Debunking IRD’s PE Directive 2077

Nepal has entered into DTA Agreement with 11 countries. Before the introduction of the Income Tax Act, 2058 DTAA were entered with India 1987, Norway 1996, Thailand 1998, Sri Lanka 1999, Mauritius 1999, Austria 2000, China 2001 and Pakistan 2001. After the introduction of the Income Tax Act, 2058 agreements were entered with South Korea 2003, Qatar 2007 and Bangladesh 2019. The provision regarding the warehouse has been covered in the Article 05: Permanent Establishment.
If we notice DTAA Article 5 (Permanent Establishment) Para 4, Sub Para (b) of DTAA with India, Mauritius, Norway, Pakistan, Qatar, Thailand, Srilanka states:
b. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, or display; 
However, in case of DTAA signed with Austria, China, South Korea and Bangladesh, Para 4, Sub Para (b) of DTAA states: 
b. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, or display or delivery; 

As stated in clauses of DTAA, the term “delivery” has been expressed in separate ways. In some countries delivery is covered whereas in some countries the term “delivery” is not covered. But irrespective of the difference the meaning of warehouse for the purpose of  same treatment is to be done while asserting whether if a warehouse constructs Permanent Establishment. Delivery functions being directly linked to the sales activity are more likely to be regarded as a integral function of the sales. But for now let’s move past that.

So the question is, does warehouse constitute a “Permanent Establishment”? Or, can a warehouse be treated as “business”? 
Para 4 of Article 5 of the Model DTAA under OECD provides exceptions to the warehouse from the definition of the Permanent Establishment. Firstly, the use of facilities solely for the purpose of storage, or display of goods or merchandise belonging to the enterprise doesn’t constitute a PE. Secondly, the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, or display, also doesn’t constitute a PE. Thirdly, the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; is also excluded from the definition of PE. And, lastly, d. the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information for the enterprise; is also excluded form the definition of PE. 

In the context that there is simply a warehouse then the warehouse may not be considered as Permanent Establishment. Whereas if there is presence of warehouse and selling office; warehouse and dependent agent; warehouse and employee for sales of goods then the warehouse is to be considered as Permanent Establishment of the Company. However, the warehouses run by third parties in the form of consignment warehouses and goods are transported to clients by third-party forwarding firms, will not create PE. 

In the case of Airlines Rotables Ltd., the Mumbai Tax Tribunal held that since none of its business activities, which led to its growth in India, were undertaken at the warehouse of the Indian company, the warehouse did not constitute a fixed place PE in India.

A relevant example from OCED Commentary: Company X is a resident of Country C. It is engaged in the business of selling goods online directly to customers in different countries including Country Y. Company X has a leased warehouse in Country Y. The employees of the warehouse are responsible for the shipment of the goods from the suppliers, stocking the goods, and delivering the goods using the services of an independent delivery service provider. Company X also has an office in Country Y which is responsible for collecting information from the customers in Country Y. The business activities carried on by Company X at the warehouse and the office likely constitute complementary functions that are part of a cohesive business operation. Therefore, both the warehouse and office are treated as the P.E. of Company X in Country Y. The profits attributable to the warehouse are those that it would have derived if it were a separate and independent enterprise performing the same storage and delivery activities. Similarly, the profits attributable to the office are those that it would have derived if it were a separate and independent enterprise performing the same information gathering activities. 

UN Model Commentary: In reviewing the United Nations Model Convention, the Committee retains the existing distinction between the two Models, but it notes that even if the delivery of goods is treated as giving rise to a permanent establishment, it may be that little income could properly be attributed to this activity. Tax authorities might be led into attributing too much income to this activity if they do not give the issue close consideration, which would lead to prolonged litigation and inconsistent application of tax treaties. Therefore, although the reference to “delivery” is absent from the United Nations Model Convention, countries may wish to consider both points of view when entering into bilateral tax treaties, for the purpose of determining the practical results of utilizing either approach. 

The newer problem with online sales: Currently, most retail multinationals are involved in online sales, with some international sellers engaged solely in digital sales. Online sales usually require that an enterprise maintain a warehouse abroad (with an adequate number of employees) where goods owned by the enterprise are stored and delivered to local customers (once sold by the enterprise). It seems indisputable that storage and delivery activities to fulfil online sales constitute an essential part of an enterprise’s distribution business and therefore do not have a preparatory or auxiliary character. As a result, under the new PE definition, these local places of business are likely to constitute a PE of the enterprise. The existence of a PE does not automatically mean a material increase in tax exposure (although it is likely to trigger additional compliance costs and administrative burden for businesses), so it may be a competitive decision to allow the creation of PE, branch units or subsidiaries in the context of increasing businesses in the particular jurisdiction. 

OECD proposes an alternative approach
In a recent publication on counteracting BEPS (Base Erosion and Profit Shifting) OECD has changed its approach to the place of taxation regarding income from distribution activities. The proposed solutions provide that businesses using consignment warehouses in other countries should pay taxes in these countries. Although the recommended BEPS version does not constitute a binding solution, it may contribute to changes in the recent favorable approach of tax authorities. Thus, businesses undertaking operations based on a consignment or foreign warehouse should consider the above risk. These new developments have taken assumption that the delivery managed through consignment warehouses could mean to indicate a significant sales activity. 

Current Status of warehouse in the Context of E-Commerce
The current status of warehouse in the context of ecommerce is that a warehouse if a passive activity. But there is a case to be made for conclusion that the warehouses of the webmall/ecommerce companies could very well create a PE as the warehousing and sales logistics of the webmall/ecommerce company, as it could be viewed as constituting a significant portion of the sales activity of the ecommerce/webmall business. But this meaning should not extend to a manufacturing company whose manufacturing activity occurs in separate jurisdiction than the jurisdiction where the warehouse is situated.
In a recent decision of the Japanese Court, a taxpayer had a warehouse located in Japan for storage and delivery and for the receipt of returned products. In analysing the existence of a PE, the court held that to qualify for PE exclusion under Art. 5(4) of the US – Japan Treaty (which is equivalent to Art. 5(4) of the OECD Model Convention) activities need to be PoA in character. The court noted in particular that a warehouse located in Japan for quick delivery to customers and the ability to handle returned products were important elements of the online retail business. Because these activities and other activities performed in Japan were in fact “significant” for an online retail business, the court upheld the existence of a PE in Japan. However, when a foreign company has both the warehouse and subsidiary company in the other jurisdiction, the activity of the foreign company, albeit from the warehouse, could be regarded as PE as there may be economic dependence between the subsidiary company and the warehouse. This rule is called Anti Fragmentation Rule.