Place of Business for Tax Purposes: an inconclusive discussion

Accounting team discussing financial report data with chart on computer screen in office, consulting people reviewing corporate strategy and business analytics metrics

Economic Definition

Shall we dare to interpret this? If yes, how? What is business? Where is the place of business? Let’s take the most generic definition of “business” and “place of business” from lawinsider.

“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 constitute 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 at earning revenues. In perspective of taxation: employment, investing and business activity are all economic activities because each of these activities 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

Definition from commentary from The Commonwealth of Symmetrica

The slice-by-slice approach adopted in the Symmetrica means that income is calculated separately for each activity of a person that constitutes an employment, business, or investment. It is, therefore, necessary to determine the character of a person’s activities in order to determine whether they are of these types.

“Employment” is the dominant definition and whether an employment exists is primarily determined according to general law. Employment is typically an earning activity consisting predominantly of the provision of labor by an individual.

“Business” is defined broadly to include trades, professions, vocations, and arrangements with a business character. In this way, the term is used throughout the Act as a shorthand reference to these types of activities. If a business activity may also be characterized as employment, primacy is given to the characterization as employment. However, unlike employment, business is an earning activity typically consisting not only of the provision of labor but of the combined provision of assets, labor and capital.

“Investment” is used as the residual manner in which income may be derived and “income from an investment” is the residual category of income. In contrast to employment and business, investment is typically an earning activity consisting predominantly of the provision of capital.

Commentary from UN and OECD Model Tax Treaties

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 FAR Test

One indication of a business is to follow the FAR test of the enterprise being subject to the test. FAR test is actually an authoritative test found in OECD Model Tax documents to establish the profit allocation methodologies to distribute the enterprise profits between its various taxable establishments. By seeking to allocate profits, the FAR test for arm’s length principle follows the approach of treating the members of a multinational enterprise group as operating as separate entities in various tax jurisdictions. Because the separate entity approach treats the members of a group as if they were independent entities, attention is focused on the nature of the transactions of the members to test if they qualify to be treated as a business enterprise – which is at the heart of what we are going to discuss in this post.

Functional analysis (FAR Test) is an understanding of the related party transactions, business operations, functions performed, assets employed and risks assumed to determine the characterization of the taxpayer’s business, so the guidelines of FAR test is also useful to delineate the meaning of a functional business.

A functional analysis involves the determination of how functions, assets (including intangible property) and risks in a business are divided up between parties involved in the transactions under review. Thus, a functional analysis serves three important purposes: (i) to provide an overview of the organization and its business operations; (ii) to identify the functions performed, risks assumed and assets employed by both the associated and independent persons, and (iii) to assess important and economically significant functions, risks and assets undertaken by both the associated and independent persons.

Functions Performed

Functions are activities performed by each person in business transactions such as procurement, marketing, distribution and sales. When all the essential business functions oriented to deliver an output or process that the business requires are performed by a unit it makes the unit capable of working independently from its parent companies. A unit acting as an assistance function for the finance or human resources or similar support function may not be functionally significant but when a part of the business operation or product is being performed by the unit it might meet the “functions performed” test of the company. This is also true from an economic sense because any increase in economically significant functions performed is compensated by an increase in profitability of the person.

Usually, when various functions are performed by a group of independent persons, the party that provides the most effort and, more particularly, the rare or unique functions would earn the most profit. For example, a distributor performing additional marketing and advertising functions is expected to have a higher return from the activity than if it did not undertake these functions. Thus it is also relevant to consider the relative importance of each function in a functional analysis for testing whether an enterprise constitutes a business. This can again be compared with what functional analysis seems to connect with the units of an enterprise. It goes to describe that: it is relevant to consider the relative importance of each function in a functional analysis. The sheer number of functions performed by a particular member of a multinational group does not necessarily mean that it should derive the greater share of the profit. A party performing the most, or more, economically significant functions of the group’s operations, albeit fewer functions relative to the other associated person, should be entitled to the greater share of the profit.

Assets Employed

In comparing functions performed, it is also important to identify and consider the assets (tangible and intangible) that are employed, or are to be employed, in a transaction. This includes the analysis of the type of assets used (e.g. plant and equipment and valuable intangibles) and the nature of the assets used (e.g. the age, market value, location, and property right protections available).

i. Tangible assets employed: Tangible assets such as property, plant and equipment are usually expected to earn long-term returns that commensurate with the business risks assumed. Profitability of a company should rightfully increase with the increase in the amount, as well as the degree, of specificity of assets employed. Quantifying these amounts whenever possible helps to determine the level of risks borne and the level of profit a company should expect.
ii. Intangible assets employed: Intangible assets are also expected to generate returns for the owners by way of sales or licensing. It is thus essential to identify the parties to whom the returns generated are attributable.

Risks Assumed

Evaluation of risks assumed is crucial in determining arm’s length prices with the economic assumption that the higher the risks assumed, the higher the expected return. Controlled and uncontrolled transactions are not comparable if there are significant differences in the risks assumed, for which appropriate adjustments cannot be made.

Types of risks:
i. Operational risk (including risks for manufacturing liability, systems failure, reliability of suppliers, inventory and carrying costs, environmental and other regulatory risks);
ii. Market risk (including industrial risks, country political risks, reliability of customers and fluctuation in demand and prices);
iii. Product risk (including product liability risk, warranty risk / costs and contract enforceability);
iv. Business risks related to ownership of assets or facilities;
v. Financial risk (including currency, commodity, interest rate and funding risks);
vi. Credit and debt collection risks (including delay or default in payment of trade receivables, default on guaranties, loans and other receivables); and
vii. Risks of the success or failure of investments in research and development.

Allocation of risks
The allocation of risks between associated persons should be based on functions performed. A functional analysis helps identify important risks, as well as differentiate between the party which bears and controls the risks in the legal contractual terms and the party which bears the risks based on the economic substance of the transaction.
In an open market the assumption is that an increased risk will be compensated by an increase in the expected return. However, this does not always mean that the actual return must necessarily also be higher, as it also depends on the degree to which the risk is actually realized.

Consistency of risk allocation with economic substance
Allocation of risks must also be consistent with the economic substance of a transaction. The best evidence, in determining whether a purported allocation of risks is consistent with the economic substance of a transaction, is in the parties’ conduct.
An additional factor to consider in examining the economic substance of a purported risk allocation is the consequence of such an allocation in an arm’s length transaction. In an arm’s length deal, it generally makes more commercial sense for one party to be allocated a greater share of those risks over which they have relatively more control and from which they can insulate themselves less costly than the other party.

The threshold for being a “business” for PE purposes is low but still demarcated

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.

Business activities: 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.

Also, Indian judiciary has also observed that where no business operations are undertaken in India, business connection is not established in the country. Asia Satellite … vs Director Of Income Tax on 31 January, 2011 which held that in order to constitute a business connection, the test to be applied was that there must be an activity of the non-resident in India having an intimate relationship of a business character with the business of the non-resident which contributes to the earning of the profit by the non-resident in his business. The Tribunal took the view that business is carried on at a place where some activity capable of producing income is carried on.

Income Tax Directive 2066: Basis of Establishment of PE

Where any foreign enterprise has its transactions in Nepal there may be a taxable presence. It is essential to determine the form and extent of its presence in Nepal and also determine its taxability. Permanent establishment is a tax construct for this purpose. The definition for permanent establishment takes the following basis of the business functions:

A. Mere supply of the goods doesn’t create a permanent establishment

“Supply” is also a component of the business but simply the supply function doesn’t create a permanent establishment in another tax jurisdiction. A foreign enterprise may have their transaction in Nepal by the reason of their supplies in Nepal but the supply function doesn’t create permanent establishment. This is mainly guided by the reason that mere supply of goods/services doesn’t create a significant value chain and active involvement within the country to have the supplier’s place of business. All the significant portion of the macro production, rendering and supply chain value is created in the country where the supplier is located rather than the place where supply is made. In most cases the supplier isn’t even concerned with the insurance and shipping of the goods/services from their godown. It is the nature of every business that makes it absurd to pin a place as a permanent establishment just because goods from another tax jurisdiction are supplied into them.

B. Foreign enterprise in another jurisdiction creates permanent establishment not foreign individual

Permanent establishment is a place of business of an foreign enterprise in another tax jurisdiction. A foreign individual without any formal enterprise with his presence in another tax jurisdiction doesn’t create permanent establishment in another jurisdiction, only a foreign enterprise’s taxable presence in another jurisdiction creates permanent establishment. A taxable presence of a foreign individual in Nepal creates individual tax liability not a permanent establishment.

C. A foreign enterprise must have a “establishment” in Nepal

A foreign enterprise must have an “establishment” in Nepal. Establishment might be in the form of Fixed Place, Service PE, Project PE, Agency PE or Insurance PE. There are different thresholds for each kind of PE which we will discuss in detail here: A Dummy’s Guide to Permanent Establishment.

D. Operation of “business” is necessary for it is necessary to be PE

It is mandatory for the non-resident enterprise to operate “business” activity to be termed as PE. Business should be a set of continuous activities and not sporadic activities or transitory activities. “Business” is the place of a non-transitory establishment to pursue economic activity.

The Meaning of Place of Business

Here we will discuss the nature of cross-border transactions. Over time, two types of cross-border transactions have emerged:

Doing business with a country

This involves foreign companies being engaged in business transactions with the residents of a country, wherein these companies conduct their business activities without setting up a business presence in this country, for instance, selling products to its residents, but transferring the titles, risks and rewards outside the country. In such a situation, the taxation mechanisms of foreign companies are usually straightforward. Such foreign companies are not taxable in the country in which purchasers of their products are located, since they neither have an official presence in it nor do they undertake any business activities in it.

Doing business in a country

This situation envisages the presence of a company in a country that is not its country of residence. In this case, the company undertakes business activities in the foreign country by establishing its formal presence in it. The activities of such a company may be conducted by its employees or an agent, or from a fixed base through which it operates in the country. The taxation-related implications of these cross-border transactions are complex.

The main questions that arise are two-fold:
(a) Which country has the right to tax the business profits earned by the foreign company through its formal presence in a country?
(b) If the country in which a foreign company has a formal presence has the right to tax the business profits earned by it by utilizing the country’s resources, how can the proportion of profits to be taxed be determined?
This is where the international tax concepts of PE and profit attribution come into play. These determine the right of a country to tax the profits of a company that is the resident of another country. They lay down the principles and factors to be considered for the constitution of a PE, and the consequent profit attribution methods and the taxation mechanisms it should use to avoid double taxation. The PE concept is recognized by most countries and has been incorporated by them in their domestic tax provisions and international tax treaties.