The services permanent establishment concept is perhaps the most noteworthy contribution to tax treaties provided by the UN model. The tax treaty concluded by South Africa and the United States in 1997, to replace the one terminated during the apartheid era, has provided an opportunity to consider thorny questions of services and permanent establishments. The South African Tax Court has recently been called on to interpret and apply provisions relating to the existence of both physical and services permanent establishments and temporal issues in the attribution of profits in AB LLC and BD Holdings LLC v SARS (13276) [2015] ZATC 2 (15 May 2015).
The facts were simple: two United States incorporated companies engaged in consulting services to airlines, agreed to provide certain strategic and financial advisory services to a South African based and operating company between February 2007 and May 2008. Three employees of the taxpayers provided the core work on the project and were each in South Africa, on a rotational basis, for three-weeks at a time. 17 employees came to South Africa as and when required. During 2007 the taxpayers’ employees were in South Africa more than 183 days. The South African customer provided a room for the employees to work.
Services permanent establishment
Article 5(2)(k) of the South Africa- United States treaty refers to “the furnishing of services, including consultancy services, within a Contracting State by an enterprise through employees or other personnel engaged by the enterprise for such purposes, but only if activities of that nature continue (for the same or a connected project) within that State for a period or periods aggregating more than 183 days in any twelve-month period commencing or ending in the taxable year concerned.”
Readers may be perplexed as to how the existence of a service permanent establishment could be in dispute in such circumstances. The services PE language in this treaty, while following the language of the UN Model, is not found in a separate sub-article, in line with the UN Model, but, instead tacked onto article 5(2), the illustrative list. On this basis, the taxpayers contended that the provision of services for sufficient duration is only prima facie, a permanent establishment, and that a service permanent establishment only exists if requirements of article 5(1) for a physical PE are satisfied.
The Tax Court rejected this argument on the basis that while Article 5(2)(a) to (f), following the OECD Model, were merely illustrative of physical PE in article 5(1), that no such relationship could be inferred in relation to services under article 5(2)(k) which it ruled was a self-standing provision. The court noted that articles 5(2)(a) – 5(2)(f)refer to a place of work, while article 5(2)(k) deals with a form of work.
The task of the court would have been made easier had it been referred to the decision of the Indian Income Tax Appeal Tribunal in Linklaters LLP v Income Tax Officer-International Taxation, Ward 1(1)(2), Mumbai ITA Nos 4896/Mum/03, 5085/Mum/03, (discussed in Schwarz in Tax Treaties, Chapter 7, para. 15-250). There, the Indian tribunal was faced with the identical issue under article 5(2)(k) of the 1993 India-United Kingdom treaty. It concluded that while art 5(2)(a) to (i) of the India-UK treaty were merely illustrative of the basic rule in art. 5(1), article 5(2)(k) was an extension of the basic rule and, therefore, constituted a freestanding category of permanent establishment as recognised by both the OECD and UN Model Conventions.
Physical permanent establishment
The Tax Court also found that there was a physical permanent establishment within article 5(1). It found that the taxpayers were, at all times, present in the room that had been made available during the tenure of the contract. It had exclusive use of this space for the entire duration of the contract. Vally J said at para 42: “To put it differently, it had at its disposal constant access to the boardroom during working hours. Access during nonworking hours was neither necessary nor requested. This flows directly from the fact that compliance with its obligations in terms of the contract required regular intensive interaction with employees of [the South African customer], which, it goes without saying, was most suitable during normal working hours.”
The court distinguished this case from the Canadian decision in The Queen v Dudney 2000 CanLII 14932 (FCA) (2000) D.T.C. 6169 on the basis that in Dudney, a sole individual providing services moved from one area to another at the customer’s premises. This conclusion, which strayed into a highly controversial issue, hotly debated, (See OECD Model Tax Convention: Revised Proposals Concerning the Interpretation and Application of Article 5 (Permanent Establishment), 19 October 2012, pp 5 to 8) is rather more doubtful. The facts found by the court are insufficient to address this issue satisfactorily. The finding that a service permanent establishment clearly existed gave full taxing rights to South Africa in any event.
Attribution of profits
The case raised an important temporal issue in the attribution of profits under article 7(1). In addition to income for services rendered in South Africa during its 2007 and 2008 years of assessment, when the permanent establishment existed, additional income in the form of a success fee was paid in 2009, when the milestone for that fee was achieved. There was no permanent establishment in 2009. It was, however, part of the income earned for the services provided during the 2007 and 2008 years and the court had no difficulty in finding that the success fee was “attributable to the permanent establishment”.
Penalties
The case is a severe warning of the risks for taxpayers who incorrectly conclude that they have no permanent establishment and therefore do not render a tax return or pay the related tax. In upholding penalties of 100% of the tax, the court was influenced by the fact that the taxpayer was an enterprise with global reach, operating in many foreign jurisdictions, and was not a novice in the area of tax liability.
Principles of treaty interpretation
It is a pity that the court did not take the opportunity to adopt the modern approach to treaty interpretation by reference to articles 31-32 of the Vienna Convention on the Law of Treaties, particularly in light of recent UK decisions that the Convention may be used to interpret treaties involving South Africa (Ben Nevis (Holdings) Ltd v HMRC [2013] EWCA Civ 578) and the United States (Anson v HMRC [2015] UKSC 44) who are not parties, on the basis that it is an accurate statement of customary international law (See my blog of 7 July 2015).
Although some customary principles of treaty interpretation are discussed and applied, their use is unsystematic and in some cases erroneous. There is no attempt to establish any hierarchy of principles, nor the interpretive value of particular sources, starting with the ordinary meaning of terms in context in light of the object and purpose of the treaty (article 31(1) VCLT). The extensive discussion on the ordinary meaning of the expression “includes especially” in article 5(2) would be put in a better context by a reference to article 32 VCLT, which permits the use of supplementary means of interpretation where the ordinary meaning is obscure or absurd. This is certainly such a case.
Better use of the model treaties, in particular the UN Model, the source of the services permanent establishment concept, would have brought the arguments to a swift conclusion. Indeed, this would be an ideal, precedent making, opportunity to refer to the Commentary to the UN Model as a supplementary means of interpretation. The history of the treaty would make it obvious that the service permanent establishment language was intended as an addition to the physical permanent establishment and not illustrative of it. Use of the VCLT as a roadmap to interpretation would have prevented and rendered unnecessary the reference to the “Technical Explanation” (presumably the standard US Treasury Technical Explanation) which would normally be rejected as being a unilateral statement unless it had been accepted by the other contracting state.
US LLCs
It was accepted in this case that US LLCs were entitled to treaty benefits. Whether this is the case may be questionable unless they have elected to be taxed as corporations in the US. See my blog of 7 July 2015 and Anson above.
I am indebted to Edlan Paul Jacobs in Johannesburg for drawing my attention to this decision.
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Dear Jonathan,
It is interesting to read your views about this topical case. With much of what you say I agree.
Two points bother me about the decision.
First is the fact that the implication of the absence of a provision in the 1997 tax treaty patterned on art. 5(3) of the OECD/US and UN Models, was not considered.
I find the structure of PE definition in the 1997 tax treaty quite odd. To draft the PE definition in this way must have been a conscious and contended decision. I say this for the following reasons.
The relationship between arts. 5(3) and 5(1) has been uncertain, but the weight of authority appears to be in the direction that art. 5(3) is divorced from meeting the requirements of art. 5(1), thereby providing a third category of PE (see e.g. the arguments by Reimer in Klaus Vogel, 4th Ed.). This is particularly so in the case of the UN Model.
I note that Technical Explanations on earlier US treaties where the PE definition was indeed patterned on art. 5(3)(b) of the UN Model (e.g. US Sri Lanka 1985), contain statements such as that under under the US Model, services would only give rise to a PE if a fixed place of business existed. This is perhaps evidence that the US unilaterally understood that art. 5(3) is divorced from art. 5(1) by the time they negotiated with South Africa in 1997.
Hence, is what we see in art. 5(2) of the 1997 treaty not a classic compromise? South Africa did not get what it wanted (i.e. art. 5(3) of the UN Model), and had to settle for second best, namely an expanded list of prima facie PEs, taking in the type of activity lost under art. 5(3) (plus a few more), but these had to be fixed places of business to align with the US position? What else could be the reason to leave an art. 5(3) entirely out of the treaty?
The second point concerns the court’s uncritical use of the Technical Explanation to the 1997 tax treaty to support its decision. The Technical Explanation contained an annotation that suggested that there was no need to comply with the fixed place of business test in art. 5(1) in the case of the services clause (art. 5(2)(k)). But this appears an odd annotation, for at least one reason. Another item (art. 5(2)(i)) deals with ships and rigs, which are clearly not fixed in the ordinary sense, but why are ships and rigs not mentioned by the Technical Explanation as the subject of an exception to complying with the fixedness test? This is a stark inconsistency with which the court did not grapple. I am not sure the court should have been so convinced by the Technical Explanation?
I have to add: The implication of this decision and the Indian case you mention is that halfway through reading the list of what one thinks are examples in art. 5(2), the meaning of the words ‘includes especially’ suddenly changes to be understood as meaning stand alone provisions. This is otherworldly and a strained use of language, bordering on the absurd. As far as I know the presumption that language bears consistent meaning in a statute, contract or treaty, applies here. That is unless there is a direction in the text that it does not, which I can’t see.
It would be interesting to hear your view.
Best wishes,
Johann
Thanks Johann
The real curiosity is why the services PE language was inserted in the illustrative list in art 5(2) in this treaty (and indeed in the India-UK treaty discussed in the Linklaters case) when the negotiators had the benefit of the UN Model since 1980. If the UN Model had been followed, it is doubtful if the existence of a services PE could have been disputed.
The taxpayer did not dispute existence of a PE under the services PE language, but only argued that “includes especially” in the introduction to art 5(2) meant that the requirement of art 5(1) for a physical establishment was also required. The opportunity to try this argument is is really a consequence of poor drafting of the treaty and a failure to follow the UN Model properly.
The issue is one where correct interpretation of the treaty is the essence of the case. I agree that the court should not have relied on the US Technical Explanation. The reasons for rejecting cases that rely on this this have been well canvassed by the English Courts in interpreting both tax and non-tax treaties (See Schwarz on Tax Treaties Chapter 4 para 12-200) and most recently this year in Macklin v HMRC (see my blog of 8 April 2015).
The court could have come to the same correct answer on this point by applying arts 31 and 32 VCLT. The “good faith” requirement in art 31 and a contextual examination of the background to the treaty (termination of the old treaty during the sanctions era and a new treaty concluded in the early days after the end of apartheid by reference to the UN Model) should have lead to this, fortified by the Indian decision in Linklaters.
The concept of PE in international Taxation is pivotal to attract tax. This is an area of perennial conflict. Many times contracts are structured in such a way a PE attribution is defeated. This is an interesting topic of constant conflict between tax payers and tax gatherers.
The subsequent development of the SERVICE PE is an attempt to bring many foreign entities who come and provide service in another foreign country without the need to have a “PERMANENT PLACE OF BUSINESS”, with in tax net. Hence an additional parameter of stay with in that country for 183 days or more is introduced. The fine point made in this case is that a PE could be attributed, either by establishing that the entity had a “permanent place of business” or that the foreign entity provided a SERVICE, for a period or periods in all aggregating to 183 days. It is not necessary to establish both the limbs in the case of a service PE.
Thanks Sreedhar. I agree. This is not a case where the taxpayer structured its operations to avoid a PE. On the contrary, since there were two US entities involved here, it may have been possible for the services to be divided between them so that neither met the 183 day threshold. That would have raised very different issues.
Here they just provided the services in South Africa. It appears they never filed any tax returns and when SARS examined this, argued about the meaning of the treaty.