Tax treaties generally provide that the business profits of a foreign enterprise are taxable in a jurisdiction only to the extent that the enterprise has in that jurisdiction a permanent establishment to which the profits are attributable. The definition of permanent establishment included in tax treaties is therefore crucial in determining whether a non-resident enterprise must pay income tax in another jurisdiction.
The BEPS Action Plan called for a review of that definition to prevent the use of certain common tax avoidance strategies used to circumvent the former Model permanent establishment definition, such as arrangements through which taxpayers replace subsidiaries that traditionally acted as distributors by commissionnaire arrangements, with a resulting shift of profits out of the jurisdiction where the sales took place without a substantive change in the functions performed in that jurisdiction.
Strategies used to avoid having a taxable presence in a jurisdiction under tax treaties may cause cross-border income to go untaxed or be taxed at low rates. Taken together, the tax treaty changes suggested in the Report on Action 7 enable jurisdictions to address BEPS concerns resulting from tax treaties, which was a key focus of the work mandated by the BEPS Action Plan.
- changes to ensure that where the activities that an intermediary exercises in a jurisdiction are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, that enterprise will be considered to have a taxable presence in that jurisdiction unless the intermediary is performing these activities in the course of an independent business.
- changes to restrict the application of a number of exceptions to the definition of permanent establishment to activities that are preparatory or auxiliary nature and will ensure that it is not possible to take advantage of these exceptions by the fragmentation of a cohesive operating business into several small operations;
- changes to address situations where the exception applicable to construction sites is circumvented through the splitting-up contracts between closely related enterprises.
To foster the implementation of these changes in the global treaty network, jurisdictions negotiated a Multilateral Instrument (the MLI) to modify existing bilateral tax treaties in 2016.
The changes to the permanent establishment definitions were integrated in the 2017 OECD Model Tax Convention and in Part IV of the MLI (Articles 12 to 15). The Multilateral Instrument (MLI) is a flexible instrument that allows jurisdictions to adopt BEPS treaty-related measures to counter BEPS and strengthen their treaty network. The MLI was signed by nearly 90 jurisdictions and about half of the MLI Signatories have so far adopted the MLI articles that implement the permanent establishment changes.