The concept of permanent establishment (PE), the tax term for ‘branch’ will change as a result of the base erosion and profit shifting (BEPS) project. Additionally, in the UK, introduction from 2015 of the diverted profits tax (DPT) tackles instances where there is an ‘avoided PE’.
Changes to PE
DPT, at 25 per cent, is higher than the standard corporation tax rate. This seems designed to encourage companies to address properly whether they have a PE in the UK. In concept, the DPT seemed designed to tackle techniques used by some large groups to avoid a profitable company within the group being taxed in the UK on trading with UK customers. The changes to the definition of PE seem to share this aim, but they equally impact upon companies first entering new territories, making it harder for low levels of activity to avoid creating a taxable presence.
The G20 commissioned the OECD to conduct the BEPS review and the member states undertook in advance to implement certain outcomes - the PE one included - so whilst the changes recommended in the final report of October 2015 are not yet binding, they are authoritative on where we can expect to end up.
How agents can create a PE
A lot could be written on the changes, but for now we focus on the way local agents can create a local PE of a foreign company.
We are looking at the definition of PE as contained within Article 5 of the OECD Model Tax Convention on Income and Capital (Model Convention), along with the OECD’s commentary. The existing Model Convention has provisions related to agents of independent status and agents other than of independent status - (dependent agents).
Dependent agents would have created a PE in the past (assuming other basic conditions were also in satisfied) if they had and habitually exercised the authority to conclude contracts on behalf of the foreign company. In future there will be a PE if the agent plays a principle role leading to the conclusion of contracts that are routinely concluded without material modification by the foreign principle.
An independent agent such as a general commission agent would not have created a PE for the foreign principal if the agent transacted in the ordinary course of their business. In this instance the change for the future is in the dividing line as to when an agent is dependent, with the new guidance saying that it cannot be taken that an agent is independent purely because the parties are not connected, and indeed independent status is less likely if the agent’s activities are performed wholly or almost wholly on behalf of one enterprise. This implies that a company engaging a sales rep working through their own personal service company could be at risk from having a local PE.
The outcome is that companies currently engaging local sales reps, say on a cost plus basis, may have to re-evaluate the roles of the companies in the supply chain. The new guidance seems to prefer local distributor models over local sales-service models. This is consistent with the OECD reports on the digital economy and intangibles, which tend towards the view that the recognition of profits should be aligned with where the value is derived – where the customer is - rather than where the intangible is owned.
DPT gives a further reason to take care. It sets out to attack instances when transactions lacking in economic substance divert profits away from the UK, and instances when a PE in the UK is avoided. Superficially, it could seem that the former relates to groups that have a presence in the UK and the latter relates to groups that have set out to avoid having a UK taxable presence. The Model Convention provides that the fact that a company in a group is controlled by a foreign company does not constitute either company as a PE of the other. However, in the past this would not have prevented a subsidiary becoming a dependent agent PE of the parent, if their links went beyond being purely a matter of control, such that the subsidiary concluded contracts on behalf of a parent – as seen for example in commissionaire structures. Experience shows that in the past tax authorities seem to have shied away from taking the point, often instead addressing the profitability of the subsidiary under a transfer pricing review. However, DPT gives HMRC the tools to tackle such instances, and it should be noted that these may apply even when the foreign parent is in a high tax jurisdiction.
Do you need to take action?
Groups may find that that it is no longer possible for their subsidiaries to carry out certain functions without accruing additional tax risks. A reorganisation of the internal supply chain, the functions carried out and the prices applied may be necessary.