• PE’s Definitions
    UN and OECD Model Conventions are (still) Fraternal Twins

    By Lorenzo Savastano

    08-06-2018

    Last 18 May 2018 United Nations released the long-awaited 2017 update to the Model Double Taxation Convention between Developed and Developing Countries, during a UN Economic and Social Council meeting in New York.

    The new treaty and commentary update the UN’s 2011 model tax treaty, reflecting changes approved in April 2017 by the UN Committee of Experts on International Cooperation in Tax Matters. That being said, it is now feasible to make a comparison between the article 5 of the OECD Model Convention, deeply shaped by the well-known BEPS project (i.e. Base Erosion and Profit Shifting plan), and the new definition of permanent establishment (PE) outlined by UN committee of experts’ work.

    The magnitude of Permanent Establishment definition

    First of all, it is important to highlight that under most tax treaties, business profits derived by an enterprise are taxable exclusively by the State of residence unless the enterprise carries on business in the other State (i.e., the source State) through a permanent establishment (PE) situated therein. This international tax law’s cornerstone is called the “nexus” rule (e.g., Articles 7 of the OECD and United Nations (UN) Model Tax Conventions), as it identifies the profits that are taxable by a country by reference to their relationship to a PE.

    On a further level of analysis, the nexus rule underpinned by a PE presence is based on the “origin of wealth”, which is a principle enunciated by a group of economists in a 1923 report, mandated by the League of Nations. In essence, the mentioned report rejected the argument that income should generally be taxed exclusively in the State of residence, and contended that taxation should be founded on a doctrine of economic allegiance: “whose purpose was to weigh the various contributions made by different states to the production and enjoyment of income”. Therefore, the determination of the jurisdiction with taxing rights depends on a nexus rule that aims at the substance of a business activity and attributes the primary right to tax to the Country in which this income-producing activity physically takes place. Ultimately, this mechanism has specific exceptions where separate distributive rules apply (e.g., Articles 6, 10, 11, 12, 13, or 17 of the OECD and UN Model Tax Convention).

    The concept of permanent establishment is found in the early model conventions including the 1928 model conventions of the League of Nations. The new UN Model, as well as OECD Model post-BEPS, reaffirms the concept but overhauls the definition for the sake of making PE status consistent with the dramatic changes of modern economy, beginning from the digitalization of traditional business model (in this regard, see the recent OECD interim report concerning Tax Challenges Arising from Digitalization).

    Defining PE: UN vs. OECD Model Convention

    Since the mandate of the UN subcommittee included taking into account OECD Model developments, article 5 of the United Nations Model Convention is largely based on Article 5 of the OECD Model Tax Convention, however it contains a number of significant differences, which are made more apparent by the new wording. Chiefly, it is possible to lay down at least the following hallmarks of the UN Model:

    • there is a 6 months’ test for a building or construction site constituting a permanent establishment, rather than the 12 months’ test under the OECD Model, and it expressly extends to assembly projects, as well as supervisory activities in connection with building sites and construction or installation projects (paragraph 3 of the UN Model article);
    • the furnishing of services by an enterprise through employees or other personnel results in a permanent establishment where such activities continue for a total of 6 months in a twelve-month period (paragraph 3(b)). By the same token, another important aspect of the 2017 UN update is that Article 5(3)(b), dealing with the creation of a permanent establishment through the furnishing of services, deletes the words “for the same or a connected project”;
    • in the paragraph 4 list of what is regarded not to constitute a permanent establishment (often referred to as the list of “preparatory and auxiliary activities”) “delivery” is not mentioned in the UN Model, but is mentioned in the OECD Model. Therefore, a delivery activity might result in a permanent establishment under the UN Model, without doing so under the OECD Model. It is relevant to note that the deletion of the word “delivery” reflects the majority view of the Committee that a “warehouse” used for that purpose should, if at least the requirements of paragraph 1 are met, be a permanent establishment. However, a 1997 study revealed that almost 75 per cent of developing countries’ tax treaties included the “delivery of goods” in the list of exceptions in paragraph 4 (a) and (b). Nevertheless, some countries regard the omission of the expression in the UN Model as an important point of departure from the OECD Model, believing that a stock of goods for prompt delivery facilitates sales of the product and thereby the earning of profit in the host country;
    • the actions of a “dependent agent” may constitute a permanent establishment, even without having and habitually exercising the authority to conclude contracts in the name of the enterprise, where that person habitually maintains a stock of goods or merchandise and regularly makes deliveries from the stock (paragraph 5 (b)). With the addition of paragraph 5(b), relating to the maintenance of a stock of goods, this paragraph is broader in scope than paragraph 5 of the OECD Model. Some developing countries believe that a narrow formula might encourage an agent who was in fact dependent to represent himself as acting on his own behalf. The UN Group of Experts noted, however, that if sales-related activities (e.g., advertising or promotion) were also conducted in that State on behalf of the resident (whether or not by the enterprise itself or by its dependent agents) and have contributed to the sale of such goods or merchandise, a permanent establishment may exist. Likewise, there is a prominent special provision specifying when a permanent establishment is created in the case of an insurance company (namely when it collects premiums in the territory of a Contracting State other than the State of residence or insures risks situated therein through a person). Consequently, a permanent establishment is more likely to exist under the UN Model approach (paragraph 6) than in OECD Model, where the insurance business’ cases are mentioned only in the Commentary;
    • an independent agent acting as such will usually not create a PE for the enterprise making use of the agent, because such an agent is effectively operating their own business providing a service.

    The UN Model indicates that such an agent devoting all or nearly all their time to a particular client and not dealing with the client on an arm’s length basis is not treated as having the necessary independence (paragraph 7). It is highly significant to stress the fact that the revised UN version makes clear that in order to automatically consider an agent as not being of “an independent status”, the essential criterion is the absence of the arm’s length relationship, irrespective of the effective number of enterprises the independent agent acts for. This formula is slightly different from the OECD Model Convention, where a person is deemed to be a PE if it acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related (see art. 5, par. 6 OECD Model).

    Basic rule: further differences in the Commentary

    In conclusion, further relevant differences between the two tax Model conventions in question, are included in the Commentary on Article 5, which represents a combination of the 2014 and 2017 OECD commentary. As a result, several aspects of the 2017 OECD commentary are not transposed in its UN “pendant”, in particular with regard to the shaping of the so-called basic rule, as per art. 5 par. 1.

    In this regard, an example is the OECD Model’s provision that underlines the importance a flexible approach when it comes to evaluate if a business model constitutes a PE. On that point, the OECD commentary affirms that “the facts and arrangements applicable at one point in time may no longer be relevant after a change in the way that the business activities are carried on in a given State” (see par. 8).

    Furthermore, UN Commentary lacks the discussion of whether an employee’s home office can be an Article 5(1) permanent establishment of the employer that should not lead to the automatic conclusion that that location is “at the disposal” of that enterprise simply because an individual who works for the enterprise (par. 18 of OECD Commentary) uses that location. Besides, the new “principles” for the “at the disposal” test are absent in the UN Model Convention.

    In conclusion, the new version of UN Model Convention adds new differences to old ones in comparison to its OECD’s yardstick. Just like two fraternal twins that, as time goes by, exacerbate their own characteristics but keep sharing the same blood.

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  • The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.

Lorenzo Savastano

Lorenzo Savastano is an Italian police officer belonging to Guardia di Finanza, a highly specialised military Corps committed in fighting economic and financial crimes, both on national and international level. He obtained two master’s degrees with honors, respectively in Law and in Economic and Financial Security. In addition, he attended several courses of advanced studies in International and Corporate Tax Law as well as in Tax crimes investigations. As aggressive tax planning and financial law enforcement specialist, he currently deals with corporate illicit activities and white collar crimes investigation.

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