 8.1 of Commentary to Article 4 “Resident” of the OECD MC.
83 According to paragraph 5 of Commentary to Article 5 “Permanent Establishment” of the OECD MC, the requirement that a place of business is fixed means that there must be a link between the place of business and a specific geographical point.
Paragraph 1 of Article 7 “Business profits”85 allows the State where PE exists to levy taxation
not only on the profits attributable to the PE having a nexus in that State86 but also on income
from other States, provided they are effectively connected with the PE.87 Paragraph 2 of
Article 21 of the OECD MC88 confirms this observation as the State where PE exist is entitled
to tax income even from other States which are effectively connected with the PE. Accordingly, it can be said that a PE is subject to worldwide taxation in the State where they exist.89
However, the manner in which PE is taxed depends on the domestic law of the PE State for e.g. if the PE State adopts a worldwide system of taxation, then PE is taxed on all the income attributable to it (i.e. domestic as well as foreign sourced income).90 Even if the PE State
adopts a territorial system and taxes only the income sourced in the PE State, the Commentary to Article 4 “Residents” of the OECD MC mentions that, Article 4 is to be interpreted in the light of its object and purpose and excluding residents of States adopting territoriality system of taxation from the scope of Article 4 is clearly not intended.91 Thus,
even if PE State adopts territorial system, PE should still fall within the scope of Article 4. H. Hamaekers expresses the view that mere economic attachment to a particular State generally results in a tax liability only in relation to the income from local sources, whereas personal attachment (i.e. residence) generally triggers a tax liability based on the worldwide income.92 Adding to H. Hamaekers view above, E. Fett mentions, “the taxation of worldwide
income attributable to PE indicates that the existence of a PE establishes a connection to the PE State that may be considered somehow more of a “personal connection” than an economic one.”93 Thus, It can be said from the above that, the PE State can levy
comprehensive tax liability on the worldwide income of the PE due to more of a personal 85 See supra note 19.
86 The taxation imposed by the State where PE exists is usually on net basis on the profit attributable to the PE in accordance with the domestic laws of that State.
87 See supra note 65, page no. 155, section 3.4.2.
88 See supra note 20.
89 B. J. Arnold and J. Sasseville, “Source Rules for Taxing Business Profits under the tax Treaties” in B. J. Arnold, J. Sasseville and E. Zolt (eds.), The taxation of Business Profits under Tax Treaties, Toronto: Canadian Tax Foundation (2003), page 110.
90 Ibid.
91 Paragraph 8.3 of Commentary to Article 4 “Resident” of the OECD MC.
92 H. Hamaekers, The Source Principle versus the Residence Principle, 3 Revista dos Tribunais 1 (1993), pp 164-175.
93 E. Fett, Chapter 5: Limitation of the Source State’s Taxing Rights in Triangular Cases – The Application of Bilateral Income Tax Treaties in Multilateral Situations (IBFD 2014), Online Books IBFD, section 5.2.4.3.
attachment (being the connecting factor to induce taxation) rather than just as an economic attachment and be considered as a residence concept.
ii) Residence dominates source principle:
The OECD MC, as a rule, confers the exclusive right of taxation to the State of residence94
and the same can be observed under Article 12 “Royalties”, paragraph 1 of Article 21 “Other Income” and paragraph 5 of Article 13 of the OECD MC.95 The OECD MC, either restricts
the source State taxing rights either to a net basis on the profit attributable to the PE in the same manner in which it would tax its own residents or levy a limited percentage of WHT on the gross amount of the income in the absence of a PE.96 Conversely, the resident State is not
restricted by any such rules and is entitled to levy comprehensive tax liability on the worldwide income of its residents according to its own domestic laws.
In other words, the residence principle overrides the source principle in States which levy comprehensive tax liability on the worldwide income of its residents and the source of income is usually irrelevant for determining whether that income is taxable in the resident State.97 As seen in point (i) of section 3.2 above, the PE State is entitled to levy
comprehensive tax liability on the worldwide income of the PE. Therefore, where a PE exist, the PE State may levy tax on the income (whether domestic or foreign) which is effectively connected with the PE without giving regards to the various source taxing rules under the OECD MC displaying similarity to the residence principle.98
Further, the resident nature of the PE can also be seen from Paragraph 5 of Article 11 “Interest” of the OECD MC99 which provides that, interest shall be deemed to arise in a
contracting State where the payer is a resident, however, when the payer has a PE and the interest payment is effectively connected and borne by that PE then, interest shall be deemed to arise in the State where that PE exists. Thus, for the purposes of determining the source of 94 See supra note 67.
95 See Article 12 “Royalties”, Article 21(1) “Other Income” and Article 13(5) “Capital Gains” of the OECD MC respectively, for detailed text.
96 See supra note 93.
97 Ibid.
98 Ibid.
interest, PE is treated equivalent to the payment of interest being made by a resident person.100
iii) Comparative analysis:
The residence feature of the PE vis-a-vis an enterprise (i.e. a separate legal entity/subsidiary) is also evident under the OECD MC.101 Firstly, Article 24(3) “Non-Discrimination” of the
OECD MC requires the PE State to levy taxation on the PE which is not less favorably taxed in comparison with a comparable resident enterprise carrying on the same activities and has a legal structure which is similar to that of the enterprise to which the PE belongs.102 The
objective is to levy an equivalent amount of taxation on the PE in comparison with a resident enterprise in the PE State carrying on the same activities.103
The Commentary to Article 24(3) mentions that a PE must be: accorded the same taxing rights as resident enterprise to deduct expenses; accorded the same facilities with regards to depreciation and reserves as resident enterprises; accorded the option of carrying forward or backward losses as resident enterprises; applied the same rules applied to resident enterprises.104 This objective comparison between the PE and a resident enterprise of the PE
State under Article 24(3) of the OECD MC indicates that the PE concept is similar enough to be taxed on residence basis instead of a source basis.105
Secondly, as mentioned in point (i) of section 3.2 above, once it is determined that there exists a PE, the next step is to ascertain the profits attributable to the PE. According to Paragraph 2 of Article 7 “Business Profits” of the OECD MC106 the profits attributable to the
PE are the profits that it might be expected to make if it were a separate and independent 100 See supra note 93.
101 See discussion in section 2.1 of Chapter II.
102 See supra note 37.
103 R. Couzin, Corporate Residence and International Taxation (IBFD Publications 2002), section 1.1.
104 See supra note 37, paragraph 40.
105 See supra note 93.
106 Article 7(2) “Business Profits” of the OECD MC reads as follows: “For the purposes of this Article and Article [23A] [23B], the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 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 engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.”
enterprise engaged in the same or similar activity under the same or similar conditions. This is the so-called AOA approach [discussed in point (iv) below] which requires application of TP concepts to determine the profits attributable to a PE on the fiction that PE operates independently from the enterprise to which it belongs. In other words, a “separate entity approach”107 displaying residence feature.
iv) AOA:
As mentioned in point (iii) above, the AOA is to attribute profits to the PE that it might be expected to make as if it were a separate and independent enterprise engaged in same or similar activity under same or similar conditions. In other words, the basic approach in determining the profit attributable to a PE works on the fiction that PE is a separate enterprise and is independent from the rest of the enterprise of which it is a part i.e. a separate entity approach.108 However, it was observed that this approach of determining the profits
attributable to the PE under Article 7 “Business Profits” of the OECD MC was implemented inconsistently among different States.109
Accordingly, the OECD acknowledged this inconsistency and recognized the need to provide a greater certainty with respect to determination of the profit attributable to a PE and published in the year 2010, “Report on the Attribution of Profits to Permanent Establishment” (hereinafter referred as 2010 OECD report).110 The key highlight of the 2010 OECD report is
that it hypothesizes PE as a separate person independent from the remainder of the enterprise or a segment or segments of that enterprise.111
With the approach of attributing profits to the PE on a separate entity basis, E. Fett writes
“Under the AOA, PEs are treated much more like independent enterprises than they were previously, at least for profit attribution purposes. This can be expressed as an increase in
107 See supra note 93, section 5.2.5.
108 Paragraph 16 of Commentary to Article 7 “Business Profits” of the OECD MC.
109 2010 Report on the Attribution of Profits to Permanent Establishment (OECD 2010), Part I, Section A, paragraph 3.
110 Attributing profits to a PE has been subject to frequent developments by the OECD and has evolved over a period of time. Discussion on these developments would not form a part of point (iv) of section 3.2 and the focus would be primarily on the latest published 2010 report on attribution of profits to PE by the OECD.
the level of independence of PEs.”112 For determining the profits attributable to the PE, they
are treated exactly in the same manner as separate legal entity (company) and the legal nature between a PE and a subsidiary is considered irrelevant.113 This means that, PE can be treated
as owning assets independently from the enterprise as a whole and the dealings between the PE and other parts of the enterprise would be treated as contractual arrangements.114
Thus, the AOA displays more features of absolute independence for PE rather than restricted independence, since PE are treated exactly in the same manner as a company for attribution of profits.115 The legal differentiation between PE and a separate legal entity seems to have
been bridged with the AOA which indicates that, PE is considered as a separate person and more of a residence concept at least for the purposes of attributing profits.
v) Characteristic of companies vis-à-vis PE:
A company is a separate legal entity which is fictionally created by the law (i.e. upon satisfaction of certain requirement of the law) which is capable of entering into contracts, own assets or be subject to liabilities and has the ability to sue or be sued just like a natural person. For tax purposes, a company is considered as a separate person116 liable to tax on its
worldwide income in the State where it is incorporated/formed due to a connecting factor and is entitled to claim complete treaty benefits. On the other hand, PE is not treated as a separate person under tax treaties but is considered only a part of the enterprise to which it belongs and is not entitled to claim treaty benefits.
One of the main reasons why companies are entitled to claim treaty benefits is because of being considered as a separate person under tax treaties and are liable to tax due to a connecting factor with the resident State.117 This connecting factor can sometime be just a
112 See supra note 93, section 5.2.5.4.
113 K. Vogel, M. Engelschalk & M. Gorl, Klaus Vogel on Double Taxation Conventions: A Commentary to the OECD, UN and US Model Conventions for the Avoidance of Double Taxation on Income and Capital: With Particular Reference to German Treaty Practice, 3rd edition, page no. 428, m. no. 64.
114 P. Baker & R. Collier, General Report in The Attribution of Profits to Permanent Establishment, IFA Cahiers de Droit Fiscal International, volume 91b, (sdu Fiscale & Financiele Uitgevers 2006), page no. 36. See also, Paragraph 15 of Commentary to Article 7 “Business Profits” of the OECD MC.
115 See supra note 113.
116 See Article 3(1)(a) of the OECD MC.
mere formal requirement of the domestic law of the resident State for e.g. place of incorporation test which does not ensure any substantial connection with the resident State.118
If that be the case, then it could happen that a PE bears a stronger nexus with the State where it exists in comparison with a company which is just merely incorporated in that State upon satisfaction of certain requirement of the law.119
Companies are considered as a separate person under tax treaties but are sometimes given the option of being treated as opaque or fiscally transparent under the domestic laws of certain States. For e.g. US check the box rules gives the option to certain companies for tax purposes to be treated as fiscally transparent and be taxed on a flow-through basis i.e. the shareholders of the company would be liable to taxation instead of the company.120 Conversely there are
also situation where various other types of entities which would generally not be considered as companies from a legal perspective (e.g. partnerships) but are treated like a separate taxable entities just like a company for tax purposes.121
Applying this analogy, if companies are given the option of being treated as fiscally transparent and other forms of entity which are not companies but are treated as companies for tax purposes then, why shouldn’t PE be given the option of being considered as a separate person under tax treaties and be treated as a resident of the State where it exists? Further, the OECD MC defines companies as “any body corporate or any entity that is treated as a body
corporate for tax purposes.”122
W. Schon mentions that, “both PE and a subsidiary might act independently in their business
operation and both might function as an element of a highly integrated value chain”123 and on
the basis of discussion under section 3.2 till now, it can be seen that not only PE has many characteristic similar to that of a company but is taxed similar to a company/corporation. The legal difference between PE and company varies according to the domestic law of the States 118 See supra note 93, section 5.2.4.5.
119 See point (i) of section 3.2 where it was discussed that PE are also comprehensively liable to tax due to a connecting factor with the PE State and this connecting factor features more of a personal connection rather than just an economic connection.
120 See supra note 93, foot note 491.
121 W. Schon, International Tax Coordination for a Second-Best World (Part I), 1 World Tax Journal (2009), Journals IBFD, page no. 107.
122 See Article 3(1)(b) of the OECD MC.
under consideration. What is a considered as PE under the domestic law of one State may be considered as a separate taxable entity under the domestic law of another State and vice versa.124
Schon further mentions “if civil and corporate law do not draw a meaningful line between
these two legal form (i.e. incorporated and non-incorporated) for domestic tax purposes, why should international law consider it to be of any importance at all? Moreover, when domestic tax law widely varies in allocating taxpayer status to incorporated and other entities, including widespread elections for business, why should international tax follow suit?”125 Therefore, it could be said that a PE falls within the definition of a ‘company’ under
Article 3(1)(b) of the OECD MC as it taxed as a body corporate for tax purposes and accordingly could be considered as a separate person and residence concept under tax treaties.
3.3 Final Remarks:
Based on the discussion under points (i) – (v) of section 3.2 above, it is clear that a PE and company share various similar characteristics with each other and are also taxed on similar basis. Due to the similarities between PE (source concept) and company (residence concept) as well as similarities between PE and residence taxation under the domestic laws as well as tax treaties, E. Fett refers PE as somewhat a hybrid concept between residence and source.126
A PE and company are two sides of the same coin but due to the legal difference between the two under the current international tax framework i.e. PE do not have separate legal personality whereas companies are considered as separate legal person, has led to a differential tax treatment between the two. However, as mentioned in point (v) of section 3.2 above, the legal differentiation between a PE and a company differs from State to State and should not be considered as a factor for not entitling PE to avail treaty benefits. Thus, PE can potentially be treated as a separate person and residence concept under tax treaties and should be eligible for availing complete treaty benefits.
124 See supra note 121.
125 See supra note 121, page no 108. The words between the parenthesis are added by E. Fett, see supra note 93, section 5.2.4.4.
J. Wheeler proposed a new approach for determining who should be eligible to avail treaty benefits127 and in doing so supports the idea of allowing PE to avail complete treaty benefit.
Wheeler writes “the new approach could solve this problem specifically by recognizing the
tax liability of the enterprises in respect of its permanent establishment as a liability imposed on it in a taxpaying capacity distinct from the taxpaying capacity of the entity as a whole. The permanent establishment, in other words, be regarded as having a “treaty capacity” and therefore be capable of claiming the benefit of the treaties concluded by the State in which it is situated”128 Allowing PE to avail complete treaty benefits by expanding the scope of
Article 4 “Resident” of the OECD MC was also recommended in the Ruding Report (1992)129
(a report prepared in 1992 for the European Commission).
Therefore, treating PE as a separate person and residence concept under tax treaties would indeed be a solution to eliminate the issues emerging from a PE triangular case as seen in section 3.1 above. Further, treating PE as a separate person under tax treaties entitled for complete treaty benefits is not only supported by various academic scholars but would also prove to be a solution for some other cross-border issues particularly, in the domain of TP. This is discussed in the next section.
3.4 Multi-Edged solution:
i) Aligning TP methodologies:
“Transfer prices are the prices at which an enterprise transfers physical goods and
intangible property or provides services to associated enterprise.”130 TP applies not only for
transactions undertaken between associated enterprises (companies) but also for dealings between the PE and other parts of the enterprise.131 Currently, Article 9 “Associated
127 For an overview, see J.C. Wheeler, The Missing Key Stone of Income Tax Treaties, 3 World Tax Journal. 2, Journals IBFD.
128 Ibid, page 286.
129 See Ruding et al., Report of the Committee of Independent Experts on Company Taxation, pp 11-16 (Office for the Official Publications of the European Communities 1992).
130 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD 2010), Preface, paragraph 11.
Enterprises” of the OECD MC132 deals with ensuring that the transactions between associated
enterprises are at arm’s length by allowing the contracting States of the associated enterprises to adjust their profits in accordance with the arm’s length principle.133 However, for dealings
between a PE and other parts of the enterprise the same rights have been assigned to the contracting States but under Article 7 “Business Profits” of the OECD MC.134
The OECD MC endorses the principle of ALP whether it be a transaction/dealing between an associated enterprise or a PE and other part of the enterprise, respectively. With the objective of bringing certainty among various States with regards to the methodology adopted while determining ALP, the OECD published in the year 2010, “OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration (2010)”, (hereinafter referred as ‘TP guidelines’). The TP guidelines are generally referred and applied for determining ALP for transactions between associated enterprises, whereas, the 2010 OECD report is applied for determining ALP for dealings between PE and other part of the enterprises.135
The methodology of 2010 OECD report with regards to attribution of profit to a PE lies in a two-step analysis: first, a functional and factual analysis is conducted by hypothesizing the PE and the remainder of the enterprise as if they were associated enterprise, each undertaking functions, owning or using assets, assuming risks and entering in dealing with each other and with unrelated enterprises. The report further mentions that, the functional and factual analysis preforms the same role in the comparability analysis in a PE context under Article 7 as it does in situations involving associated enterprises under Article 9 “Associated Enterprises” of the OECD MC.136 Second, the remuneration of any dealings between the
hypothesized enterprises is determined by analogy to Article 9 (i.e. referring to the TP
132 Article 9(1) of the OECD MC reads as follows: “Where (a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or (b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”
133 Paragraph 1-2 of Commentary to Article 9 “Associated Enterprises” of the OECD MC.
134 Paragraph 24 of Commentary to Article 7 “Business Profits” of the OECD MC.
135 see point (iv) of section 3.2.
