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BEPS: revised PE proposals

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Despite some strong opposition being voiced in the consultation process, the OECD is pressing ahead with its agenda of expanding the BEPS permanent establishment (PE) concept. The revised PE proposals contain a number of specific points that will clearly have an impact on existing structures and arrangements. These result particularly from two areas of change: a materially widened dependent agent rule (and a narrowed independent agent exemption); and the narrowing of the specific activity PE exemptions, coupled with the introduction of a tougher anti-fragmentation rule. In practice, these changes are also likely to fuel tax authority interest in the existing PE rules.

The OECD has now released its revised proposals for changes to the threshold permanent establishment (PE) rule in art 5 of the OECD Model. The new discussion draft of 15 May 2015 (see updates the earlier OECD proposals from October 2014, moving from possible options to single recommendations on each of the various areas where change is proposed.

Dependent agent rule 

The most important change relates to the tightening of the dependent agent rule in art 5(5) of the OECD Model to deal with commissionaire and similar arrangements. From a policy perspective, the OECD has made it clear that where the activities of an intermediary (i.e. agent) are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, that foreign enterprise should be considered to have a taxable nexus in that country, unless the intermediary is performing these activities in the course of an independent business.

Previously, four options had been proposed, which have now been narrowed to a single proposal. This new test reflects a greater focus on the substance of the role of the agent. It applies where an agent acting on behalf of an enterprise habitually ‘concludes contracts, or negotiates the material elements of contracts’ that:

  • are in the name of that enterprise;
  • broadly, relate to property owned by that enterprise; or
  • are for the provision of services by that enterprise.

This dependent agent rule does not apply if the agent concerned qualifies as an ‘independent agent’ under the terms of art 5(6). In October 2014, the introduction of a significant restriction to the terms of that exemption was proposed; namely, to bar an agent which acts exclusively or almost exclusively for one person or associated enterprises from being an independent agent. The discussion draft notes that there have been strong objections to the proposed narrowing of the independent agent exception in art 5(6) of the OECD Model; nevertheless, it has been decided to proceed with this proposal, though with two modifications. First, the concept of ‘associated enterprises’, which has to date been used in the expression of the independent agent test, is to be replaced by a narrower connected parties concept; broadly, this is based on the vote and value of a company’s shares or on de facto control. Second, it is now made clear that the test in art 5(6) should not automatically exclude an unrelated agent from acting exclusively for one enterprise (though the bar on independent agent status remains as it was for an agent acting exclusively or almost exclusively for connected parties). This modification is clearly good news and entirely sensible in the case of unrelated principals, though the benefits of the modified connected party test seem diluted by the inclusion of the more subjective test of control which is based on ‘all the relevant facts and circumstances’.

Recognising that new concepts are contained in this test (e.g. ‘negotiates the material elements of contracts’), the OECD paper also includes proposed text to revamp the relevant commentary in the OECD Model on the dependent and independent agent tests. This explains that a contract can be concluded without any active negotiation, for example, where an agent accepts an offer by a third party to enter into a standard contract.

It also clarifies that the meaning of the phrase ‘material elements of contracts’ may vary depending on the nature of the contract concerned, but would typically include the determination of the parties between which the contract will be concluded, as well as the price, nature and quantity of the goods or services to which the contract applies. It states that the phrase must be interpreted in the light of the object and purpose of the dependent agent test; and that the test applies to a person who acts as the salesforce of the enterprise and, in doing so, makes or accepts contractual offers, even if standard contracts are used for that purpose.

These points are very likely to impact upon existing business processes and will need to be further explored; for example, what range of activities will constitute ‘accepting’ a contract? It will also be important to assess the interaction of online activity and local physical activity by agents to understand where the line is drawn. The revised dependent agent test is designed to apply to:

  • contracts that create rights and obligations that are legally enforceable between the enterprise on behalf on which the person is acting and the third parties with which these contracts are concluded; and
  • contracts that create obligations that will effectively be performed by the enterprise rather than by the person contractually obliged to do so (e.g. commissionaire arrangements).

It has also been clarified that these PE changes are not intended to address BEPS concerns relating to the transfer of risks between related parties through low risk distributor arrangements, as this issue is best addressed through the BEPS work on action 9 (risk and capital). Such distributors should not be caught by the revised tests discussed above because, assuming that title in any goods passes to the distributor in the relevant arrangements, they are selling their own property and are not acting on behalf of another enterprise.

Specific activity exemptions

There has been extensive discussion of – and various options proposed for – the specific activity exemptions contained in art 5(4) of the OECD Model, according to which a PE is deemed not to exist where a place of business is used solely for certain designated activities. Rejecting the alternative option of amending the terms of certain individual exemptions, it is now proposed to restrict all of the exemptions in art 5(4) to activities that are of a ‘preparatory or auxiliary’ character. Additional commentary is also proposed to clarify the meaning of that phrase.

The proposed commentary states that preparatory activity is generally undertaken in contemplation of what constitutes the essential and significant part of the activity of the enterprise as a whole; it therefore takes place during a relatively short period. An auxiliary activity, on the other hand, generally supports the essential and significant part of the activity of the enterprise as a whole, without being part of it. In the context of an online business, the proposed commentary also includes some fairly pointed comments on large warehouses used for storage and delivery, failing the preparatory or auxiliary test.

The October 2014 discussion draft also included some particularly controversial proposals to address the situation where activities are being fragmented between related parties. Though the vast majority of commentators expressed strong objections to the alternatives put forward, the OECD has nonetheless decided to proceed here too. The rule proposed is that the preparatory or auxiliary exemption of art 5(4) will not be available if, broadly speaking:

  • there is an existing PE in that state of the enterprise concerned or an affiliate; or
  • there is no such PE, but the overall activity resulting from the combination of the activities of those connected enterprises is not of a preparatory or auxiliary character.

However, for the rule to apply, it must be the case that the combined business activities represent ‘complementary functions that are part of a cohesive business operation’. Two examples are proposed for inclusion in the commentary to illustrate the operation of this rule.

Splitting up of contracts

The original proposals to address BEPS concerns included alternative measures to deal with the artificial splitting up of contracts to circumvent the 12 month ‘building site’ PE rule (which also covers installation projects) in art 5(3).

It is now proposed that the appropriate way to deal with the issue is to add an example in the commentary on the application of the principal purpose test (from the work on treaty abuse in action 6). The proposed example indicates that an attempt to split a 22 month construction project into two 11 month contracts involving related parties, where the arrangement is designed to exploit the terms of the 12 month exemption, will not be respected.

An optional automatic rule (which aggregates contracts for connected activities by related parties at the same site) is to be included in the commentary for states that wish to deal expressly with the issue.


The two options originally proposed for the specific expansion of the PE test in the insurance sector have now been dropped. It is not proposed to add a specific rule for this sector to the terms of art 5. For those in the insurance sector, this news will be welcome but is unlikely to be an end to the matter. In practice, it is likely to mean that those tax authorities which have concerns relating to cases where a large network of exclusive local agents is used to sell insurance for a foreign insurer will have to pursue them by other means; specifically, under the more general changes proposed for the tightening of the dependent agent rule.

Issues relating to the attribution of profits

The discussion draft acknowledges the need to provide additional guidance on the attribution of profits, particularly outside the financial sector, and to take account of other work in progress on intangibles, risk and capital. It is therefore proposed to continue work in this area after September 2015, but with a view to provide the necessary guidance by the end of 2016.

While it is clearly helpful for a more considered view to be applied in relation to the attribution issues, this means that a very important part of the overall PE package will now be invisible as the BEPS measures are finalised over the remainder of 2015. Real taxpayer concerns about a multitude of PEs being created in circumstances where there is no additional profit at stake, beyond that produced by existing transfer pricing methodologies, are therefore presumably left in limbo.

Next steps

Interested parties have a short window – up to 12 June 2015 – during which to send comments on what is now proposed. These new proposals are then to be discussed by the OECD’s Working Part 1 in late June, when they will be asked to finalise the changes to the OECD Model Treaty.