Permanent Establishment: Double Taxation Convention - Case Study Example

Insert Name: Tutor: Course: Date: 1. Permanent establishment—double taxation convention Case facts Mr Beckham is an employee of Gullit BV (Netherlands). Gullit BV offers several services to related group companies. The related group company, Houllier Sarl in France has asked Gullit BV for assistance in the sale of machinery to Houllier’s prospect in “your country”. The value of this contract is US$500 million. Gullit BV has the power of attorney to negotiate with Houllier’s prospect in order to conclude the contract. Mr Beckham has the responsibility of overseeing the negotiations. He has daily meetings with the prospect in “your country”. Gullit BV has rented a loft in “your country” to house Mr Beckham. Here Mr Beckham can relax after the lengthy negotiations, plan his strategy and do his administration. The loft is furnished with Louis XVI antique furniture and modern communications equipment, like a fax, a computer, email, telephone etc (Skaar 14). Permanent establishments A permanent establishment is described as a fixed place of business via which activities of a business organization are entirely or partially carried out. The term permanent establishment also includes a management place, a branch, an office, a factory, a workshop, a quarry or any other place where natural resources can be extracted. Gullit BV (Netherlands) is intending to create a permanent establishment for the Houllier Sarl firm of France in ‘My Country’ by assisting in the sale of machinery. Thus Gullit BV is an agent of the Houllier sarl that is intending to create a permanent establishment in ‘My Country’. A permanent establishment also includes a building site, a construction project, installation project or supervisory activities and therefore, the above sale of machinery is a permanent establishment. Permanent establishments include projects or activities that last for more than six months. Other examples of permanent establishments include installations, drilling rig or ship utilized in exploration or exploitation of natural resources and furnishing services such as consultancy services by a firm or an enterprise via employee or other workers engaged by the firm with such intentions (Skaar 15). Exceptions Permanent establishments do not include the use of facilities entirely for the purpose of storage, display or delivery of commodities or merchandise owned by the enterprises, maintenance of a stock of commodities and merchandise owned by the business firm for the purpose of storage, display and delivery and maintenance of stock of products or merchandise owned by the firm with the intention of processing especially by another firm. Other non-permanent establishments the repairs of a fixed place of business exclusively for the intention of purchasing commodities or merchandise, or of gathering information for the organization and the maintenance of a fixed place of business exclusively with the intention of carrying on, for the organization, any other activity of a preliminary or support character. The maintenance of a fixed place of trading wholly for any combination of the activities mentioned in the above examples provided that the entire activity of the fixed place of trade resulting from this combination is of a preliminary or supporting character (Skaar 70). Types of permanent establishment The concept of permanent establishment does not only include a fixed place of business but may also include an agent who is legally separate from an organization but evidently connected and dependent upon the firm so that a permanent establishment exists by extension through the activities of the agent. Gullit BV in our example is an agent of Houllier Sarl of France and thus a permanent establishment exists. This type of permanent establishment is clearly described in paragraph 5 and 6 of Article 5 which bridges the Gap between common law and civil law. There are therefore two types of permanent establishments: a fixed place of trade (associated enterprise) and a dependent agent (unassociated enterprise). The concept of a permanent a permanent establishment exists in all three Model Conventions. It has an objective of being the condition essential for the taxation of commerce profits under the residence and source principles.  A permanent establishment can be taxed on its income and assets by the nation in which it is situated. This liability to be taxed is dependent on resident principle except when the enterprise has a permanent establishment in another nation to which returns are attributable.   Countries look for the existence of a permanent establishment as a prerequisite to fix fiscal liability. Treaties look to permanent establishments to assign the Nations right to tax (Skaar 70). The permanent establishment idea is significant because it differentiates between business organizations trading with other nations and those trading within a nation. This is a considerable distinction because business organizations trading within a nation are liable to taxation on the income and assets resulting from its physical existence through a permanent establishment.  This ensures that trade activities are not taxed by a State unless there is a considerable economic association between the permanent establishment and the Nation. Problem of double taxation Business firms carrying out cross-border transactions must consider the prospect of the transactions resulting to a permanent establishment with the intention of avoiding the problem of double taxation where possible. Under most global Double Tax Agreements, where a permanent establishment exists, the nation in which the permanent establishment is located has the right to tax any returns resulting from such permanent establishment. in general a permanent establishment results when a foreign investor has some existence in another nation or where the foreign investor has a dependent agent in that nation who customarily exercises an influence to contract as the investors representative. It is regularly clear that a permanent establishment exists in association with foreign investor and, in these cases no amount of bright structuring or tinkering can change the issue. Once a permanent establishment has been created that foreign company or enterprise earns returns from the establishment. The issue of Double Tax Agreement thus becomes applicable but can at times offer investor relief alongside the source regulations. When applying the requirements for Double Tax Agreements concerning permanent establishments, the specific facts and conditions of every investment are important in deciding whether a permanent establishment exists. Therefore, whenever a firm considering any kind of international transaction, specialized advice is necessary to ensure that the transaction in place is viable (Skaar 14). 2. Tax consequences- Purchasing and Service Company in Hong Kong Foreign company registration options in Hong Kong Low tax regime, a facilitator to the Mainland China market, world class infrastructure, a free economy are some of the many aspects that are attracting raising number of foreign investors and business firms in Hong Kong. A subsidiary business firm, branch office and representative office are the main trading structures availed to foreign business firms which are ready to establish their presence in Hong Kong. The choice of the particular trade structures is usually based on the foreign firm’s business plans and objectives. Many of the small to midsize business firms opt for a subsidiary or a representative office, while the bugger business choose to set up a representative office (UN 388). Subsidiary company A subsidiary is basically a private limited firm incorporated in Hong Kong. Hong Kong permits100% foreign ownership of business firms which implies that a wholly-owned subsidiary firm can be established in Hong Kong. Establishing a subsidiary is the most frequent and preferred choice for most foreign business firms as it offers limited liability and abundant tax advantages. A subsidiary is a detached legal entity from its overseas parent firm therefore the liabilities of the subsidiary business firm do not expand to the parent company. Furthermore, locally incorporated business firms can gain privileged access to the Mainland China markets and gain from the open trade accord with China. The fundamental necessities for registering a subsidiary business firm are: approval of business firm name, local registered address, at least one manager and shareholder, a local resident business firm secretary and an auditor. The business firm must have share capital though minimum prerequisites do not exist. For taxation objectives, a subsidiary is handled as a Hong Kong resident business firm and is entitled for tax exemptions and incentives applicable to local business firms (UN 388). Branch Office A branch office like a subsidiary is a lawfully incorporated entity except that a branch office is treated as an extension of the foreign parent company and is not a separate legal entity in its own right. This makes the foreign parent business firms accountable and responsible for all the debts and liabilities of the branch office. Like a subsidiary company, a branch office must be registered with the Hong Kong's Companies Registry. The essential requirements to open a branch office are: business firm business approval, a local resident authorized representative and an existing place of business in the country. In many cases branch offices are under similar legal and tax compliance. Representative Office Foreign companies that wish to get market insight, disclosure and a better comprehension of the Hong Kong commerce environment before establishing a full-fledged office can choose establishing an agent office first. A representative office can not participate in profit making actions and is not handled as a legal entity. It cannot make or form any contracts, make deals on behalf of the business firm increase invoices or letters of credit nor participate in business practices. The agent office has to limit itself to support and liaison actions, carrying out market research and co-coordinating practices on behalf of the parent business firms (UN 400). Since an agent office has no legal standing, the parent business firm holds implicit liability for all of its business activities. A representative office generally has foreign administrative personnel and locally selected support staff. There are no registration necessities with the Companies Registry, no minimum capital necessities and no compliances such as filing tax proceeds or maintaining financial records etc. The only condition is to register with the domestic Revenue Department and get a Business Registration Certificate. Is a tax shelter available No loss, outgoing or expenditure when a business firm issues shares as deliberation for assets or services offered to that business firm, it is neither a loss nor an outgoing of the business firm and is thus not deductible under the common deduction provision of s 8-1 of the Income Tax Assessment Act 1997. This does not consider the character of the assets or services to be acquired by the business firm as well as their intended application. The Commissioner had considered that this expands to all cases where it is a prerequisite of the Tax Act that the business firm must have sustained a loss, outgoing or expenditure – for instance trading supply deductions and R&D deductions. Set-off of obligations when a business firm has a liability to reimburse money deliberation for assets or services, and the firm’s establish that that commitment against the vendor's commitment to subscribe for shares in the firm, the organization has nevertheless sustained a loss, outgoing or expenditure. The two commitments that is, one to pay for assets or services in cash and the other to pledge for shares are then each freed by the set-off. However if, in regard to law or facts fact, the contract or agreement does not result to two accessible cross-obligations, payments can not be done by setting off. As a result, this will not lead to loss or outgoing, or expenditure acquired by the organization and thus deduction will not be made (UN 400). Discarding of trading stock outside the ordinary course of business Where a business firms purchases trading stock of the merchant being part of a sale of business, and trades shares as consideration, disposing of the available stock is not within the ordinary course of the vendor's firm or business activities. Under particular provisions, the organization is handled as having acquired the trading stock for the value included in the vendor's quantifiable returns for the assets, which would normally be the market worth of the shares. So, the business firm will have obtained the operational stock for a value equal to the market value of the shares (UN 400). Cost base for depreciating assets The value of any depreciating property obtained by any business firm for the purposes of Division 40 of the Tax Act that is, capital payment includes the market worth of any non-cash repayments offered as consideration of the given shares. Therefore the shares sold to cater for a depreciating asset will be part of the cost base to be amortized under Division 40. Cost base for capital gains tax purposes Shares offered as consideration are assets given, or requisite to be given, in respect of the acquisition of an asset. 3. Tax advantages of the preferred equity certificates Luxembourg Holding The discussion below describes the tax treatment of Luxembourg holding company. The company also provides for special tax systems for controlled private equity investment. A Luxembourg SOPARFI subject to the firm’s corporate income tax may be viable, under certain conditions for a participation exemption which offers very favorable tax handling for dividends and capital benefits on the nature of shares in a subsidiary. Capital contribution tax At the moment, a capital tax of 0.5% is deducted on equity contributions to a SOPARFI that is, upon incorporation or raise in capital. The capital tax is however expected to be done away with at the beginning of Year 2010. Certain transactions like contribution on all assets and liabilities or reasonable shareholdings may gain from exemptions. However for those transactions to which exemption is not viable, hybrid debt instruments, normally referred to as PECs or Preferred Equity Certificates permit to remedy the capital tax issue (Brent, 2009). Corporate income tax A SOPARFI may participate in any activities within its corporate intention as outlined in its articles of incorporation. It is under Luxembourg corporate income tax on its global profits at a maximum rate of 29.63 percent if addressed in Luxembourg City. This also encompasses a 4 percent unemployment fund supplement and the 6.75 percent public business tax for Luxembourg City. It is subject to lessening or exemptions that may affect pursuant to appropriate bilateral tax accords (Brent, 2009). Participation exemption for dividends In principle, a SOPARFI is viable for a participation exemption for being eligible to dividends acquired from its subsidiary. Dividends got by a SOPARFI are qualified for the contribution exemption under the following circumstances: The SOPARFI must have total shares amounting to at least 10 percent in the share capital of the subsidiary or otherwise, the acquisitions expense of the shareholding should be at least EUR 1.2 million. The subsidiary must conform to the subject-to-tax test aiming to exempt dividends emerging in tax havens or paid off by of-shore firms. The SOPARFI must consistently hold or pledge to hold title to its shareholding for a period of not less than 12 months. Capital gains tax exemption The net worth of capital benefits got from SOPARFI upon the disposition of shares in a subsidiary is tax exempt on condition that the following circumstances exist: The SOPARFI must own a share of not less than 10 percent in the share capital owned by the subsidiary or otherwise, the acquisition expenses of the shareholding must exceed EUR 6 million. The subsidiary must conform to the subject-to-tax test aiming to exempt dividends emerging in tax havens or paid off by of-shore firms. The SOPARFI must consistently hold or pledge to hold title to its shareholding for a period of not less than 12 months. Capital losses on the retailing of shares are in theory tax deductible. Particular anti-abuse stipulations take effect in case a non-qualifying shareholding has been swabbed with a qualifying participant. The participation exemption is not allowed for a period of five years for capital gains got from new shares. Deductions of financing costs Financing expenses like interest and other expenses associated with the acquisition and organization of a shareholding are basically tax deductable. This is however limited to the extent that they surpass the exempt (dividend or capital gain) returns realized. However recapture taxation applies to former interest deductions if at a later stage capital benefits are realized on the exempt participation. Withholding tax Dividend distribution Dividend distribution by a SOPARFI is based on withdrawing tax at a rate of 15 percent. This tax may however be minimized or avoided by through a viable tax agreement or the community directives. Interest Interest payments are basically exempt from withdrawing tax as per the regulations of Luxembourg domestic law. This excludes interest on particular profit sharing bonds or similar securities and interest awarded as a profit share in regard to silent partnership type of agreement. Interests paid to EU persons within the range of EU are also exempted from this regulation. Preferred equity certificates Preferred Equity Certificates or PECs are Luxembourg hybrid financing instruments with distinct equity characteristics like long maturity, income sharing and subordinated. The hybrid aspects of such instruments are consequences of tax treatment as equity in the jurisdiction of the PEC owner and treatment as debt in Luxembourg. The PECs are basically awarded to remedy the issue of the capital contribution tax on one side and dividend withdrawing tax on the other side. Considering the equity aspects, it is basically advisable to find an advance declaration of the Luxembourg tax authorities to prevent the risk of re-categorization on interest payments into positive dividends (Brent, 2009). Debt equity ratio Luxembourg tax law does not include general debt-equity ration stipulations. However in real life situations, tax authorities basically require a debt-equity ratio of approximately 85:15. When taking care of the fixed assets. Investing on a shareholding with more debt is normally satisfactory though the interest is not considered disproportionate (Brent, 2009). 4. Holding Companies-Big Apple Case Big Apple LLP, a New York City based firm is intending to bid for the shares in Food Industries Overseas BV, which is an intermediary holding firm in Netherlands and an international market leader in fast moving consumer commodities. Big Apple is intending to push down a maximum of acquisition debt and utilize the interest expense and also avoid all withdrawing tax and capital duty. There are two scenarios to consider in this case: Acquisition and Tax Consolidation and Acquisition and no Tax Consolidation. Big Apple must thus consider the advantage of various tax systems to optimize the benefits of tax loses and create different methods of generating losses in case they do not exist. Big Apple should also find ways and means of leveraging acquisition efficiency in order to push down a maximum of acquisition debt. The firm should also be careful to prevent jeopardizing prevailing tax losses and find possible means of refreshing expiring losses. The company must also consider utilizing cross border planning techniques in an effort to maximize the use of tax losses. Considering that the target firm holds 100% subsidiaries in Taiwan and 30% interests in a contractual joint-venture with a Chinese company, the best location for the acquisition would thus be in Taiwan (Kail 1). The emerging interest charges will be deducted from the local subsidiary future profits depending on the type of financial instrument used by Big Apple. If the firm opts to use the hybrid instruments, then the financing of the company will be treated differently by the tax system of the nation receiving the finance and that of the nation providing the finances. Hybrid Instruments have an advantage in that they create mismatches between two or more tax jurisdictions and also between accounting standards and tax rules. They also raise credit and solvency ratings and enhance capital structure. They are particularly important in mitigating for capital duty. Hybrid instruments are governed by International Accounting Standards (IAS). Equity instrument is any contract that provides a verification of residual interest in the assets of an enterprise after deducting its liabilities. Financial liability is the liability to deliver cash or other financial interests. Many countries use domestic classification principles while ignoring tax treatment of Hybrid Instruments in other nations. Cross border tax planning provides a mismatch in nature of financial instruments to combine tax advantages of equity, that is, income fit for tax credit or exceptions and debt (interest tax deductable). Cross-border tax planning also involves withholding tax considerations and review of the rules for determining the timing and the amount of deductions in the source nation and income of recipient nation. Hybrid debt has two main differences: Timing differences and Permanent differences. In timing differences, accruals based deductions expenses and costs are compared to the receipts basis taxation of income. Withdrawing taxation on redemption basis is also considered against granting tax credits on accruals. In the permanent differences, tax deductible interest is considered against divided income fit for tax relieve and tax deductible deemed interest versus deemed interest income recognition (Kail 2). Factors to take into consideration Some of the factors to take into consideration include the strategic logic which is based on the six determinants: market similarities, market complementarities, functional similarities, functional complementarities, market control, and purchasing authority, organizational integration which is based on three determinants attainment experience, relative dimension, cultural compatibility. Another consideration is the financial/price viewpoint which is depicted by three determinants: acquisition payment, bidding process, and due assiduousness. Financial instruments IFRS 9 financial instruments bring about a new categorization and measurement system for financial resources within its range. Due to that the continuing discussions in regard to measurements of own credit risk when appropriately valuing financial liabilities as well as accounting for financial liabilities will proceed under IAS 39 until additional modifications are made by the IASB to IFRS 9. IFRS 9 recommends that: debt instruments adhering to both a ‘business model’ test and a ‘cash flow features’ test are measured at amortized expenses that is, the application of fair value is not mandatory in some limited situations investments in equity instruments can be selected as ‘fair value via other inclusive income’ with only dividends being recognized in profit or loss all other instruments and their derivatives are measured at fair value with collection recognized in the profit or loss the idea of ‘entrenched derivatives’ is not applicable to financial assets within the range of the Standard and the whole instrument must be categorized and calculated in accordance with the regulations mentioned above. Unquoted equity instruments can not be calculated at cost less impairment and therefore they must be at fair value. IFRS 9 recommends that in deciding the measurement characteristic for a financial asset that is, amortized cost or fair value, a party must use two categorization criteria – a business model test and a cash flow distinctiveness test. If the financial asset meets the two categorization criteria, the financial asset normally must be calculated at amortized cost. A party may irreversibly opt for on initial appreciation to allocate a financial asset as fair value via profit or loss (FVTPL) if that description abolishes or considerably minimizes an accounting difference had the financial asset been calculated at amortized cost. This is described as “fair value option” (Kail 2). Business Model Test The business model test recommends that a firm should assess whether its business purpose for financial assets is to accumulate the contractual cash flows of the resources rather than recognize their fair value transformation from sale before their contractual maturity. This determination is carried out at a business unit level and not a personal financial instrument level and thus is not founded on management’s intention for specific instruments (Kail 2). Cash Flow Characteristics Test IFRS 9 recommends that a firm should assess the contractual cash flow features of a financial asset. The idea is that only instruments having contractual cash flows of principal and interest on principal can meet the amortized cost calculations. IFRS 9 expresses interest as reflection for the time worth of money and credit risk linked with the principal outstanding within a particular period. Thus, an investment in a translatable debt instrument would not be eligible because of the addition of the translation option, which is not thought to represent expenses of principal and interest (Kail 2). Works cited Brent Springael. Luxembourg holding company rules. Retrieved from Kail Padgitt. State business Tax climate. Retrieved from Skaar, Arvid. Permanent establishment: erosion of a tax treaty principle. New York: Kluwer Law and Taxation Publishers, 2000 United Nations. Treaty series. New York: Kluwer Law and Taxation Publishers, 2000 Read More