Debunking IRD’s PE Directive 2077

Work in Progress !!

For PE concepts, please visit my other blog: A Dummy’s Guide to Permanent Establishment. We will be discussing here some of the problems that can be identified in the list of examples provided in PE Directive, 2077 issued by IRD. Let’s go: 

Fixed Place PE

उदाहरण २.२.२: American Sports Inc.

मानौं, American Sports Inc. ले आफ्नो सामान नेपालमा बिक्रि वितरण गर्ने उद्देश्यले दरबारमार्गमा शाखा कार्यालय खोलेको रहेछ । आयकर ऐन, २०५८ मा निकाय वा प्राकृतिक व्यक्तिलाई कर लाग्ने व्यवस्था गरिए तापनि गैर बासिन्दाको शाखामात्र भएपनि स्थायी संस्थापनको रूपमा कर लाग्र्दछ । स्थान प्रधान रहेको अवस्थामा सो संरचना कति दिन नेपालमा प्रभावकारी रह्यो गणना गरिरहन पर्दैन ।

Comments: The mere presence of business activity does not amount to Permanent Establishment. Paragraph 2 of the Article 5 (Concerning the definition of PE) provides a list of the Permanent Establishment, however, the OECD Commentary on the same provides that such list is to be seen as non-exhaustive list and it should satisfy the requirement of paragraph 1. Paragraph 1 of Article 5 provisions the general definition of the Permanent Establishment. The Definition of permanent establishment provides following elements:

  • Disposal Test: Place of business which covers any premises, facilities or installations at the disposal of a foreign enterprise.
  • Permanence Test: The place of business has to be a “fixed” one and a certain degree of permanency should be present. Degree of permanency is determined by evaluating if the intention for the place of business is of purely temporary nature.
  • Business Activity Test: For a place of business to constitute a permanent establishment the enterprise using it must carry on its business wholly or partly through it.

This example assumes that the presence of branch office will ipso facto constitute the permanent establishment, disregarding the business activity test. As aforementioned, the list of permanent establishments provided under Paragraph 1 should be subject to the general definition pursuant to Paragraph 1 i.e, all the aforementioned tests should be examined. This given example in the Directive is completely silent in activity test. 

A PE is a construct only for tax purposes. Depending on the activities of a foreign enterprise in Nepal it could trigger one/few of the several forms of PE. The consequence of having a PE in a jurisdiction is that the operation of Foreign Enterprise in Nepal will be viewed distinctly and the transfer pricing rules should be applied to reasonably determine the revenues and expenses attributable to the unit in that particular jurisdiction. Once a PE is triggered, it is more likely than not that the foreign enterprise will also be treated as having branch office in the same jurisdiction, which may also lead to having indirect taxes (e.g. Sales Tax, Value Added Tax, Excise Duties) liability in the jurisdiction. 

As per the prevalent Companies Laws in Nepal, a foreign enterprise’s branch office or contact office could be present in Nepal. A Contact Office is typically only allowed to: (i) corresponding/communicating with stakeholders in Nepal on behalf of foreign company, (ii) providing any assistance to import / use the products and services of the foreign company without receiving any considerations, (iii) to make necessary coordination with agent/distributors in Nepal. When a foreign enterprise is exploring the possibility of generating direct sales from activity within Nepal, establishment of a Branch Office may be necessary, as a Contact Office is not permitted to carry out such commercial activities through its office in Nepal. 

An important aspect to note from the above example in the context of business than can be conducted by a branch office. The activity of a foreign company’s branch office in Nepal to import the products and supply and distribute the products directly into Nepal is essentially considered to be “trading” activities. “Trading” activities (with an exception) is listed in the negative list of Foreign Investment and Technology Transfer Act. Although it is also not clear as to whether investment made to fund the branch operation in Nepal is “foreign investment”, Office of the Company Registrar, which registers branch office under the Companies Act doesn’t usually register a branch office with a sole business objective of trading goods in Nepal. In my view this should not be the case, which we will discuss further in another post. <link to the other blog here>

So what options to foreign enterprise have to supply their goods into Nepal? Generally such enterprises have adopted the following options: (1) Direct Sales Arrangement, (2) Limited Risk Distributor Arrangement (may be accompanied by establishing Contact Office in Nepal and appointment of independent market sourcing consultants in Nepal), and (3) Establishing a subsidiary company with foreign investment in Nepal involved not only in sales but also in manufacturing of products. Under the current market practice, several companies have appointed consultants with limited roles to carry out limited research and marketing sourcing activities in Nepal in addition to direct sales / distributor arrangement in Nepal. There has not been very strict instances of regulatory authorities inspecting or taking action against such practices. So also in reference to the negative list of foreign investments in Nepal for trading activities, the most suitable arrangement of operation could be: (i) registration of contact office in Nepal, and/or (ii) Distributorship Arrangement, and/or (iii) appointment of independent consultants for research and market sourcing activities. These alternatives have also been discussed in the Companies Directive, 2072.  

Going back to the main question: Is Branch always a PE? What is the intention behind providing the term “branch ” the indicative list of PEs in Model Tax Treaties? If this is to be viewed against the background of definition for Fixed Place PE?
The objective of providing a non-exhaustive list of the forms of establishment that could be likely be fixed place establishment is to provide guidance to the contracting states and authorities on what units of foreign enterprise are likely to satisfy the test of the fixed place PE that are discussed above. This paragraph contains a list, by no means exhaustive, of examples, each of which can be regarded, prima facie, as constituting a permanent establishment. As these examples are to be seen against the background of the general definition given in definition of Fixed Place PE, it is assumed that the Contracting States interpret the terms listed, “a place of management”, “a branch”, “an office”, etc. in such a way that such places of business constitute permanent establishments only if they meet the requirements of Fixed Place PE. It has been necessary to include this indicative list because developing countries often wish to broaden the scope of the term “permanent establishment” and this indicative list although by no means being an exhaustive list, suggests the nature of units that may qualify as being the fixed place PE. This view has been supported by this case law: AB LLC and BD Holdings LLC

उदाहरण ३.३.५: France SARL

मानौं, नेपालमा दर्ता रहेको लयेँ प्रा.लि. ले फ्रान्स कम्पनी (France SARL) बाट केही सामान आयात गर्न खरिद सम्झौता गरेको रहेछ । फ्रान्स कम्पनी (France SARL) ले आफ्नो कारखानामा उत्पादन भएको सामान नेपालमा गोदाम गरी राख्ने गरेको रहेछ । उक्त कम्पनीले लयें प्रा.लि. लाई सोही गोदामबाट नेपालमै स्टोर गरेको सामान उपलब्ध गराएछ । नेपालमा बिक्रि कार्य भएकाले सो बिक्रि फ्रान्स कम्पनी (France SARL) को नेपालमा संचालित व्यवसाय हुन्छ । फ्रान्स कम्पनी (France SARL) ले आफ्नो गोदामबाट नदिई नेपालमै खरिद गरेको सामान आपूर्ति गरेको भए तापनि नेपालमै बिक्रि गरिएकाले त्यो पनि नेपालमा संचालित व्यवसाय मानिन्थ्यो ।

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. 

उदाहरण ३.३.२ : USA LLC

मानौं, अमेररकि कम्पनी (USA LLC) को नेपालमा कारखाना रहेछ । उक्त कारखानाले आफूलाई चाहिने कच्चा पदार्थ र सहायक कच्चा पदार्थ नेपालमा नै खरिद गर्ने गरेको रहेछ । सो कम्पनीले उक्त कच्चा पदार्थ नेपालमा किने वा नकिने जेसुकै गरे तापनि स्थायी उत्पादनको क्रियाकलाप नेपालमा भएकाले सो नेपालमा रहेको व्यावसायिक क्रियाकलाप हुन्छ । उत्पादनको स्थान नेपाल भएकाले उत्पादित सामान नेपालमा बिक्रि हुनु वा नहुनु वा विदेशमा बिक्रि हुनु वा नहुनुले नेपालको व्यावसायिक क्रियाकलाप र स्थायी संस्थापन पहिचानमा फरक पर्दैन ।

Economic Interpretation of "Business" and Comments from Model Tax Laws of UN and OECD

The above example is correct. However there is one burning question regarding the meaning and context of Pe that is best if dealt here. What is a “business” for PE purposes? When does a foreign enterprise’s functions in Nepal constitute its PE in Nepal? Need there be a whole organization of the foreign enterprise for it to be treated as enterprise in Nepal? What are the tests for it? Shall we dare to interpret this?

In normal economic sense, “Business” refers to the organized efforts to pursue an economic activity. Here, two key concepts arise “organized efforts” and “economic activity”. “Place of business” means the place of a non-transitory establishment to pursue business. In this context the concept of organized efforts in a business activity refers to: (i) Economic Activity constituting earning of revenues, (ii) Production/purchase and Sales of goods and services, (iii) Continuity and regularity and (iv) Risks and uncertainty. Economic activity are the activities that constitutes earning of revenues. The meaning of Activity for tax purpose should mean an economic activity. Any economic activity is indicated by Land/Resource Decisions, Labor Decisions, Entrepreneurship Decisions and Capital Decisions aimed in earning revenues. In perspective of taxation: employment, investing and business activity are all economic activity because each of these activity in some form constitutes some form of or combination of Land/Resource Decisions, Labor Decisions, Entrepreneurship Decisions and Capital Decisions. But what really distinguishes business activity from investing and employment activity are:
1. Business activity constitutes all Land/Resource Decisions, Labor Decisions, Entrepreneurship Decisions and Capital Decisions
2. Business activity includes production/purchase and Sales of goods and services
3. Business activity is characterized by Continuity and regularity
4. Business activity involves risks and uncertainty

Commentary from UN and OECD
The Convention does not contain an exhaustive definition of the term “business”, which, should generally have the meaning which it has under the domestic law of the State that applies the Convention. The question whether an activity is performed within an enterprise or is deemed to constitute in itself an enterprise has always been interpreted according to the provisions of the domestic laws of the Contracting States. No exhaustive definition of the term “enterprise” has therefore been attempted in the commentaries or Model DTAAs. However, it is provided that the term “enterprise” applies to the carrying on of any business. Since the term “business” is expressly defined to include the performance of professional services and of other activities of an independent character, this clarifies that the performance of professional services or other activities of an independent character must be considered to constitute an enterprise, regardless of the meaning of that term under domestic law. States which consider that such clarification is unnecessary are free to omit the definition of the term “enterprise” from their bilateral conventions. 

The threshold for being labeled as a “business” for the purpose of PE is pretty low

An important characteristics of a business is “continuity of business”. Isolated events should not constitute a business connection and the foreign company should be able to demonstrate continuity of its business activities in a State. There should be a real and intimate connection between the business activities of the foreign company and its activities in Nepal, including business activities such as back office operations and support services, which do not generally constitute a PE in the country. Judiciaries around the world has now also observed and took a view that business is carried on at a place where some activity capable of producing income is carried on. Asia Satellite vs Director Of Income Tax on 31 January, 2011. So in this context, the threshold for determining what constitutes a “business activity” for the purpose of PE is pretty low.