Tax Treaties Business Profits (2013).ppt

7/27/2019 Tax Treaties Business Profits (2013).ppt

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Mongolia: Improving Capacity in

International Tax Enforcement

Topic Three: Business Profits

Sydney Law School

Michael Dirkis


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Scope of this session

The purpose of the session is to first explorethe a key jurisdictional attachment rule under

tax treaties, the concept of permanentestablishment (PE) (Art 5)

The balance of the session will be exploringthe:

Business Profits Article (Art 7)

Associated enterprise (Art 9).Arts 7 & 9 both deal with same issue thedivision of business profits between separatebusiness units within a single economic entity.


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Scope of this session [2]

Income derived by a resident fromindependent professional services is dealt with

under Art 7 in post -2003 Australian treaties. In

pre-2003 treaties it is dealt with under the

former Art 14 of the OECD Model.

As Art 14 also still exists in the UN Model, our

examination will also explore Art 14.


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1. Concept of PE

Most cross

border transactions do not involvethe establishment of a subsidiary company or abranch office in a foreign country. They involveeither cross border sales, without any presence inthe foreign state, or investment in assets in thestate (eg shares).A PE arises where there is sufficient presence, asdetermined by the tax treaty, in a state where thebusiness activity is conducted. PEs include:

bank branchesindependent professional service providers suchas engineers & architectspossibly e-commerce activities


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Role of PEs in tax treaties

The PE concept serves three functions in taxtreaties:

a jurisdictional threshold test (sufficientpresence must exist before a country can taxbusiness profits derived therein (underprincipally Art 7))

a source rule (ascribes the source of income to

the country in which the activity is undertaken)a quasi residence rule (as sufficient presencemeans that the foreign enterprise will be taxed

as a resident on its business profits)


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Differences between UN & OECD model

The UN Model:Art 5(3)(a) creates services permanentestablishment which deems a PE if a non-resident enterprise furnishes services in the

source country for more than 183 days in any 12months in respect of the same or connectedproject).

the time periods are shorter (eg building projectonly 6 months under Art 5(3)(a) of UN Model,while 12 months under Art 5(3) of the OECDModel).


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Differences between UN & OECD model

Delivery operations can constitute a PE inthemselves as they are not listed in theexclusions in Art 5(4)

A dependent agent can arise if the agentmaintains stock and regularly makes deliverieseven where contracts are not concluded (Art5(5)(b))

A deemed PE can be created in respect ofinsurance where the premiums are collected ina country or the risks insured are situated there(Art 5(6))


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Definition of a PE [1]

A PEis defined in Art 5(1) as being a fixed placeof business through which the business of an

enterprise is wholly or partly carried on.Enterprise is defined in Art 3(1)(c) as applyingto the carrying on of any business.OECD Commentary on Art 3(1)(c) states thequestion whether an activity is performed within anenterprise or is deemed to constitute in itself anenterprise has always been interpreted accordingto the provisions of the domestic laws of theContracting States. No definition, properlyspeaking, of the term enterprise has thereforebeen attempted in this Article. (para 4)


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Businessis defined in Art 3(1)(h) to includethe performance of professional services &

other activities of an independent character.

Thus, under Art 5(1) for a PE to exist:there must be a place of business;

the place of business must be fixed (both in

terms of physical location & in terms of time); &the business of the enterprise must be carried

on through this fixed place.


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OECD Commentary - Art 5(1): examples of what

does & does not constitute a PE:

a meeting in customers offices is not PE, while the

parent companys staff working in a subsidiarys offices

could be a PE (paras 4 & 4.3)deliveries to a loading dock is not a PE (para 4.4)

painter working for 2 years, 3 days a week in a single

building could have a PE (para 4.5, cf 5.3)

paving a road could be a PE (para 4.6) a consultant trainer working in different branches is

not a PE, but if it in different offices within the same

branch there could be (para 5.4)

storage & retrieval of documents not a PE


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Article 5(2)

Article 5(2) lists examples which will onlyconstitute a permanent establishment if the primary

definition in Art 5(1) is satisfied, being:

a place of management;

a branch;

an office;

a factory;

a workshop;

a mine, an oil or gas well, a quarry or any other

place of extraction of natural resources.


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Article 5(2)

Art 5(2) of Australian tax treaties also listsagricultural, pastoral or forestry property. The

OECD Model includes these activities under Art

6(1).


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Article 5(3)

Art 5(3) of Australian tax treaties provides that abuilding site or construction or installation projectconstitutes a permanent establishment only if it lastsmore than 6 months. This departs from OECD Modelwhich adopts a 12 month period.

The phrase building site or a construction,installation or assembly project includes not onlyplaces used for the construction of buildings but alsofor the construction of roads, bridges or canals, the

renovation (involving more than mere maintenance orredecoration) of buildings, roads, bridges or canals, thelaying of pipelines and excavating and dredging (OECDCommentary, Art 5, para 17).


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Departures from the OECD Model

The Australian model of Art 5 varies from the OECD

Model (see Arts 5(4) to (6), (8) and (11) of NZ treaty)

as Australia reserves the right (OECD Commentary

para 46) to treat an enterprise as having a PE if:

it carries on activities relating to natural resources (NZtreaty Art 5(4)(b)); or

it operates substantial equipment with a certain

degree of continuity (NZ treaty Art 5(4)(c)); or

a person acting in that state on behalf of the

enterprise manufactures or processes in that state

goods belonging to the foreign enterprise (so called

cost tolling processing) (NZ treaty Art 5(8)).


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Preparatory or auxiliary activities

Art 5(4) recognises that certain activities do notgenerally give rise to a PE (eg, the use of facilitiessolely for storage, display or delivery). These activitiesare ordinarily of a preparatory or auxiliary characterand are unlikely to give rise to substantial profits. A PE

will not exists as the necessary economic linkbetween the activities of the enterprise & the countryin which the activities are carried on does not exist inthese circumstances.

However, Australias treaties provide that theactivities will only not to constitute a PE only if theactivities are of a preparatory or auxiliary character.


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Preparatory or auxiliary activities

The aim is to stop enterprises structuring theirbusiness so that most of their activities fall within

the exceptions.

It means that where the listed activities are notpreparatory or auxiliary in relation to the

enterprise, but instead constitute core business

activities of the enterprise, the enterprise will not

be excluded from having a PE if it satisfies Art

5(1).


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Natural resource activities Art 5(4)(b)

Where an enterprise carries on activities(including the operation of substantial

equipment) in the exploration for, or exploitation

of, natural resources or standing timber within a

country for a period exceeding 90 days in any12-month period, it will be deemed to have in

that country a PE through which those activities

are performed (NZ treaty Art 5(4)(b)).


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Substantial equipment Art 5(4)(c) [1]

If an enterprise operates substantial equipment ina country for one or more periods which exceed, inthe aggregate, 183 days in any 12-month period,the activity will be deemed to be performed through

a PE.The words operation and operates ensure thatonly active use of substantial equipment assets willbe captured, not merely leasing of substantial

equipment.Whether the equipment is substantial dependson the relevant facts & circumstances of eachindividual case (TR 2007/10).


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Some examples of substantial equipment, are: industrial earthmoving equipment or construction

equipment used in road building, dam building orpowerhouse construction;

manufacturing or processing equipment used in afactory; or

oil or drilling rigs, platforms and other structures usedin the petroleum, gas or mining industry.

The words operation and operates ensure thatonly active use of substantial equipment assets will becaptured, not merely leasing of substantial equipment.


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However, the use of a bare boat charter of barges inAustralian waters amounted to a substantial

equipment PE under the specific wording of Art 4(3)(b)

the Singapore treaty (McDermott Industries (Aust) Pty

Ltd v Commissioner of Taxation (2005) 59 ATR 358)However, this decision applies only where the

wording use and by, for or under contract is used in

the substantial equipment paragraph of a PE Article in

an Australian tax treaty.Further a PE will not arise under such Articles where

the equipment is merely supplied under a hire

purchase agreement.


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Cost tolling processing

In Australian treaties where goods or merchandisebelonging a foreign enterprise are processed or

manufactured in Australia by a person acting on

behalf of that enterprise, the activity (cost tolling

processing) will be deemed to be performed througha PE.However, a PE does not exist where the person

is an independent agent.

The approach recognises that substantial value may

be added by the processing or manufacturingactivities carried out for an enterprise by an

intermediary in Australia (See New Zealand treaty Art

5(8)).


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Services - Art 5(4)(a) [1]

Australia also adopts the alternative services PEprovision as set out in the OECD Commentary on Art 5

(para 42.23). Under this provision a PE will deemed to

exist :

where an enterprise performs services through anindividual who is present in a country for a period

exceeding 183 days in any 12-month period, & more

than 50 per cent of the gross revenues attributable to

active business activities of the enterprise during this

period are derived from those services (NZ treaty Art

5(4)(a)(i)); or


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where an enterprise performs services in a country fora period exceeding 183 days in any 12-month period, &

those services are performed for the same project or

for connected projects through one or more individuals

(being an entrepreneur or employees) who are present& performing such services in that country (NZ treaty

Art 5(4)(a)(ii)).

The first test applies in the case of self-employed

persons or other small business enterprises where the

profits of the business are mainly derived from the

activities of one person, while the second test applies

to entrepreneurs or employees.


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However, services performed by an individual onbehalf of one enterprise shall not be considered to be

performed by another enterprise through that individual

unless that other enterprise supervises, directs or

controls the manner in which these services areperformed by the individual (NZ treaty Art 5(5)).

Similarly, services performed through an individual

who is present and performing such services in a State

for any period not exceeding 5 days shall be

disregarded, unless such services are performed by

that individual in that State on a regular or frequent

basis (NZ treaty Art 5(5)).


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Agents

Art 5(5) of the OECD Model deems an enterprise tohave a PE if a person acts on its behalf in the other

country where that person has & habitually exercises

an authority to conclude contracts on behalf of the

enterprise (a dependent agent) unless the activitiesare of a preparatory or auxiliary character (NZ treaty Art

5(8)).

Art 5(6) of the OECD Model states that a business

carried on through an independent agent will not give

rise to a PE provided that the agent is acting in the

ordinary course of their business (NZ treaty Art 5(9)).


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Anti-avoidance provision- Art 5(6)

The OECD Model Commentary (at para 18)recognises that time thresholds in Article 5 may give

rise to abuses & suggests bilateral negotiations to

prevent such abuse.

An anti-avoidance rule (broadly consistent with intentof Art 5(5) of the OECD model) has been included

Australian treaties to counteract contract splitting.

It ensure that where associated enterprises carry on

connected activities, the periods will be aggregated indetermining whether an enterprise has a PE in the

country in which the activities are being carried on (NZ

treaty Art 5(6)).


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Subsidiary companies

Generally, a subsidiary company will not be aPE of its parent company (ie a separate legal

entity carrying on own business activities).

Art 5(7) of the OECD Model states that asubsidiary company will be a PE if the subsidiary

permits the parent company to operate from its

premises such that the tests in Art 5(1) are met,

or the subsidiary acts as an agent such that a

dependent agent PE is constituted (NZ treaty Art

5(10)).


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Electronic commerce

The OECD Commentary to Art 5 notes (at paras 42.1- 42.10) that:

a web site & the hosting arrangement will not give rise

to a PE

generally the Internet Service Provider (ISP) will notcreate an agency PE

the place a server is located can be a PE if a

enterprise, carrying on a business through a website,

has a server at its disposal (owned) & operates theserver

The sales of digital products into Australia through a

website will not normally give rise to a PE.


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Discussion Question

Questions 1-8


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2. Business Profits Article (Art 7) Introduction [1]

Art 7 deals with the division of business profitsbetween a branch (a PE) & its head office.

The wording of Art 7 in the OECD Model had beenconstant since 1977. A revised version of Art 7 wasadopted on 22 July 2010. This version of Art 7 has notbeen adopted in any of Australias tax treaties nor in2011 UN Model.

Although the OECD approach is to interpret existingtreaties in light of the most recent commentary, theOECD has recognised that as the 2010 wording is sodifferent to the pre 2010 version of Art 7 that it is notpossible to apply the commentary in thesecircumstances.


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Introduction [2]

Thus, the OECD has retained the 2008 Commentaryon Art 7 as an annexure as . . . it will continue to be

relevant in the interpretation of bilateral tax conventions

that use the previous wording of the Article.

However, as the 2008 OECD Commentary was itselfa major rewrite of the 2005 Commentary, its impact is

still being assessed and it has not been fully integrated

in Australian tax treaty practice.

Thus, this examination will focus upon the version of

Art 7 as it is broadly the Art 7 in all Australias existing

treaties & will use the 2005 OECD Commentary.


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Right to tax business profits 2008OECD Art 7(1) [1]

The profits of an enterprise of a ContractingState shall be taxable only in that State unless

the enterprise carries on business in the other

Contracting State through a permanent

establishment situated therein. If the enterprise

carries on business as aforesaid, the profits of

the enterprise may be taxed in the other State

but only so much of them as is attributable tothat permanent establishment


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Right to tax business profits [2]

Under Art 7(1) of the 2008 OECD Modelmerely providing a Contracting State with the

right to tax business profits and does not affect

the determination of the quantum of the profits

that are to be attributed to the PE.

For Art 7(1) to apply there must be a PE. If

there is no PE in the country of source there can

be no taxation of business profits in that country

(Thiel).


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Right to tax business profits [3]

The profits of the enterprise must arise from abusiness conducted through the PE (eg, if anenterprise derives dividends or interestunconnected with the PE, then the dividends orinterest may only be taxed in accordance with Arts

10 & 11 of the treaty).UN Model in Art 7(1) mirrors most of the wordingof the Art 7(1) of the OECD Model, it adopts a forceof attraction approach (rejected by the OECD) by

seeking to capture not only the profits attributable tothe PE, but profits attributable sales of goodssimilar to those sold through the PE & profits fromother business activities similar to those carried on

through the PE.


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Allocation of Profit: 2008 OECD & UN Art7(2)

Subject to Art 7(3), where anenterprise of a Statecarries on business in the other State through a PE

situated therein, there shal l in each Contract ing

Statebe attributed to that PE the profits which i t m ight

be expected to makeif it were a dist inct & separateenterpr iseengaged in the same or s im i lar act iv i t ies

under the same or similar conditions & deal ing whol ly

independent ly w ith the enterpr ise of wh ich i t is a

PE. The key conditions have been highlighted.The OECD approach is to apply the arms length

principle of Art 9, as articulated in the OECD Transfer

Pricing Guidelines, to the PE under Art 7(2).


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Allocation of Profit: 2008 OECD Art 7(3)

Ensures that the expenses of a PE (includingexecutive & general administrative expenses)

are taken into account in attributing profits to a

PE, in particular if the expense is incurred

outside the PEs jurisdiction, or is not incurred

exclusively for the PE (eg Arts 7(3) Australian

treaties with Russia & NZ).


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Allocation of Profit: UN Model Art 7(3)

UN Model Art 7(3), with minor draftingdifferences, reproduces the entire text of Art 7(3) ofthe 2008 Model.The balance of art 7(3) of the UN Model includesadditional detail to clarify what expenses are denied

It expressly denies a deduction for amounts paidor charged, (otherwise than towards reimbursementof actual expenses), by the PE to the head office . .. by way of royalties. . . in return for the use of

patents or . . . or by way of commission for specificservices performed . . ., or, except in the case of abanking enterprise, by way of interest on moneylent by or to the head office . . . or any of its otheroffices.


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Allocation of Profit OECD 2008 Arts 7(4)& (5))

Art 7(4) is mirrored in Art 7(4) of the UN Model

Art 7(4) includes a clause that allows it to apply its

domestic law where the information available to the

competent authority is inadequate to determine the

profits to be attributed to a PE (see Arts 7(4) Aus/NZtreaty). It is not adopted in Australian treaties consistent

with its reservation

Art 7(5) of the OECD Model prohibits an attribution ofprofits to a PE by reason of the mere purchase of

goods or merchandise for the enterprise (Arts 7(4)

Aus/Finnish tax treaty).


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Allocation of Profit 2008 OECD Arts 7(6)& (7)

Art 7(6) in the 2008 OECD Model (UN Art 7(5))prescribes that a method of allocation once used

should not be changed merely because in a

particular year some other method produces more

favourable results (see Art 7(5) Aust/China & Art7(6)Aust/Japan treaties).

Art 7(7) (in the 2008 OECD Model UN Art 7(6))

provides that where income or gains are specificallydealt with under other Articles then the provisions of

those Articles should not be affected by Art 7 (Arts

7(5) Aust/NZ & Aust/Chile treaties).


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Articles specific to Australian tax treaties

Non-resident insurers reservation Arts- givesthe right to apply domestic law relating to the

taxation of income from insurance with non-resident

insurers (Arts 7(6) Aust/NZ). It preserves Australia's

domestic law position (in Div 15 of the ITAA 1936).

Trust reservation Artsgives the right to tax a

share of business profits, originally derived by a

trustee from the carrying on of a business through aPE in Australia, to which a resident of the other

state is beneficially entitled (Arts 7(7) Aust/Chile).


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Time limitation Arts - inserts specific a timelimit for the adjustment of profits attributable to a

PE of the enterprise (7 years from the date of

filing (see Aust/NZ & Aust/Chile treaties Arts

7(8)).


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3. Associated Enterprises (Art 9)

Article 9 deals with associated enterprises (suchas parent and subsidiary companies andcompanies under common control).It authorises the reallocation of profits between

related enterprises in a State and the othercontracting State on an arms length basis wherethe commercial or financial arrangements betweenthe enterprises differ from those that might be

expected to operate between unrelated enterprisesdealing wholly independently with one another.Art 9 of the OECD model mirrors Art 9 of the UNModel


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Threshold tests - Art 9 (1) [1]

There are two preconditions to triggering Art 9.First, under the association test either;

the enterprise must participate directly or

indirectly in the management, control or capitalof an enterprise of the other Contracting State;

or

the same persons participate directly orindirectly in the management, control or capital

of an enterprise of a Contracting State and an

enterprise of the other Contracting State.


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Threshold tests - Art 9 (1) [2]

Second, under the uncommercial terms test

conditions operate between the two enterprises intheir commercial or financial relations which differfrom those which m ight be expected to operatebetween independent enterprises dealing whollyindependently with one another.If both tests are satisfied then any profits which,but for those conditions, might have beenexpected to accrueto one of the enterprises, but,by reason of those conditions, have not soaccrued, may be included in the profits of thatenterprise and taxed accordingly.


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Correlative adjustments - Art 9 (2)

Art 9(2) of the OECD Model requires other

State to make an appropriate adjustment to

relieve the double taxation where the rewriting

of transactions between associated enterprises

may give rise to economic double taxation(taxation of the same income in the hands of

different persons).

This in usually enacted as Art 9(3) in Australiantreaties


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Consistent with its reservation in respect Art 9 of

the OECD Model, an Article (usually Art 9(2)) hasbeen inserted in Australias tax treaties since 1994to preserve the applicability of Australias domestictransfer pricing rules (savings clause).

Another departure by Australia from the OECDModel is an Article (usually Art 9(4)) which specifiesa time limit for the adjustment of the profits of the

enterprise under paragraph 1 or 2 of this Article.The provision originated in the 2008 Aust/Japantreaty and is reflected in Australias most recent taxtreaties.


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Difference under the UN Model

The UN Model contains an additionalparagraph (Art 9(3)) which provides that theobligation to make a correlative adjustmentunder Art 9(2) will not occur where judicial

procedures have resulted in a final ruling that bytheir actions (which gave rise to a profitadjustment) one party is liable to penalty fraud,gross negligence or wilful default.

It has been criticised as it applies when onlyone of the parties to a transaction hascommitted such an act.


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Discussion Question

Questions 1-3

4 I d d t P f i l i


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4. Independent Professional services(former Art 14) [1]

Although Art 14 was deleted from the OECDConvention on 29 April 2000, its scope needsto be briefly examined as it continues operatein both the UN Model and many Australiantreaties.

Similar to Arts 7 & 9, under Art 14(1) of theUN Model the income will generally be taxedonly in the country of residence, unless there

is a fixed base in the other state or theperson is present in the other state for aprescribed period or periods in any 12 monthperiod.

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Art 14 [2]

Country of source has the right to tax, butonly so much of the income as is attributable

to services performed from that fixed base or

in the other State during such period or

periods.

In 19 of Australias treatiesthe fixed base

has been adopted as a sole test.

The fixed base test is augmented in other

treaties by the use a 183 day presence test

adopted from the UN Model.50


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Art 14 [3]

An additional monetary limit test is used inconjunction with the two alternate tests infurther five treaties (Philippines, Malta, PapuaNew Guinea, Fiji and Kiribati).

Art 14(2) of the UN Model defines"professional services" to include servicesperformed in the exercise of independentscientific, literary, artistic, educational or

teaching activities as well as in the exercise ofthe independent activities of physicians,lawyers, engineers, architects, dentists &accountants.

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Discussion Question

Question 1

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Tax Treaties Business Profits (2013).ppt