Double Taxation: US, UN and OECD Models Permanent Establishment and Business Profits - Essay Example

Double Taxation: US, UN and OECD Models – Permanent Establishment and Business Profits 0 Introduction In an article entitles ‘Double Tax Treaties: The Basics and Benefits’ (Zarb: 50) indicates that as a result of globalization the issue relating to double taxation has been brought into the limelight. Double taxation agreements relates to persons that are resident of one or both states which are party to the treaty (UN 2001: 7). These agreements normally last for a period of five (5) years (Zarb: 50). The growth of MNC’s along with electronic commerce has brought the issue into sharp focus. However, attempts to deal with the problem of double taxation goes back to the early 1920’s. Although the US has not adopted the OECD model treaty, the model has played a great role in the treaties that the US has entered into since 1963. In fact the Technical Explanation US Model Convention points to the OECD model in explaining permanent residence (US: 2006). The OECD Model Tax Convention contains the treaty concept of permanent establishment which is used mainly to determine taxation rights when a business entity in one country derives profits from a business in another country (OECD: 2012). Double taxation treaties are bilateral agreements between countries and serves to: facilitate a reduction in or an elimination of the problem of double taxation of income; establish cooperation between authorities in contracting states on tax matters; facilitates the promotion of trade between contracting countries so that normal flow of capital is not negatively affected; divides revenue in a fair manner; and fights against tax evasion and fraud (Zarb: 51). This paper looks at the three models of double taxation – Unites States (US) model and compares it with the United Nations (UN) model and the OECD model in order to determine what similarities or differences exists among them in order to inform people who do not understand the provisions contained in them. These three models are used as points of reference in bilateral agreements (Zarb: 53). The paper looks specifically at the definition of permanent establishment and business profits. These models are important because they apply to agreements between different countries. The US model relates to double taxation agreements between the US and other countries with which they have agreements. The UN model relates to agreements between developed and developing countries while the OECD model relates to members of the OECD. The definition of permanent establishment is important as it relates to the profits of a business. It needs to be established whether or not this exists to determine which country is eligible to receive taxes on the business profits of an entity. If this is left to the enterprise then it will seek to have its income taxed in a country where the rate of tax is less then the country of residence or the lower of the tax rates of two countries in which residency exists. 2.0 Permanent establishment as the qualification for the taxation of business profits In order to determine where business profits become taxable an enterprise needs to first determine whether the criteria for permanent establishment has been met. There are a number of rules that needs to be met for this to take place. Additionally, there are a number of exceptions that limits certain benefits. All three models apply to persons who reside in one or both Contracting States. 2.1 US Model Convention The term permanent establishment is important as its existence is of paramount importance in the taxation of business profits by the US of one of its residents who may also be a resident in another Contracting State or country with which the US has an agreement (US 2006, p 15). Permanent establishment is defined in the model as a fixed location through which the business is carried on partially or wholly. The general principle is that the place of business must be fixed – having an immovable structure or physical location where the business is carried out with some level of permanency. The model provides a list of various types of business places that are representative of a permanent establishment. Rules in relation to whether a building site or a construction, project relating to assembly or installation, a drilling rig or ship used for exploration of natural resources can be classified as a permanent establishment are also considered. The site and exploration activities have to be for a period exceeding 12 months for them to be so classified. A drilling rig however, which constitutes an exploitative activity should last for just in excess of six months in order to qualify if production begins after six months. Although, the 12 month rule applies to each project or site, if the projects are interdependent then it constitutes a single project and therefore qualifies as a permanent establishment. The time spent by sub-contractors on a site is treated as part of the general contractor’s time and is used in making a determination. If the contractor or sub-contractor is on and off site over a period then the time from beginning to the end qualifies (US : 16). Details of exceptions to the general rule in relation to activities which have a fixed location but which do not qualify are also provided. Agents can also qualify if they are authorized to finalize contracts on which the enterprise is bound with regularity. The OECD uses the term “in the name of the enterprise” rather than binding on the enterprise (US: 17). Agents are also required to be legally independent in order to qualify. The test is whether or not agents take instructions from the enterprise. Failing this agents do not qualify. Economic independence needs to be established. This exists when agents bear their own risks. A determination of whether agents act solely and even almost exclusively for the principal rather than having a wide range of clients are important in establishing economic independence. This explanation suggests that a mere existence in a Contracting State in excess of the qualifying period does not of itself qualify a permanent establishment (US: 18). Instead it is dependent on the aforementioned. 2.2 The OECD Model The OECD model seems to be that from which the US model was derived as the definition and lists are similar. The duration of time for which the enterprise needs to be operating in the other Contracting State to qualify as a permanent establishment is also similar. 2.3 The UN Model The UN model includes most of the matters in the OECD and US Model’s convention but covers a broader range of activities (See UN Model: 107). However, it differs in a number of ways. The duration for building sites to be deemed permanent establishment is only six month compared to 12. It is not very firm on the independence criteria for agents and provides another option for qualifying as a permanent establishment (UN 2012: 11). In this regard the UN Convention on double taxation indicates that if agents have no authority but maintains a stock of goods or merchandise from which goods are delivered regularly then that constitutes a permanent establishment (UN 2012:11). The convention also makes specific reference to insurance enterprises while the other models do not. 3.0 Business Profits The term business profits encompasses income that can be attributed to the trade or business (US Model: 20; OECD Model: UN Model: ). Business profits of an enterprise are subject to taxation in a Contracting State if the enterprise has a branch or office in that State which qualifies as a permanent establishment. If the enterprise does not satisfy all the requirements then a permanent establishment does not exists for taxation purposes. Therefore, the profits of that business are subject to taxation in the other State. Business profits relating to rental of property by a permanent establishment are subject to taxation on a net basis in the Contracting State. Business profits for shipping operations are dealt with in Article 8. The taxpayer may choose the set of rules that result in the lowest tax payable in order to calculate taxation. However, mixing both rules is not allowed. The income that is subject to taxation should deduct not only expenses incurred by the permanent establishment but administrative expenses connected with its operations but which are dealt with at the home office. In relation to transfer pricing no income is deemed to come from simply purchasing goods for the enterprise. Additionally, the basis used in arriving at business profits should be consistent from year to year. Furthermore, if business profits include income dealt with under other articles then the other articles will take precedence. The benefits of Article 7 - Business profits are also subject to Article 22 on limitation of benefits (US: 27). The UN model has no rules in relation to terms of the attribution of profits to a permanent establishment on the basis of simply purchase of good and merchandise as n the US model. However, Article 7 points out that this matter has not been resolved (UN 2012: 14). In terms of expenses deductible in arriving at business profit the UN model does not consider commission, royalties and interest charged in relation to use patents and other intellectual property. The UN Model also allows taxation of Sales in the source country of similar goods sold in the permanent establishment (Lennard: 7). 4.0 Conclusion There are sufficient similarities among the models to allow for harmonization of the double taxation convention. The US is a member of both the OECD and the United Nations and there is no reason why this cannot materialize. The relevant steps should be taken to move towards one double taxation model. This will remove any thought of tax evasion by businesses. References Lennard, Michael. The UN Model Tax Convention as Compared with the OECD Model Tax Convention – Current Points of Difference and Recent Developments. January 2009. Web. 8 December 2012. OECD. Interpretation and Application of Article 5 (Permanent Establishment) of the OECD - 12 October 2011 to 10 February 2012. OECD, 2012. Print US Department of Treasury. United States Model Technical Explanation Accompanying The United States Model Income Tax Convention of November 15, 2006. Web. 8 December 2012. < http://www.treasury.gov/press-center/press-releases/Documents/hp16802.pdf> United Nations. United Nations Model Double Taxation Convention between Developed and Developing Countries. New York: United Nations, 2011. Print Zara, Bert J. Double Tax Treaties: The Basics and Benefits. CPA Journal, March 2011: 50 – 3. Print Read More