Issue 97 – 11 December 2009


As this is the last newsletter of 2009, I would like to take this opportunity of thanking all our readers for taking the time to review our articles and to send us your valuable comments. I would also like to thank our clients for making 2009 the happiest and, bizarrely, in the worst recession we have had for decades, the most successful year we have enjoyed for a long time. And I would also like to thank our colleagues around the world for their help in contributing to this success, and I look forward to working with them even more closely in 2010 with the new Association that I am setting up. I will explain this more in the January 2010 Newsletter, but it is a professional association of contributors to my “big red book” International Tax Systems and Planning Techniques, which will provide networking opportunities for all members and assist further in providing quick and comprehensive advice to our clients. 

I have just returned from Mumbai where I was invited to speak at the 15th Annual Conference on International Taxation established by Professor Roy Rohatgi. There were several academic professors from Norway, Austria, Australia, Denmark the US, Canada and Switzerland as well as the Indian specialists who presented to a 450 strong and very successful conference. My presentation was “International Tax Issues related to Investing in the European Union”, but I thought I would highlight in this Newsletter two topics discussed by other speakers and the Panel as a whole, which are so relevant in the current environment. 

The first relates to the concept of permanent establishments, i.e. whether a person can be taxed in another country as a result of limited trading in that country; the second relates to beneficial ownership of income and whether double tax treaty provisions are respected by tax administrations. 

Stripping away all technical jargon, suppose I fill a van with home grown brussels sprouts from my garden and take the next Eurostar to Belgium. I park my van in the Grande Place and sell my brussels sprouts in Brussels, making a profit. Clearly, this is a trade carried on in Belgium, and I should be subject to Belgian taxation. However, the double tax treaty between the UK and Belgium, as with all double tax treaties, is intended to facilitate international trade without putting obstacles in its way, and being subject to Belgian taxation would certainly be an obstacle which would encourage me to cancel my Eurostar ticket. It is for this reason countries concluding double tax treaties with each other accept that there has to be a permanent establishment in place before a country is able to tax trading profits arising therein. The article below centres on two very current issues: 

Does property development constitute a permanent establishment? 

Do servers create a permanent establishment in e-commerce? 

The second article reviews the application of double tax treaties where the recipient of income may not be considered to be the beneficial owner of such income. Several court cases have established in recent years the criteria which should be considered, and my article also discusses whether countries can simply override the provisions of double tax treaties where it suits them. 

Finally, to all of our readers, Lara and I (and of course Giselle) wish you a very happy Christmas and sincerely hope that a healthy and prosperous 2010 awaits you. 

Permanent Establishments 

The OECD definition of the term ‘permanent establishment’ means a fixed place of business through which the business of an enterprise is wholly or partly carried on. Thus there must be physical presence at a specific location, which is fixed in terms of place and duration, and the physical place must be where the business is wholly or partly carried on. And then of course it is only the profits that can be attributed to that place of business that should be taxed in the relevant jurisdiction. 

Clearly, a temporary place of business (such as my van in the Grande Place in Brussels) is not a fixed place of business, and generally it is considered that anywhere which has a duration of less than six months could not be considered a fixed place of business. And the most important point is whether I have a right to use premises, even if they are indeed fixed and exist for more than six months. Thus I must either own, rent or otherwise have premises available to me as a result of a legal right. So if I had signed up with the Belgian authorities to occupy a stall for 12 months, even if I am only physically in Belgium for one or two months, I would have the legal right to use fixed premises at a specific location for a certain duration, and this is where my business is carried on. Ergo, a permanent establishment (taxable presence) would exist. 

Property developments 
Turning first to the issue of whether a property development is in itself a permanent establishment. In fact, the UK tax authorities have taken this line in specific cases where double tax treaty permanent establishment provisions are relevant. These cases relate to non-resident owners of real estate that have entered into contracts with local builders to develop land with the intention ultimately either to rent the completed development or to sell it. 

HMRC regard the non-resident companies as trading in the UK, and this in undeniable. The question is whether there is a permanent establishment in place. All the normal arguments that could be raised by HMRC are not relevant in these cases, i.e. the independent contractors are not dependent agents since they enter into contracts with many non-related owners as part of their ordinary business, and there is no other dependent agent in the UK which could create a permanent establishment. So we have to go back to the basics as above. 

The business of the property owner is to develop property, but this is carried on through its fixed place of business in its country of residence, not in the UK. Certainly part of the business will be carried on at the property itself, but not through where the property is located. Indeed, the legal right to occupy the land is contractually held by the independent contractors until completion, and the real estate owner has no right to use the land for any business purposes until the development has been completed. Thus it cannot be denied that the business is property development but it is not carried on by the non-resident company through the site in the UK, it is merely the object of the business activity. 

Further arguments relate to the question of who owns the physical assets that serve as the basis for the business activity. In this case, the cranes, scaffolding, materials and of course personnel, are all “owned, rented or otherwise at the disposal” of the independent contractor, not the real estate owner. The business activity is development, using all of these physical assets, and therefore it is the business of the independent contractor that is carried on at the physical location, not the business of the real estate owner that is carried on through that fixed place of business. 

E-commerce and servers 
The case of a server in e-commerce has similar fundamentals. The business of e-commerce may be conducted by an entity in a jurisdiction in which no servers are located. These may be the premises where the entity is located through which the e-commerce activity is carried on, but is there an argument that the activity is also carried on where the servers are located? I agree to this, much like the Grande Place is where the sales of my brussels sprouts take place. However, the fundamentals require us to ask the following questions: 

Is there a physical location for the servers? The answer is yes, and is this fixed? Again the answer is yes. 

Does the e-commerce trading entity own the physical assets that serve as a basis for the business activity i.e. the servers? If the answer is no, then does the entity have a legal right to enter the premises and use the physical assets? 

In the case of servers hosted by independent companies, the entity would generally sign up to a hosting contract, using servers owned by these independent companies, and certainly they would have no legal right to enter the premises of the hosting entity without permission. The key question to ask in any issue involving legal right (whether by ownership or through contracts) is whether the entity can be removed from the fixed location without its consent. In the majority of cases therefore, the servers do not dictate the existence of a permanent establishment / taxable presence for the trading entity. 

Beneficial Ownership 

I have written many articles on treaty shopping and the more recent trend of introducing Limitation of Benefits (LOB) clauses when negotiating double tax treaties. The LOB clauses essentially examine whether the recipient entity is really the beneficial owner of income and therefore entitled to benefit from the relevant treaty. Nowadays, however, there is a further worrying trend, and that is that countries are overriding the provisions of double tax treaties in contravention to the basic principles of the Vienna Convention on the Law of Treaties. 

The latest example was announced only last week on 2 December 2009 by the Russian tax administration amending Article 7 of the Russian Tax Code. This article states that the provisions in international treaties should have priority over domestic tax rules. The draft law now states that if it is determined that the factual recipient of income is not a tax resident of the State with which the Russian Federation has concluded an international tax treaty, then the provisions of the treaty will not apply to such relevant income. 

Certainly, when advising clients on the creation of international tax structures, I state that it is essential for there to be economic substance for any entity that is established for tax beneficial purposes. Thus, Controlled Foreign Company (CFC) rules will not apply where subsidiary companies have “exempt activities” which reflect economic substance in the form of premises, assets, equity at risk and the functional capacity required to carry out these activities through relevant personnel. Similarly, for either ultimate or intermediary holding companies, they also should have economic substance, although clearly their activities are limited to the holding of assets and investments rather than trading activities. Therefore such holding companies may not require premises and staff, but must nevertheless have directors who are capable of fulfilling the tasks of management of such assets. 

And the management should be effective management, which of course must be considered on a case by case basis. One of the recent cases involving beneficial ownership is the Indofoods case on which I have reported in previous Newsletters. Here, a Dutch company was interposed in order to obtain treaty benefits, but in fact was mandated to hand over its income to another entity within the Indofoods Group, and actually made no profit on the transaction in which it was involved. Clearly there could be no effective management attributed to the activities of the Dutch company, and in this case it was not considered to be the beneficial owner of the income for which treaty relief was claimed. 

One must look at the provisions of double tax treaties very closely to see what is the wording of specific provisions. The dominant language must also be understood in case of conflicts in interpretation of specific provisions. Thus for example the term ”beneficially owned” may be differently interpreted than the term “beneficially held”, since for example the registration in the share register of an entity may mean that a company is indeed beneficially held by a specific entity, although it may not be beneficially owned by that entity. 

But as explained above, the more worrying development is that tax authorities may simply disregard specific provisions where it suits them, stating that as far as they are concerned double tax treaties should not be used for the purposes of tax avoidance. In this, they are helped by the title of most double tax treaties entered into under previous OECD models, which is a Convention “For the Avoidance of Double Taxation and the Prevention of Fiscal Avoidance”. In many instances, tax structures not only avoid double taxation, but even single taxation in the source country is avoided without there being any corresponding taxation in the recipient entity. In such a case, tax authorities may justifiably claim that the treaty is not being used to avoid double taxation but it is indeed used for fiscal avoidance purposes and therefore should be disregarded. Certainly this is a line that has been taken in court cases to date and may become more prevalent in the future.