Leased Equipment: When Does a Permanent Establishment Exist?

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1 Leased Equipment: When Does a Permanent Establishment Exist? Keith R. Evans* PRÉCIS Comme dans la plupart des opérations commerciales transfrontalières, la situation fiscale du bailleur qui réside dans un pays mais loue du matériel à un preneur dans un autre pays diffère selon que le bailleur a ou non un établissement stable dans le pays de ce dernier (le pays d origine) par l entremise duquel il exerce ses activités. Selon la convention modèle de l OCDE et les conventions fondées sur ce modèle, il n y a pas d imposition dans le pays d origine s il n y a pas d établissement stable. Cependant, un grand nombre des pays membres de l OCDE se sont réservés le droit d imposer les opérations de location de matériel comme s il s agissait de redevances. Lorsque c est le cas, l absence d un établissement stable dans le pays d origine fait que le montant brut du revenu de location est assujetti à une retenue d impôt, plutôt qu à l impôt sur les bénéfices qui serait autrement levé aux taux normaux sur le montant du revenu net attribuable à l établissement stable. Il a toujours été difficile de déterminer s il existe un établissement stable en raison des aspects particuliers qui découlent de la nature des opérations de location de matériel. Dernièrement, l incertitude s est accrue en ce domaine en raison de l érosion progressive, dans les lois fiscales internationales, des exigences rigoureuses associées à la détermination de l existence d un établissement stable. Le présent article fait état de la situation législative actuelle en ce qui concerne les exigences devant être respectées pour qu il y ait un établissement stable, en insistant sur les aspects propres aux contrats de location-exploitation transfrontaliers, et précise de quelle façon ces exigences sont en train de changer graduellement. En conclusion, l auteur tente d évaluer la probabilité que l on conclue à l existence d un établissement stable dans divers arrangements structurels mis au point pour les contrats de location-exploitation transfrontaliers. ABSTRACT As in most cross-border commercial transactions, the tax position of a lessor that is resident in one country but leases equipment to a lessee in another country will depend on whether the lessor has a permanent establishment in the latter (the source country) through which the lessor s business is being carried on. Under the OECD model * Associate professor, Faculty of Law, Dalhousie University, Halifax. I would like to thank Steve Brogden for his research assistance and comments on drafts of this article, and my colleague Faye Woodman for her comments on an earlier draft. All errors and omissions remain mine and mine alone. (2002) vol. 50, n o 2 489

2 490 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 treaty and treaties based on that model, in the absence of a permanent establishment, no source-country taxation will arise. However, a large number of OECD countries have reserved the right to tax equipment rentals as if they were royalties. Where that is the case, the absence of a permanent establishment in the source country will result in the rental income being subject to a withholding tax on the gross rental revenue, rather than to income tax that would otherwise be levied at normal rates on the net amount of income attributable to a permanent establishment. The determination of whether a permanent establishment exists has always been complicated by special considerations arising from the nature of equipment-leasing operations. Recently, uncertainty in this area has been increasing, owing to a gradual erosion in international tax law of the strict requirements for finding that a permanent establishment exists. This article examines the current state of the law in respect of the requirements for the existence of a permanent establishment, with specific reference to the relevant issues relating to cross-border operational lease arrangements, and it reviews the ways in which these requirements are gradually changing. The concluding section considers the likelihood that a permanent establishment may be found to exist under various alternative structural arrangements for cross-border operational leases. KEYWORDS: TAX TREATIES PERMANENT ESTABLISHMENT OECD MODEL TREATY ROYALTIES LEASED EQUIPMENT INTRODUCTION The ability to tax rents derived from the leasing of equipment gives rise to a classic conflict between the right to tax on the basis of the source of the income and the right to tax on the basis of the residence of the owner of the equipment, where the lessor s operations and those of the lessee are in different taxing jurisdictions. In general, it can be argued that the source of income from leasing equipment is the location in which the equipment is put to use, and it is on this basis that the source jurisdiction will claim its right to tax the owner of the equipment, even where that owner is based or resident in another state. 1 Where the lessor s jurisdiction of residence taxes on a worldwide basis, the prospect for significant double taxation emerges. To the extent that double taxation makes the leasing business uneconomical, the economies of both states will suffer. Most tax treaties negotiated to avoid such double taxation employ, to a greater or lesser extent, the concept of a permanent establishment as the means to resolve such conflicts. If the lessor does not have a permanent establishment in the source state, the lessor s tax position will depend on whether that state has agreed to completely forgo its taxation rights, or instead has retained a restricted right (usually applied by way of a reduced rate of withholding tax on the gross amount of the rentals). If the lessor has a permanent establishment in the source state, full taxation rights vest in that state; these rights are usually exercised through the application of domestic tax rates against the net income/profit attributable to that permanent establishment. The threshold issue is therefore whether or not a lessor has a permanent establishment in the source state. There is no clear and definitive answer under the model international tax agreements, and particularly the OECD model tax

3 leased equipment: when does a permanent establishment exist? 491 convention, 2 as to when leased equipment, and related activities of a lessor, might create a permanent establishment in a source state. In some instances, it could be claimed that the mere presence of the equipment itself is enough to create such an establishment. In most instances, something more will be required. This article explores the issue of when a lessor of equipment will be found to have a permanent establishment in another state. To set the stage, it is necessary to analyze the tax position for income derived from the leasing of equipment under the model treaties. LEASE PAYMENTS AND THE MODEL TREATIES Until an amendment in 1992, 3 the starting point for determining the taxation of profits from leasing equipment under the OECD model was the definition of royalties. Included in the concept of a royalty was a payment of any kind received as consideration for the use of, or the right to use, industrial, commercial, or scientific equipment. 4 Similar wording is used in the definition of royalties in the UN model agreement, 5 but not in the US model convention. 6 If rent for equipment is classified as a royalty under a treaty definition, the royalty provisions apply unless the rent is beneficially owned by a resident of the other contracting state that carries on business in the source state through a permanent establishment in that state and the rent is effectively connected to that permanent establishment. Where these conditions arise, the business profits/permanent establishment provisions will apply. 7 If rent is not within the treaty definition of royalties, and the rent is properly classified as business profit for an enterprise, the only area of concern is the business profits/permanent establishment issue. While both the OECD (before 1992) and the UN models defined royalties to include payments for the rental of industrial, commercial, or scientific equipment, they adopted a fundamentally different approach to taxation of such payments by the state of source. Under article 12(1), the OECD model exempted the payment from taxation in the source state unless it was effectively connected to a permanent establishment there (although a large number of OECD member countries 8 reserved the right to tax such payments by applying a reduced withholding rate). By contrast, the UN model preserves source-state taxation rights on a reduced withholding tax basis. 9 This position is consistent with the objective of the UN model to allow developing countries greater scope to tax on the basis of source. The result under the former OECD provisions was that rental payments escaped tax in the source state unless they were connected to a permanent establishment in that state, 10 while under the UN model, the source state retained (and continues to retain) authority to tax rental payments, either on the basis of a percentage withholding on the gross amount of those payments under the royalty provisions, or through taxation of the net rental income to the extent that the rentals are connected to a permanent establishment in the source state. In 1992, the OECD model was revised to remove equipment rentals from the definition of royalties. This amendment may appear odd, given that, under that model, even if rent were included as a royalty, it would have escaped source-state

4 492 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 taxation unless it was connected to a permanent establishment. However, no fewer than 12 of the 24 OECD member countries had entered reservations to article 12 of the model so as to maintain a limited right to tax royalties at source, including rents paid for the use of equipment. 11 The 1992 amendment was made on the basis of a recommendation from the OECD Committee on Fiscal Affairs to the effect that member countries (and specifically those that had reserved the right to tax royalties at source) should not subject rental income to tax at source under the royalty provisions. 12 Implementation of this recommendation would effectively have left the income to be taxed under the business profits provisions of the treaty, on a net profit basis, but only if the non-resident maintained a permanent establishment in the source state to which those profits were connected. The initiative appears to have failed. 13 In the context of the original recommendation, Australia, Canada, and Italy reserved the right to continue to treat equipment rentals as royalties subject to withholding tax, and Japan, New Zealand, Portugal, Spain, and Turkey reserved the right to tax such income at source. With the exception of Japan, these reservations have continued under the amended model and have been augmented by similar reservations by the Czech Republic, Hungary, Korea, Poland, Greece, and Mexico 14 a total now of 13 reservations from the 30 current OECD members. ROYALTY VERSUS BUSINESS PROFITS TREATMENT The policy rationale for non-inclusion of rental payments in the definition of royalties, as articulated by the OECD s fiscal committee, 15 is compelling. Five considerations held sway among the majority of the committee and seem even to have been accepted by some of the countries that entered reservations to the committee s report. 16 Of the five reasons, the first is largely doctrinal. The committee noted that leasing income is different in nature from the other enumerated inclusions within the definition of royalties, all of which deal with income from intangibles with a substantial intellectual content. The same is not true of rentals. Consequently, the committee concluded that it was inappropriate for the definition of royalties to extend to such payments. The other four reasons are economic in nature, relating to the objective of tax conventions namely, the avoidance of double or excessive taxation of profits and prevention of the harmful effects that such taxation can have on the international movement of, and trade in, goods and services: 1. The inclusion of rentals in the OECD model definition of royalties was designed to ensure that a zero rate of tax applied at source on such payments. This zero-rating is the basis for the taxation of all royalties under that model. The committee noted that the inclusion of rent within the definition of royalties in the model was not designed to recommend the levying of tax at source on rent in those countries that reserved the right to tax the more traditional kinds of royalties by way of a withholding tax.

5 leased equipment: when does a permanent establishment exist? If leasing payments are treated as royalties, in those states that have reserved the right to tax royalties, the tax is applied against the gross payment made. Under this approach, excessive tax can arise in two ways: a. the lessor is denied a deduction in the source country for any expenses associated with that revenue stream, including depreciation costs and costs of financing the acquisition of the asset; and b. the tax at source may not be fully creditable in the jurisdiction of residence where the income is taxed on a net basis the source tax on gross can easily exceed the level of the residence-state tax on the net income from foreign leasing, and a loss of credit can result where the residence state also imposes excess credit limitations. This excessive tax impact can have a significant deterrent effect in a business sector such as leasing, where the profit margin is small in comparison with the overall lease payment In those states where a withholding tax is applied on the basis of the pre-1992 OECD model, tax on gross rental payments applies only in the absence of a permanent establishment. However, where such an establishment exists, tax is applied on a net basis. As a result, the source-state tax burden can be higher in those situations where a permanent establishment does not exist than in those where it does. Purists will not like this result because it can lead to a strange reversal of the more traditional roles in litigation in this area where the taxpayer is arguing that a permanent establishment does exist under the treaty and the tax authority is arguing otherwise. 4. Further double taxation problems emerge under the domestic law of states that deem the state of residence of the payer of the royalty to be the source of the payment, rather than the state in which the equipment is situated. 18 In addition, tax equity concerns should favour non-royalty treatment. The particular concept involved is that taxpayers in comparable circumstances should be accorded comparable tax treatment. Assume that one company, company A, carries on a business of selling goods from its state of residence; another company, company B, supplies identical goods but for rent from its base in that same state; and both companies have exactly the same limited operational activities to support their sale/lease operations in the source jurisdiction, which fall well short of having a permanent establishment there. Logically, company A and company B should be taxed in the same way by the source state. However, in those countries that have reserved their right under the OECD model to treat rental payments as royalties or that adhere to the UN model, comparable treatment is not accorded. Company A will escape taxation in the source state, but company B will be subject to withholding tax on its rental revenues. As the permanent establishment framework is accepted as the basis for taxation rights in the context of the sale of tangible goods (subject, of course, to the current debate relating to the appropriateness of the traditional permanent establishment principles in respect of sales of goods effected through electronic commerce channels), it should apply equally to the rental of such

6 494 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 goods where the rental income is a business profit of the enterprise. Likewise, adherence to the principle of tax neutrality would dictate that a business decision to purchase or lease equipment in a cross-border situation should not be determined on the basis of vastly different tax treatment for the two alternative ways in which the equipment could be supplied. There is also a risk that the bar for the existence of a permanent establishment may be lowered as a result of royalty treatment of rental revenues. Any such change would have an impact on the international tax regime far beyond the limited circumstances of cross-border leasing. This risk would materialize if courts strove to find that a leasing company had a permanent establishment in the source country, in an attempt to minimize the opportunity for double taxation by allowing the leasing company to pay source-state tax on a net basis in respect of profits attributable to such an establishment, rather than at the flat rate on gross payments that would otherwise apply. The outcome could be that enterprises conducting non-leasing operations would be subjected to increased taxation in source locations. While the doctrinal, economic, and tax equity/neutrality rationales support non-royalty treatment, the only support for royalty treatment for rental payments appears to be the protection of the tax base of the source country. 19 The fiscal policy rationale of obtaining a greater share of tax on the basis of source is of key concern where the source country is a developing country (as reflected in the royalty definition of the UN model), but the large number of continuing reservations on this issue in the context of the OECD model demonstrates that some developed countries also share this concern. As suggested earlier, in light of those reservations, the objective of the fiscal committee in recommending the 1992 amendments to article 12 appears to have been defeated. The committee itself seems to have accepted the possibility for such failure, noting that where member countries wished to levy withholding at source on equipment rental payments, such withholding should be applied through specific treaty provisions separate and apart from the royalty provisions, and with a rate lower than that which applies to royalties generally. 20 LEASING ACTIVITIES IN THE SOURCE STATE Against this background, the question whether an enterprise resident in one state has a permanent establishment in another state from which rental income is derived will be crucial to determining the fiscal burden of the enterprise in the source state in cases where a double taxation agreement exists between the two states. Under pure OECD model treaties, the answer to this question will determine whether the enterprise pays no tax at all or, instead, pays tax on net income attributable to the permanent establishment in the source state. For countries like Canada, which have reserved the right to treat income from the rental of equipment as a royalty subject to withholding tax, or for countries with treaties based on the UN model, the revenue will be subject either to withholding tax on the gross rental payment in cases where no permanent establishment exists, or to tax on the net income from any leasing activity attributable to a permanent establishment. 21

7 leased equipment: when does a permanent establishment exist? 495 The existence, or absence, of a permanent establishment is hugely dependent upon exactly what the lessor does by way of activity in the source state. That level of activity can vary widely from the mere presence of equipment in the source state to the operation of a branch by the lessor, complete with premises and personnel responsible for inspection and maintenance of the equipment, and for general support of the rental activity in that state. There is little question that the latter conditions should and do constitute a permanent establishment. 22 The real issue is where the line is to be drawn short of such a complete branch presence. The difficulty in drawing this line was expressly recognized by the OECD s fiscal committee when it analyzed a number of leasing scenarios from the perspective of whether a permanent establishment exists: 23 Comments Does a permanent establishment exist? Leased equipment operated, serviced, Yes, at least if these activities are carried inspected and maintained by the lessor s out under the direction, responsibility, own personnel stationed permanently in and control of lessor the source state Leased equipment operated, serviced, Generally, no inspected, and maintained wholly by the lessee Leased equipment operated, serviced, No, if carried out under the direction, inspected, and maintained by the lessor by responsibility, and control of the lessee; its own personnel stationed otherwise disputable permanently in the state of residence, or independent enterprises hired by the lessor Leased equipment: Disputable if inspection and operated and serviced by the lessee or maintenance are not under the direction, responsibility, and control of the lessee inspected and maintained by the lessor Maintenance of an office in the source state According to the principle of article 5 to be in contact with the market, conclude contracts, deliver the equipment, etc., but not participating in operation, servicing, inspection, and maintenance of leased equipment The remainder of this article explores the legal principles that will apply in deciding whether a permanent establishment exists in respect of leasing activity in a source state, with a view to determining whether the analysis above is still current. In this context, it is important to note the following parameters of the review. The discussion is confined to operating leases; it does not extend to finance leases, where the leasing company is used to fund the lessee s acquisition of the equipment. 24 Finance leases impinge on the interest provisions of tax treaties and

8 496 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 hence raise a host of considerations outside the scope of this article. As well, the article does not address the question whether a permanent establishment exists where dependent or independent agents of the lessor are present in the source state. The position with respect to the use of agents is no different in the leasing context than in the case of any other commercial endeavour, and therefore need not be addressed here. 25 LEASING ACTIVITIES AS A FIXED PLACE OF BUSINESS: ARTICLE 5(1) OF THE OECD MODEL The definition of permanent establishment requires an enterprise to have a fixed place of business through which the business of the enterprise is wholly or partly carried on in the source state. 26 The remaining provisions of the model treaties dealing with the concept of a permanent establishment either outline specific kinds of operations that prima facie fall within this primary definition or exclude operations that might otherwise fall within it. Therefore, in addressing whether leasing activities in a source state constitute a permanent establishment, the overriding question is whether or not there is a fixed place of business of the lessor in that state through which the business of the lessor is carried on. Before we consider the specific components of the treaty definition, it is useful to review, briefly, two early judicial interpretations of the expression permanent establishment. In 1962, the Supreme Court of Canada addressed the meaning of the term in the domestic context, in determining whether a permanent establishment exists in a particular province. In the course of deciding that a home office set up in Quebec by a sales representative of a company was not sufficient to create a permanent establishment of the company in Quebec, the court noted: [T]he word establishment contemplates a fixed place of business of the corporation, a local habitation of its own. The word permanent means that the establishment is a stable one, not of a temporary or tentative character. 27 In 1957, in the US treaty context, the United States Tax Court provided the following interpretation: The term permanent establishment normally interpreted suggests something more substantial than a license, a letterhead and isolated activities. It implies the existence of an office, staffed and capable of carrying on day-to-day business of the corporation and its use for such purpose, or it suggests the existence of a plant or facilities equipped in the ordinary routine of such business activity. The descriptive word permanent in the characterization permanent establishment is vital in analyzing the treaty provisions. It is the antithesis of temporary or tentative. It indicates permanence and stability. 28 Turning now to the precise requirements of the treaty definition, there are three key conditions to the existence of a permanent establishment: 29

9 leased equipment: when does a permanent establishment exist? there must be a place of business; 2. that place of business must be fixed; and 3. the business of the enterprise must be carried on through that fixed place. Place of Business The commentary on the OECD model specifically states that machinery and equipment can, on its own, be a place of business. 30 It thus leaves open the possibility that the mere presence of certain equipment might meet this part of the definition. It seems clear that machinery and equipment of a certain significance is considered a place of business in most countries. 31 It may be wrong to conclude from this statement that small, portable, or mobile equipment can never constitute a place of business, although such equipment may be less likely to meet either the requirement that the equipment be fixed or the requirement that it be a place through which the business of the enterprise is carried on. 32 In general, it might now be possible to state that a place of business is any physical object that is commercially suitable to serve as the basis of a business activity, 33 and that the taxpayer has an appropriate right to use or ability to control, for the purposes of the business. 34 The Fixed Component The need for the place of business to be fixed re-emphasizes the general concept of permanence. There are, in fact, two aspects to the condition of being fixed : a locational or geographical aspect, and a temporal aspect. In respect of the former, fixed generally connotes a link to a geographical point or a distinct place. In the case of equipment that may give rise to a fixed place of business, it is enough that the equipment remain at a particular site. 35 Traditionally, apart from the special circumstances of construction enterprises (addressed below), the fact that equipment was moved from place to place within a source state resulted in a finding that the place of business was not fixed. 36 However, the notion that a place of business must be tied to a specific location has been subject to gradual erosion. There are now a number of authorities stating that a fixed place can be found to exist even though the equipment has been relocated from site to site, provided that relocation takes place under one integrated contract for a single customer and provided that a rather indeterminate geographical proximity test is met. 37 This interpretation is likely restricted to cases where the activities with which the equipment is associated are clearly of a peripatetic nature, such as offshore drilling. 38 Hence, it is possible for movable places of business to be treated as fixed if the movable item is used at fixed points within a proximate area for one customer on a repetitive or continuous basis for a sufficient period of time, at least where the nature of the business requires periodic relocation of the equipment. The temporal element in the concept of fixed base emphasizes that the place of business should not be established for a temporary purpose. 39 This requirement echoes the general comments quoted above from both the Supreme Court of Canada and the United States Tax Court. In general, therefore, the place of business in the

10 498 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 source state must exist for a sufficient period of time to give the required degree of permanence; it need not, however, be everlasting. 40 In appropriate circumstances, owing to the special nature of certain business activities that never achieve a great degree of permanence, a fixed place can be permanent even if it lasts for a limited time. 41 Hence, in Fowler v. MNR, 42 the maintenance of a stand at the Pacific National Exhibition from which knives were sold for a three-week period annually over a period of some 16 years was enough to create a permanent establishment. The court was satisfied that a sales outlet maintained at approximately the same location over such an extended period possessed the same attributes as an office or a branch. Given the nature of the business in question, the mobility of the operation did not detract from the existence of a permanent establishment in Canada. It is not clear how long a place of business must exist before it becomes fixed or permanent. However, in the absence of a deeming treaty provision, presence in a source state for a certain period of time will not in and of itself create a permanent establishment; 43 the other requirements of article 5(1) still need to be met. In the United States, it appears that a presence of less than one year is considered to be temporary, while periods longer than one year, but generally less than two years, may, depending on the facts, also qualify as temporary. 44 In the construction field (discussed below), the OECD model fixes a 12-month period of permanence, and until recently, there appeared to be little support for the application of the 12-month test to other fields. 45 Draft Revisions to the Commentary Both the temporal and the locational aspects of a fixed base are addressed in the 2002 draft revisions to the OECD commentary, 46 in at least three areas. First, where the business activities are peripatetic and equipment is moved between neighbouring locations, a single place of business will be considered to exist where the locations to which the equipment is moved constitute a coherent whole, commercially and geographically, with respect to the business being conducted. 47 Where, however, there is no commercial coherence, the fact that activities may be carried on within a limited geographical area should not result in that area being considered a single place of business. 48 In the latter case, each separate location will need to be examined to determine whether any operation constitutes a separate permanent establishment. While these revisions will extend the current ambit of the commentary, the amendment reflects the decisions in the cases mentioned above and therefore does not appear to change the way in which the model has been interpreted in practice. If the proposed revisions are adopted, it will be clear that both geographical and commercial coherence are required. The revisions note that an area in which activities are carried on as part of a single project that constitutes a commercially coherent whole may lack the necessary geographical coherence to be considered a single place of business and thus may fail to meet the fixed requirement of a permanent establishment. An example is given: a consultant travels from bank branch to bank branch at various locations in the source state to provide training services under a single contract with the bank. 49

11 leased equipment: when does a permanent establishment exist? 499 Second, the commentary revisions deal with short-term but recurrent activities taking place over a number of years. In such cases, each period of activity needs to be considered in combination with the number of times during which the place of business is used for that activity, which may extend over a number of years. 50 This amendment seems to echo the result in the Fowler decision. In any event, given the nature of the activities described, it should not have much direct impact on leasing issues. Finally, the draft revisions address the issue of the period of time needed to meet the required degree of permanency under article 5(1), although they do not propose a clear solution. The draft notes: While the practices followed by Member countries have not been consistent in so far as time requirements are concerned, experience has shown that permanent establishments normally have not been considered to exist in situations where a business had been carried on in a country through a place of business that was maintained for less than six months. One exception has been where the activities were of a recurrent nature; in such cases, each period of time during which the place is used needs to be considered in combination with the number of times during which the place is used (which may extend over a number of years). Another exception has been made where activities constituted a business that was carried on exclusively in that country; in this situation, the business may have a short duration because of its nature but since it is wholly carried on in that country, its connection with that country is stronger. Conversely, practice shows that there were many cases where a permanent establishment has been considered to exist where the place of business was maintained for a longer period. For ease of administration, countries may want to consider these practices when they address disagreements as to whether a particular place of business that exists only for a short period of time constitutes a permanent establishment. 51 While it is clear from this statement that operations that last for less than six months should not constitute a permanent establishment (other than in the exceptional cases), the draft revisions fall far short of suggesting that the carrying on of a business at a fixed place for more than six months automatically creates the required degree of permanency. In a draft discussion paper on regulation 105 treaty-based waivers, the Canada Customs and Revenue Agency (CCRA) addressed these aspects of the draft revisions prior to their release by the OECD. 52 The CCRA, while not purporting to make these statements in the context of when a permanent establishment might be found to exist, suggests that the OECD favours a short (at least initial) six-month demarcation threshold: [I]t is apparent that consideration that activities which exceed 6 months in duration will be indicative of a permanent establishment is supportable under the OECD Model Convention. Activities which last less than six months but take place on a recurring basis may also result in a finding that a permanent establishment exists. 53 The draft revisions quoted above indicate that there is no clear consensus on a six-month threshold. To create permanence for business activity of such short

12 500 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 duration is not in keeping with the approach generally adopted by members of the OECD, as noted in the draft itself. It appears clear that, if the draft is adopted, business activities lasting less than six months (excepting those in construction, where the preferred standard is 12 months, and activities such as recurrent trade fair attendance, which is inherently temporary) will not be treated as meeting the required degree of permanence. If the activity lasts longer than six months, it may, but need not, on the basis of local practice and the kind of business involved, be seen as permanent. It remains to be seen whether the exceptionally strict approach outlined by the CCRA in its discussion draft will be supported by the courts, either in Canada or elsewhere, should the OECD draft revisions be adopted. The establishment of a time guideline shorter than the standard applied to construction/installation projects is strange. Such activities are, by their very nature, of limited duration. The time discussion in the OECD commentary generally tends to suggest that where activities are by nature brief, the time needed to establish permanence should be shorter than that for activities that in the normal course of business last for much longer periods. Furthermore, such a general rule can produce an anomaly in the leasing field. For example, a lessor may lease two identical pieces of equipment to two customers in the same source state, one of which is used on a construction site, and the other in a context that clearly does not fall within article 5(3). If there were a 6-month rule of thumb for activities other than those in the construction industry, the first equipment lease would not constitute a permanent establishment if it was needed for only 10 months (subject, of course, to qualification of the equipment as a construction project under the article 5(3) provisions, as discussed below), but the second would be a permanent establishment if the lease was scheduled to last only 7 months and the equipment was returned at the end of that term. Carrying on Business Through the Fixed Place To summarize to this point, mobile equipment in a source state may be treated as a place of business in that state and will be viewed as fixed in cases where the equipment is used at a particular place for more than a temporary period, or where it is used at a number of sites in a proximate geographical area as part of a coherent commercial project for a sufficient period of time. In such cases, the permanence requirements may well be met although, at present, the length of time required for permanence is far from clear. However, as all three requirements of article 5(1) must be met before a permanent establishment will be found to exist, a determination of whether leased equipment constitutes a permanent establishment should be decided on the basis of the final element, namely, whether the business is carried on wholly or partly through the fixed place of business. 54 This determination has a two-part requirement: (1) the business must be carried on in whole or in part (2) through the fixed place of business. In respect of the latter, there is little in the current commentary regarding the requirement that the business must be carried on through the place of business; however, the draft revisions propose to add a statement that [t]he words through which must be

13 leased equipment: when does a permanent establishment exist? 501 given a wide meaning so as to apply to any situation where business activities are carried on at a particular location that is at the disposal of the enterprise for that purpose. 55 This addition appears merely to emphasize a requirement that has always been present in the OECD model, and it should be interpreted in conjunction with the requirement that the business be carried on, in whole or in part, by the enterprise. The concept of carrying on business is not defined in the OECD model. Where a treaty term is not defined, the domestic law and, in particular, the domestic tax law of the contracting states becomes relevant. 56 The concept is prevalent in the domestic law of many states. In the United States, taxing power is significantly tied to the issue of whether the taxpayer is engaged in a trade or business within the United States. This is a similar, albeit not exactly comparable, concept to carrying on a business, and it is settled law that the mere management of investments and the collection of rents, interest, and dividends is insufficient to constitute the carrying on of a trade or business. 57 In Australia, the fact that a business has to be carried on connotes the need for repetitive or recurrent, rather than isolated, activity in the relevant location. 58 In Canada, the case law suggests that the determination of whether a business is being carried on is a factual one. Specifically, it is a determination that appears to require a functional analysis of the activities that must be conducted in order to generate the income, so that a decision can be made as to where the operations that produce the income take place. 59 A requirement of recurrence also appears relevant. 60 In the leasing context, the courts have indicated that they will review a range of functions apart from the location of the equipment to determine whether a lessor is carrying on business in Canada. These factors include the place where the rental contract is made; the place where the rental rates are determined; the place where the equipment is delivered and where the rental commences; the place where payment is made or received; the location of employee activities connected with the rental business; and the place where the equipment is sourced or bought. 61 On the basis of all such factors, the issue is whether, in substance, the business is being carried on in Canada as opposed to somewhere else. It should be noted that Canada also statutorily extends the concept of carrying on business in the context of non-resident activities; 62 however, that provision does not expressly deal with issues relating to the leasing of equipment, and in any event, it would be all but excluded by the business profits provisions of treaties. If the test is to examine the totality of the business and decide where the business giving rise to the income is being carried on, the mere collection of rent from equipment located in the source state without other activity by the lessor is unlikely to be viewed as the carrying on of a business through that equipment (assuming that the equipment in question constitutes a fixed place of business). 63 This conclusion is supported by the decision in the Dredging case 64 in the Netherlands, where the court did not allocate to a permanent establishment of a partnership/partners the rental income derived by a partner from the provision of equipment to the partnership. The court did not view the rental income in question as being separately

14 502 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 taxable as business profits derived from the carrying on of a business by the partner through the equipment itself. Likewise, in the Malaysian case of Walter Wright (Singapore) Pte. Ltd. v. DGIR, 65 the court found that a Singapore company that provided cranes and trucks under a rental arrangement to a related Malaysian company did not have a permanent establishment in Malaysia as a result of the fact that the equipment was located in Malaysia. Are Employees/Personnel Needed at the Business Location? Lessors might be tempted to argue that the need to carry on business through a place of business requires the presence of personnel of the enterprise at that location for the purpose of conducting and carrying on that business. 66 This position is alluded to in several places in the OECD commentary. 67 If this reasoning were correct, the mere presence of leased equipment would never create a permanent establishment. However, as a result of a review of the OECD model and commentary necessitated by the advent of electronic commerce, and specifically the question whether a server constitutes a permanent establishment, the position has emerged that while the presence of personnel is usually required for the conduct of business, there may well be businesses that may be at least partly carried on without personnel. 68 Therefore, human intervention is not a requirement for the existence of a permanent establishment. 69 It appears that, instead, a functional analysis is applied in making the determination: Where an enterprise operates computer equipment at a particular location, a permanent establishment may exist even though no personnel of that enterprise is required at that location for the operation of the equipment. The presence of personnel is not necessary to consider that an enterprise wholly or partly carries on its business at a location when no personnel are in fact required to carry on business activities at that location. This conclusion applies to electronic commerce to the same extent that it applies with respect to other activities in which equipment operates automatically, e.g. automatic pumping equipment used in the exploitation of natural resources [emphasis added]. 70 A functional analysis of this nature will require an examination of the nature of the activities performed at the location in light of the business that is carried on by the enterprise, 71 to determine whether the functions located in the source state are an essential and significant part of the business of the enterprise as a whole. 72 With this change to the commentary, lessors can no longer argue that the absence of personnel of the leasing enterprise in the source state means that no permanent establishment exists. However, the revision does not infringe on the basic position of the OECD s fiscal committee, described above, that generally, leased equipment operated, serviced, inspected, and maintained by the lessee, or under the direction of the lessee, does not create a permanent establishment for the lessor. A functional analysis that focused on the activities of the lessee and the operation of the equipment in the source state would favour a finding that a business was being carried on in the source state by the lessee, and not by the lessor,

15 leased equipment: when does a permanent establishment exist? 503 in such circumstances. 73 In this situation, the asset in question is clearly the subject of the business, and not the place through which the business is carried on. 74 This view is supported elsewhere in OECD documentation: 1. In the context of the leasing of containers, the OECD s fiscal committee stated, [I]t may be doubtful whether there is or is not a permanent establishment in the State of a customer [of a container leasing company] by the mere fact of the presence of containers there. 75 The committee in that context reviewed various kinds of activities of leasing companies in the container field, and it is clear from the discussion that simply having containers in a country would not cause the leasing company to have a permanent establishment there. 2. The OECD commentary considers an example of a company involved in the supply of gaming machines and concludes, A permanent establishment does not exist if the enterprise merely sets up the machines and then leases the machines to other enterprises. A permanent establishment may exist, however, if the enterprise which sets up the machines also operates and maintains them for its own account Elsewhere in the commentary, there is a statement to the effect that [i]f the fixed place of business is leased to another enterprise, it will normally only serve the activities of that enterprise instead of the lessor s; in general, the lessor s permanent establishment ceases to exist, except where he continues carrying on a business activity of his own through the fixed place of business The new functional analysis described in the quotation above also refers to the operation of the equipment. When equipment is leased to another party, and the lessee is responsible for all aspects of operation, maintenance, inspection, etc., the business that is being carried on in the source state is that of the lessee and not that of the lessor. This interpretation coincides with the general approach that for a business to be carried on through a fixed place of business, a degree of active operation 78 or active conduct of the enterprise 79 is required. One Permanent Establishment, Several, or None It is important to bear in mind that if a lessor has a permanent establishment in the source state, it does not follow that all of the lessor s rental income from that state is taxable to that permanent establishment. Only that portion of the profits of the enterprise that is attributable to the permanent establishment is taxable in the source state 80 (unless the treaty is based on the UN model, in which case income from business activities carried on in the other state of the same or a similar kind as that which is effected through the permanent establishment is also taxable). 81 Therefore, where the treaty provisions in question are based on the OECD or US models, each item of rental equipment, or groups thereof being used in relevant geographical proximity for a common customer, and the activities associated with

16 504 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 that equipment, need to be evaluated separately from the perspective of whether a permanent establishment exists. It is therefore possible to have a situation where some rental activity is taxed on a permanent establishment basis and some not. As a result, a distinction must be made between the position that applies when there is equipment supplied at one location for one customer in the source state, but the nature of the activity is such that the equipment is moved regularly from one site to another over the course of the contract, and the position that applies when the lessor supplies a large number of items to different customers for use at different sites for different projects in the source state. In respect of the former, the business is peripatetic, and the permanent establishment issue must be analyzed from the perspective of whether the movable place of business can be treated as fixed owing to the long-term use of the equipment on a regular basis at several sites within a proximate area. In respect of the latter, the leasing of equipment to different customers at disparate and commercially unconnected sites would traditionally have been analyzed from the perspective of whether any of the separate sites met the requirements of a permanent establishment and, if so, what profit was attributable to each such establishment. While the changes made to the OECD commentary over the years have reflected a gradual relaxation of the thresholds against which the existence of a permanent establishment is measured, even the latest 2002 draft revisions to the commentary do not change the need for a separate permanent establishment analysis in the scattered equipment scenario. 82 The changes, if approved, will confirm that there can be a grouping as regards mobile equipment used for a coherent commercial whole, but this grouping is examined in relation to the contract under which the equipment is used, or the customer to which it is connected. While the rental of equipment to a host of different customers in various locations in a source state may be commercially coherent for the lessor, it is not commercially coherent in the way required by the revisions. 83 Furthermore, there is likely to be no geographical coherence in such cases. If a lessor can support such scattered business from locations wholly outside the source state, the prospect remains that a permanent establishment does not exist. THE INCLUSIVE PROVISIONS: ARTICLE 5(2) In article 5(2), all of the three model treaties provide identical listings of places that are included in the term permanent establishment. Permanent establishment is said to include a place of management; a branch; an office; a factory; a workshop; and a mine, an oil or gas well, a quarry, or other place of extraction of natural resources.

17 leased equipment: when does a permanent establishment exist? 505 The list, being inclusive, provides illustrative examples and not definitive types of permanent establishment. 84 Being inclusive, the article might be taken to mean that all such operations are automatically permanent establishments, but this is not so. Instead, an enumerated place will be treated as a permanent establishment only if it meets the full requirements and conditions of article 5(1). 85 In other words, an office, workshop, factory, etc., is a permanent establishment only if it is also a fixed place of business through which the business of the enterprise is wholly or partly carried on. Accordingly, this list might better be viewed as indicative examples of places of business, rather than of permanent establishments. The list does not specifically state that pieces of equipment can constitute a permanent establishment. However, the provisions can be relevant to lessors for example, where the lessor maintains a workshop in the source state that is under the management and control of the lessor and at which the lessor inspects and maintains the equipment during the lease term. The same situation arises if the facility is used by the lessor as a centre at which to service the equipment (subject to the auxiliary activity discussion below) between rental contracts. In such circumstances, the combined effect of the inclusive provision in article 5(2) and the primary definition in article 5(1) is that this place of business is likely to constitute a fixed place of business through which the leasing business is carried on in the source state, creating a permanent establishment. A permanent establishment would also likely exist if the lessee, on a relatively long-term basis, made space available in the source state to an employee or employees of the lessor in order for those employees to supervise and direct the movement of equipment in the source state, to monitor the need for and arrange repairs, to ensure rents were collected, etc., 86 unless the lessor s employees in such a case, while in the source state, were temporarily under the operational control of and subject to direction by the lessee in respect of those repairs, etc. Some care should be exercised to check the precise wording of treaties based on these models to ensure that they do not add to the list of items treated as permanent establishments. The original treaty between Canada and the United States, for example, contained a provision that stated that [t]he use of substantial equipment or machinery within one of the Contracting States at any time in any taxable year by an enterprise of the other Contracting State shall constitute a permanent establishment of such enterprise in the former State for such taxable year. 87 This provision not only raised the prospect that the presence of equipment in and of itself might be enough to constitute a permanent establishment, but also operated as a deeming provision. Therefore, equipment, if substantial and if used by the taxpayer in the source state at any time in any year, created a permanent establishment even when the main operative provisions of article 5(1) were not otherwise satisfied. It should be noted that the treaty wording focused on use and not ownership of the equipment. 88 However, such a provision need not be determinative

18 506 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 of the issue for lessors. Where a treaty contains such phraseology, lessors can claim that equipment that is leased to a lessee, and is maintained, inspected, and operated by the lessee, is used by the lessee and not by the lessor and therefore should not in any event create a permanent establishment of the lessor. 89 The only Canadian treaty that retains general provisions of this nature (apart from those treaties that contain specific provisions to deal with specialized equipment used in the natural resource field, discussed below) appears to be that with New Zealand. This treaty contains a provision that deems an enterprise to have a permanent establishment in the source state if substantial equipment or machinery is, for a period longer than six months, used or installed by, for, or under contract with that enterprise in that state. 90 As leased equipment rented for more than six months would be equipment under contract with that enterprise, if the test of substantiality is met, the mere presence of the equipment beyond the six-month time limit would create a permanent establishment for the lessor under that treaty. BUILDING AND CONSTRUCTION SITES: ARTICLE 5(3) Enterprises engaged in building and construction activities present a special problem for tax treaty purposes because these activities are often, by nature, transitory and impermanent. Once the project is completed, the site is dismantled, and the enterprise in question moves on. Consequently, the OECD model provides that a building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months. 91 It is in this context that we also see the first significant difference among the three major model treaties. The UN model includes in the list of encompassed activities both an assembly project and supervisory activities in connection with any of the listed activities, and in keeping with the expanded scope of tax authority for the source state, lessens the required period of presence to six months. 92 The US model, by contrast, follows the OECD model and adopts the 12-month time frame, but includes in the list of activities an installation or drilling rig or ship used for the exploration or exploitation of natural resources. 93 In fact, this addition in the US model may not actually represent an expansion of the OECD and UN provisions, since exploratory drilling and many other exploration activities can reasonably be characterized as construction activity. 94 This characterization is more likely if the 2002 draft revisions to the commentary are adopted because, under those revisions, the commentary will confirm that the concept of an installation project is not restricted to an installation related to a construction project, but also includes the installation of new equipment. 95 Under this provision, for enterprises engaged in equipment-leasing activities, it might be argued that the rental of equipment leased for use in connection with a construction or installation activity for a period longer than 12 months causes that equipment itself to become a building/construction/installation project and hence a permanent establishment of the lessor, whether or not the lessor operates the equipment and is in the construction/installation sector of the economy. This

19 leased equipment: when does a permanent establishment exist? 507 interpretation might hold if the provisions of article 5(3) are in effect provisions that deem a permanent establishment to exist provided that the activity in question is related to construction/installation and provided that it lasts for 12 months or more. However, article 5(3) of the OECD model is not a deeming provision, and even here the guiding principles remain those set forth in article 5(1). 96 The special construction provisions were made a separate part of article 5 for systemic reasons. Article 5(3) was originally part of article 5(2) in the 1963 OECD model treaty, but was moved to a separate position within the article in 1977 to avoid a claim that the listed article 5(2) items did not otherwise have to satisfy the full requirements of article 5(1), including the requirement of permanency. 97 Therefore, the relocation of the construction project provisions to a separate position within article 5(3) does not change the general need for construction projects, like all other permanent establishments, to meet the requirements of article 5(1), other than the temporal aspect of permanence. It is simply the temporal aspect of a fixed base that is abridged by the stipulated 12-month rule in article 5(3). 98 Therefore, if the lessor does not have a fixed place of business through which the leasing business is carried on in the source state within the meaning of article 5(1), article 5(3) cannot have an impact on the outcome even if the lease extends for more than 12 months. Where the other article 5(1) provisions are met, as in situations where the lessor is the operator of the equipment at a construction or installation project site, article 5(3) does come into play to establish the minimum time period required at 12 months, at least in those cases where it is possible to claim that the equipment is a construction or installation project in its own right. Hence, the operation of an anchored semi-submersible drilling vessel at a number of sites on the US continental shelf for one customer over a two-and-a-half-year period was held to be a permanent establishment of a Dutch enterprise under the US-Netherlands tax convention. 99 Likewise, rented scaffolding can be a permanent establishment of the lessor when the lessor is responsible for reconfiguring the scaffolding to accommodate changes made to the building and for dismantling it at the end of the project. In the latter case, it appears that a construction or assembly project would exist under Article 5(3) 100 once the 12-month time limit was exceeded. The significance of article 5(3) therefore rests in the time stipulations: once a foreign enterprise has a place of business through which its business, in the construction field, is carried on in the source state, and the activities in question extend beyond the time frame specified, the permanence or temporal requirement of a fixed base is established. 101 The provisions do not create a fixed base under the second, geographical requirement, although, as the commentary makes clear, the need to move the equipment around within the confines of a coherent single project does not destroy the existence of an appropriate geographical nexus. 102 THE EXCLUSIONARY PROVISION: ARTICLE 5(4) Where an enterprise has a fixed place of business through which its business is carried on in the source state, and hence has a permanent establishment there under articles 5(1) to 5(3), that fixed base will not be treated as a permanent establishment

20 508 canadian tax journal / revue fiscale canadienne (2002) vol. 50, n o 2 if the operations conducted through that base can be brought within one of the categories of operation expressly excluded under article 5(4). Article 5(4) is a deeming provision, such that a facility is excluded from the definition even if it would otherwise constitute a permanent establishment under article 5(1). 103 In the leasing context, the relevant provisions of article 5(4) of the OECD model state that the term permanent establishment does not include a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; [104] b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; d) e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character; f ) the maintenance of a fixed place of business solely for a combination of activities mentioned in subparagraphs a) to e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character. [105] The first exclusion is perhaps the most significant for a leasing enterprise because it suggests that a fixed base can be maintained by the enterprise in the source state for the purpose of effecting delivery of the equipment to customers and the return delivery thereof at the end of the lease term. Under the second provision, use of an independent third party for this purpose would also be excluded. If, however, the depot in the source state is also used for the purpose of maintenance and repair of the goods by the enterprise upon their return to the depot, the facility is not within the exclusion because the facility is no longer used solely for storage or delivery. The combination provisions in article 5(3)(f) appear to be of little assistance to the lessor in such cases, for the commentary itself states: A permanent establishment could also be constituted if an enterprise maintains a fixed place of business in order to supply spare parts to customers for the machinery supplied to such customers, or to maintain or repair such machinery, as this goes beyond the pure delivery mentioned in sub-paragraph a) of paragraph Would the situation be different if the lessor engaged an independent third party in the source state to perform the repair, parts, and maintenance functions? One might be tempted in that context to call in aid the provisions of article 5(4)(c), to the extent that such repair activities might be classified as processing. As this term is not defined in the model, reference must be made to the domestic law. In Canada, at least, repair is unlikely to be classified as processing because the courts look for the goods in question to be changed in form, appearance, or characteristics, or for the goods to become more marketable as a result of the