Permanent Establishment Basics & Cloud Computing

Transcription

1 Permanent Establishment Basics & Cloud Computing San José State University High Technology Tax Institute Academy October 18, 2013 William R. Skinner, Esq. (650) Fenwick & West LLP Silicon Valley Center 801 California Street Mountain View, CA Phone:

2 Overview Permanent Establishment (PE) Basics Review US Model Treaty PE Definition & Application Recent Developments OECD Guidance on E-Commerce Cloud Computing Federal Income Tax Applications International and Section 199 2

3 Permanent Establishment (PE) Basics 3

4 Background Definition of PE Sales NRE (Germany) US Customers US Presence Income tax treaties commonly provide that business profits of a non-resident enterprise (NRE) are taxable in the source country only if attributable to a permanent establishment that the NRE maintains therein. 4

5 Spectrum of Source Country Activities Little or No Contracts Extensive Contracts No Direct Activities Remote Activities Transitory Activities Limited Function Office Full Office License IP to Subsidiary or Third Party Sell to Local Customers over Internet Traveling Employees Local Office for Promotion & Market Intelligence Sales Activity Earn Investment Returns Advertise Locally Site/ Customer Visits Rep Office Manufacturing Trade Shows Management Level of local connections and contacts determine whether NRE will have a taxable presence (i.e., PE) in the state of source. 5

6 Permanent Establishment (PE) Treaty Provisions Article 5 Typical structure of Article 5: Articles 5(1) and 5(2) basic test of PE Article 5(3) special rules for construction sites and performance of services (if applicable) Article 5(4) exception for preparatory and auxiliary activities Articles 5(5) and 5(6) treatment of agents of NRE Article 5(7) a subsidiary / affiliate is not in itself a PE of related parties. 6

7 Permanent Establishment (PE) Treaty Provisions Article 7 Typical structure of Article 7: Article 7(1) only profits attributable to the PE are taxed Articles 7(2), 7(3) and 7(5) apply as quasi-arm slength approach to determining profits attributable to a PE Article 7(4) no profits attributable to purchasing activity Article 7(7) income realized after PE ceases to exist remains subject to tax 7

8 Permanent Establishment (PE) Treaty Provisions Flowchart Step 1: Is there a fixed place of Business (Art. 5(1))? Is there a local agent with contracting authority (Art. 5(5))? Step 2: Is the agent a dependent agent Step 3: Are the local activities more than merely preparatory or auxiliary (Art. 5(4))? If the answer to all of these questions is yes, the NRE has a PE and is subject to tax on its profits attributable to the PE (Art. 7). 8

9 Review of PE Definition Article 5(1) and 5(2) Article 5(1) the term permanent establishment means a fixed place of business through which the business of an enterprise is wholly or partly carried on. Article 5(2) lists examples such as an office, factory, workshop, place of management, branch, or mine / quarry. 9

10 Review of PE Definition Article 5(1) Component Parts Article 5(1) s basic test can be broken down into several sub-elements: A place i.e., a physical presence at a location A fixed place the same place is used for activities with some permanence or regularity. At the disposal of NRE has legal right to use or effective control of the place of business Through which activities are carried on. 10

11 Review of PE Definition Article 5(4) Preparatory / Auxiliary Activities Certain activities, carried on through a fixed place of business, do not create a PE: Use of facilities solely for storage, display, or delivery of goods Maintenance of a stock of goods solely for purpose of storage, display or delivery Maintenance of a stock of goods solely for purposes of processing by another enterprise Use of a place of business solely for purchasing activities or collecting information Any other activity that is of a preparatory or auxiliary character. 11

12 Review of PE Definition Article 5(4) Example 1 USP Dutch CFC Third-Party Agent (Spain) Concludes Sales Contracts Customer Inventory in Spanish Warehouse Ships Goods to Fill Orders Maintaining stock of goods solely for storage or delivery is preparatory or auxiliary, and should not create PE. Agency PE issues need to be considered (discussed below). 12

13 Review of PE Definition Article 5(4) Example 2 USP Manufactures Product Dutch CFC Third-Party Contract Manufacturer (China) Service Fee Raw Materials WIP End Product Maintaining stock of goods solely for processing by another enterprise is preparatory or auxiliary and thus should not create a PE. 13

14 Review of PE Definition Article 5(7) Article 5(7) provides that the fact that a resident entity is owned or controlled by the NRE shall not be taken into account in determining whether either company has a PE in the other state. A subsidiary is not in itself a PE; however, its activities may give rise to a PE under the same standards applicable to an unrelated party. 14

15 Review of PE Definition Article 5(7) Subsidiary Not a PE Branch Office Subsidiary NRE NRE US Factory Arm s Length Transfer Price US Subsidiary Sale of Product or Mfg. Services Manufacturing Manufacturing Branch office / factory is a PE under Articles 5(1) and 5(2). US Sub is, in itself, generally not a PE of NRE 15

16 Review of PE Definition Articles 5(5) and 5(6) Agency PEs Even if the NRE has no fixed place of business, it still may have a PE due to the activities of a local agent. Article 5(5) provides that where a person, other than an agent of independent status, acts on behalf of the NRE and has and habitually exercises in the contracting state an authority to conclude contracts that are binding on the NRE, then the NRE will have a PE in respect of the agent s activities, unless the agent s activities are preparatory or auxiliary. Article 5(6) provides an exception for activities of a broker, general commission agent, or other agent of independent status acting in the ordinary course of business. 16

17 Review of PE Definition Agency PE Key Components The agency PE test has several key elements: Authority to conclude contracts key is negotiation and conclusion of binding agreement; more than merely participating in negotiations; but signing contract is not necessary or sufficient. Habitually exercise authority in the state no bright line rules. However, activities must be performed in the state of source. Agent of Independent Status two-part test to determine independence: (1) legally independent and free from control and (2) economically independent and bearing business risk. More than preparatory / auxiliary activities e.g., agent whose activities are limited to solely purchasing goods on behalf of the NRE is OK. 17

18 Review of PE Definition Agency PE Example 1 USP Swiss CFC Commission Third-Party Agent (Spain) Negotiates & Concludes Sales $ Customer Third-party agent enters sales contracts on behalf of Swiss CFC in Spain. It will not create a PE if agent is of independent status and acting in ordinary course of business. 18

19 Review of PE Definition Agency PE Example 2 USP Cost-Plus Commission Swiss CFC Spanish CFC $ Negotiates & Concludes Sales Customers Analysis is the same, except concluding that Spanish CFC is of independent status will be difficult. 19

20 Review of PE Definition Agency PE Example 3 USP Swiss CFC X% Suggested Retail Price Spanish CFC Sale of Goods Resale of Goods Books Sales Revenue $ Spanish Customers Spanish CFC conducts Spanish business in its own name; and does not purport to act as agent of Dutch CFC. If implemented correctly, a local distributor, such as Spanish CFC here, generally should not create a PE. 20

21 Permanent Establishment (PE) Treaty Provisions Article 7 If a PE exists, the NRE is taxable only on the business profits that are attributable to the PE. PE should be attributed the profits it would earn as a separate enterprise, dealing at arm s length, under the same or similar conditions. Art. 7(2). OECD issued lengthy report on attribution of profits emphasis is on location of Key-Entrepreneurial Risk- Taking (KERT) Functions. Article 7(3) permits the PE to claim deductions, allocable to its business, including G&A expenses incurred at the PE or elsewhere (e.g., home office). 21

22 PE: Current Developments 22

23 PE Current Developments The Commissionaire Fills orders on behalf of Zimmer France Zimmer UK Ltd $ Minus Commission $ Zimmer France SAS French Customers Contracts of Sale in name of Zimmer France Zimmer France sells goods to customers as undisclosed agent of UK principal. UK principal regularly fulfils Zimmer France s contracts. Held: Zimmer France not an Article 5(5) agent PE under France UK treaty, because it did not conclude contracts in the name of Zimmer UK. 23

24 PE Current Developments The Commissionaire Status of commissionaire depends on the particular country involved and local interpretations. For example, several recent cases have addressed the commissionaire: Boston Scientific (Italy 2012) (not a PE) Dell (Norway 2011), rev g lower court (not a PE) Zimmer (France 2010), rev g lower court (not a PE). Dell (Spain 2012) (commissionnaire was a PE) 24

25 PE Current Developments The Roche Vitamins case Manufacturing Service Fee Roche Vitamins (Spain) Marketing Service Fee $ Spanish Manufacturing Sub Spanish Marketing Sub Spanish Customer Makes Product Raw Materials WIP End Products Sale of Goods Held: Spanish court found Roche Swiss principal to have a Spanish PE consisting of both manufacturing activities of manufacturing subsidiary and sales activities of marketing subsidiary. 25

26 OECD Guidance on E-Commerce 26

27 Electronic Commerce PE Issues NRE (Germany) Computer Servers (Netherlands) All Employees Provides Customers with Software through Dutch Servers NRE (China) Third Party (US) Contracts with Third Party to Host Software Should the NRE be deemed to have a permanent establishment in the server location in either or both of the above fact patterns? 27

28 E-Commerce PE Issues Key Questions Should a website accessible by residents of the source country be sufficient nexus to subject the NRE to tax? When are operations of a server owned or leased by the NRE sufficient to be a PE? How should contracts with a third party or affiliate to host the NRE s website or software applications be treated? 28

29 Review of OECD E-Commerce Report OECD Model Treaty commentary provides important guidance on when PEs arise in e-commerce. Art. 5 Commentary, 42.1, et seq. Generally, the OECD distinguishes between physical facilities owned or leased by the NRE (which may be a PE) and an intangible online presence (generally not a PE) , A website hosted on another enterprise s servers has no physical location and thus by itself is not an Article 5(1) PE of the NRE Website itself also is not a person and cannot be an agent within the meaning of Art. 5(5)

30 Review of OECD E-Commerce Report If the NRE owns, leases, or has at its disposal, servers or computer equipment at a fixed location, then that server may be a PE under normal standards. A PE will not be created where the NRE owns a server that merely performs preparatory or auxiliary functions, such as advertising, supplying or gathering information, data backup. However, equipment and/or personnel that perform core functions can create a PE for example, concluding the contract, processing payment, and shipping goods for delivery in the case of an online merchant. 30

31 Electronic Commerce PE Issues Customers Provides Software Sells Products NRE (China) Arm s Length Fee Webhosting Services US Sub Article 5(7) treats subsidiary the same as an unrelated party. Therefore, absent special facts or agency relationship, in principle, US Sub s hosting of software generally should be treated the same as third-party hosting company. 31

32 Recent Cases Ebay (India Oct. 2012) Indian tribunal ruled that Swiss company did not have PE in India on income earned from use of online marketing platform in India. Local subsidiary provided marketing and support services, but did not negotiate and conclude contracts on behalf of the Swiss NRE. Reversing lower court, tribunal held that Indian marketing sub s activities related to online sales did not include contracting in name of NRE, and thus did not create a PE. NRE s non-indian personnel concluded all contracts with end-users. It appears that the server was located outside of India. 32

33 Recent Cases Dell (Spain 2012) Irish principal sold products through online store managed and operated out of France. Spanish sub marketed and supported sales to mid- and large-sized customers. Spanish court found online store to be a Spanish PE, despite lack of servers or physical facilities in Spain. Court also found that Spanish Sub s activities such as trading, selling, and delivery of products, gave rise to an agency PE. Court dismissed taxpayer s reliance on OECD commentary despite Spain s withdrawal of its objection to commentary in

34 Selected Recent Administrative Rulings Canadian ruling ( R3) US Parent formed Canadian subsidiary to own and operate a data center for its online business. Canadian Sub employed data center personnel and charged USP an arm s length service fee. Held: US Parent did not have a permanent establishment. Note US Parent employees ability to remotely access the servers to install software, monitor software and hardware performance, etc., did not place servers at USP s disposal. 34

35 Selected Recent Administrative Rulings Swedish Tax Board Ruling (June 12, 2013) Foreign Parent Y formed Foreign Subsidiary X. X leased premises and operated a server in Sweden. X used the server to store software applications belonging to Y. The operation was fully automated and controlled remotely by non-swedish employees. Held: X had a PE in Sweden consisting of using servers to provide storage services. Y, however, did not have a PE. The Swedish tax authorities are appealing this ruling. 35

36 Cloud Computing 36

37 What is Cloud Computing? U.S. Commerce Department NIST Report divides cloud computing into three classifications: Software as a Service (SAAS). The capability provided to the consumer is to use the provider s applications running on a cloud infrastructure. The interface is a web-browser or thin client application. Platform as a Service (PAAS). Consumer deploys onto the cloud infrastructure consumer-created or -acquired applications created using programming languages and tools supported by the provider. Infrastructure as a Service (IAAS). The capability provided to the consumer is to provide processing, storage, networks, and other fundamental computing resources where the consumer is able to deploy and run arbitrary software. 37

38 Important Tax Questions for Cloud Computing Character of Income should Cloud Computing be viewed as a transfer of property (lease or license of software and/or computing power) or a softwareenabled service? Bundled Services how to analyze services included in the cloud transaction (e.g., data storage, tech support)? Sourcing Income Where does cloud clouding income arise and in which jurisdiction(s) can it be taxed? If Cloud Computing is a service, where is the service performed? 38

39 Federal Income Tax Applications Background on Software Income Treas. Reg (issued in 1998) provides guidance on certain classes of software income for international tax purposes. Licenses or transfers are viewed as IP transactions if the transaction transfers one or more significant copyright rights : 1. Right to make copies of the software for public distribution 2. Right to prepare derivative works 3. Rights to publicly display or make a public performance of the software. If all substantial rights are transferred, the transaction is a sale. Otherwise, it is a license giving rise to royalty income. 39

40 Federal Income Tax Applications Background on Software Income Licenses or transfers of software without copyright rights being conveyed are treated as transfers of tangible property (copyrighted article). Example: End-user license or site license to use a specified number of copies for internal business purposes. The character of income depends on the terms of the license grant: If perpetual the transaction is a sale of tangible property (generally inventory) If limited term / subscription the transaction is treated as a lease of tangible property. 40

41 Federal Income Tax Applications Example of Treas. Reg Taxpayer s Deployment Methodology Transaction Typical Treatment Original Equipment Manufacturer (OEM) Sale or License or IP Distributor or Reseller IP License or Sale of Goods, Depending How Structured Customer Buys Box in Store Sale/Lease of Goods Customer Downloads Program Customer Subscribes to SAAS Sale/Lease of Goods??? Character of SAAS transaction is not answered by Reg

42 Federal Income Tax Applications Sample Fact SAAS Pattern Customer (utility) subscribes to acquire use of an electronic power monitoring application from a Canadian technology provider. The provider places monitoring devices on the utility s plant, and then allows the utility s employees log on to the provider s server to analyze plant performance, create reports, etc. The customer pays a fixed annual fee per device deployed on site. The customer owns any data and reports created, but cannot download the provider s software or use it on another machine. Assume that the customer is located in the United States and the provider s servers are located in Canada. 42

43 Federal Income Tax Applications Steps to Analysis of Example 1. Character of Income is the income from the provision of services or a lease / license of software (with embedded services)? 2. Source of Income is the income U.S. source, Canadian source or some combination of both? 3. Treaty Analysis if US source, is this income subject to U.S. tax under the US Canada Treaty? Consider a) Withholding taxes on FDAP income b) Net basis taxation of business profits attributable to a PE 4. Subpart F Implications if the Canadian company is a CFC, is the income subpart F income? 43

44 Federal Income Tax Applications Step 1 Character of Income Section 7701(e)(1) of the Code provides a list of several, non-exclusive factors for distinguishing a service contract from a lease: the service recipient is in physical possession of the property, the service recipient controls the property, the service recipient has a significant economic or possessory interest in the property, the service provider does not bear any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract, the service provider does not use the property concurrently to provide significant services to entities unrelated to the service recipient, and the total contract price does not substantially exceed the rental value of the property for the contract period. 44

45 Federal Income Tax Applications Step 1 Character of Income cont. Selected Section 7701(e) decisions regarding service v. lease characterization: Tidewater, 565 F.3d 299 (5 th Cir. 2009) taxpayer provided a fully-staffed vessel to customer on a time charter. Court treated this as a lease, focusing on customer s control over ultimate use of the vessel during the charter period. Xerox, 656 F.2d 659 (Fed. Cl. 1981) photocopiers placed on government s premises were provided under a service contract. Court emphasized that company could replace individual copiers and provided comprehensive services for the single periodic fee. Smith, TC Memo medical scanner on hospital premises was used to provide a service scanner was operated by provider s employees and charged a fee per usage. Camera that was operated by hospital employees and provided for a fixed monthly fee was leased. 45

46 Federal Income Tax Applications Step 2 Source of Income Source of income depends on character of income, as different rules apply for leases and services. Services income source to place of performance of the services. Piedras Negras, 43 BTA 297 (1941) radio station s advertising income was sourced where the performers and equipment were used to make the broadcasts. Reg (e), Ex. 5 income from cloud-based software delivery was Possession-sourced where company s servers, software developers and people maintaining the software were all located in the U.S. Possession. Leasing Income source to where the property being leased is located. 46

47 Federal Income Tax Applications Step 3 Taxation under a Treaty Withholding Tax. Many U.S. tax treaties exempt rents, royalties, and service fees from withholding tax. Thus, character of income for Treaty purposes may not be critical. Position in minority of certain treaties source country can collect withholding taxes on leases of commercial, scientific or industrial equipment. Tax on Business Profits Attributable to PE. Does the Canadian company have a permanent establishment? If not, there generally cannot be U.S. tax on business profits under the Treaty. 47

48 Federal Income Tax Applications Step 4 Subpart F Analysis Different subpart F tests govern leasing vs. services income. Lease of property General rule. Leasing income is subpart F income (passive FPHC income). Exceptions. Active marketing of the property being leased by the CFC s own employees. CFC regularly produces or manufactures, or acquires and adds substantial value to, property being leased. Services income General rule. Services income is subpart F income if (i) the services are performed outside the CFC s home country, and (ii) the services are performed for, or on behalf of, a related person, or rely on a U.S. related person s substantial assistance. Exceptions. None. 48

49 Federal Income Tax Applications Section 199 Section 199 provides an incentive tax rate (approximately 32%) for taxable income derived from U.S. production activities (QPAI). Software programming is treated as manufacturing, and thus software created by US employees in whole or significant part can give rise to QPAI. However, only income from the sale, rental, lease, license or other disposition of the software qualifies as QPAI for Sec. 199 purposes. See IRC 199(c)(4)(A). 49

50 Federal Income Tax Applications Section 199 Income from a download or disc deployment of software meets Sec. 199 s transfer requirement. See Reg (i)(6)(v), Ex. 4. Income from online services, such as internet access services, online banking services, providing access to online electronic books, newspapers and journals, does not meet the transfer requirement. See Reg (i)(6)(ii). However, income from providing customers with access to software over the internet will be deemed to qualify if one of two special comparability tests are met (see following slide). 50

51 Federal Income Tax Applications Section 199 Comparability Tests The regulations treat cloud-based software revenue as derived from a lease / license under either of the following two conditions: 1. Taxpayer itself regularly makes U.S.-produced software available by download or disc, which has only minor or immaterial differences to the cloud offering. 2. Other competitors of the taxpayer make substantially identical software available by download or disc. Substantially identical means software that a. Has the same functional result for the customer, and b. Has a significant overlap of features or purpose. 51

52 Federal Income Tax Applications Section 199 Examples The examples and other authorities provide limited guidance on the two comparability tests. Same exact software meets either test. Reg (i)(6)(v), Examples 4-6. Showing that software is in the same general class or type of application (e.g., payroll software and inventory control applications) does not satisfy either test. Id., Example 7. product category. All online games are deemed to be identical under a special rule. See id., Example 8. What if the taxpayer provides a bundle of applications or functions for a single fee, and no single third party provides all of the same functions? See CCA

53 IRS CIRCULAR 230 DISCLOSURE To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice in this communication (including attachments) is not intended or written by Fenwick & West LLP to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. 53