Understanding and Avoiding Business Nexus and Taxation across Borders under BEPS by Andre Benayoun, JD
Posted on August 16, 2017
Gone are the days when multinational companies could reduce or eliminate their tax liabilities by taking advantage of broad language contained in various income tax treaties that the U.S. had effectuated with other foreign jurisdictions. In 2015, the Organization for Economic Cooperation and Development (OECD) introduced a new framework that aims to prevent businesses from exploiting gaps in different countries’ tax systems and artificially shifting their profits to low- or no-tax jurisdictions. Under this Base Erosion and Profit Shifting (BEPS) Action Plan, barriers have been put into place to block businesses from implementing strategies that had previously allowed them to take advantage of exceptions to U.S. income tax treaties and avoid creating a tax nexus that would have otherwise required them to pay taxes in that country.
By amending tax treaties to ensure that corporate profits are taxed in the jurisdiction where real economic activities generate those profits and create value, the BEPS Action Plan aims to eliminate these legal practices of tax avoidance. In turn, businesses around the globe will not only be required to adjust their financial and tax reporting, but also to plan and prepare revised guidelines for those activities they, their employees, or their agents may take while working abroad.
What is the BEPS Action Plan?
At its core, the BEPS Plan features 15 recommended best practices for increasing tax transparency and information sharing between international tax authorities; improving voluntary compliance with cross-border tax-treaty consistency; and making the taxation of corporate profits more certain and predictable among all participating countries.
How Does Business Nexus Affect Taxability?
One area of particular interest is Action Item 7, which aims to prevent multinational enterprises from artificially avoiding permanent establishment (PE) status, or a “substantial economic presence,” in a jurisdiction that would otherwise trigger a related tax liability in that country. Historically, a PE has been defined to include:
- a physical “fixed place of business” in a country (a “fixed place PE”), or
- a dependent agent (be it an individual or a corporation) in that country that “habitually exercises the authority to conclude contracts on the enterprise’s behalf,” (a “dependent agency PE”).
These loose definitions, along with several exceptions to the rules, had permitted many enterprises to avoid creating PEs, or business nexus, in foreign countries. Common tactics the businesses employed included the use of commissionaire or toll arrangements, specific activity exemptions (e.g. preparatory and auxiliary services and warehousing facilities), and splitting up contracts.
In an effort to curb artificial avoidance of permanent establishment status and accompanying tax liabilities, BEPS Action Item 7 expands the definition of dependent agency PE to involve all situations in which a closely related agent or person acts on the behalf of an enterprise. This includes not only the conclusion of contracts, but also any contracting for the “transfer of ownership or granting of rights to use” any property owned by the enterprise, or that the enterprise has a right to use or any contract for which the enterprise promises to provide services.
Under this expanded definition, a multinational enterprise will have a dependent agency PE in a contracting state where it has an agent whose activities “lead to the conclusion of contracts” in the name of the enterprise, or for the transfer of goods or services by the enterprise. The only exception will apply to those enterprises that hire truly independent intermediaries, whose businesses are separate and unrelated from the enterprise, and who do not work exclusively for the enterprise.
Action Item 7 also limits taxable nexus to “fixed places of business” where an entity conducts activities that are not considered “preparatory or auxiliary” to its core business. Only those short-term activities that “support, without being part of, the essential and significant part of the activity of the enterprise as a whole” will escape PE treatment. This may include maintaining stock of goods for storage, display, delivery or processing, as well as purchasing or collecting information for both brick-and-mortar and online businesses. Note, however, that these very same activities may, under certain circumstances, comprise an essential (or significant) part of the operating entity’s business activity.
For example, a large, online distributor that makes its money by warehousing the products of others and delivering such products in a timely fashion may now have more trouble arguing that its warehouse facilities are preparatory rather than the essence of its business. As such, they may no longer rely on this exception to avoid a local tax nexus in the jurisdiction in which they maintain such warehouses.
These revised definitions may give way to a flood of PE-creating activities for which businesses will be exposed to greater tax liabilities and administrative costs in additional countries, even when they have in place well-established policies concerning the “do’s” and “don’ts” of cross-border activities. In fact, under the BEPS package, businesses will need to reexamine their compliance with the principles of cross-border business activities to ensure that they do not run afoul of these new, broader definitions of when a tax nexus may be created abroad.
How May My Business Minimize Exposure to Permanent Establishment Status?
Businesses and their executives must closely assess their cross-border activities to identify and correct instances in which they may be inadvertently creating taxable PE.
For example, consider a U.S. company that hires one of its foreign subsidiaries to act as a sales agent for its product in a local market. Historically, the sales agent or its employees would not sign contracts with a local customer, but instead, perform all of the negotiations and other related activities that led to the eventual contract signing between the third-party customer and the ultimate U.S. parent company. Under the old definition of dependent agency PE, the U.S. company could first argue that the related subsidiary was independent. However, even if it treated the agent as dependent, the U.S. company could still argue that the agent did not have the authority to sign contracts, and did not habitually do so, thereby allowing the company to avoid a local tax nexus.
However, under the new, expanded definition, a related party, such as the one described above, would almost surely be treated as dependent; the company would be unable to make the first argument that the foreign subsidiary could be considered independent under the old definition. Furthermore, under the new definition of dependent agency PE, it is not required that the agent habitually sign contracts. Rather, it is only required that such agent’s activities lead to the conclusion of contracts in the name of the U.S. parent company. In such a case, the same activities that did not give rise to a local tax nexus under the old definition, would, indeed, give rise to a tax nexus under the new rules.
To avoid triggering taxable PE status under Action Item 7, businesses may need to restructure existing sales arrangements, and/or implement new policies and procedure for selling their goods and services across borders in the future. International tax advisors can help businesses analyze the substance of their cross-border activities and make recommendations for restructuring business activities, including transfer pricing adjustments 1) to minimize risk of creating a tax nexus in the first place; and 2) to reduce the amount of the income tax exposure associated with a taxable nexus, if one could not be avoided.
About the Author: Andre Benayoun, JD, is an associate director of International Tax Services with Berkowitz Pollack Brant where he works with inbound and outbound multinational businesses and nonresident aliens on a variety of matters, including structuring for mergers, acquisitions and liquidations; planning for profit repatriation; treaty analysis; tax efficient debt financing; and pre-immigration tax planning. He can be reached at the firm’s Miami office at 305-379-7000 or via email at firstname.lastname@example.org.