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San José State University High Technology Tax Institute Academy October 18, 2013
Permanent Establishment Basics & Cloud Computing
William R. Skinner, Esq. [email protected] (650) 335-7669
Overview
Permanent Establishment (PE) Basics
Review US Model Treaty PE Definition &
Application
Recent Developments
OECD Guidance on E-Commerce
Cloud Computing
Federal Income Tax Applications – International and
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Permanent Establishment (PE)
Basics
Background – Definition of PE
Income tax treaties commonly provide that business
profits of a non-resident enterprise (NRE) are taxable
in the source country only if attributable to a permanent
establishment that the NRE maintains therein.
NRE (Germany)
US Presence US Customers
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Spectrum of Source Country Activities
Level of local connections and contacts determine
whether NRE will have a taxable presence (i.e., PE) in
the state of source.
• License IP to Subsidiary or Third Party
• Sell to Local Customers over Internet
• Traveling Employees
• Local Office for Promotion & Market Intelligence
• Sales Activity
• Earn Investment Returns
• Advertise Locally
• Site/ Customer Visits
• “Rep Office” • Manufacturing
• Trade Shows • Management Little or No Contracts Extensive Contracts No Direct Activities Remote Activities Transitory Activities Limited Function Office Full Office
Permanent Establishment (PE)
Treaty Provisions – Article 5
Typical structure of Article 5:
Articles 5(1) and 5(2) – basic test of PE
Article 5(3) – special rules for construction sites and
performance of services (if applicable)
Article 5(4) – exception for “preparatory and auxiliary
activities”
Articles 5(5) and 5(6) – treatment of agents of NRE
Article 5(7) – a subsidiary / affiliate is not in itself a PE
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Permanent Establishment (PE)
Treaty Provisions – Article 7
Typical structure of Article 7:
Article 7(1) –only profits attributable to the PE are taxed Articles 7(2), 7(3) and 7(5) – apply as
quasi-arm’s-length approach to determining profits attributable to a PE
Article 7(4) – no profits attributable to purchasing
activity
Article 7(7) – income realized after PE ceases to exist
Permanent Establishment (PE)
Treaty Provisions – Flowchart
Step 1:
Is there a fixed place of Business (Art. 5(1)) ?
Is there a local agent with contracting authority (Art. 5(5))?
Step 2: Is the agent a “dependent agent”
Step 3: Are the local activities
more than merely “preparatory or auxiliary” (Art. 5(4))?
If the answer to all of these questions is yes, the NRE has a PE and is subject to tax on its profits attributable to the PE (Art. 7).
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Review of PE Definition
Article 5(1) and 5(2)
Article 5(1) – “the term “permanent
establishment” means a fixed place of business
through which the business of an enterprise is
wholly or partly carried on.”
Article 5(2) lists examples such as an office,
factory, workshop, “place of management,”
branch, or mine / quarry.
Review of PE Definition
Article 5(1) – Component Parts
Article 5(1)’s basic test can be broken down into
several sub-elements:
A “place”– i.e., a physical presence at a location A fixed place – the same place is used for activities
with some permanence or regularity.
“At the disposal of” – NRE has legal right to use or
effective control of the place of business
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Review of PE Definition
Article 5(4) – Preparatory / Auxiliary Activities
Certain activities, carried on through a fixed place of
business, do not create a PE:
Use of facilities solely for storage, display, or delivery of goods
Maintenance of a stock of goods solely for purpose of storage, display or delivery
Maintenance of a stock of goods solely for purposes of processing by another enterprise
Use of a place of business solely for purchasing activities or collecting information
Any other activity that is “of a preparatory or auxiliary character.”
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Review of PE Definition
Article 5(4) – Example 1
Maintaining stock of goods solely for storage or delivery is preparatory or auxiliary, and should not create PE.
Agency PE issues need to be considered (discussed below).
Third-Party Agent
(Spain) Customer
USP
Inventory in Spanish Warehouse
Ships Goods to Fill Orders
Dutch CFC
Concludes Sales Contracts
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Review of PE Definition
Article 5(4) – Example 2
Maintaining stock of goods
solely for processing by another enterprise is preparatory or
auxiliary and thus should not create a PE.
Third-Party Contract Manufacturer
(China)
USP
Raw Materials WIP End Product
Manufactures Product Dutch CFC
Service Fee
Review of PE Definition
Article 5(7)
Article 5(7) provides that the fact that a resident
entity is owned or controlled by the NRE shall not be
taken into account in determining whether either
company has a PE in the other state.
A subsidiary is not in itself a PE; however, its
activities may give rise to a PE under the same
standards applicable to an unrelated party.
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Review of PE Definition
Article 5(7) – Subsidiary Not a PE
Branch office / factory is a PE under Articles 5(1)
and 5(2).
US Sub is, in itself, generally not a PE of NRE
NRE Subsidiary Manufacturing NRE US Factory Branch Office Manufacturing Arm’s Length Transfer Price Sale of Product or Mfg. Services US Subsidiary
Review of PE Definition
Articles 5(5) and 5(6) – Agency PEs
Even if the NRE has no fixed place of business, it still may have a PE due to the activities of a local agent.
Article 5(5) provides that where a person, other than an agent of independent status, acts on behalf of the NRE and has and habitually exercises in the contracting state an authority to conclude contracts that are binding on the NRE, then the NRE will have a PE in respect of the
agent’s activities, unless the agent’s activities are preparatory or auxiliary.
Article 5(6) provides an exception for activities of a broker, general commission agent, or other agent of independent status acting in the ordinary course of business.
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Review of PE Definition
Agency PE – Key Components
The agency PE test has several key elements:
Authority to conclude contracts – key is negotiation and
conclusion of binding agreement; more than merely participating in negotiations; but signing contract is not necessary or sufficient.
Habitually exercise authority in the state – no bright line rules.
However, activities must be performed in the state of source.
Agent of Independent Status – two-part test to determine
independence: (1) legally independent and free from control and (2) economically independent and bearing business risk.
More than preparatory / auxiliary activities – e.g., agent whose
activities are limited to solely purchasing goods on behalf of the NRE is OK.
Review of PE Definition
Agency PE – Example 1
Third-party agent enters sales contracts on behalf of
Swiss CFC in Spain. It will not create a PE if agent is of independent status and acting in ordinary course of
Third-Party Agent (Spain) USP
Customer Swiss
CFC
Commission
$
Negotiates & Concludes Sales
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Review of PE Definition
Agency PE – Example 2
Analysis is the same, except concluding that Spanish CFC is of independent status will be difficult.
Spanish CFC USP
Customers Swiss
CFC
Cost-Plus Commission
$
Negotiates & Concludes Sales
Review of PE Definition
Agency PE – Example 3
Spanish CFC conducts Spanish business in its own name; and does not purport to act as agent of Dutch CFC. If implemented
correctly, a local distributor, such as Spanish CFC here, generally
Spanish CFC USP
Spanish Customers Swiss
CFC X% Suggested
Retail Price
$
Resale of Goods Sale of Goods
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Permanent Establishment (PE)
Treaty Provisions – Article 7
If a PE exists, the NRE is taxable only on the
business profits that are “attributable to” the PE.
PE should be attributed the profits it would earn as a
separate enterprise, dealing at arm’s length, under
“the same or similar conditions.” Art. 7(2).
OECD issued lengthy report on attribution of profits – emphasis is on location of Key-Entrepreneurial Risk-Taking (KERT) Functions.
Article 7(3) permits the PE to claim deductions,
allocable to its business, including G&A expenses
incurred at the PE or elsewhere (e.g., home office).
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PE – Current Developments
The Commissionaire
Zimmer France sells goods to customers as undisclosed agent of UK principal. UK principal regularly fulfils Zimmer France’s contracts.
Held: Zimmer France not an Article 5(5) agent PE under France – UK treaty, because it did not conclude contracts in the name of Zimmer UK. Zimmer UK Ltd French Customers Zimmer France SAS Fills orders on
behalf of Zimmer France
$
Contracts of Sale in name of Zimmer France
$ Minus Commission
PE – Current Developments
The Commissionaire
Status of commissionaire depends on the particular
country involved and local interpretations. For
example, several recent cases have addressed the
commissionaire:
Boston Scientific (Italy 2012) (not a PE)
Dell (Norway 2011), rev’g lower court (not a PE) Zimmer (France 2010), rev’g lower court (not a PE). Dell (Spain 2012) (commissionnaire was a PE)
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PE – Current Developments
The Roche Vitamins case
Held: Spanish court found Roche Swiss principal to have a Spanish PE consisting of both manufacturing activities of manufacturing subsidiary and sales activities of marketing subsidiary.
Roche Vitamins (Spain) Spanish Customer Spanish Marketing Sub Manufacturing Service Fee
Sale of Goods Marketing Service Fee Spanish Manufacturing Sub Raw Materials WIP End Products Makes Product $
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Electronic Commerce PE Issues
Should the NRE be deemed to have a permanent
establishment in the server location in either or both of the above fact patterns?
NRE (Germany)
Third Party (US)
Contracts with Third Party to Host Software
All Employees NRE
(China)
Computer Servers (Netherlands)
Provides Customers with Software through
E-Commerce PE Issues – Key Questions
Should a website accessible by residents of the
source country be sufficient nexus to subject the
NRE to tax?
When are operations of a server owned or leased by
the NRE sufficient to be a PE?
How should contracts with a third party or affiliate
to host the NRE’s website or software applications
be treated?
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Review of OECD E-Commerce Report
OECD Model Treaty commentary provides important guidance on when PEs arise in e-commerce. Art. 5 Commentary, ¶¶ 42.1, et seq.
Generally, the OECD distinguishes between physical
facilities owned or leased by the NRE (which may be a PE) and an intangible online presence (generally not a PE). ¶¶ 42.2-3., 42.5-42.9.
A website hosted on another enterprise’s servers has no
physical location and thus by itself is not an Article 5(1) PE of the NRE. ¶ 42.3.
Website itself also is not a “person” and cannot be an agent within the meaning of Art. 5(5). ¶ 42.10.
Review of OECD E-Commerce Report
If the NRE owns, leases, or has at its disposal, servers or
computer equipment at a fixed location, then that server may be a PE under normal standards.
A PE will not be created where the NRE owns a server that merely performs preparatory or auxiliary functions, such as advertising, supplying or gathering information, data
backup.
However, equipment and/or personnel that perform core functions can create a PE – for example, concluding the contract, processing payment, and shipping goods for delivery in the case of an online merchant.
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Electronic Commerce PE Issues
Article 5(7) treats subsidiary the same as an unrelated party. Therefore, absent special facts or agency relationship, in
principle, US Sub’s hosting of software generally should be treated the same as third-party hosting company.
US Sub
Webhosting Services NRE
(China) Customers
Arm’s Length Fee
• Provides Software
Recent Cases – Ebay (India Oct. 2012)
Indian tribunal ruled that Swiss company did not have PE in India on income earned from use of online marketing platform in India.
Local subsidiary provided marketing and support
services, but did not negotiate and conclude contracts on behalf of the Swiss NRE.
Reversing lower court, tribunal held that Indian marketing sub’s activities related to online sales did not include
contracting in name of NRE, and thus did not create a PE. NRE’s non-Indian personnel concluded all contracts with end-users.
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Recent Cases – Dell (Spain 2012)
Irish principal sold products through online store managed and operated out of France. Spanish sub marketed and supported sales to mid- and large-sized customers.
Spanish court found online store to be a Spanish PE, despite lack of servers or physical facilities in Spain. Court also found that Spanish Sub’s activities such as trading, selling, and delivery of products, gave rise to an agency PE.
Court dismissed taxpayer’s reliance on OECD
commentary despite Spain’s withdrawal of its objection to commentary in 2008.
Selected Recent Administrative Rulings
Canadian ruling (2012-0432141R3) – US Parent formed Canadian subsidiary to own and operate a data center for its online business. Canadian Sub employed data center personnel and charged USP an arm’s length service fee.
Held: US Parent did not have a permanent establishment.
Note US Parent employees’ ability to remotely access the servers to install software, monitor software and hardware performance, etc., did not place servers at USP’s disposal.
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Selected Recent Administrative Rulings
Swedish Tax Board Ruling (June 12, 2013) –
Foreign Parent Y formed Foreign Subsidiary X. X leased premises and operated a server in Sweden. X used the server to store software applications belonging to Y.
The operation was fully automated and controlled remotely by non-Swedish employees.
Held: X had a PE in Sweden consisting of using servers to provide storage services. Y, however, did not have a PE. The Swedish tax authorities are appealing this ruling.
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What is Cloud Computing?
U.S. Commerce Department NIST Report divides
cloud computing into three classifications:
Software as a Service (SAAS). The capability provided to the
consumer is to use the provider’s applications running on a cloud infrastructure. The interface is a web-browser or “thin” client application.
Platform as a Service (PAAS). Consumer deploys onto the cloud
infrastructure consumer-created or -acquired applications created using programming languages and tools supported by the
provider.
Infrastructure as a Service (IAAS). The capability provided to
the consumer is to provide processing, storage, networks, and other fundamental computing resources where the consumer is able to deploy and run arbitrary software.
Important Tax Questions for Cloud Computing
Character of Income – should Cloud Computing be
viewed as a transfer of property (lease or license of
software and/or computing power) or a
software-enabled service?
Bundled Services – how to analyze services included
in the cloud transaction (e.g., data storage, tech
support)?
Sourcing Income – Where does cloud clouding
income arise and in which jurisdiction(s) can it be
taxed? If Cloud Computing is a service, where is the
service performed?
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Federal Income Tax Applications—
Background on Software Income
Treas. Reg. 1.861-18 (issued in 1998) provides guidance on certain classes of software income for international tax purposes.
Licenses or transfers are viewed as IP transactions if the transaction transfers one or more significant “copyright rights”:
1. Right to make copies of the software for public distribution 2. Right to prepare derivative works
3. Rights to publicly display or make a public performance of the
software.
If “all substantial rights” are transferred, the transaction is a sale. Otherwise, it is a license giving rise to royalty
Federal Income Tax Applications—
Background on Software Income
Licenses or transfers of software without copyright rights being conveyed are treated as transfers of tangible
property (copyrighted article).
Example: End-user license or “site license” to use a
specified number of copies for internal business purposes.
The character of income depends on the terms of the license grant:
If perpetual the transaction is a sale of tangible property (generally inventory)
If limited term / subscription the transaction is treated as a lease of tangible property.
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Federal Income Tax Applications—
Example of Treas. Reg. 1.861-18
Character of SAAS transaction is not answered by Reg. 1.861-18.
Taxpayer’s Deployment Methodology
Transaction Original Equipment Manufacturer (OEM) Distributor or Reseller Customer Buys Box in
Store Customer Downloads Program Customer Subscribes to SAAS Typical Treatment
Sale or License or IP
IP License or Sale of Goods,
Depending How Structured
Sale/Lease of Goods
Sale/Lease of
Federal Income Tax Applications—
Sample Fact SAAS Pattern
Customer (utility) subscribes to acquire use of an electronic power monitoring application from a Canadian technology provider. The provider places monitoring devices on the
utility’s plant, and then allows the utility’s employees log on to the provider’s server to analyze plant performance, create
reports, etc.
The customer pays a fixed annual fee per device deployed on site.
The customer owns any data and reports created, but cannot
download the provider’s software or use it on another machine.
Assume that the customer is located in the United States and the provider’s servers are located in Canada.
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Federal Income Tax Applications—
Steps to Analysis of Example
1. Character of Income – is the income from the provision
of services or a lease / license of software (with embedded services)?
2. Source of Income – is the income U.S. source, Canadian
source or some combination of both?
3. Treaty Analysis – if US source, is this income subject to
U.S. tax under the US–Canada Treaty? Consider
a) Withholding taxes on FDAP income
b) Net basis taxation of business profits attributable to a PE
4. Subpart F Implications – if the Canadian company is a CFC, is the income subpart F income?
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Federal Income Tax Applications—
Step 1 – Character of Income
Section 7701(e)(1) of the Code provides a list of several, non-exclusive factors for distinguishing a service contract from a lease:
the service recipient is in physical possession of the property, the service recipient controls the property,
the service recipient has a significant economic or possessory interest in the
property,
the service provider does not bear any risk of substantially diminished receipts or
substantially increased expenditures if there is nonperformance under the contract,
the service provider does not use the property concurrently to provide significant
services to entities unrelated to the service recipient, and
the total contract price does not substantially exceed the rental value of the
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Federal Income Tax Applications—
Step 1 – Character of Income cont.’
Selected Section 7701(e) decisions regarding service
v. lease characterization:
Tidewater, 565 F.3d 299 (5th Cir. 2009) – taxpayer provided a
fully-staffed vessel to customer on a time charter. Court treated this as a lease, focusing on customer’s control over ultimate use of the vessel during the charter period.
Xerox, 656 F.2d 659 (Fed. Cl. 1981) – photocopiers placed on
government’s premises were provided under a service contract. Court emphasized that company could replace individual copiers and provided comprehensive services for the single periodic fee.
Smith, TC Memo 1989-318 – medical scanner on hospital
premises was used to provide a service – scanner was operated by provider’s employees and charged a fee per usage. Camera that was operated by hospital employees and provided for a fixed monthly fee was leased.
Federal Income Tax Applications—
Step 2 – Source of Income
Source of income depends on character of income, as
different rules apply for leases and services.
Services income – source to place of performance of
the services.
Piedras Negras, 43 BTA 297 (1941) – radio station’s advertising
income was sourced where the performers and equipment were used to make the broadcasts.
Reg. 1.937-3(e), Ex. 5 – income from cloud-based software
delivery was Possession-sourced where company’s servers,
software developers and people maintaining the software were all located in the U.S. Possession.
47
Federal Income Tax Applications—
Step 3 – Taxation under a Treaty
Withholding Tax. Many U.S. tax treaties exempt
rents, royalties, and service fees from withholding
tax. Thus, character of income for Treaty purposes
may not be critical.
Position in minority of certain treaties – source country can collect withholding taxes on leases of “commercial,
scientific or industrial equipment.”
Tax on Business Profits Attributable to PE. Does the
Canadian company have a permanent establishment?
If not, there generally cannot be U.S. tax on business
profits under the Treaty.
Federal Income Tax Applications—
Step 4 – Subpart F Analysis
Different subpart F tests govern leasing vs. services
income.
Lease of property –
General rule. Leasing income is subpart F income (passive FPHC
income).
Exceptions.
• Active marketing of the property being leased by the CFC’s own employees. • CFC regularly produces or manufactures, or acquires and adds substantial
value to, property being leased.
Services income –
General rule. Services income is subpart F income if (i) the services are
performed outside the CFC’s home country, and (ii) the services are performed for, or on behalf of, a related person, or rely on a U.S. related person’s substantial assistance.
49 Federal Income Tax Applications—
Section 199
Section 199 provides an incentive tax rate (approximately 32%) for taxable income derived from U.S. production activities (QPAI).
Software programming is treated as manufacturing, and thus software created by US employees in whole or
significant part can give rise to QPAI.
However, only income from the “sale, rental, lease,
license or other disposition” of the software qualifies as QPAI for Sec. 199 purposes. See IRC § 199(c)(4)(A).
Federal Income Tax Applications— Section 199
Income from a download or disc deployment of software meets Sec. 199’s transfer requirement. See Reg. 1.199-3(i)(6)(v), Ex. 4.
Income from online services, such as internet access services, online banking services, providing access to online electronic books, newspapers and journals, does not meet the transfer requirement. See Reg.
1.199-3(i)(6)(ii).
However, income from providing customers with access to software over the internet will be deemed to qualify if one of two special comparability tests are met (see
51 Federal Income Tax Applications—
Section 199 – Comparability Tests
The regulations treat cloud-based software revenue as derived from a lease / license under either of the
following two conditions:
1. Taxpayer itself regularly makes U.S.-produced
software available by download or disc, which has only “minor or immaterial differences” to the cloud offering.
2. Other competitors of the taxpayer make
“substantially identical” software available by download or disc. Substantially identical means software that—
a. Has the same functional result for the customer, and b. Has a significant overlap of features or purpose.
Federal Income Tax Applications— Section 199 – Examples
The examples and other authorities provide limited guidance on the two comparability tests.
Same exact software meets either test. Reg. 1.199-3(i)(6)(v),
Examples 4 - 6.
Showing that software is in the same general class or type of
application (e.g., payroll software and inventory control
applications) does not satisfy either test. Id., Example 7. product category.
All online games are deemed to be identical under a special rule. See id., Example 8.
What if the taxpayer provides a bundle of applications or functions for a single fee, and no single third party
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