BEPS from a Private client perspective
Part II: Permanent Establishments
On 5 October 2015, the OECD released its final reports in connection with the Base Erosion and Profit Shifting (BEPS) Project.
Certain aspects of the BEPS project will have an impact on Irish individuals and business owners, privately held Irish corporations, and global families and their private wealth structures, including the following:
1. Accessing treaty benefits (e.g. no CGT protection, preferential withholding tax rules)
2. Denial of interest deductions, which will impact financial arrangements
3. Increased tax exposures
4. Additional reporting obligations/compliance burdens and costs
5. Increase of taxation audits and taxation under worldwide income systems and
6. More-effective, cross-border dispute resolution through improvement of the mutual agreement procedure.
In Part I of this three-part article on the impact of BEPS on private clients, we considered the changes being proposed to the transfer pricing rules under the BEPS project.
Part II of this article focuses on the changes being made to the rules on permanent establishments and the ‘trigger points’ that have the potential to create a foreign tax exposure for Irish Entrepreneurs with a presence in more than one country.
On 5 October 2015, ahead of the G20 Finance Ministers’ meeting in Lima on 8 October, the OECD Secretariat published 13 papers and an Explanatory Statement outlining consensus Actions under the Base Erosion and Profit Shifting (‘BEPS’) Project. These papers include and consolidate the first seven reports presented to and welcomed by the G20 Leaders at the Brisbane Summit in 2014. The output under each of the BEPS Actions is intended to form a comprehensive and cohesive approach to the international tax framework, including domestic law recommendations and international principles under the model tax treaty and transfer pricing guidelines. The recommendations are broadly classified as ‘minimum standard’, ‘best practice’ or ‘recommendations’ for governments to adopt. The G20/OECD and other governments will be continuing their work on some specific follow-up areas during 2016 and into 2017.
As part of the 2015 output, the OECD Secretariat issued a final report in relation to preventing the artificial avoidance of permanent establishment status (Action 7), which introduces model treaty changes. The report builds on proposals put forward in the G20/OECD’s discussion drafts from October 2014 and May 2015 and updates the definition of permanent establishment (taxable presence) in Article 5 of the OECD’s model tax treaty and associated commentary.
The final report makes wide-reaching changes to the existing threshold for creating a permanent establishment to tax the trading profits of a company in an overseas country. Groups may find that in the future some trading profits are to be taxed primarily in a different country from the one under the current rules. As anticipated, commissionnaires and other forms of undisclosed agency arrangements will create a permanent establishment of their principal. These and other arrangements will be determined by a new test of which party ‘habitually plays the principal role’ in generating sales or making purchases where the contracts are ‘routinely concluded without material modification’ by the contracting entity. (This is a significant improvement on the draft proposals as it focusses on one party taking the lead, rather than allowing for the actions of multiple parties to generate multiple claims over the taxing rights). The commentary to the model tax treaty (but not the treaty wording itself) contains a clear statement of the policy intention that buy-sell distributors, including limited risk distributors, should not create a permanent establishment of their principals (although the simultaneous holding of stock locally by a principal is likely to create a permanent establishment due to the anti-fragmentation rule).
Because of the potential impact on commercial trading arrangements, these changes remain a key area of concern for all businesses As a result, there will be additional compliance costs for businesses in determining areas of uncertainty. This may include, for example, by whom (and where) the principal role leading to the conclusion of contracts is played (particularly in relation to business travel by sales people).
The G20/OECD have agreed to provide further guidance, with appropriate time for analysis, on applying the principles for attributing profit to permanent establishments (as set out in the OECD’s 2010 Report on the Attribution of Profits to Permanent Establishments) to non-financial services businesses by mid-2017. It remains possible that there will be limited additional profit attributed to some of the newly-created permanent establishments, particularly where there are no ‘significant people functions’ in the local country.
The report notes that the changes it sets out are ‘prospective only’ and do not affect the interpretation of the former provisions of the OECD model tax treaty and treaties in which those provisions are included.
Impact on Irish entrepreneurs
The changes to the existing threshold for creating a foreign permanent establishment of an Irish privately owned company are potentially extremely far reaching. Given Ireland’s limited size and population, in order to achieve scale and significant growth in revenue and margins many Irish businesses will seek to engage with a larger market via leveraging sales opportunities in Northern Ireland and the wider UK region. As part of this evolution, often sales personnel will be recruited in those territories for the purposes of having a ‘face on the ground’ that can meet with prospective clients/customers and develop profitable business relationships. While historically this type of business model could be designed in such a way to limit foreign permanent establishment exposures arising, in a post-BEPS world achieving the same level of comfort from a tax risk point of view will be much more challenging.
What we are seeing in practice in response to the changes likely to become effective for 2017 and subsequent years is a desire to set up a ‘BEPS proof’ structure that will stand the course of time as foreign tax authorities around the world look to implement the changes to the permanent establishment rules. Ultimately, for a sales and marketing activity some examples of what this may involve include moving to a commission-on-sales type model or, taking the UK as an example, booking UK sales in a UK subsidiary with a royalty/fee back to Ireland for services or intangibles provided by Ireland for the purposes of growing the UK business.
The key message to take away from this second part of our three-part series of articles is that the rules for creating a taxable presence in foreign jurisdictions are changing and our recommendation is to consider your current business models and any potential permanent establishment risks attaching to same with a view to rectifying the position prior to 2017 when the new rules on when a permanent establishment can be treated as having been created will likely come into play.