JIMÉNEZ &
GONZÁLEZ
Abogados
The treatment of permanent establishment, business profits and royalties in colombian tax treaties: Chile, Spain and Switzerland.
OSWALDO ANDRÉS GONZÁLEZ BARRERA, LLM
Partner
Introduction.-
The free market reforms that Colombia has enacted in the early 90's have increased the flow of foreign direct investment of capital in the country and have permitted the opening of the local economy into the global scenario. Thus, the Colombian Government has recognized the importance of adopting certain policies to increase the amount of foreign capital coming to the country. At the same time, the lack of modern technology of its productive infrastructure promoted the adoption of a policy to fix that problem and modernize its economy. On the other hand, there is a latent problem of double taxation of income. In fact, there are sufficient causes that trigger the need of a defined policy and practice of negotiating double taxation conventions. Therefore, the Government of Colombia adopted a policy to get into negotiations of double taxation conventions with countries which have developed a strong commercial relationship with Colombia, and have increased their direct investment within the country during the last decade.
As the Considerations Report presented by the Government of Colombia to the Colombian Congress states in the case of the Treaty with Switzerland, the international tax policy that Colombia has designed for its treaty negotiations was not available until March of 2007, in fact, two years later than the signing of the first DTC with Spain. That Report exposed the aspects that Colombia would consider during its treaty negotiation practice. Also, it suggests that Colombia would follow the general scope of the OECD Model Convention, and adopt different approaches taken from other treaty models in specific provisions.
Therefore, the main objective of this work is to determine whether or not and to what extent the OECD Model Convention is followed by the Tax Treaties that Colombia has recently signed with Spain, Switzerland and Chile, especially on articles relating to the concepts of permanent establishment, business profits and royalties. Despite the fact that only the treaty with Spain has entered into force, it is important to analyze the general approach of the other two treaties in order to verify the existence or not of an international tax policy with respect to those three provisions.
The second objective of this paper relates to distinguishing the main differences between the treaties as expressed in the permanent establishment, business income and royalties articles.
The permanent establishment article in the treaties with Spain, Switzerland and Chile.-
A. Treaty with Spain.
Article 5 of the Treaty signed between Colombia and Spain which has been ratified recently, reflects and follows the current the OECD Model Convention definition and use of the concept of permanent establishment almost entirely. The language used in the article is the same language described in the OECD Commentary on Article 5 as the determination of the right of a Contracting State to tax the profits of an enterprise of the other Contracting State. The definition of the term in paragraph 5.1 contains the same conditions defined in the OECD Commentary as the existence of a “place of business”, which must be “fixed”, and the “carry on” of the business of the enterprise through it. [1] Consequently, the language of this paragraph has the same meaning as paragraph 5.1 of the 2006 U.S. Model Income Tax Convention.
On paragraph 5.2, the Treaty simply identifies the same illustrative list of examples of a permanent establishment that the OECD Model and the US Model had. Nothing is added at all in this paragraph. As an important point of view, it can be noted that in this Treaty Colombia has not negotiated for the inclusion of the exploration activities within subparagraph f) despite having an intense presence of multinational enterprises doing exploration of natural resources within its territory.
On paragraph 5.4 the Treaty lists the same exceptions to the concept of permanent establishment that the OECD Model and the US Model do. As the OECD Commentary denotes, the exceptions are covered by the same feature of being preparatory or auxiliary activities, e.g. the use of facilities solely to store, display or deliver merchandise, or for the purposes of processing by another enterprise. The same conclusion holds for purposes of purchasing goods or merchandise, or collecting information, or any other activity of a preparatory or auxiliary character. Any combination of the listed activities shall not constitute a permanent establishment as long as it would not create an activity with a character other than preparatory or auxiliary. Therefore, the language of the paragraph 5.4 reflects the same construction and language of the Models listed before.
Similarly, the paragraph 5.5 of the article under study follows the same language of OECD and US Model Income Tax conventions to specify that, notwithstanding the concept of permanent establishment defined in paragraphs 5.1 and 5.2, an enterprise from one Contracting Stated is deemed to have a permanent establishment in the other Contracting State with respect to activities carried on by an dependent agent with sufficient authority to conclude contracts on behalf of the enterprise. Under the OECD Commentary, [2] this dependent agent should not maintain either a residence or a place of business in the other Treaty Country, and should habitually sign into contracts which are the business proper of the enterprise. These conclusions seem to be applicable to the Treaty with Spain as long as there is no difference in the language of the Treaty and the OECD Model on Income Tax Convention.
Finally, concerning paragraph 5.7, the Treaty signed between Colombia and Spain reflects the general conclusion accepted in both the OECD Model and the US Model that the mere ownership or control relationship between a parent and a subsidiary company does not define for itself the existence or not of a permanent establishment.
2. Main differences: Concessions to Colombia as a Developing country
Notwithstanding the influence of the OECD Model on the permanent establishment article described before, under paragraph 5.3 of the Treaty a building site or construction or installation project shall constitute a permanent establishment if it lasts more than six months, a period of time which is shorter than the 12 months rule of both the OECD and the US Models. That difference could be sustained for two reasons. One can assume that Spain has just given as a concession to Colombia because of its condition of developing country, the right to consider as a permanent establishment a given construction or installation project that lasts for more than six months. However, because of being the first bi national tax treaty negotiated and signed by Colombia, it is arguable that this country had not developed an international tax policy with a defined position with respect to this issue at the time of the negotiations, and the result could be due to other factors. On the other hand, it is also possible that the reason for this result refers to the effect of the reservation on the paragraph 3 of the OECD Model that Spain has been made. [3] Nevertheless, Spain has not executed its reservation to the paragraph 3 with respect to the right to include supervisory activities within the scope of the paragraph 3 of the Treaty with Colombia. As a matter of discussion, it can be argued that the tax treaty policy of one or both of the Contracting States could have been influenced by the UN Model Convention, which has a quite similar conclusion regarding paragraph 5.3. However, the scope of this paper does not include the analysis of the UN Model, and a further discussion is not relevant at this point.
3. The Arm's Length principle on transactions with independent agents
The Treaty between Colombia and Spain includes the general rule of the paragraph 5.6 of the OECD Model, which denies the possibility to consider as a permanent establishment of an enterprise of the other state, the mere presence and acting as an independent agent like a broker, general commission or any other kind of independent agent on behalf of the enterprise. Therefore, the language used in the Treaty implies the requisites introduced by the OECD Model Commentaries of legal and economic independence from the enterprise, and the acting of the independent agent within its ordinary course of business when representing the enterprise.
Nevertheless, paragraph 5.6 includes an additional requirement for the independence of the agent, which is the application of the arm's length principle in the transactions between the independent agent and the enterprise. This requirement escapes the OECD Model and the US Model schemes, and somehow approaches the article 5.7 of the UN Model, which has not been taken into account in this comparison.
4. The Treaty Protocol includes a repealed Colombian surtax on profits
The Protocol of the Treaty has a special provision that excludes from taxation in Colombia the business profits of the Spanish residents that is generated through a permanent establishment with respect to a Colombian Surtax recently repealed. Therefore, the provision has no current importance apart from being proof of the current lack of bargaining power from the Colombian point of view.
B. Treaty with Switzerland.
1. The application of the OECD Model Convention as a general trend
Colombia has signed a Tax Treaty with Switzerland that follows the same strategy used in the earlier Treaty with Spain concerning the permanent establishment provision. Indeed, the general trend of article 5 takes the same language used in the Treaty with Spain. Paragraph 5.1 follows the accepted version of the OECD Model and the US Model and includes the three requisites of the concept of permanent establishment: a place of business which is fixed and the carrying on of the business through it. Paragraph 2 does not change the position taken previously and includes the same list of examples of permanent establishment of the article 5.2 of the OECD Model and the US Model.
The same comment given to paragraph 5.4 of the Treaty with Spain could be applied to that paragraph in the Treaty concluded with Switzerland. The provision excludes the same list of preparatory or auxiliary activities, or any combination of them from the concept of permanent establishment that paragraph 5.4 of the OECD Model does. Moreover, paragraph 5.5 identifies the same language of the paragraph 5.5 of the OECD Model with respect to the deemed permanent establishment due to the existence of the dependent agent of the enterprise who has an authority to conclude contracts which are binding on the enterprise. The same conditions referred before in the case of Treaty with Spain apply in this case.
Lastly, there is no difference between the language used in the paragraph 5.7 of the Treaty with Switzerland and the OECD Model and the US Model concerning that the mere consideration of being a company which is controlled or owned by a company of the other Contracting State shall not of itself constitute a permanent establishment. At this point, it is possible to assume that Colombia fixed a position when negotiating the permanent establishment provision with the two OECD countries as discussed before.
2. Main differences: Concessions to Colombia as a developing country
Following the same language of the Treaty with Spain, Colombia seems to have achieved in the negotiations the reduction of the time frame of the paragraph 5.3 with respect to a building site or construction or installation project to constitute a permanent establishment. As it was commented before, if any of those activities last more than six months, there shall be considered to be a permanent establishment in the country where the activities take place. Thus, with respect to the analysis given in the case of Spain, we have a second reason now to believe that Colombia has adopted a position in this matter following the UN Model Convention. Nevertheless, since Switzerland has not made a reservation on the paragraph 5.3 of the OECD Model as Spain has, it is reasonable to say that in this Treaty Colombia has learned something about dealing with OECD countries and has imposed its developing country position.
3. An unexpected mistake: no current extraction of natural resources is mandatory in order to qualify as a permanent establishment
Notwithstanding the similarities among the two Treaties mentioned before, there is a small difference in the language of subparagraph f) of paragraph 5.2. The provision of the Treaty with Switzerland includes as a permanent establishment the sole existence of a place of natural resources without the word “extraction”. [4] One can argue that it was only a lack of attention and a drafting mistake that will not give rise to any further problem in the interpretation of subparagraph f), and the mere interpretation of the OECD Commentary would be enough to avoid misunderstandings. However, the neither the OECD Model Commentaries nor the UN Model Convention Commentaries analyze the issue[5]. Nevertheless, there is no practical difference between the language of the Treaty and the language of the OECD Model Convention since there would not be any income to tax prior to extraction. Therefore, the provision would apply as if it includes the “extraction” requisite.
4. The Arm's Length principle on transactions with independent agents
Paragraph 5.6 has the same language on both Treaties. As It has been explained before, the provision follows the basic rule from the OECD Model. Thus, the concept of permanent establishment is not applied whenever an enterprise from one Contracting States carries on business in the other Contracting State thorough an independent agent as a broker, commission agent or any other kind of agent. As the language of the provision is the same than the Treaty with Spain, the given considerations would apply to this Treaty as well.
However, the last part of the paragraph 5.6 attaches the arm's length principle to the transactions between the enterprise and the independent agent in the other Contracting State as a requisite to avoid the consideration of a permanent establishment for the enterprise. This latest provision of the paragraph 5.6 seems to reflect the language of the article 5.7 of the UN Model Double Taxation Convention.[6]
C. Treaty with Chile.
1. The application of the OECD Model Convention as a general trend
The definition of the concept of permanent establishment in article 5.1 follows of the general trend of the OECD Model Convention. Thus, the same consideration described before applies. In paragraph 5.2 the Treaty includes the same illustrative list of places considered to be a permanent establishment than the paragraph 5.2 of the OECD Model and the US Model does.
Nonetheless, the subparagraph f) of the article 5.2 introduces exploration activities of natural resources in addition to the extraction activities as a condition to be considered as a permanent establishment, following the current scope of the OECD Model and the US Model. This provision has been authorized by the Commentaries on the OECD Model to be inserted in the Treaties upon agreement of the parties. [7]
2. The importance of exploration activities and services in the definition of permanent establishment
Article 5.3 of the Treaty with Chile includes two different provisions. Under paragraph 5.3 a) if a building site, or construction or project lasts more than six months, as Colombia has previously agreed in the other two Treaties reviewed, shall be considered as a permanent establishment. This is a change of the 12 months rule of paragraph 5.3 of the OECD Model and the US Model, which seems to be applied by Colombia as a general policy in the treaties analyzed in the present paper. However, in this case none of the countries is a member of the OECD. Additionally, the Treaty introduces supervisory activities in connection with the building or construction site as a condition that triggers permanent establishment treatment.
The other provision in paragraph 5.3 includes in the permanent establishment concept the furnishing of services of the enterprise by its employees or other personnel engaged for that purpose for a period or periods of time aggregating more than 183 days in any twelve-month period. This provision includes also consultancy services. Moreover, the final sentence of this second subparagraph provides that whenever similar services were performed in the same country by two associated enterprises, the period of time of each performance should be aggregated in order to verify the 183 days rule that triggers the permanent establishment condition.
The Commentaries on the OECD Model present the issue regarding the taxation of services rendered by an enterprise of a treaty country in the territory of the other treaty country. The current Commentaries on the OECD Model Convention include a new alternative provision that authorizes the members to deal with the taxation on services on that article.[8] Nevertheless, this provision has not been used in this Treaty.
Thus, the subparagraph 5.3.b) of the Treaty follows the UN Model on this particular point. Anyhow, the provision of the Treaty between Colombia and Chile does not adopt the entire language of the subparagraph 5.3.b) of the UN Model Double Taxation Convention. Instead, it changes its six-month rule for a period of time longer than 183 days as noted before. Generally speaking, this provision shows relative evidence of the weight of the UN Model on the tax treaties negotiations between two developing countries like Colombia and Chile.
3. The exclusion of preparatory and auxiliary research, advertising and information activities on the permanent establishment definition
The paragraph 5.4 of the Treaty lists almost the same exceptions as the same paragraph in the OECD Model and the US Model, except that it excludes from the permanent establishment concept a fixed place of business held by the enterprise with the only purpose of pursuing research, advertising and management information activities.
The provision also eliminates the reference to any other activity of a preparatory or auxiliary character. Therefore, it can be assumed that the list of activities of the paragraph 5.4 is exhaustive and no analogy interpretation is allowed.
As the language of the paragraph 5.4 indicates, it does not include the subparagraph f) of the OECD Model Convention. Therefore, under paragraph 5.4 of this Treaty, any combination of activities mentioned in this subparagraph shall constitute a permanent establishment. This is an outcome which is different from the point of view of the OECD, US and UN models on income tax conventions.
4. Other similarities and differences in the treaty with Chile
The Treaty with Chile has the same language used by the OECD Model in the paragraph 5.5 concerning activities of dependent agents of an enterprise of one Treaty Country, thus, the affirmations transcribed before with respect the Treaties with Spain and Switzerland, are completely applicable now.
Also, under the paragraph 5.6, an insurance company collecting premiums or insuring risks in the other Treaty Country, is deemed to have a permanent establishment in that other Treaty Country if that activity is carried on through a agent different than an independent agent which is defined in paragraph 5.7. This is a provision different from the OECD Model, and follows the language of paragraph 6 of article 5 of the UN Model.
Finally, paragraph 7 of article 5 includes the same provision as in the other two Treaties analyzed before regarding the carrying on of business of an enterprise through an independent agent in the other Treaty Country who acts in the ordinary course of business. Thus, in this case, that agent will not be considered as a permanent establishment of the enterprise. However, the language of the paragraph requires that the transactions and relationship between the enterprise and the independent agent should be hold on at an arm's length basis.
3. Business profits article in the treaties with Spain, Switzerland and Chile.-
1. All three treaties follow the OECD Model Convention
The language of the business profits article in the three Treaties signed by Colombia with Spain, Switzerland and Chile is similar to the language generally accepted and established by the OECD Model. As the Commentaries on the OECD Model Convention denote, the purpose of Paragraph 1 of article 7 is to fix limits on the right of one Contracting State to tax the business profits of enterprises of the other Contracting State. Therefore, that Contracting State could tax only the profits that are attributable to the permanent establishment of the enterprise located within that Country. Thus, the other Treaty Country could tax only the business profits of the enterprise that is not attributable to the permanent establishment situated in the other Contracting State.
Paragraph 2 contains the accepted version of the OECD Model which allows the calculation of the profits attributable to the permanent establishment of transactions with independent enterprises, associated enterprises and other parts of the same enterprise from which is a part of, under the principles and methods related to the application of the arm's lengths principle. Under paragraph 3 of the Treaties, an amount of expenses is allowed as a deduction when determining the profits attributable to the permanent establishment applying the arm's length principle. Under the Treaty with Chile, the rule of paragraph 3 indicated that the determination of the expenses allowed to the permanent establishment shall be made following the internal law of the Treaty Country where it is located.
The only relevant difference with the OECD Model Convention is the elimination of the paragraph 4 of article 7 of the OECD Model in the Treaty signed with Spain. Since Spain, as a member of the OECD, has not made any reservation or observation on the article 7 of the OECD Model Convention, there is no evident reason to that exclusion. Nevertheless, it can be argued that on this particular point, the Treaty between Colombia and Spain follows the US Model which does not include such a provision. Oppositely, the other two Treaties have included the same language of paragraph 4 of the OECD Model. This provision indicates a method of apportioning of the total profits of the enterprise based on its various parts in lieu of the arm's length profit estimation of the paragraph 3. Paragraphs 5, 6 and 7 of the three Treaties follow the same language of the OECD Model, therefore no further comment should be given.
4. Royalties.-
1. The application of residency principle as a general rule
Article 12 on the three Treaties contains the basic language of article 12 of the OECD Model Convention which gives predominance to the taxation of royalties in the country of residence of the beneficial owner.
2. The 10% withholding tax on the gross amount of the royalty by the source country
However, under the language of the paragraph 1 of article 12, royalties are not only taxed in the country of residence of the beneficial owner. Because of the change of the term “shall be taxable only” of the OECD Model for the term “may be taxable”, the provision allows the taxation of royalties by the country of source of the payments. Therefore, an additional paragraph was added to the three Treaties (Paragraph 2) allowing the Contracting State in which the royalty arises, the source country, to tax the royalty under its internal law subject to a maximum rate of 10% of the gross payment if the beneficial owner of the royalty is a resident of the other Contracting State. This is a general concession from Colombia where the rate for royalties is 34% in the absence of any international obligation. Only the treaty with Switzerland includes a provision delegating to the mutual agreement procedure among the competent authorities of the Contracting States the design of procedures to apply this paragraph. This is the clearest example of the influence of the UN Model Convention on negotiations of double tax treaties between developed and developing countries.
3. The definition of royalties includes a broader scope than the OECD Model
Paragraph 3 of the article 7 in all the three treaties involves the same language than the OECD Model Convention. Nonetheless, it introduces a broader scope of the concept of royalties. For example the provision includes not only cinematographic films but also any other films or tapes for the reproduction of image and sound. It also lists as royalties the payments for the use or the right to use commercial, industrial or scientific equipment. Those items are characterized as royalties following the article 12.3 of the UN Model Convention. This treatment differs from the OECD Model which characterized that payment as a leasing income under the concept of business profits on article 7. As a matter of fact, the paragraph introduces in the definition of royalties payments that arise from services such as technical services, consultancy services and technical assistance.
Lastly, none of the three Treaties includes in this article as royalty the gain for alienation of qualified property contingent on the productivity, use or disposition, as the US Model does in its paragraph 12.2 (b), This can be explained because that clause is considered contrary to the official interpretation of the OECD Model Convention.[9]
4. The concepts of residency and permanent establishment as a rule to determine the country of source of the royalty
As indicated before, the basic language of article 12 of the OECD Model Convention is followed by the respective provisions of each Treaty, especially on paragraph 4 which is similar to paragraph 4 of the Model. Thus, a royalty attributed to a permanent establishment in one Treaty Country will be taxed in that country under article 7, rather than the Treaty Country of residence of the enterprise under paragraph 12.1.
The Treaty with Chile has a singular provision that includes the concept of fixed base of business for purposes of royalties that are treated as independent personal services income in article 14 of that Treaty. The other two Treaties have not drafted such an article following the OECD Model Convention.
Additionally, the concept of permanent establishment is used in paragraph 12.5 to determine that the source of the payment shall be located on the Treaty Country where the permanent establishment is located rather than the Treaty Country of residence of the enterprise when the royalties are borne on that permanent establishment.
The last paragraph of each article of all the three treaties has the same language of the paragraph 12.4 of the OECD Model and imposes the same limitation and the application of the arm's length principle in royalty dealings among associated enterprises.
5. Conclusions.-
Colombia follows the OECD Model Convention as a starting point in its short tax treaty negotiations experience.
There are several differences between the OECD Model Convention and the Colombian tax treaties based on concessions for developing countries. These provisions follow the UN Model Convention as a general trend. Examples of that tendency are the broader concept of permanent establishment adopted in the treaties and the taxation of royalties by the country of source.
Colombia has included in those three initial treaties the concept of services as an important rule for the definition of permanent establishment and royalty.
Finally, there is an important feature among the treaties analyzed. The Treaty with a non OECD country such as Chile has a broader definition of the concept of permanent establishment than the Treaties with OECD countries as Spain or Switzerland. This is a reflection of the importance of the UN Model Convention on the treaties between two developing countries.
6. References.-
OECD Committee on Fiscal Affairs. Model Tax Convention on Income and on Capital. Condensed Version. 2008.
· UN, Commentaries on the articles of the United Nations Model Double Taxation Convention between Developed and Developing Countries. Revision 1999.
· Vogel, Klaus. Klaus Vogel On Double Taxations Conventions. Kluwer Law International. London 1997, Third Edition.
[1] OECD Committee on Fiscal Affairs. Model Tax Convention on Income and on Capital. Condensed Version. 2008. Pg. 77.
[2] OECD Committee on Fiscal Affairs, 2008, pp 92 et seq.
[3] OECD. Committee on Fiscal Affairs, 2008, pp 112. “49. Spain reserves its position on paragraph 3 so as to be able to tax an enterprise having a permanent establishment in Spain, even if the site of the construction or installation project does not last for more than twelve months, where the activity of this enterprise in Spain presents a certain degree of permanency within the meaning of paragraphs 1 and 2.”
[4] Colombia Switzerland Income Tax Convention, signed on October 27, 2007. “5.2) f) a mine, an oil or gas well, a quarry or any other place of natural resources.”
[5] UN, Commentaries on the articles of the United Nations Model Double Taxation Convention between Developed and Developing Countries. PP 72 et seq.
[6] UN Model Double Taxation Convention. Paragraph 5.7, last sentence. “However, when the activities of such an agent are devoted wholly or almost wholly on behalf of that enterprise, and conditions are made or imposed between that enterprise and the agent in their commercial and financial relations which differ from those which would have been made between independent enterprises, he will not be considered an agent of an independent status within the meaning of this paragraph.”
[7] OECD. Committee on Fiscal Affairs, 2008, pp 86.
[8] OECD. Committee on Fiscal Affairs, 2008, pp 102 et seq.
[9] Vogel, Klaus. Klaus Vogel On Double Taxations Conventions. Kluwer Law International. London 1997, Third Edition. Pg. 795.
