Lowering The Already Low Permanent Establishment Threshold

John Allen Paulos, professor of mathematics at Temple University in Philadelphia, Pennsylvania said, “Uncertainty is the only certainty there is”. This equally applies to the concept of permanent establishment (PE) in international tax.

The OECD released the updated model tax convention, commentary and countries reservations on 23 November, 2017. The updated model reflects the work on the Multilateral instrument (MLI). The MLI is a tool to update thousands of tax treaties globally to reflect the changes required to these treaties as a result of the OECD Base Erosion and Profit Shifting (BEPS) project.

The purpose of this article is to analyze the impact of India’s key observations on the concept of PE (virtual PEs, low risk distributors and contract conclusion criteria) in the revised OECD model tax treaty and commentary. India has made a total of 21 new observations. This is more than the observations made by certain other non-OECD members such as China, Indonesia, Singapore and Brazil put together.

PE Based On Significant Economic Presence Or Virtual PE

The first significant comment from India is that it reserves the right to include a provision to the effect that an enterprise having a significant economic presence (as defined in the BEPS report on digital economy) in India will be deemed to have a PE in India. As per the BEPS report on digital economy, the significant economic presence will be determined on the basis of factors that evidence a purposeful and sustained interaction with the economy of that country via technology and other automated tools. These factors would be combined with a factor based on revenue derived from remote transactions into the country to ensure that only cases of significant economic presence are covered. The revenue factor imply that value generated from the users or user data will be reflected in the revenue derived from a country. The other factors to be considered in combination with revenue are:

• Digital factors such as local domain name, local digital platforms or local payments option; or
• User factors such as number of monthly active users, volume of data collected from the country or online contract conclusion.

The above comment relates to changes in the treaty itself. Therefore, for any such change to take effect, it will need to be brought in via treaty negotiations.

In addition to the above, India has also made reservations on the interpretation of the revised commentaries. India has stated that a website may constitute a PE where it leads to significant economic presence of an enterprise. Further, it has stated that an enterprise can be considered to have a PE through a website on any equipment, if opening the website on that equipment leads to downloading of cookies – to (a) collect data from that equipment; and (b) process/share the data with the enterprise.

All the above observations are a significant departure from the existing rules on PE. Under the existing rules, significant economic presence in the context of PE is typically determined based on physical presence in a country. However, India’s reservation on the interpretation could lead to allegation of PE by the Revenue authorities even if an enterprise has no or limited physical presence in the country but has significant economic presence otherwise.

Increasingly more and more countries have been voicing concern that the current rules are not adequate to tax nexus due to significant digital presence in a country. The EU and UK’s discussion draft on digital economy are a case in point. The EU discussion draft states that alternative indicators for significant economic presence are required to protect taxing rights in the new digitalized business models. The UK discussion draft highlights the need to consider the active participation of users (and the value it creates) in determining how the taxable profits of certain digital businesses are allocated between countries.

India’s comments together with increasing concern on this issue raised by other countries highlight that this will be an area of interest not just in India but globally as well and disputes in this area are bound to increase. Till the time there’s a multilaterally agreed and implemented solution on this, the number of countries taking unilateral measures will increase and will thereby lead to double taxation and more uncertainty.

PE And Low-Risk Distributors

The second significant reservation from India is on PE in case of a ‘low-risk distributor’. India considers that distribution of goods by a related party where the risks are not born by it, may give rise to a PE of the enterprise whose goods are being sold. One can argue that this is more of a Transfer Pricing issue and not a PE issue. If a distributor has been stripped-off of risk ‘artificially’ and is being paid a low margin, the solution lies is fixing the margin based on the actual functional profile of the distributor. Even the OECD while releasing the final report on PE made it clear that BEPS concerns related to the transfer of risks between related parties through low-risk distributor arrangements are best addressed through the work on Transfer Pricing.

PE Even If Contracts Are Not ‘Routinely’ Concluded

The third significant comment pertains to the contract conclusion criteria. The PE threshold has been widened by the BEPS project to include an agent habitually playing the “principal role leading to the conclusion of contracts that are routinely concluded without material modification”. The objective is to tackle the situation where a contract is substantially negotiated in a country but is not formally concluded there as it is finalized or approved outside. India has stated that it reserves the right to not use the word ‘routinely’ in the PE threshold. Think of a scenario where contracts are not routinely concluded without material modification, i.e., only few contracts are concluded without material modifications, while majority of the contracts are concluded with modifications. Based on India’s observations, India will arguably allege a PE even in such a situation.

This again relates to changes in the treaty article. Therefore, for any such change to have an effect, it will need to be brought in via treaty negotiations.

One can argue that there’s a disproportionate amount of noise on the lowering of the PE threshold as only handful of countries have accepted the low threshold. For example, out of India’s prominent trading partners, only Japan, France, Netherlands and Indonesia have accepted the low threshold. The low threshold will not apply to India’s other prominent trading partners either because they haven’t signed the MLI to begin with (e.g., the USA, UAE and Saudi Arabia) or they have not included India in the list of treaties impacted by the MLI (Germany and China) or they haven’t accepted the low threshold (UK, Singapore, Korea, Australia, Sweden, etc.).

Even if only few countries have accepted the low PE threshold, no one can deny that the debate and litigation on PE will further intensify as in spite of the low threshold this has been a hugely litigious subject.

Legal Status Of Observations And Reservations On The OECD Commentary

Before concluding, it will not be out of place to analyze the legal status of the observations and reservations on the OECD commentary.

The OECD commentary states that observations by countries to the commentary usefully indicate the way in which those countries will apply the provisions of the Article.

The Tax Tribunals in India have held that reservations and observations to the commentary are relevant only to the extent of interpreting tax treaties entered into after those reservations or observations have been made. This is because the other contracting state was aware of India’s position on the commentary after this date and thereafter chose to enter into the treaty. Such observations or reservations cannot retrospectively apply to the treaties in existence on that date. As a tax treaty is an agreement between two countries, the same cannot be unilaterally modified by one country declaring its suo moto position.

Conclusion

One of the significant changes made to the treaties by the BEPS project is the lowering of threshold required for creation of a PE. If the MLI lowered the PE threshold, the reservations from India have lowered the threshold further. Even if courts don’t consider such reservations as legally binding on the existing treaties, it does signal that there will be considerable scrutiny of sales structures from PE perspective by the Revenue authorities.

Eleanor Roosevelt, Former First Lady of the United States said, “If life were predictable it would cease to be life, and be without flavor”. While unpredictability does make life interesting and fun, it doesn’t make doing business easy as investors do prefer and look for tax certainty. Considering India’s aggressive stance on the PE provisions, it won’t be surprising if India starts interpreting the existing treaties (including treaties with countries that haven’t accepted the low PE threshold) aggressively leading to more uncertainty and litigation.

Jitendra Jain is Executive Director – Transfer Pricing at PricewaterhouseCoopers.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.