17 Jan 2020
Multilateral Instrument: The Application of Specific Activity Exemption Article to Covered Tax Agreements
Action 7 - 2015 Final Report under the OECD/G20 BEPS Action Plan, titled “Preventing the Artificial Avoidance of Permanent Establishment Status” (the Action 7 Final Report), addresses the issue of artificial avoidance of permanent establishment (PE) status, and that includes a review of the definition to prevent the use of certain common tax avoidance strategies that are currently adopted to circumvent the existing PE definition. Those strategies result in shifting profits out of the country where the sales took place without a substantive change in the functions performed in that country, including (i) the use of commissionaire arrangement to replace subsidiaries that traditionally acted as distributors, (ii) the splitting-up of contracts, and (iii) the exploitation of the specific exceptions to the PE definition provided for by Article 5(4) of the 2014 OECD Model Tax Convention (the MTC), an issue which is particularly relevant in the digital economy.
The Action 7 Final Report introduced the changes made to the definition of PE in Article 5 of the OECD Model Tax Convention, which are used as the basis for tax treaties negotiations. The changes are also incorporated in the multilateral instrument (the MLI), which operates alongside the existing tax treaties by modifying the application of the tax treaty provisions. Specifically, article 13 of the MLI – the Artificial Avoidance of PE Status through the Specific Activity Exemption – has been drafted to address some of the concerns the Action 7 final report identified.
From the policy perspective, certainty and clarity are of great concerns to tax administrations and taxpayers alike in matters of international taxation. How contracting jurisdictions allocate the respective taxing rights certainly falls under the scope of certainty. Yet the allocation of taxing rights depends very much on how PE status is defined. How a PE status is defined among others depends on how specific activity exception is determined. The determination of specific activity exception in turn depends on whether the preparatory or auxiliary condition needs to be taken into consideration. If yes, then one must determine (i) whether a specific activity is of preparatory or auxiliary character; and (ii) whether a combination of specific activities constitutes complementary functions that are parts of a cohesive business operation that is not merely preparatory or auxiliary in nature. Adding an important element to uncertainty regarding the allocation of taxing rights, the ever-evolving world of information and communication technology has continued to exert influence on existing business model and process, and that will alter the view which people share in considering whether or not an activity has a preparatory or auxiliary character. The status quo is that contracting jurisdictions sharing different views on the aforesaid issues cannot reach a consensus on them. Therefore, the MLI article on the artificial avoidance of PE status with respect to specific activity exception includes options or alternative provisions giving rise to different outcomes.
From a technical perspective, Article 13 provides for three alternative options under Article 13(1), and three opt-out provisions (reservations) under Article 13(6). A party is permitted to withdraw a reservation or replace it with one that is more limited in scope, but cannot shift its position in the opposite direction with respect to pre-existing CTAs after confirming its initial position. As exemplified in this article, an opt-in provision and an alternative provision have something in common as the application of these two types of options is subject to any reservations made. But there are differences between the two. An opt-in provision applies only if both parties make a matched notification. Thus, the adoption of an opt-in provision gives rise to the same outcome as it must be applied symmetrically. In contrast, the adoption of an alternative provision may result in different outcomes as it can be applied asymmetrically.
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