“Permanent Establishment” May Not Be So Permanent

(Prepare for Change)

“Permanent Establishment” May Not Be So Permanent (Prepare for Change)

The United Kingdom (“UK”) recently announced plans to introduce a new Diverted Profits Tax (“DPT”) which seeks to effectively extend UK taxing jurisdiction over profits, that despite being derived from UK customers, are not cur-rently subject to UK corporate tax. Known as the “Google Tax” (which originates from the perceived abusive use by Google and other major businesses) of the current Permanent Establishment (“PE”) requirements for local country taxation that are included in most existing double tax treaties, the new tax will be distinct from the existing 21% UK Corporation Tax. The DPT will be charged at a rate of 25% on revenue from UK-based economic activity that is determined to escape UK taxation through what are deemed to be “contrived arrangements.”

The DPT legislation is expected to provide that the tax will be applied to non-residents if it is reasonable to assume, as one of their main purposes, that these arrangements are designed to avoid giving rise to a UK PE. This may include substantive arrangements that have legitimate commercial or other rea-sons why they are structured in that fashion. Further, for both non-residents (where a UK tax avoidance main purpose cannot be established) and for UK residents and UK PEs, a charge to DPT will apply if there is an “effective tax mismatch” arising from transactions with a related party and the counter party to the party has “insufficient economic substance.”

An “effective tax mismatch” will exist where the relevant transactions give rise to a reduction in the principal entity’s UK tax (either by increasing the deductible expenses or by reducing its taxable income), and the corresponding increase of the non-UK tax liability of the other party to the transaction is less than 80 percent of the UK tax saved. “Insufficient economic sub-stance” will be found where the value of the tax benefit from the relevant transactions exceeds any other financial benefit, or where the tax benefit exceeds the economic benefit provided

by the staff of the other party, provided that it is “reasonable to assume” that the transactions were designed to secure the tax reduction.

With the DPT’s taxation of “diverted profits” looming in the UK, the PE standard, one of the basic planning tenets of multinational taxation, will descend into an area of significant, subjective interpretation that businesses will need to re- examine. More troubling, however, are possible DPT imitators in other countries that may be expected to follow. Additionally, the UK’s unilateral action comes ahead of the multi-jurisdictional actions being considered by the OECD’s Base Erosion and Profit-Shifting (“BEPS”) project action committees.

BEPS Action 7 proposes changes to the existing PE defini-tion that would overturn long-held standards that are critical elements of the tax planning fabric of many companies’ foreign operating structures. For example, under existing treaty provisions, a PE can be asserted where the foreign

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representative has the authority to conclude contracts on behalf of the foreign company and exercises such authority on a habitual basis. Under the BEPS Action 7 proposals, this would be eased to a much lesser standard, where activities that are significant and integral to the contract eventually agreed by the parent may provide a basis to assert tax on the sale by the offshore company. The proposals have raised objections from multinational companies and practitioners, and will signifi-cantly increase the burden on tax authorities to administer the new standards and contend with their disregard of negotiated treaties.

While in line with the objectives of BEPS Action 7 proposals, the UK’s Google Tax undermines BEPS’ laudable goal of creating coordinated and consistent solutions to cross-border taxation issues. The UK’s unilateral moves signal that the separate country treatment of major international tax issues are likely to continue in spite of BEPS.

The offending arrangements, that would be subjected to the DPT, would include situations where significant sales activity occurs in the UK, but stops just short of the conclusion of a con-tract, thereby avoiding UK tax. The operation of the PE rules within existing tax treaties defines taxable presence as requir-ing a PE, which entails a physical presence. Further, at least as currently interpreted by countries such as the UK, the treaties essentially require the affiliates or subsidiaries of a corporate group to be treated as if they have a separate, independent existence from one another. As a result, Google (and others) escapes tax on activities in a country such as the UK, despite having a local affiliate whose employees deal with customers. Google’s UK company is treated as providing only “market-ing” services, with actual sales of advertising being booked to Google’s non-UK, Irish branch. These are the situations target-ed by the new DPT.

What should multinationals be doing now? Review of existing foreign company business activities and le-gal structures should be undertaken to assess the exposure of the arrangement giving rise to a PE and tax obligations in the affected countries. Multinationals should review their current legal and operating structures to determine the potential impact of DPT, the anticipated DPT clones, and the possible adoption of BEPs Action 7 changes to the PE definitions. Consistent with the continuing trend in both international and domestic tax planning, some comfort should be found where:

• The business substance of the foreign operating structure, and not tax avoidance, drives the operating structure.

• The economic value contributed to the business arrangement and the financial benefit of the tax reduction coincide.

• A formal taxable UK presence (e.g. legal entity, PE) is created in the UK.

• “Arms-Length” transfer pricing is in place throughout the organization’s global business structure.

While DPT is destined to be debated in the international courts, the application of the “near-miss” of PE status should be avoid-ed. By being more severe in some respects than corporation tax, the DPT provisions appear to strong-arm targeted foreign companies to avoid the new tax and restructure. By declaring more UK profits, subject to regular corporate tax, they would then avoid the punitive DPT liability.

For more information on the UK’s Diverted Profits Tax and the proposed BEPS Action 7 Permanent Establishment changes, or to assess how they may impact your multinational operations, please call us.

A c c o u n t i n g T a x A d v i s o r y

Smart Devine provides a full range of accounting, advisory, tax and investigative forensic and litigation services to organizations across a variety of industries.

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SMART DEVINE CAN HELP YOUDoug Nakajima has over 30 years of experience in federal and international tax and strategic business planning, serving a U.S. and foreign client base of multinational manufac-turing, service and technology businesses. He has advised clients on the tax treatment of domestic and cross-border transactions, inbound and outbound business expansion strat-egies, domestic and cross-border acquisitions, dispositions and reorganizations, intercom-pany transfer pricing analysis, documentation and audit defense, treaty interpretation, and repatriation planning. Doug has worked extensively with tax advisors in foreign countries to develop global structures that minimize U.S. and foreign tax exposures, and in this role, has forged effective working relationships with key professionals throughout North America, Europe, Asia and the Pacific Rim. For more information, please contact Doug Nakajima at 267.670.7307 or dnakajima@smartdevine.com

DOUGLAS W. NAKAJIMA, J.D., LL.M. Managing Director, Tax Services

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