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05 October 2018
Definition of 'permanent establishments'
Attribution of profits to permanent establishments – new indications
Examples reported in Additional Guidance on the Attribution of Profits to Permanent Establishments
On 22 March 2017 the Organisation for Economic Cooperation and Development (OECD) issued the Additional Guidance on the Attribution of Profits to Permanent Establishments. This report is contextualized within the OECD's Base Erosion and Profit Shifting (BEPS) project and the related 15 Action Plans, as developed with the G20.
In order to ensure that the proposed measures are implemented, the OECD recently issued:
This article examines how the OECD's recommendations concerning permanent establishments have been implemented in Italy.
The Additional Guidance on the Attribution of Profits to Permanent Establishments is a continuation of the measures set out in BEPS Action 7 concerning methods to prevent the artificial avoidance of permanent establishment status.
The OECD's recommendations concerning the definition of a 'permanent establishment' have been transposed into Italian law through the revision of Article 162 of the Income Tax Code (in the context of the Budget Law 2018).
The main amendments introduced by the revised Income Tax Code can be summarised as follows:
As anticipated in BEPS Action 7, the Additional Guidance on the Attribution of Profits to Permanent Establishments confirms the following:
The Additional Guidance on the Attribution of Profits to Permanent Establishments is therefore limited to:
In an Italian context, the functionally separate entity approach is included in the new version of Article 152(2) of the Income Tax Code following the amendments introduced by Legislative Decree 147/2015 (the Internationalisation Decree), albeit sometimes formulated differently in the treaties to which Italy is a party, especially for those stipulated before the revision of the 2010 Model Tax Convention for the Avoidance of Double Taxation on Income and Capital.
Example one: warehousing, delivery, merchandising and information collection activities
The first example proposed in the Additional Guidance on the Attribution of Profits to Permanent Establishments concerns changes to Article 5(4) of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital. This would affect the new Article 162(4)bis of the Income Tax Code regarding activities that are exempted from being considered permanent establishments on the condition that they have a "preparatory or auxiliary" character.
The example concerns a non-resident company located in country R which sells goods directly to consumers in country S via an online platform. However, the company has in country S:
Both sites (the warehouse and the office) perform functions that, considered individually, do not constitute a permanent establishment under the Income Tax Code's exemption.
The combination of activities carried out in the two locations, which have complementary functions and form part of a unitary business operation, excludes their preparatory or auxiliary character under the anti-fragmentation rule referred to in Article 5(4)(1) of Model Tax Convention for the Avoidance of Double Taxation on Income and Capital, meaning that two permanent establishments of the non-resident entity are located in country S.
The authorised OECD approach should be applied in this case and an appropriate arm's-length method employed.
The Additional Guidance on the Attribution of Profits to Permanent Establishments then provides the following examples concerning the new provisions on intermediaries set out in Articles 162(6) and (7) of the Income Tax Code:
Example two: commissionaire structure (related intermediary)
Example two concerns activities performed by non-independent agents that habitually conclude contracts on behalf of non-resident companies, as covered by Article 162(6) the Income Tax Code and Article 5(5) of the Model Tax Convention for the Avoidance of Double Taxation on Income and Capital.
Under step one of the authorised OECD approach, a functional and factual analysis shows that the commissionaire performs significant people functions relevant to the assumption of inventory risk and the disposition of said inventory. As a result, the permanent establishment is deemed to be the economic owner of the inventory and the related inventory risk is therefore attributable thereto. The commissionaire is remunerated through a commission and has no credit rights towards final customers. An internal deal between the permanent establishment and its head office is recognised, consisting of the sale of goods by the head office and its branch.
Under step two of the authorised OECD approach, the profits attributable to the permanent establishment for the sale of goods are recognised as the arm's-length profits that the head office would have made with an independent entity performing the same function and bearing the same risks as the permanent establishment. For tax purposes, the profits attributed to the permanent establishment are determined by considering the revenues from the sale of goods to final customers minus the cost of goods sold and the commission paid to the permanent establishment, and further additional expenses related to, the permanent establishment.
Additional factors that could affect this analysis include:
Example three: sale of advertising online (related intermediary)
Example three concerns the case of an intermediary which, on the basis of a service agreement, carries out marketing activities for the sale of advertising space in the permanent establishment's country of residence, deciding the volume, type and form of advertising to be carried out.
The conclusions reached are as follows:
Example four: procurement of goods (related intermediary)
Example four is similar to example three, but the intermediary operating in country S is responsible for concluding purchase agreements (widgets), and not for their sale, in the name and on behalf of the principal.
A permanent establishment is recognised and internal dealing between it and its parent company is assumed, consisting of the sale of inventory from the first to the second. The arm's-length remuneration relating to price follows the transfer pricing rules indicated in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and considers – due to the fact that warehouse management is carried out by intermediary staff – the assets used and the risks assumed in the performing of such functions, attributing them to the permanent establishment. In determining the permanent establishment's income, the costs for the purchase of goods from third parties, the commission paid to the intermediary and the permanent establishment's operating expenses are deductible.
The OECD's recommendations on the definition of a 'permanent establishment' have been transposed into Italian law through the amendments to Article 162 of the Income Tax Code.
Article 162 now includes updates with regard to the 'negative list' of activities that do not constitute a permanent establishment, the anti-fragmentation rule and details of the requirements that give rise to a permanent establishment based on the activities of intermediaries habitually concluding contracts on behalf of non-resident companies ("dependent agent permanent establishment"). However, Article 162 makes no reference to the splitting-up of contracts, where the time needed to configure a permanent establishment is fragmented into various contracts. In addition, a new case has been added, whereby a permanent establishment can also be deemed to exist when "a significant and continuous economic presence in the territory of the country [is] built in such a way as not to make its physical consistence in the territory".
As regards the attribution of profits to permanent establishments, Article 152(2) of Income Tax Code transposes the OECD's functionally separate entity approach. Under this approach, the arm's-length standard applies where a permanent establishment is a distinct entity, so that its attributable profits are those that it would have earned if it had been a separate and independent enterprise engaged in similar activities under the same or similar conditions, taking into account the functions performed, the assets used and the risks assumed.
For further information on this topic please contact Marco Abramo Lanza, Oliviero Cimaz or Valentina Bertolini at Studio Legale Tributario Biscozzi Nobili by telephone (+39 02 763 6931) or email (email@example.com, firstname.lastname@example.org or email@example.com). The Studio Legale Tributario Biscozzi Nobili website can be accessed at www.slta.it.
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