House of Representatives

Explanatory Memorandum

(Circulated by authority of the Minister for Revenue and Financial Services, Minister for Women and Minister Assisting the Prime Minister for the Public Service, the Hon Kelly O'Dwyer MP)

Chapter 4 - Avoidance of permanent establishment status

Outline of chapter

4.1 This Chapter explains the way in which the Multilateral Convention will modify Australia's Covered Tax Agreements to address the avoidance of permanent establishment status through:

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the use of certain intermediary arrangements;

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the use of specific activity exemptions; or

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splitting-up contracts.

Context of amendments

4.2 A permanent establishment is a taxable presence threshold for determining whether a jurisdiction can tax business profits derived by a foreign resident enterprise. Under tax agreements, a jurisdiction can generally only tax such profits to the extent they are attributable to a permanent establishment of that foreign enterprise located in that jurisdiction. Thus, a foreign enterprise can avoid local taxation of business profits by implementing arrangements that circumvent the existing treaty-based definition of permanent establishment.

4.3 Common strategies to frustrate the intended operation of the definition of permanent establishment include:

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using certain intermediary arrangements to perform functions that could have otherwise been undertaken by the enterprise itself;

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exploiting the existing exceptions from the definition of permanent establishment, including through fragmentation of activities that fall within those exceptions; and

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dividing a building site or construction or installation project contract into several parts amongst related persons so that each contract does not exceed the specified time period that deems a permanent establishment to exist.

4.4 The BEPS Final Report on Action 7 (Preventing the Artificial Avoidance of Permanent Establishment Status) recommended changes to the definition of 'permanent establishment' in the OECD Model to address these strategies.

4.5 Articles 12 to 15 of the Multilateral Convention implement those Action 7 recommendations.

Summary of new law

4.6 Part IV (Avoidance of Permanent Establishment Status) of the Multilateral Convention contains rules that aim to restore source country taxation in a number of cases where cross-border income would otherwise go untaxed or would be taxed at very low rates as a result of existing tax agreement provisions that define permanent establishment:

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Article 12 - artificial avoidance of permanent establishment status through commissionnaire arrangements and similar strategies;

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Article 13 - artificial avoidance of permanent establishment status through the specific activity exemptions;

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Article 14 - splitting-up of contracts; and

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Article 15 - definition of a person closely related to an enterprise.

4.7 Article 12 ensures that where an intermediary habitually concludes contracts or habitually plays the principal role in concluding substantially finalised business contracts in a jurisdiction on behalf of a foreign enterprise, that arrangement will be deemed to constitute a permanent establishment.

4.8 Australia has provisionally indicated that it will reserve the right for Article 12 not to apply to its Covered Tax Agreements. This means that the 'Permanent Establishment' articles of Australia's Covered Tax Agreements will not be modified by Article 12 of the Multilateral Convention.

4.9 Article 13 ensures that the specific activity exceptions from the definition of permanent establishment are limited to activities that are genuinely preparatory or auxiliary in nature and prevents the foreign enterprise, either alone or with its related entities, from fragmenting its activities to qualify for this exclusion.

4.10 Australia has provisionally indicated that it will adopt Article 13 and will choose to include the requirement that each of the specific activity exceptions must individually be of a preparatory or auxiliary character, and make a reservation to restrict the application of this requirement to its Covered Tax Agreements that do not already contain corresponding rules.

4.11 Article 14 prevents related entities from dividing building or construction-related contracts into several parts to avoid rules that apply specified time periods to deem a permanent establishment to exist in a jurisdiction.

4.12 Australia has provisionally indicated that it will adopt Article 14 and make a reservation for Article 14 not to apply to provisions in its Covered Tax Agreements relating to the exploration for or exploitation of natural resources.

4.13 Article 15 defines the circumstances in which a person is considered to be closely related to an enterprise for the purposes of Articles 12, 13 and 14. Adopting Article 15 is mandatory for jurisdictions that choose to adopt any of Articles 12, 13 or 14 (in part or in full).

Detailed explanation of new law

A person closely related to an enterprise

4.14 Some paragraphs of the Articles in Part IV of the Multilateral Convention refer to a person closely related to an enterprise.

4.15 For the purposes of those paragraphs, Article 15 provides that the phrase means a person who has control of another or both persons are under common control of the same persons or enterprises. This is assessed on a case-by-case basis, dependent on the facts and circumstances of each case. [Article 15(1) of the Multilateral Convention]

4.16 As per paragraph 120 of the Commentary on Article 5 (Permanent establishment) of the OECD Model, this 'would cover... situations where a person or enterprise controls an enterprise by virtue of a special arrangement that allows that person or enterprise to exercise rights that are similar to those that it would hold if it possessed directly or indirectly more than 50 per cent of the beneficial interests in the enterprise'.

4.17 Furthermore, a person is automatically considered to be closely related to an enterprise if:

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one possesses directly or indirectly more than 50 per cent of the beneficial interests in the other; or

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another person possesses directly or indirectly more than 50 per cent of the beneficial interest in the person and the enterprise.

[Article 15(1) of the Multilateral Convention]

4.18 Where a person is a company, the total voting power and value of the company's shares or of the beneficial equity interest in the company is considered to be the amount of beneficial interest in the person. [Article 15(1) of the Multilateral Convention]

4.19 Article 15(2) allows a jurisdiction to make the reservation not to apply Article 15 to its Covered Tax Agreements where it has made the reservations not to apply Articles 12, 13 and 14.

4.20 Australia recognises that adopting Article 15 is necessary for the coherent operation of Articles 13 and 14 in Part IV of the Multilateral Convention.

4.21 Therefore, Australia has provisionally indicated that it will adopt Article 15 without reservation, which is consistent with its recent treaty practice.

Addressing use of intermediary arrangements

4.22 Australia has provisionally made the reservation allowable under Article 12(4) to not adopt Article 12. On this basis, Article 12 will not modify Australia's Covered Tax Agreements and thus not be part of Australian domestic law.

4.23 Broadly, Article 12 provides that a foreign enterprise is deemed to have a permanent establishment in a jurisdiction:

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if a person in the jurisdiction acting on behalf of the foreign enterprise habitually concludes contracts or habitually plays the principal role in concluding substantially finalised business contracts that are:

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in the name of the foreign enterprise;

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for the transfer of the ownership of, or the granting of the right to use, property owned by the foreign enterprise or which the enterprise has the right to use; or

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for services provided by the foreign enterprise;

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unless the person carries on business in that jurisdiction and is an independent agent for the foreign enterprise acting in their/its ordinary course of business.

[Articles 12(1) and (2) of the Multilateral Convention]

4.24 A person is not considered to be an independent agent if the person acts exclusively or almost exclusively for an enterprise to which it is closely related. [Article 12(2) of the Multilateral Convention]

4.25 A jurisdiction that has not made the reservation allowable under Article 12(4) must adopt both paragraphs 1 and 2 of Article 12 to replace similar provisions in a Covered Tax Agreement and must notify the Depositary of these provisions in its Covered Tax Agreements to be replaced. The replacement is effective only if both Parties to the Covered Tax Agreement make the same notification. [Articles 12(3), (5) and (6) of the Multilateral Convention]

4.26 Australia will consider adopting the rules contained in Article 12 bilaterally in future tax agreements to enable bilateral clarification of their application in practice. In this regard, Australia has already agreed to equivalent rules in the German agreement.

4.27 It would be possible for Australia to adopt Article 12 in the future by lifting its proposed reservation, which would be subject to Australia's domestic treaty-making requirements.

Addressing use of specific activity exemptions

4.28 Australia has provisionally adopted Article 13 and has made the reservation allowable under Article 13(6)(b) to restrict the application of Article 13(2)(Option A) to Covered Tax Agreements that do not already contain corresponding rules.

4.29 Tax agreements generally contain a list of specific activities, such as warehousing or purchasing goods, that are exceptions to the definition of permanent establishment (the specific activity exemptions).

4.30 Consistent with the Commentary on Article 5 (Permanent establishment) of the OECD Model, the listed specific activity exceptions are to reflect that even though the listed activities of a place of business 'contribute to the productivity of the enterprise... the services it performs are so remote from the actual realisation of profits that it is difficult to allocate any profit' to those activities, therefore they are not treated as permanent establishments (see paragraph 58 of the Commentary on Article 5 (Permanent establishment) of the OECD Model).

Preparatory and auxiliary requirement

4.31 To address situations where the list of excepted activities included in Article 5(4) (Permanent establishment) of the OECD Model give rise to BEPS concerns, paragraph 12 of the BEPS Final Report on Action 7 recommended that the OECD Model provision be modified so that each of the exceptions included in that provision is restricted to activities that are otherwise of a 'preparatory or auxiliary' character.

4.32 An activity is generally considered to be of a preparatory or auxiliary character if it is not 'an essential and significant part of the activity of the enterprise as a whole', which is assessed on a case-by-case basis (see paragraph 59 of the Commentary on Article 5 (Permanent establishment) of the OECD Model).

4.33 Article 13 provides a jurisdiction with three options in respect of a preparatory or auxiliary requirement for the specific activity exceptions in its Covered Tax Agreements. These options are:

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include the requirement that each of the specific activities must be of a preparatory or auxiliary character in order to be excluded (Option A);

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only add the preparatory or auxiliary requirement for any other activity (other than those specifically listed) or for any combination of the listed activities (Option B); or

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apply neither option (i.e. not choose Option A or B).

[Articles 13(1) to (3) of the Multilateral Convention]

4.34 Australia has provisionally chosen Option A to modify its Covered Tax Agreements by replacing relevant parts of provisions to include the requirement that each of the specific activities must be of a preparatory or auxiliary character. [Article 13(5) of the Multilateral Convention]

4.35 Australia has also provisionally invoked the reservation in Article 13(6)(b) to limit the modification to Covered Tax Agreements that do not already contain corresponding provisions. Australia has provisionally indicated that its tax agreements with Finland, New Zealand and South Africa contain such corresponding provisions. [Article 13(6) of the Multilateral Convention]

4.36 The requirement choice is effective only if both Parties to a Covered Tax Agreement choose the same option and notify the Depositary of the affected bilateral provisions to be subject to that choice. [Article 13(7) of the Multilateral Convention]

Anti-fragmentation rule

4.37 In addition, the exceptions are open to exploitation by enterprises through fragmentation of activities in order to qualify for the exceptions.

4.38 Article 13 also provides that the specific activity exceptions will not apply where the business activities of the enterprise or a closely related enterprise are carried out, within the same jurisdiction, and constitutes complementary functions that are part of a cohesive business operation. The change in application prevents the fragmentation of activities by the foreign enterprise itself or with related entities to qualify for the specific activity exemptions (which would otherwise be a permanent establishment). [Articles 13(4) and (5) of the Multilateral Convention]

4.39 Australia has provisionally indicated that it will adopt the anti-fragmentation rule for its Covered Tax Agreements. The change in application is effective only if both Parties to a Covered Tax Agreement have not opted out of the anti-fragmentation rule and notified the Depositary of the affected bilateral provisions to be subject to the change. [Article 13(8) of the Multilateral Convention]

4.40 Australia's provisional positions are consistent with its recent treaty practice.

4.41 Based on the known or proposed adoption positions of other Signatories to the Multilateral Convention, Article 13 is expected to modify Australia's tax agreements with Argentina, Belgium, Chile, Fiji, France, India, Indonesia, Ireland, Italy, Japan, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Romania, Russia, the Slovak Republic, South Africa, Spain, Turkey and the United Kingdom.

Addressing splitting-up of contracts

4.42 Australia has provisionally adopted Article 14 but has made the reservation allowable under Article 14(3)(b) to not apply Article 14 to the provisions of Covered Tax Agreements that deem a permanent establishment to exist in relation to offshore natural resource activities.

4.43 Most tax agreements deem a permanent establishment to exist where a building site or a construction or installation project exceeds a specified time period. This can be circumvented by dividing a contract for a project into several contracts so that each contract does not exceed the specified time period, so that the building site or construction or installation project is not deemed to be a permanent establishment and any profits avoid local taxation where the project is located.

4.44 For the purpose of determining whether the specified time period threshold has been reached, Article 14 provides for the replacement of an anti-contract splitting provision in a tax agreement (or addition of such a provision if there is no existing provision) so that the time period is the total time period of:

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activities carried on by a foreign enterprise that total more than 30 days at a building site, construction or installation project, or supervisory or consultancy activities in connection with such sites or projects; and

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connected activities carried on by closely related persons of the foreign enterprise at the same site or project during different periods that are more than 30 days each.

[Article 14(1) and (2) of the Multilateral Convention]

4.45 Consistent with paragraph 53 of the Commentary on Article 5 (Permanent establishment) of the OECD Model, whether an activity is a connected activity is assessed on a case-by-case basis. In making that assessment, the Commentary includes the following indicative list of relevant factors:

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whether the contracts for the different activities were concluded with the same person or related persons;

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whether the conclusion of additional contracts is a logical consequence of a previous contract concluded with the same person or related persons;

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whether the activities would have been covered by a single contract absent tax planning considerations;

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whether the nature of the work involved under the different contracts is the same or similar; and

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whether the same employees are performing the activities under the different contracts.

4.46 The same circumstances may also prompt the application of a provision in a Covered Tax Agreement as modified by Article 7 of the Multilateral Convention (i.e. Principal Purposes Test). Article 7 is discussed above in Chapter 3 of this explanatory memorandum.

4.47 Article 14 does not affect the application of any bilateral anti-contract splitting provisions in Covered Tax Agreements that are applicable to activities other than those carried on at a building site, construction or installation project, or supervisory or consultancy activities in connection with those sites or projects.

4.48 The replacement of an existing anti-contract splitting provision in a Covered Tax Agreement is only effective if both Parties to a Covered Tax Agreement do not make the reservation in Article 14(3)(a) (to not apply Article 14 at all) and notify the Depositary of the affected bilateral provisions to be replaced. [Article 14(4) of the Multilateral Convention]

4.49 Australia has provisionally indicated that Australia's tax agreements with Chile, Finland, France, Japan, New Zealand, Norway, South Africa, Switzerland, Turkey and the United Kingdom contain such a provision.

4.50 Otherwise, the anti-contract splitting provision contained in Article 14(1) will modify Australia's Covered Tax Agreements to the extent of any inconsistency between Article 14(1) and the relevant provisions of those Covered Tax Agreements, and provided that the relevant partner jurisdictions to a Covered Tax Agreement have not opted out of Article 14 entirely. [Article 14(4) of the Multilateral Convention]

4.51 Australia has provisionally made the reservation under Article 14(3)(b) to not apply Article 14 to provisions in Covered Tax Agreements that deem a permanent establishment to exist in relation to exploration for or exploitation of natural resources and provisionally indicated that Australia's tax agreement with Norway contains such a provision.

4.52 On this basis, the application of Article 20(3) of Australia's tax agreement with Norway will not be affected by the Multilateral Convention.

4.53 Australia's provisional position to adopt Article 14 is consistent with its recent treaty practice.

4.54 Based on the known or proposed adoption positions of other Signatories to the Multilateral Convention, this Article is expected to modify Australia's tax agreements with Argentina, Fiji, France, India, Indonesia, Ireland, the Netherlands, New Zealand, Norway, Romania, Russia and the Slovak Republic.