The impact of BEPS Action 7 on operating models

For the past few decades, in search of lower cost and innovation, the majority of multinationals have steadily moved from a decentralised operating model – where functions (usually those relating to valuable activities of strategy and control) along the entire value chain occur in the same country – to one where certain functions, for a region or globally, are centralised in one country.

Whatever the business reasons are for these decisions, centralised operating models create cross-border business activities between related entities of multinational groups. Moreover, a move to a centralised model often has a negative impact on the profitability of the entity in the same countries where strategic or risk-bearing functions have been moved to a centralised location. In these situations, it is not surprising that tax authorities of such countries view such changes with some scepticism and assert that they are the result of base erosion and profit shifting (BEPS) measures taken by multinationals to minimise taxes paid in their countries.

To tackle this, the OECD's BEPS Action Plan focuses on 15 key areas to ensure that profits are taxed where the economic activities generating those profits are performed and where value is created, while at the same time giving businesses greater certainty by reducing disputes over the application of international tax rules and standardising compliance requirements.

The action items deal with issues relating to the coherence of tax rules, substance of business arrangements and transactions, as well as the transparency of information disclosure by taxpayers to tax authorities about their cross-border business arrangements.

In this article, we will focus on the impact BEPS Action 7: Preventing the Artificial Avoidance of Permanent Establishment (PE) Status will have on centralised operating models.

International operating models with certain centralised functions generally share the following key features:

• The centralisation of functions and risks in one location or legal entity (the principal).

• The central company (principal) is responsible for controlling key risks, performing strategic management functions and providing centralised services, such as procurement, product development and other support services, such as marketing, IT, HR, legal, accounting and finance, on a regional or global basis.

• The ownership of all valuable intellectual property resides with the principal.

• The principal operates its business by entering into contractual arrangements with local entities for the activities shown in Table 1.

It is also possible for group entities to enter into cross-border contractual arrangements between themselves.

R&D	Local entity operates as a limited risk contract R&D service provider to the principal
Manufacturing	Local entity operates as a limited risk toll or contract manufacturer for the principal: In a contract manufacturer scenario, the contract manufacturer buys raw materials, processes them and sells the finished goods back to the principal A toll manufacturer, however, buys neither raw materials nor finished goods; the principal owns the inventory physically located at the toll manufacturer’s premises throughout the production process
Sales and marketing	Local entity operates as a limited risk distributor or agent (either on a disclosed or undisclosed basis) with risks such as market, currency and inventory borne by the principal

The main PE issue associated with centralised operating models is whether a PE has been created for the principal, due to:

• The activities of the local sales entity creating binding obligations (whether legal, economic or both) for the principal toward third parties;

• The holding of the principal's inventory at the warehouse of a local entity;

• The holding of the principal's inventory at the premises of the local manufacturing entity;

• The activities of the local entity exceeding what is preparatory or auxiliary to the main business of the principal; and

• The activities of the principal's employees who frequently travel abroad to do business or perform services on its behalf.

Diagram 2 illustrates the potential PE risk that can arise if the activities in blue are performed in a country that has adopted Action 7 changes to its treaties with the country in which the principal is tax-resident.

Before Action 7, the activities highlighted in blue generally did not create a PE because they were specifically excluded under the relevant article of the applicable double tax treaty or were structured that they did not exceed prescribed thresholds required to create a PE. Post-Action 7, however, these activities could create a PE, as the exemptions from PE status have been tightened and the thresholds have been lowered.

Action 7 proposes changes to the PE definition in Article 5 of the OECD Model Tax Convention (the OECD Model) to prevent multinationals from setting up arrangements that enable them to operate in another country without creating a PE. Action 7 will have an impact on the following aspects of centralised operating models:

• Commissionaire and similar arrangements (for example, sales agents);

• Facilities, such as warehouses, owned by the foreign principal used for storage, delivery or purchase of inventory;

• Inventory owned by the foreign principal held at facilities used for storage, delivery, display or processing (for example, toll manufacturing and consignment stock);

• Models where functions that could be seen as "complementary business activities forming part of a cohesive business operation" are carried out by group entities at the same or different place(s) in the same country; and

• Models where contracts for projects or services are allocated to, or performed by, several related group entities.

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If more than one of these activities occur in a country, there is a risk they may be aggregated to create a PE in that country if they can be seen as complementary to each other and forming part of a cohesive business operation.

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Commissionaire arrangements have long been the subject of much tax literature as to whether they create a PE for the principal or not. It is worth mentioning that, in the past few years, more and more tax authorities have been asserting that a PE has been created in their jurisdiction if a local commissionaire habitually enters into contracts that are binding on the foreign principal, even if those contracts are not actually in the name of that principal. Those commissionaires are, in their opinion, dependent on the principal.

These issues have also been considered in several court cases in countries such as France, Italy, Norway and Spain with varying outcomes. The two main aspects of the commissionaire arrangement that are relevant to the PE discussion are (i) whether the commissionaire creates a PE for the principal through its activities that binds the principal to third parties either legally or economically; and (ii) whether the commissionaire is legally or economically dependent on the principal.

Action 7 widens the application of the existing Article 5(5) of the OECD Model, so that an enterprise will be deemed to have a PE in the other country if it has another person acting there on its behalf and, in doing so, that person habitually concludes contracts or plays the principal role leading to the conclusion of relevant contracts that are routinely concluded without material modifications by the enterprise.

In other words, if a principal has an agent that is actively involved in generating sales locally and the agent's actions directly result in the conclusion of contracts by the principal, such activities could give rise to a PE. Under the new rules, employees of the principal who frequently travel to the other country to do business on its behalf may inadvertently create a PE for it, if they habitually engage in such activities.

The activities described, however, will not create a PE for the applicable enterprise if:

• The activities are limited to the "preparatory or auxiliary" activities described in Article 5(4) as modified by Action 7

Or

• The activities are carried out by independent agents under Article 5(6). Here, Action 7 has modified the independent agent exception so that commissionaires that act exclusively, or almost exclusively, for the principal or closely related parties (defined as a party having more than 50% of the beneficial interest in the other party or of the aggregate vote and value of the other party's shares) are automatically seen as dependent and will create a PE risk.

From a practical perspective, it will become more and more important to know not only how many days employees spend in another country, but also what activities they perform while there. However, it will still be a practical problem for the principal to determine when a PE has been created, as Action 7 does not specify objectively how to measure whether the threshold has been exceeded.

Action 7's changes to Article 5(5) mean that commissionaires that are not independent could now create PEs, even if their activities are limited to concluding or mediating standard contracts without active negotiation on their part or getting contracts formally (routinely) approved, signed or concluded outside of their country of operation without any material modifications. As long as the concluded contracts create an obligation for the principal to perform, it does not matter if the principal is undisclosed or that the contract is in the commissionaire's own name.

The management of cross-border sales teams will need to be more rigorous in future as it becomes more important to implement strict guidelines for how employees of both the principal and the local entity should act under the centralised model. For example, with respect to the authority to decide on pricing, discounts or changes to terms and conditions in order to manage PE risk.

Another area affected by Action 7 is the use of facilities for the storage, delivery or purchase of inventory by a foreign principal. Article 5(4) of the OECD Model specifically exempts certain activities from creating a PE where a place of business is used solely for activities listed in that paragraph.

Action 7 will modify the wording of Article 5(4) so that each of the listed exemptions from PE status is restricted to activities that are of a preparatory or auxiliary character, or the overall activity of the fixed place of business is of a preparatory or auxiliary character, taking into account the nature of the principal's business.

This means that it will be necessary for businesses to check whether such activities constitute an essential and significant part of the principal's core business. If so, it will not be considered preparatory or auxiliary, and will therefore not be exempt from PE status. For instance, procurement offices can now create a PE if the purchasing activity is considered to be an essential and significant part of the foreign enterprise's activity. Taxpayers should note, however, that even if this activity is preparatory or auxiliary on its own, the anti-fragmentation rule could apply to overturn this exception (see discussion in 4 below).

As for situations involving principal-owned inventory held at a related or third-party warehouse, these may now create a PE if:

• The principal has unlimited access to the place where inventory is held for the purposes of inspecting and maintaining those goods (that is, it has the place at its disposal), or

• The inventory-holding activity is an essential and significant part of its overall business (that is, not preparatory or auxiliary).

Another common inventory-holding scenario that may now present multinationals with potential PE risk involves the use of consignment inventory arrangements where ownership of the consigned inventory placed at the premises of the customer remains with the principal. In such situations, the principal may need to re-evaluate its options for its end-to-end supply chain management, ie. whether to keep the existing consignment inventory structure (bearing in mind that this may actually be a prerequisite to doing business in the other country for certain industries) or move toward a local inventory ownership structure (which has the drawback of making supply chain management more cumbersome and potentially inefficient).

Likewise, the same logic applies to situations involving principal-owned inventory held at a toll manufacturer for processing. Once again, even if the activity is preparatory or auxiliary on its own, the anti-fragmentation rule could apply to overturn this exception (see discussion in 4 below).

This means that the policies and procedures in place regarding warehouse or toll manufacturer access and stock control will need to be evaluated to see if they need to be modified to ensure that no PE is created, as if the principal has premises at its disposal, there is no further need to evaluate whether the inventory holding activity performed at this place is of a preparatory or auxiliary character.

Perhaps the biggest impact of Action 7 is the introduction of an 'anti-fragmentation' rule to prevent the use of the Article 5(4) specific activity exemptions to avoid PE status artificially, such as fragmenting a cohesive operating business into several smaller operations in order to argue that each part is merely engaged in preparatory or auxiliary activities.

Previously, the activities performed at each place of business were viewed separately when determining whether or not a PE exists. In the future, all places of business will be viewed on a combined basis if the activities at these places can be seen as complementary functions that are part of a cohesive business operation.

If this is the case, the anti-fragmentation rule would apply so that the activities, when viewed on a combined basis, exceed what is considered preparatory or auxiliary, meaning that not all places of business will be able to take advantage of the exemptions in Article 5(4) to argue that no PE has been created.

The impact of the anti-fragmentation rule means that it will be more important than ever for multinationals to be able to substantiate the business reasons for allocating various functions and risks along value chains over different group entities within the same jurisdiction. Obviously, many multinationals have moved to functional specialisation and matrix structures where there is a deliberate separation of, for example, sales from manufacturing, or where manufacturing in one country focuses on producing similar products for multiple jurisdictions. These would appear to be logical reasons for the perceived legal and managerial fragmentation of key activities along the value chain.

Action 7 also affects situations where contracts connected to the same projects or services are allocated among related parties and if the splitting-up of such contracts was done primarily to avoid PE status under Article 5(3). Under today's rules, such situations do not create a PE because the contracts are allocated to related parties for durations shorter than the 12-month threshold prescribed under Article 5(3).

Going forward, the 'principal purpose test' (PPT) will apply to contracts allocated among related parties if they are connected to the same projects or services so that the 12-month threshold is exceeded and a PE is created. In these situations, multinationals will have to show that the principal purpose of splitting up those contracts was not to avoid a PE status under Article 5(3). This means that proper documentation should be kept as records of the main reasons (eg. commercial, regulatory or legal) for splitting up the contracts across several related parties.

The impact of Action 7 on centralised operating models will have implications on the sustainability of existing operating models and the design of new operating models.

It will become more challenging for multinationals to find the right balance between risk management and control versus creating dependency in seeking to design an efficient operating model. There may be the need to re-evaluate the necessity of centralising certain key processes and functions, to perform a review of the roles and responsibilities relating to the management of those key processes and performance of those functions, as well as check where those roles are being performed and whether they need to be moved.

Improvements to the oversight, data collection and documentation of where people are, what they are doing and who they are doing it for will be key to assessing whether the existing operating model is robust enough to withstand PE risk challenges and whether there are opportunities for improvement.

Joost Vreeswijk EY Tel: +41 58 286 2409 joost.vreeswijk@ch.ey.com Joost Vreeswijk is the EMEIA leader of EY's operating model effectiveness practice. Joost has 17 years of experience in designing and delivering operating model changes in complex international environments across Europe, Asia Pacific, China and the US. His experience includes six years of driving hands-on operating model change in an industry role, reporting to the CEO of a $20 billion technology company. Joost has designed and implemented numerous large scale change processes that focus on business streamlining, simplification and the implementation of central management companies, procurement hubs, supply chain companies, manufacturing footprint redesign as well as revised sales and channel management set-ups. Joost works across business, technology and tax disciplines.

Ai-Leen Tan EY Tel: +41 58 286 4229 ai-leen.tan@ch.ey.com Ai-Leen Tan is an executive director with the EY Global ITS knowledge centre and member of EY's EMEIA Tax Centre operating model effectiveness practice focusing on permanent establishment issues and developments around the world, particularly the impact of BEPS Action 7 on existing operating models. Ai-Leen also has 10 years of experience advising multinational clients on transfer pricing planning, documentation and audit defence matters.