Mongolia: Improving Capacity in International Tax Enforcement

Topic Three: Business Profits

Michael Dirkis Sydney Law School

Scope of this session The purpose of the session is to first explore the a key jurisdictional attachment rule under tax treaties, the concept of permanent establishment (PE) (Art 5) The balance of the session will be exploring the: Business Profits Article (Art 7) Associated enterprise (Art 9). Arts 7 & 9 both deal with same issue the division of business profits between separate business units within a single economic entity.
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Scope of this session [2] Income derived by a resident from independent 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.

1. Concept of PE
Most crossborder transactions do not involve the establishment of a subsidiary company or a branch office in a foreign country. They involve either cross border sales, without any presence in the foreign state, or investment in assets in the state (eg shares). A PE arises where there is sufficient presence, as determined by the tax treaty, in a state where the business activity is conducted. PEs include: bank branches independent professional service providers such as engineers & architects possibly e-commerce activities
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Role of PEs in tax treaties

The PE concept serves three functions in tax treaties: a jurisdictional threshold test (sufficient presence must exist before a country can tax business profits derived therein (under principally 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 presence means 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 permanent establishment which deems a PE if a nonresident enterprise furnishes services in the source country for more than 183 days in any 12 months in respect of the same or connected project). the time periods are shorter (eg building project only 6 months under Art 5(3)(a) of UN Model, while 12 months under Art 5(3) of the OECD Model).
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Differences between UN & OECD model

Delivery operations can constitute a PE in themselves as they are not listed in the exclusions in Art 5(4) A dependent agent can arise if the agent maintains stock and regularly makes deliveries even where contracts are not concluded (Art 5(5)(b)) A deemed PE can be created in respect of insurance where the premiums are collected in a country or the risks insured are situated there (Art 5(6))
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Definition of a PE [1]
A PE is defined in Art 5(1) as being a fixed place of business through which the business of an enterprise is wholly or partly carried on. Enterprise is defined in Art 3(1)(c) as applying to the carrying on of any business. OECD Commentary on Art 3(1)(c) states the question whether an activity is performed within an enterprise or is deemed to constitute in itself an enterprise has always been interpreted according to the provisions of the domestic laws of the Contracting States. No definition, properly speaking, of the term enterprise has therefore been attempted in this Article. (para 4)
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Definition of a PE [2]

Business is defined in Art 3(1)(h) to include the 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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Definition of a PE [3]
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 only constitute 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 lists agricultural, 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 a building site or construction or installation project constitutes a permanent establishment only if it lasts more than 6 months. This departs from OECD Model which adopts a 12 month period. The phrase building site or a construction, installation or assembly project includes not only places used for the construction of buildings but also for the construction of roads, bridges or canals, the renovation (involving more than mere maintenance or redecoration) of buildings, roads, bridges or canals, the laying of pipelines and excavating and dredging (OECD Commentary, 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 (NZ treaty 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 not generally give rise to a PE (eg, the use of facilities solely for storage, display or delivery). These activities are ordinarily of a preparatory or auxiliary character and are unlikely to give rise to substantial profits. A PE will not exists as the necessary economic link between the activities of the enterprise & the country in which the activities are carried on does not exist in these circumstances. However, Australias treaties provide that the activities will only not to constitute a PE only if the activities are of a preparatory or auxiliary character.
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Preparatory or auxiliary activities

The aim is to stop enterprises structuring their business so that most of their activities fall within the exceptions. It means that where the listed activities are not preparatory 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 any 12-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 in a country for one or more periods which exceed, in the 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 that only active use of substantial equipment assets will be captured, not merely leasing of substantial equipment. Whether the equipment is substantial depends on the relevant facts & circumstances of each individual case (TR 2007/10).
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Substantial equipment Art 5(4)(c) [2]

Some examples of substantial equipment, are: industrial earthmoving equipment or construction equipment used in road building, dam building or powerhouse construction; manufacturing or processing equipment used in a factory; or oil or drilling rigs, platforms and other structures used in the petroleum, gas or mining industry. The words operation and operates ensure that only active use of substantial equipment assets will be captured, not merely leasing of substantial equipment.
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Substantial equipment Art 5(4)(c) [3]

However, the use of a bare boat charter of barges in Australian 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 merchandise belonging 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 through a 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 manufacturing activities 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 PE provision 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 an individual 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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Services - Art 5(4)(a) [2]

where an enterprise performs services in a country for a 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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Services - Art 5(4)(a) [3]

However, services performed by an individual on behalf 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 are performed 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 to have 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 activities are 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 intent of 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 in determining 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 a PE of its parent company (ie a separate legal entity carrying on own business activities). Art 5(7) of the OECD Model states that a subsidiary 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 not create 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 the server 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 profits between a branch (a PE) & its head office. The wording of Art 7 in the OECD Model had been constant since 1977. A revised version of Art 7 was adopted on 22 July 2010. This version of Art 7 has not been adopted in any of Australias tax treaties nor in 2011 UN Model. Although the OECD approach is to interpret existing treaties in light of the most recent commentary, the OECD has recognised that as the 2010 wording is so different to the pre 2010 version of Art 7 that it is not possible to apply the commentary in these circumstances.
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Introduction [2]
Thus, the OECD has retained the 2008 Commentary on 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 itself a 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 2008 OECD Art 7(1) [1]

The profits of an enterprise of a Contracting State 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 to that permanent establishment
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Right to tax business profits [2]

Under Art 7(1) of the 2008 OECD Model merely 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 a business conducted through the PE (eg, if an enterprise derives dividends or interest unconnected with the PE, then the dividends or interest may only be taxed in accordance with Arts 10 & 11 of the treaty). UN Model in Art 7(1) mirrors most of the wording of the Art 7(1) of the OECD Model, it adopts a force of attraction approach (rejected by the OECD) by seeking to capture not only the profits attributable to the PE, but profits attributable sales of goods similar to those sold through the PE & profits from other business activities similar to those carried on through the PE.
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Allocation of Profit: 2008 OECD & UN Art 7(2)

Subject to Art 7(3), where an enterprise of a State carries on business in the other State through a PE situated therein, there shall in each Contracting State be attributed to that PE the profits which it might be expected to make if it were a distinct & separate enterprise engaged in the same or similar activities under the same or similar conditions & dealing wholly independently with the enterprise of which it 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 (including executive & 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 drafting differences, reproduces the entire text of Art 7(3) of the 2008 Model. The balance of art 7(3) of the UN Model includes additional detail to clarify what expenses are denied It expressly denies a deduction for amounts paid or charged, (otherwise than towards reimbursement of 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 specific services performed . . ., or, except in the case of a banking enterprise, by way of interest on money lent by or to the head office . . . or any of its other offices.
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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/NZ treaty). It is not adopted in Australian treaties consistent with its reservation Art 7(5) of the OECD Model prohibits an attribution of profits 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 & Art 7(6)Aust/Japan treaties). Art 7(7) (in the 2008 OECD Model UN Art 7(6)) provides that where income or gains are specifically dealt 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- gives the 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 Arts gives the right to tax a share of business profits, originally derived by a trustee from the carrying on of a business through a PE in Australia, to which a resident of the other state is beneficially entitled (Arts 7(7) Aust/Chile).
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Articles specific to Australian tax treaties

Time limitation Arts - inserts specific a time limit 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 (such as parent and subsidiary companies and companies under common control). It authorises the reallocation of profits between related enterprises in a State and the other contracting State on an arms length basis where the commercial or financial arrangements between the enterprises differ from those that might be expected to operate between unrelated enterprises dealing wholly independently with one another. Art 9 of the OECD model mirrors Art 9 of the UN Model
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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 capital of an enterprise of the other Contracting State; or the same persons participate directly or indirectly 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 in their commercial or financial relations which differ from those which might be expected to operate between independent enterprises dealing wholly independently with one another. If both tests are satisfied then any profits which, but for those conditions, might have been expected to accrue to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise 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 Australian treaties
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Articles specific to Australian tax treaties

Consistent with its reservation in respect Art 9 of the OECD Model, an Article (usually Art 9(2)) has been inserted in Australias tax treaties since 1994 to preserve the applicability of Australias domestic transfer pricing rules (savings clause). Another departure by Australia from the OECD Model is an Article (usually Art 9(4)) which specifies a 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/Japan treaty and is reflected in Australias most recent tax treaties.
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Difference under the UN Model

The UN Model contains an additional paragraph (Art 9(3)) which provides that the obligation to make a correlative adjustment under Art 9(2) will not occur where judicial procedures have resulted in a final ruling that by their actions (which gave rise to a profit adjustment) one party is liable to penalty fraud, gross negligence or wilful default. It has been criticised as it applies when only one of the parties to a transaction has committed such an act.
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Discussion Question

Questions 1-3

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

Although Art 14 was deleted from the OECD Convention on 29 April 2000, its scope needs to be briefly examined as it continues operate in both the UN Model and many Australian treaties. Similar to Arts 7 & 9, under Art 14(1) of the UN Model the income will generally be taxed only in the country of residence, unless there is a fixed base in the other state or the person is present in the other state for a prescribed period or periods in any 12 month period.
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Art 14 [2]

Country of source has the right to tax, but only 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 treaties the 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.
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Art 14 [3]

An additional monetary limit test is used in conjunction with the two alternate tests in further five treaties (Philippines, Malta, Papua New Guinea, Fiji and Kiribati). Art 14(2) of the UN Model defines "professional services" to include services performed in the exercise of independent scientific, literary, artistic, educational or teaching activities as well as in the exercise of the independent activities of physicians, lawyers, engineers, architects, dentists & accountants.
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Discussion Question

Question 1

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