The Challenges of Taxing Profits Attributed to Permanent Establishments: A South African Perspective

• Jurisdiction: South Africa
• Date: 25 May 2019
• Author: Annet Wanyana Oguttu
• Pages: 773-803
• Published date: 25 May 2019

The Challenges of Taxing Prof‌its Attributed to

Permanent Establishments: A South African

Perspective

ANNET WANYANA OGUTTU*

University of South Africa

1 Introduction

When countries enter into a tax treaty, the treaty lays down the rules for the

taxation of income by the two countries. Tax treaties are usually signed on

the basis of a particular model and they generally follow the provisions of the

prescriptive articles in the latter.

1

It is a principle of international tax treaties

that the prof‌its of an enterprise of a contracting state are taxable only in that

state, unless the enterprise carries on business in the other contracting through

a permanent establishment (‘a PE’) situated therein. Even if a PE exists, only

the prof‌its attributable to the PE are taxable.

2

Thus, the signif‌icance of a PE is

that it gives the country in which it is situated (the source country) the right to

tax its income, even though the PE has no separate legal existence.

3

The approach recommended by the Organisation for Economic

Co-operation and Development (OECD)

4

for attributing prof‌its to PEs

requires that a PE be treated as a separate legal entity and that transfer

* LLB (Makerere University, Uganda) LLM with Specialisation in Tax Law (Unisa) H Dip in

International Tax Law (UJ) LLD (Unisa).Associate Professor, Department of Mercantile Law, College

of Law, University of South Africa. This article is based on a paper presented at the 1st International

Workshop on Transborder Commercial Law, held in Sandton, South Africa (19–20 October 2009), a

summarised version of which is also published in (2010) 64 (3) Bulletin For International Taxation165,

in which recent developments in relation to the new Article 7 of the OECD Model TaxConvention are

discussed.

1

In principle, there are three models for drafting double taxation agreements, which have been

developed over time. Firstly, there is the Model Tax Convention on Income and Capital, published by

the Organisation for Economic Co-operation and Development (‘OECD’). This model was prepared

by developed countries of the world and embodies rules and proposals by capital-exporting countries.

Then there is the United Nations Model Double Taxation Convention. This Model has been drafted

between developed and developing countries and it attempts to ref‌lect the interests of developing

countries. Lastly, there is the United States Model, which is followed by most treaties that the USAhas

signed with other countries, including South Africa. See Lynette Olivier & Michael Honiball

International Tax: A South African Perspective 4 ed (2008) at 7; Radhakishan Rawal The Taxation of

Permanent Establishments: An International Perspective 2 ed (2006) at 1.

2

Article 7(1) of the OECD Model Tax Convention on Income and on Capital: Condensed Version

(July 2008).

3

As clarif‌ied further on in the article, a PE is an unincorporated business (for instance, a branch). It is

not a separate legal entity; therefore, its property and activities are considered to be for its foreign parent

company, which is liable for tax on the income of the PE. By contrast with a PE, a subsidiary company

is a separate legal entity distinct from its parent company. Thus a subsidiary is taxable in the country

where it is incorporated. See ArvidA Skaar Permanent Establishment: Erosion of a Tax TreatyPrinciple

(1991) at 1.

4

See OECD ‘History of the OECD’, available at http://www.oecd.org/document/63/0,2340,and_

2649_201185_1876671_1_1_1_1,00. html (visited on 2 March 2009); JG Salinas ‘The OECD Tax

Competition Initiative: ACritique of its Merits on the Global Market Place’ (2003) 25 Houston Journal

of International Law 531 at 538.

773

(2009) 21 SA Merc LJ 773

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pricing

5

rules applied to separate legal entities be applied to the PE. Of course,

this gives rise to conf‌licts in the application of the domestic tax laws of some

countries. This article sets out the workings of the OECD prof‌it attribution

rules, the criticisms of these rules and the challenges of applying these rules

from a South African perspective. The article also sets out the views of some

commentators on how these challenges can be resolved, and f‌inally offers a

recommendation for resolving the problem from a South African perspective.

2 The Definition of the PE Concept, Its Role in International Tax

Law and How PEs are Taxed

Before discussing the issues pointed out above, it is important that the

relevance of the OECD in this respect should brief‌ly be explained. The OECD

is an international organisation established in 1961 to contribute to economic

development and growth in its member countries. Through its publication on

topics such as taxation, it encourages dialogue and consensus that can

encourage economic development and change in the market economy.

Though its primary focus is on member countries, its additional goals of

contributing to the expansion of world trade and the development of the world

economy affect non-members as well.

6

The OECD Model Tax Convention

and its Commentary on the articles in the Model Convention are not legally

binding. However, when countries sign a tax treaty that is based on the OECD

Model Convention, the terms of that treaty are legally binding on those

countries. In interpreting the terms of tax treaties (which are internationally

classif‌ied as international agreements), customary international law interpreta-

tion rules have to be applied.

7

These include the Vienna Convention on the

Law of Tax Treaties,

8

a codif‌ication of customary international law that is

applied internationally to interpret treaties.

9

Its art 32 provides that

supplementary means of interpretation (which include the Commentary on the

OECD Model Convention) can be taken into account in interpreting the terms

of the treaty.

The PE concept is def‌ined in art 5(1) of the OECD Model Tax Convention

as ‘a f‌ixed place of business through which the business of an enterprise is

wholly or partly carried on’.

10

In terms of this def‌inition, the place of business

has to be f‌ixed in a geographical sense and permanent in duration. Article 5(2)

sets out as the examples of PEs a place of management, a branch, an office, a

5

Explained below.

6

OECD ‘History of the OECD’ op cit note 4.

7

Klaus VogelKlaus Vogel on Double Taxation Conventions: a Commentary to the OECD-, UN-, and

US Model Conventions for the Avoidance of Double Taxationon Income and Capital, with Particular

Reference to German TreatyPractice 3 ed (1997) in the Introduction in par 28. In South Africa, s 233 of

the Constitution of South Africa, 1996, states that ‘[w]hen interpreting legislation, every court must

prefer any reasonable interpretation of the legislation that is consistent with international law over any

alternative interpretation that is inconsistent with international law’.

8

23 May 1969.

9

Olivier & Honiball op cit note 1 at 33.

10

Paragraph 2 of the Commentary to art 5 of the OECD Model Convention.

(2009) 21 SA Merc LJ774

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