1 Key Issues relating to Permanent Establishment 9 October 2008 (15:30-17:00) ASATSUMA Akiyuki Rikkyo University (Tokyo)

2 issues Why we need PE concept? PE & FE (fixed establishment) Trigger of source tax Taxable income & PE Attribution of profits to a PE PE & electronic commerce Agent PE Profit sharing & PE

3 Why we need PE concept? (1) 2 kinds of tax jurisdiction on income –Residence tax jurisdicion –Source tax jurisdiction income flow income flow Income earner  payer Income earner  payer Residence country Source country

4 Why we need PE concept? (2) Sometimes it is said that source of income is “illusion”. Certainly, it is “logically” true. Income is defined as “income = consumption + net increase of wealth”. The definition of income only looks at personal situation. Logically income does not have geographical attributes.

5 Why we need PE concept? (3) Even though logically income has no geographical source, in actual, can we abandon a concept of source of income? Can we allocate tax authority only according to residence? Can we give up taxing income from real estate which is own by foreign person?

6 Why we need PE concept? (4) Foreign corp subsidiary (taxable) Foreign corp branch (non taxable) R-country S-country S-country should have tax authority on domestic source income of foreign residents. However, source tax authority should not be unlimited because of the difficulty of tax compliance for foreign residents.

7 PE & FE (fixed establishment) Income tax: PE Consumption tax: FE PE threshold is lower than FE threshold. –A vending machine can be a PE. –FE needs human intervention. PE is taxable only on its net income. FE is taxable on gross sales amount.

8 Trigger of source tax (1) PE is justification of source tax. PE is limitation on source tax. German type: PE (Betriebsstätte) concept is a symbol of domestic businesses of non-residents. Income attributable to a domestic (German) PE is domestic source income and is subject to source taxation according both to domestic tax law and to tax treaties.

9 Trigger of source tax (2) US type: A non-resident’s domestic (US) business yields domestic source income and is subject to US source taxation according to US domestic tax law. However, under tax treaties, US cannot tax a non-resident’s business income if he has no PE. Domestic business and PE are somewhat resemble but not equal.

10 Taxable income & PE (1) Entire income principle (Old US; Japan): If a non-resident has a PE, then all domestic source income is subject to source taxation at the hand of the PE, regardless whether the income is derived by the PE. It is called as “force of attraction”. Now US applies “effectively connected income” principle, resembled next slide.

11 Taxable income & PE (2) Attributed income principle (Germany): Domestic source business income is income attributable to a domestic PE. Business income not attributable to a PE is not subject to source taxation. OECD Model Tax Convention §7 (1) adopts this principle.

12 Attribution of profits to a PE (1) “functionally separate entity” approach A PE is a part of a non-resident, does not have legal personality. We do not imagine a contract between my left hand and my right hand. However we must “hypothesize” the PE as a “distinct and separate enterprise” and recognize “dealings” between the PE and other parts of the non-residents.

13 Attribution of profits to a PE (2) Even if total profits of the non-resident is 100, the PE’s profits can be more than 100 if the PE did good jobs and it can also be minus if it did bad jobs. We must determine: –Functions of activities of the PE –Risks attributed to the PE –Assets, obligations and capital of the PE

14 Attribution of profits to a PE (3) Basically profit attributed to a PE is determined, referring arm’s length principle applied to transactions between affiliated companies. However the lack of legal personality might raise differences. (ex. Creditworthiness)

15 Attribution of profits to a PE (4) Old version of OECD Commentary does not recommend recognizing intra- payments of royalties or interests from/to a PE to/from foreign parts of a non-resident. New version will recommend recognizing intra-payments. However issues of withholding are blank.

16 PE & electronic commerce (1) music download  money flow  supplier user Foreign Japan music download  money flow  supplier user Foreign Japan If the foreign supplier has no PE in Japan, then Japan cannot tax the income paid from Japanese users. If the payment is royalty, then Japan can tax under some tax treaties.

17 PE & electronic commerce (2) OECD said that a computer server can be a PE. (cf. A vending machine can be a PE) However income attributed to the server PE would be very small, if not zero. Therefore electronic commerce will give little tax revenue to users’ country (Japan).

18 PE & electronic commerce (3) PE threshold should be amended? We can say that PE threshold should be amended if business circumstances are changed. PE is not sacred. PE is a crystal of compromise between countries. PE is not genuinely led from logic. Electronic commerce can be said as big change.

19 PE & electronic commerce (4) However, should users’ country (Japan) have tax authority? PE is an indication of income source. What is source of income? Suppliers’ business [PE taxation]: Japan isn’t location of suppliers’ business. Users’ demand [royalty taxation]: Japan is location of demand.

20 PE & electronic commerce (5) Historically PE taxation has been executed along with an image that geographical source of income is located at the place of suppliers’ business. If only existence of electronic commerce in Japan can be a PE, tax practices would not be workable. For example, we do not have expenditure allocation rule in the context of such virtual PE.

21 PE & electronic commerce (6) However, tax treaties allocate source tax jurisdiction not only looking at suppliers’ business, but also payers; for example, royalty taxation. It is not ridiculous to claim that also demand country should have tax authority in contexts of electronic commerce; but PE taxation on electronic commerce would be impractical.

22 Agent PE (1) principal agent-----trading partner (R 1 co.) (A 1 ) (S 1 co.) head office branch----trading partner (R 2 co.) (S 2 co.) R-county S-country Not only a branch but also an agent can be a PE, because both R 1 & R 2 participate in S-country’s market through an agent or a branch.

23 Agent PE (2) If A 1 is an independent agent, A 1 does not do R 1 ’s business but do A 1 ’s own business. If A 1 is a dependent agent, A 1 can be said as doing R 1 ’s business and can be a PE. However, does R 1 really do its business in S-country? Certainly S-country provides market in both cases, but R 1 physically exists only in R-county.

24 Agent PE (3) Providing market or demand is non justification for PE taxation. In case of R 1, S-country’s taxing power should be limited on income attributed to A 1 ’s activity. Do we still need agent PE concept? If A 1 is not compensated by R 1 along with arm’s length principle because A 1 is dependent, then §7 (2) increases tax revenue of S-country.

25 Agent PE (4) If A 1 is compensated along with arm’s length principle, do we still apply §7 (2)? Some people say that in such cases R 1 ’s agent PE would have no income. OECD concluded that income of A 1 and income of R 1 ’s agent PE are different. Does OECD consider providing market as base for PE taxation?

26 Agent PE (5) Germany Italy Philip Morris GmbH A-co.----I-co. PMG sold tobacco to I-co. A-co. was a member of Philip Morris group and had only acted as liaison of contracts between PMG and I-co. But A-co. was considered as an agent PE by Italian supreme court. Did PMG really do its business in Italy?

27 Profit sharing & PE (1) shareholder corporation partner partnership R-country S-country A corporation is a taxable entity. A non- resident shareholder bears tax on dividend income. A partnership is a transparent entity. However, the partnership is usually seen as a PE of a non-resident partner.

28 Profit sharing & PE (2) silent partner (N-co.) business (J-co.) Netherlands Japan J-co. did business and distributed the business profits to N-co. but this income is characterized as “other income” (§23). J- co. was not considered as a PE of N-co. However Netherlands did not tax N-co., considered as having a PE in Japan!

29 Profit sharing & PE (3) shareholder corporation creditor debtor partner partnership R-country S-country Entity characterization Deductibility of payment Withholding tax or PE recognition