This article originally appeared in the September edition of The Taxpayer
The 1997 Assessment Act states that, if you are a foreign resident, your assessable income includes the ordinary income you derive from Australian sources (e.g. from sales to Australian customers). In practice, however, it can be difficult for Australia to tax many non-residents on their Australian income. This is because it can be difficult for the ATO to detect business income which has a source in Australia and, where detected, challenging to collect the tax on that income.
In recognition of these difficulties, Australia will not tax the Australian-sourced income of our treaty partners, unless the non-resident has a sufficient presence in Australia. This sufficient presence is referred to as a ‘permanent establishment’ (PE). Practically, this means that a non-resident will likely need to lodge an Australian return if it has a PE in Australia.
What if the non-resident is not from a treaty country?
The bulk of Australia’s trade and investment involves countries with which Australia has entered into a Double Taxation Treaty (DTT). Furthermore, Treasury is frequently negotiating new treaties – for example a treaty was signed with Chile in April 2010. Nevertheless, there are still many countries, from Afghanistan to Zimbabwe, where no such agreement is in place. Where there is no DTT in place, Australia does not require non-residents to have Australia to have a PE before it will tax them on their Australian business profits.
Where a non-resident business has a PE in Australia, our DTTs only allow Australia to tax the profits that are attributable to that PE. When calculating which profits to attribute to a PE, the ‘functionally separate entity’ approach is applied. Broadly, this means that the PE will be taxed on the profits it might be expected to make if it were a separate and independent enterprise, dealing with other parts of the enterprise at arm’s length.
The OECD Model
Australia’s tax treaties generally closely match the OECD’s Model Tax Convention (model treaty) and therefore this article focuses upon the clauses of this model convention and its official commentary. Under the model convention, there are broadly three types of PEs that can be construed:
- A fixed place of business PE (Article 5(1)),
- A construction or project PE (Article 5(3)), and
- An agency PE (Article 5 (5-6)).
Each of these are discussed in detail below.
The BEPS Project
The permanent establishment concept has been around for many years – it dates back to the 1800s and the Austro-Hungarian empire. The OECD’s model treaty can trace its origins to the League of Nations. As you can imagine, international business has grown enormously, and undergone substantial changes during the intervening years.
The OECD’s BEPS (Base Erosion and Profit Shifting) project represents the most significant attempt to address the challenges of a modern, complex global economy in decades. The project is divided into 15 ‘actions’, with Action 7 focusing on permanent establishments. Broadly, the OECD is proposing to expand the definition of a permanent establishment to counter multinational enterprises that seek to avoid PE status via what it sees as artificial arrangements.
The OECD’s specific proposals, contained in the final report on Action 7, are discussed in detail below. It is expected that, over the coming 18 months or so, the countries involved (including Australia) will amend their bilateral tax treaties (via a multilateral instrument) to reflect the proposed changes.
The general definition
Paragraph 1 in Article 5 of the model treaty contains the general definition of the term “permanent establishment”. It states:
“For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.”
A PE therefore has three elements:
- There must be “a place of business”,
- That place of business must be “fixed”, and
- The business of the enterprise must be carried on “through” that fixed place
Place of business
The OECD commentary explains that the term place of business covers premises, facilities or installations, whether or not they are used exclusively in carrying on the business of the enterprise. Furthermore, a place of business may exist where an enterprise merely has a certain amount of space at its disposal (i.e. even if this space is not owned or rented by the enterprise).
Determining when a facility is at the disposal of an enterprise can be a difficult and contentious issue. Clearly the mere presence of a representative of an enterprise at a location does not necessarily mean that the location is at the disposal of that enterprise. However, where an employee of a company is permitted to use an office at the premises of another company (e.g. a subsidiary) for an extended period of time, that office can be said to be at the disposal of the former company. It appears that the extent of the presence at a location, the activities performed at a location and the effective power to use a location may be relevant.
The commentary explains that there must be a stable link between the place of business and a specific geographic point. Furthermore, the business must have a certain degree of temporal permanency. The ATO has ruled, and the OECD has suggested, that, as a guide, six months or more is sufficiently ‘permanent’. However, this is not a hard and fast rule – each case is a question of fact and degree. A place of business may constitute a PE even though it exists for a very short period of time, due to the nature of the business.
The commentary advises that the word ‘through which’ must be given a wide meaning “so as to apply to any situation where business activities are carried on at a particular location that is at the disposal of the enterprise for that purpose”.
The listed examples
Paragraph 2 provides specific examples of a PE. It states that the term includes especially:
“a) a place of management;
- b) a branch;
- c) an office;
- d) a factory;
- e) a workshop, and
- f) a mine, an oil or gas well, a quarry or any other place of extraction of natural
These examples are by no means exhaustive and are to be seen against the background of the general definition.
Building sites etc
Paragraph 3 of the model treaty states:
“A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.”
The term ‘building site or construction or installation project’ includes not only the construction of buildings but also the construction or renovations of roads, bridges or canals, the laying of pipelines and excavating and dredging.
The twelve-month requirement applies to each individual site or project. The commentary explains that the period commences when the contractor begins work, including preparatory work, in the country where the construction is to be established. Seasonal or other temporary interruptions should be included.
The BEPS project identified that some multinational enterprises have split-up contracts between closely related parties in order to abuse the twelve-month requirement and artificially avoid permanent establishment status. To address these concerns, a principal purpose test will be added to the model treaty. The commentary will be updated to explain that, where it would be reasonable to conclude that one of the principal purposes for the conclusion of separate contracts was to obtain the benefit of the exclusion in paragraph 3, it would not be appropriate to grant that benefit. Some states may wish to expressly provide for the time periods of separate contracts between closely related enterprises to be combined.
Specific activity exemptions
Article 5(4) lists a number of business activities that are not permanent establishments, even if they satisfy a definition contained in one of the earlier paragraph (e.g. even if they are carried on through a fixed place of business). The common feature of these activities is that they are, in general, preparatory or auxiliary activities.
The exemptions listed in paragraph 4 are:
- The use of facilities solely for the purpose of storage, display or delivery of goods
or merchandise belonging to the enterprise;
- The maintenance of a stock of goods or merchandise belonging to the enterprise solely for:
- The purpose of storage, display or delivery; or
- The purpose of processing by another enterprise;
- The maintenance of a fixed place of business solely for the purpose of;
- Purchasing goods or merchandise or of collecting information, for the enterprise;
- Carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;
An exemption is also available for any combination of activities mentioned above, provided that the overall activity is of a preparatory or auxiliary character. While not defined in the model treaty, a preparatory activity can be understood as one that is carried on in contemplation of carrying on the essential and significant part of the activity of the enterprise as a whole. An auxiliary activity is one that is carried to support or supplement, without being part of, the essential and significant part of the activity of the enterprise as a whole.
The key criterion, therefore, is whether the activity forms an essential and significant part of the enterprise as a whole. In practice, it is often difficult to distinguish between activities which have a preparatory or auxiliary character and those which are the core or main activities of the business. As a guide, an activity that requires a significant proportion of the assets or employees of the enterprise is less likely to be preparatory or auxiliary.
The changing nature of international business means that activities which were previously considered to be merely preparatory or auxiliary may nowadays constitute core business activities. Therefore, some enterprises have been able to artificially avoid PE status via the specific activity exemptions, beyond the intend application of paragraph 4.
Accordingly, most of the countries involved in the BEPS project have agreed to amend the paragraph, so that it explicitly provides that an activity will only excluded where the overall activity of the fixed place of business is of a preparatory or auxiliary character. Therefore, the listed activities will become simply common examples of activities that are covered by the paragraph, not those that automatically qualify for an exemption.
In some circumstances, an entity will be treated as having a permanent establishment if it has a dependant agent (e.g. an employee) acting on its behalf in a contracting state, even if it does not have a fixed place of business in that state. As it currently stands, paragraph 5 states that a permanent establishment exists where a dependent agent “has, and habitually exercises, an authority to conclude contracts in the name of the enterprise”.
The commentary explains the importance of looking beyond legal formalities.
“Lack of active involvement by an enterprise in a transactions may be indicative of a grant of authority to an agent. For example, an agent may be considered to possess actual authority to conclude contracts where he solicits and receives (but does not formally finalise) orders which are sent directly to a warehouse from which goods are delivered and where a foreign enterprise routinely approves the transactions.”
The OECD has expressed concern that it has sometimes been possible to artificially avoid having a PE under article 5(5) through commissionaire arrangements. Broadly, a commissionaire is a person who acts in his or her own name for the account of a principal. Under a typical arrangement the commissionaire sells products in a State in its own name but on behalf of a principal. That principal is contractually bound to deliver (through the commissionaire) the goods sold to the customer, while the commissionaire is contractually bound to collect the proceeds and remit it to the principal (in exchange for a commission). Importantly, no relationship is created between the customer and the principal. Under civil law jurisdictions, the activities of a commissionaire are not attributed to the principal and therefore, through such an arrangement a foreign enterprise is able to sell its products in another state without creating a taxable presence.
Similar strategies that seek to avoid the application of article 5(5) involve situations where contracts are substantially negotiated in a State, but finalised abroad.
To address these concerns, paragraph 5 will be amended to state that a permanent establishment will exist where a dependent agent is acting in a contracting state on behalf of an enterprise and:
“in doing so, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are:
- in the name of the enterprise, or
- for the transfer of ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or
- for the provision of services by the enterprise”
The principal role leading to the conclusion of a contract will typically be played by the person who convinced the third party to enter into a contract with the enterprise (e.g. where the conclusion of a contract directly results from the actions of that person). The phrase would not apply where a person merely promotes and markets the goods or services of an enterprise in a way that does not directly result in the conclusion of contracts.
Paragraph 5 will not apply where the agent is performing their activities in the course of an independent business.
As it presently stands, paragraph 6 states that:
“an enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business”
An independent agent will typically be responsible to the principal for the results of their work, will not be not subject to significant control with respect to the manner in which that work is carried out and will often represent numerous principals. The distinction between dependent and independent agents is therefore akin to the distinction between employees and contractors for PAYG withholding purposes.
There is concern among OECD countries that some agents are being inappropriately being classified as independent, despite being closely related to the foreign enterprise on behalf of which they are acting. To address these concerns, paragraph 6 will be amended to include the proviso that:
“Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, that person shall not be considered to be an independent agent”.
A person is closely related to an enterprise if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same person or enterprises. The new paragraph 6 will expressly provide that a person will also be closely related to an enterprise where:
- Either one possesses, directly or indirectly, more than 50% of the beneficial interests in the other; or
- A third person possesses, directly or indirectly, more than 50% of the beneficial interests in both the person and the enterprise