November 18, 2015

Tax Alert: G20 Leaders Approve OECD Proposals for Comprehensive Global Reform of the International Tax System, Including Redefinition of “Permanent Establishment”

Measures Will Impact Financial Services, Investment Fund, Aviation Leasing and Other Sectors

G20 finance ministers last week finally approved the wide-ranging “BEPS” reforms to the international tax system. The measures include a proposed new OECD treaty definition of “Permanent Establishment” under which the mere negotiation of contracts could create a taxable permanent establishment. The changes are anticipated to affect the tax affairs of large numbers of multinational businesses, including financial services firms, the investment fund sector (for example, private equity and debt lending funds) and certain specialist industries such as aircraft leasing operators.


The BEPS Project was launched by the OECD and G20 in 2013 to tackle “base erosion and profit shifting”, i.e., tax planning strategies that shift profits of multinational enterprises from high-tax jurisdictions to low-tax jurisdictions. BEPS is made up of 15 Action Points ranging from the tax treatment of digital businesses to transfer pricing: BEPS Action 7 (the subject of this alert) concerns the creation of permanent establishments. Specifically, Action 7 seeks to reduce significantly the circumstances under which multinational businesses can avoid the creation of a permanent establishment in foreign tax-treaty jurisdictions in which they operate. In essence, under Action 7, taxation of multinational businesses in foreign jurisdictions will be significantly increased, unless businesses restructure procedures or operations.

Presently, under OECD model treaty provisions (and a number of national taxation regimes, for example, the United Kingdom) a permanent establishment arises in a particular jurisdiction if a nonresident company has either a fixed place of business there or an agent with authority to “conclude contracts” on its behalf in that jurisdiction (generally referred to as an “agency permanent establishment”), unless, broadly speaking, that agent is legally and economically independent of the nonresident company.

Many international businesses, including financial services firms, private equity funds and other investment funds (for example, debt lending and aircraft leasing funds) have structured their affairs such that a local affiliate or investment management entity in a different jurisdiction (the “agent”) is not considered to be “concluding” relevant contracts, notwithstanding extensive participation in the contract negotiations by the local affiliate or investment management professionals. Under existing double-tax treaties (and those jurisdictions that have adopted the OECD model into their national tax regimes), this is achieved by ensuring, broadly, that final approval concerning the conclusion of contracts is performed outside the local jurisdiction in which the agent operates—for example, by the board or investment committee located in a different country. Accordingly, if structured correctly, substantial negotiations could often be conducted in the jurisdiction of the affiliate or management entity without creating a permanent establishment because no contracts were formally concluded in that jurisdiction.

What Is Changing?

Under BEPS Action 7, the mere negotiation of contracts can now create a taxable permanent establishment. Specifically, Action 7 will amend the treaty concept of “agency” permanent establishment such that a permanent establishment will arise if the agent is “acting in a Contracting State on behalf of an enterprise and […] habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise […]”.

Thus, where, for example, (i) a financial institution hires an affiliate in another jurisdiction to advise a client based in the ‘home’ jurisdiction of the financial institution and the affiliate is essential in arranging an investment by the client; (ii) an offshore private equity debt fund, while maintaining overall responsibility for lending decisions, contracts with a fund manager in an onshore jurisdiction to source deals and negotiate the terms of loans on behalf of the fund; or (iii) an airline seeks to lease an aircraft from a foreign lessor, and the foreign lessor conducts the negotiations in the country in which the airline is based, there would be a significant risk of creation of a permanent establishment. The new test, therefore, will require a large number of businesses to modify their international operations to avoid this result. (It should be noted that while the present position of the United States is that it will not adopt the BEPS proposals, the foregoing is already a concern for businesses seeking to avoid a permanent establishment in the United States. Specifically, existing U.S. case law, as well as positions enunciated by the U.S. Internal Revenue Service, support attribution of activities of U.S. agents to non-U.S. persons.)

What Is the Expected Impact of BEPS Action 7?[1]

It is anticipated that the new provisions will require multinational businesses either to accept the existence of a permanent establishment, or where commercially feasible, change the way in which relevant entities interact with each other. The latter will almost invariably involve adherence to guidelines that will be significantly more restrictive than those presently used to avoid the creation of a permanent establishment.

It should be noted that the existing permanent establishment carve-out for independent agents is kept under Action 7; however its ambit is significantly curtailed. Under the new test, a person acting “exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related” will no longer be treated as an independent agent. Preparatory or auxiliary activities will continue to be excluded from the definition of permanent establishment; however, the scope of these activities is reduced under Action 7.

When and How Will the Proposals Be Implemented?

The proposals call for changing the permanent establishment concept in double-tax treaties around the world. This will require amendment of such treaties. In light of the large number of global tax treaties, individual negotiation and amendment is simply not feasible. Therefore, amendments to the permanent establishment threshold are anticipated to be effected through the use of a “multilateral instrument”, expected to come into force in 2016 or 2017. Under this “multilateral instrument”, all tax treaties between the countries that sign the instrument would immediately be amended.

Whilst the multilateral instrument will allow widespread implementation of BEPS and thus provides a sensible way forward, it is not a panacea for all ills. First, some countries, including, as noted, the United States, have not accepted the BEPS proposals and will not sign up for the multinational instrument.[2] Treaties with such countries will, therefore, not be amended. It is not yet clear how the resulting split of jurisdictions and treaty models will play out in practice. Second, some countries may decide only to implement certain of the BEPS proposals, and the multilateral instrument would, therefore, presumably have to allow this. Again, the implications are not known, including whether this will be an incentive for some jurisdictions to cherry pick provisions. Third, many countries have a slow ratification process for treaties and related instruments, which could draw out the approval process.

Accordingly, whilst there have been indications that a multilateral instrument could be finalised and ready for countries to sign as early as the end of 2016, it is likely that many treaties will not be amended until sometime after that. It is therefore expected that countries that wish to take earlier action will put in place unilateral measures under their own domestic law. One such example would be the UK’s controversial “diverted profits tax”, ushered in in 2014 in response to the low levels of corporation tax paid by a number of certain corporations in the United KingdomK and that, among other things, taxes non-UK corporations (in particular, technology companies) at punitive rates where profit shifting through the avoidance of a UK permanent establishment is suspected.

What Should Businesses Do?

While the proposals will not come into force until late 2016 at the earliest, it would be advisable for multinational businesses, including investment funds, to assess early on whether the proposals are likely to affect them. If so, a time horizon for remedial measures should be considered and relevant jurisdictions be monitored—both to track implementation of BEPS and to establish whether individual jurisdictions may follow the United Kingdom in taking interim measures. Where existing operating procedures will cause the creation of a permanent establishment and local taxation under new BEPS Action 7, a time frame for transition should be considered so as to make any necessary operational adjustments in a timely manner.

Kaye Scholer will continue to monitor the situation and provide further updates.

[1] While this alert focuses on Action 7, it should be noted that other BEPS Actions will also impact the investment management and finance sector. For example, Action 4 on interest payments, and, in particular, Action 11 on treaty abuse, may require rethinking of certain tax structures used by private equity funds or aircraft lessors, among others.

[2] Although the United States has agreed to participate in the multilateral instrument discussions particularly for the purpose of being involved with discussions regarding mandatory binding arbitration, to date, as noted above, the US government has not indicated that it has any plans to implement or adopt any BEPS measures through the multilateral instrument. As it relates to the permanent establishment provision of the BEPS proposals, there is a view that certain aspects of the provisions are not in the best interest of US-based multinationals. Nevertheless, the US Treasury recently released updated drafts to the US Model Tax Convention on Income, (the US Model), which serves as a starting point for the US Treasury’s treaty negotiations. Included in the updated US Model is a proposed rule addressing so-called “exempt permanent establishments” that would deny treaty benefits in certain situations in which income would otherwise remain untaxed.

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