Leased Equipment: When Does a Permanent Establishment Exist?

Transcription

Leased Equipment: When Does a
Permanent Establishment Exist?
Keith R. Evans*
PRÉCIS
Comme dans la plupart des opérations commerciales transfrontalières, la situation
fiscale du bailleur qui réside dans un pays mais loue du matériel à un preneur dans un
autre pays diffère selon que le bailleur a ou non un établissement stable dans le pays
de ce dernier (le pays d’origine) par l’entremise duquel il exerce ses activités. Selon la
convention modèle de l’OCDE et les conventions fondées sur ce modèle, il n’y a pas
d’imposition dans le pays d’origine s’il n’y a pas d’établissement stable. Cependant, un
grand nombre des pays membres de l’OCDE se sont réservés le droit d’imposer les
opérations de location de matériel comme s’il s’agissait de redevances. Lorsque c’est
le cas, l’absence d’un établissement stable dans le pays d’origine fait que le montant
brut du revenu de location est assujetti à une retenue d’impôt, plutôt qu’à l’impôt sur
les bénéfices qui serait autrement levé aux taux normaux sur le montant du revenu net
attribuable à l’établissement stable.
Il a toujours été difficile de déterminer s’il existe un établissement stable en raison
des aspects particuliers qui découlent de la nature des opérations de location de
matériel. Dernièrement, l’incertitude s’est accrue en ce domaine en raison de l’érosion
progressive, dans les lois fiscales internationales, des exigences rigoureuses associées à
la détermination de l’existence d’un établissement stable. Le présent article fait état de la
situation législative actuelle en ce qui concerne les exigences devant être respectées
pour qu’il y ait un établissement stable, en insistant sur les aspects propres aux contrats
de location-exploitation transfrontaliers, et précise de quelle façon ces exigences sont en
train de changer graduellement. En conclusion, l’auteur tente d’évaluer la probabilité que
l’on conclue à l’existence d’un établissement stable dans divers arrangements structurels
mis au point pour les contrats de location-exploitation transfrontaliers.
ABSTRACT
As in most cross-border commercial transactions, the tax position of a lessor that is
resident in one country but leases equipment to a lessee in another country will
depend on whether the lessor has a permanent establishment in the latter (the source
country) through which the lessor’s business is being carried on. Under the OECD model
* Associate professor, Faculty of Law, Dalhousie University, Halifax. I would like to thank
Steve Brogden for his research assistance and comments on drafts of this article, and my
colleague Faye Woodman for her comments on an earlier draft. All errors and omissions
remain mine and mine alone.
(2002) vol. 50, n o 2
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treaty and treaties based on that model, in the absence of a permanent establishment,
no source-country taxation will arise. However, a large number of OECD countries have
reserved the right to tax equipment rentals as if they were royalties. Where that is the
case, the absence of a permanent establishment in the source country will result in the
rental income being subject to a withholding tax on the gross rental revenue, rather
than to income tax that would otherwise be levied at normal rates on the net amount of
income attributable to a permanent establishment.
The determination of whether a permanent establishment exists has always been
complicated by special considerations arising from the nature of equipment-leasing
operations. Recently, uncertainty in this area has been increasing, owing to a gradual
erosion in international tax law of the strict requirements for finding that a permanent
establishment exists. This article examines the current state of the law in respect of the
requirements for the existence of a permanent establishment, with specific reference to
the relevant issues relating to cross-border operational lease arrangements, and it
reviews the ways in which these requirements are gradually changing. The concluding
section considers the likelihood that a permanent establishment may be found to exist
under various alternative structural arrangements for cross-border operational leases.
KEYWORDS: TAX TREATIES ■ PERMANENT ESTABLISHMENT ■ OECD MODEL TREATY ■ ROYALTIES ■
LEASED EQUIPMENT
INTRODUCTION
The ability to tax rents derived from the leasing of equipment gives rise to a classic
conflict between the right to tax on the basis of the source of the income and the
right to tax on the basis of the residence of the owner of the equipment, where the
lessor’s operations and those of the lessee are in different taxing jurisdictions. In
general, it can be argued that the source of income from leasing equipment is the
location in which the equipment is put to use, and it is on this basis that the source
jurisdiction will claim its right to tax the owner of the equipment, even where that
owner is based or resident in another state.1 Where the lessor’s jurisdiction of
residence taxes on a worldwide basis, the prospect for significant double taxation
emerges. To the extent that double taxation makes the leasing business uneconomical, the economies of both states will suffer.
Most tax treaties negotiated to avoid such double taxation employ, to a greater
or lesser extent, the concept of a permanent establishment as the means to resolve
such conflicts. If the lessor does not have a permanent establishment in the source
state, the lessor’s tax position will depend on whether that state has agreed to
completely forgo its taxation rights, or instead has retained a restricted right
(usually applied by way of a reduced rate of withholding tax on the gross amount of
the rentals). If the lessor has a permanent establishment in the source state, full
taxation rights vest in that state; these rights are usually exercised through the
application of domestic tax rates against the net income/profit attributable to that
permanent establishment.
The threshold issue is therefore whether or not a lessor has a permanent
establishment in the source state. There is no clear and definitive answer under
the model international tax agreements, and particularly the OECD model tax
leased equipment: when does a permanent establishment exist?
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convention,2 as to when leased equipment, and related activities of a lessor, might
create a permanent establishment in a source state. In some instances, it could be
claimed that the mere presence of the equipment itself is enough to create such an
establishment. In most instances, something more will be required.
This article explores the issue of when a lessor of equipment will be found to
have a permanent establishment in another state. To set the stage, it is necessary to
analyze the tax position for income derived from the leasing of equipment under
the model treaties.
L E A S E P AYM E N T S A N D T H E M O D E L T R E A T I E S
Until an amendment in 1992,3 the starting point for determining the taxation of
profits from leasing equipment under the OECD model was the definition of
“royalties.” Included in the concept of a royalty was a payment of any kind received
as consideration for the use of, or the right to use, industrial, commercial, or
scientific equipment.4 Similar wording is used in the definition of royalties in the
UN model agreement,5 but not in the US model convention.6
If rent for equipment is classified as a royalty under a treaty definition, the
royalty provisions apply unless the rent is beneficially owned by a resident of the other
contracting state that carries on business in the source state through a permanent
establishment in that state and the rent is effectively connected to that permanent establishment. Where these conditions arise, the business profits/permanent
establishment provisions will apply.7 If rent is not within the treaty definition of
royalties, and the rent is properly classified as business profit for an enterprise, the
only area of concern is the business profits/permanent establishment issue.
While both the OECD (before 1992) and the UN models defined royalties to
include payments for the rental of industrial, commercial, or scientific equipment,
they adopted a fundamentally different approach to taxation of such payments by
the state of source. Under article 12(1), the OECD model exempted the payment
from taxation in the source state unless it was effectively connected to a permanent
establishment there (although a large number of OECD member countries8 reserved the right to tax such payments by applying a reduced withholding rate). By
contrast, the UN model preserves source-state taxation rights on a reduced withholding tax basis.9 This position is consistent with the objective of the UN model
to allow developing countries greater scope to tax on the basis of source. The result
under the former OECD provisions was that rental payments escaped tax in the
source state unless they were connected to a permanent establishment in that
state,10 while under the UN model, the source state retained (and continues to
retain) authority to tax rental payments, either on the basis of a percentage withholding on the gross amount of those payments under the royalty provisions, or
through taxation of the net rental income to the extent that the rentals are connected to a permanent establishment in the source state.
In 1992, the OECD model was revised to remove equipment rentals from the
definition of royalties. This amendment may appear odd, given that, under that
model, even if rent were included as a royalty, it would have escaped source-state
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taxation unless it was connected to a permanent establishment. However, no fewer
than 12 of the 24 OECD member countries had entered reservations to article 12
of the model so as to maintain a limited right to tax royalties at source, including
rents paid for the use of equipment.11 The 1992 amendment was made on the basis
of a recommendation from the OECD Committee on Fiscal Affairs to the effect
that member countries (and specifically those that had reserved the right to tax
royalties at source) should not subject rental income to tax at source under the
royalty provisions.12 Implementation of this recommendation would effectively
have left the income to be taxed under the business profits provisions of the treaty,
on a net profit basis, but only if the non-resident maintained a permanent establishment in the source state to which those profits were connected. The initiative
appears to have failed.13 In the context of the original recommendation, Australia,
Canada, and Italy reserved the right to continue to treat equipment rentals as
royalties subject to withholding tax, and Japan, New Zealand, Portugal, Spain, and
Turkey reserved the right to tax such income at source. With the exception of
Japan, these reservations have continued under the amended model and have been
augmented by similar reservations by the Czech Republic, Hungary, Korea, Poland, Greece, and Mexico14—a total now of 13 reservations from the 30 current
OECD members.
R O YA LT Y V E R S U S B U S I N E S S P R O F I T S
TREATMENT
The policy rationale for non-inclusion of rental payments in the definition of
royalties, as articulated by the OECD’s fiscal committee,15 is compelling. Five
considerations held sway among the majority of the committee and seem even to
have been accepted by some of the countries that entered reservations to the
committee’s report.16 Of the five reasons, the first is largely doctrinal. The committee noted that leasing income is different in nature from the other enumerated
inclusions within the definition of royalties, all of which deal with income from
intangibles with a substantial intellectual content. The same is not true of rentals.
Consequently, the committee concluded that it was inappropriate for the definition of royalties to extend to such payments.
The other four reasons are economic in nature, relating to the objective of tax
conventions—namely, the avoidance of double or excessive taxation of profits and
prevention of the harmful effects that such taxation can have on the international
movement of, and trade in, goods and services:
1. The inclusion of rentals in the OECD model definition of royalties was
designed to ensure that a zero rate of tax applied at source on such payments. This zero-rating is the basis for the taxation of all royalties under
that model. The committee noted that the inclusion of rent within the
definition of royalties in the model was not designed to recommend the
levying of tax at source on rent in those countries that reserved the right to
tax the more traditional kinds of royalties by way of a withholding tax.
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2. If leasing payments are treated as royalties, in those states that have reserved
the right to tax royalties, the tax is applied against the gross payment made.
Under this approach, excessive tax can arise in two ways:
a. the lessor is denied a deduction in the source country for any expenses
associated with that revenue stream, including depreciation costs and
costs of financing the acquisition of the asset; and
b. the tax at source may not be fully creditable in the jurisdiction of residence
where the income is taxed on a net basis—the source tax on gross can
easily exceed the level of the residence-state tax on the net income from
foreign leasing, and a loss of credit can result where the residence state
also imposes excess credit limitations.
This excessive tax impact can have a significant deterrent effect in a business
sector such as leasing, where the profit margin is small in comparison with
the overall lease payment.17
3. In those states where a withholding tax is applied on the basis of the pre-1992
OECD model, tax on gross rental payments applies only in the absence of a
permanent establishment. However, where such an establishment exists, tax
is applied on a net basis. As a result, the source-state tax burden can be
higher in those situations where a permanent establishment does not exist
than in those where it does. Purists will not like this result because it can
lead to a strange reversal of the more traditional roles in litigation in this
area where the taxpayer is arguing that a permanent establishment does
exist under the treaty and the tax authority is arguing otherwise.
4. Further double taxation problems emerge under the domestic law of states
that deem the state of residence of the payer of the royalty to be the source
of the payment, rather than the state in which the equipment is situated.18
In addition, tax equity concerns should favour non-royalty treatment. The
particular concept involved is that taxpayers in comparable circumstances should
be accorded comparable tax treatment. Assume that one company, company A,
carries on a business of selling goods from its state of residence; another company,
company B, supplies identical goods but for rent from its base in that same state; and
both companies have exactly the same limited operational activities to support
their sale/lease operations in the source jurisdiction, which fall well short of having
a permanent establishment there. Logically, company A and company B should be
taxed in the same way by the source state. However, in those countries that have
reserved their right under the OECD model to treat rental payments as royalties or
that adhere to the UN model, comparable treatment is not accorded. Company A
will escape taxation in the source state, but company B will be subject to withholding tax on its rental revenues. As the permanent establishment framework is accepted as the basis for taxation rights in the context of the sale of tangible goods
(subject, of course, to the current debate relating to the appropriateness of the
traditional permanent establishment principles in respect of sales of goods effected
through electronic commerce channels), it should apply equally to the rental of such
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goods where the rental income is a business profit of the enterprise. Likewise,
adherence to the principle of tax neutrality would dictate that a business decision
to purchase or lease equipment in a cross-border situation should not be determined on the basis of vastly different tax treatment for the two alternative ways in
which the equipment could be supplied.
There is also a risk that the bar for the existence of a permanent establishment
may be lowered as a result of royalty treatment of rental revenues. Any such
change would have an impact on the international tax regime far beyond the
limited circumstances of cross-border leasing. This risk would materialize if courts
strove to find that a leasing company had a permanent establishment in the source
country, in an attempt to minimize the opportunity for double taxation by allowing
the leasing company to pay source-state tax on a net basis in respect of profits
attributable to such an establishment, rather than at the flat rate on gross payments
that would otherwise apply. The outcome could be that enterprises conducting
non-leasing operations would be subjected to increased taxation in source locations.
While the doctrinal, economic, and tax equity/neutrality rationales support
non-royalty treatment, the only support for royalty treatment for rental payments
appears to be the protection of the tax base of the source country.19 The fiscal
policy rationale of obtaining a greater share of tax on the basis of source is of key
concern where the source country is a developing country (as reflected in the royalty
definition of the UN model), but the large number of continuing reservations on
this issue in the context of the OECD model demonstrates that some developed
countries also share this concern. As suggested earlier, in light of those reservations,
the objective of the fiscal committee in recommending the 1992 amendments to
article 12 appears to have been defeated. The committee itself seems to have accepted
the possibility for such failure, noting that where member countries wished to levy
withholding at source on equipment rental payments, such withholding should be
applied through specific treaty provisions separate and apart from the royalty
provisions, and with a rate lower than that which applies to royalties generally.20
L E A S I N G A C T I V I T I E S I N T H E S O U R C E S TA T E
Against this background, the question whether an enterprise resident in one state
has a permanent establishment in another state from which rental income is derived
will be crucial to determining the fiscal burden of the enterprise in the source state
in cases where a double taxation agreement exists between the two states. Under
pure OECD model treaties, the answer to this question will determine whether the
enterprise pays no tax at all or, instead, pays tax on net income attributable to the
permanent establishment in the source state. For countries like Canada, which
have reserved the right to treat income from the rental of equipment as a royalty
subject to withholding tax, or for countries with treaties based on the UN model,
the revenue will be subject either to withholding tax on the gross rental payment in
cases where no permanent establishment exists, or to tax on the net income from
any leasing activity attributable to a permanent establishment.21
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The existence, or absence, of a permanent establishment is hugely dependent
upon exactly what the lessor does by way of activity in the source state. That level
of activity can vary widely from the mere presence of equipment in the source state
to the operation of a branch by the lessor, complete with premises and personnel
responsible for inspection and maintenance of the equipment, and for general
support of the rental activity in that state. There is little question that the latter
conditions should and do constitute a permanent establishment.22 The real issue is
where the line is to be drawn short of such a complete branch presence.
The difficulty in drawing this line was expressly recognized by the OECD’s fiscal
committee when it analyzed a number of leasing scenarios from the perspective of
whether a permanent establishment exists:23
Comments
Does a permanent establishment exist?
Leased equipment operated, serviced,
inspected and maintained by the lessor’s
own personnel stationed permanently in
the source state
Yes, at least if these activities are carried
out under the direction, responsibility,
and control of lessor
inspected, and maintained wholly by
the lessee
Generally, no
inspected, and maintained by the lessor by
No, if carried out under the direction,
responsibility, and control of the lessee;
otherwise disputable
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its own personnel stationed
permanently in the state of residence, or
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independent enterprises hired by the
lessor
Leased equipment:
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operated and serviced by the lessee or
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inspected and maintained by the lessor
Maintenance of an office in the source state
to be in contact with the market, conclude
contracts, deliver the equipment, etc., but
not participating in operation, servicing,
inspection, and maintenance of leased
equipment
Disputable if inspection and
maintenance are not under the direction,
responsibility, and control of the lessee
According to the principle of article 5
The remainder of this article explores the legal principles that will apply in
deciding whether a permanent establishment exists in respect of leasing activity in
a source state, with a view to determining whether the analysis above is still
current. In this context, it is important to note the following parameters of the
review. The discussion is confined to operating leases; it does not extend to finance
leases, where the leasing company is used to fund the lessee’s acquisition of the
equipment.24 Finance leases impinge on the interest provisions of tax treaties and
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hence raise a host of considerations outside the scope of this article. As well, the
article does not address the question whether a permanent establishment exists
where dependent or independent agents of the lessor are present in the source
state. The position with respect to the use of agents is no different in the leasing
context than in the case of any other commercial endeavour, and therefore need
not be addressed here.25
LEA SING ACTIVITIE S A S A FIXED PLACE OF
B U S I N E S S : A R T I C L E 5 ( 1 ) O F T H E O E CD M O D E L
The definition of “permanent establishment” requires an enterprise to have a fixed
place of business through which the business of the enterprise is wholly or partly
carried on in the source state.26 The remaining provisions of the model treaties
dealing with the concept of a permanent establishment either outline specific kinds
of operations that prima facie fall within this primary definition or exclude operations that might otherwise fall within it. Therefore, in addressing whether leasing
activities in a source state constitute a permanent establishment, the overriding
question is whether or not there is a fixed place of business of the lessor in that
state through which the business of the lessor is carried on.
Before we consider the specific components of the treaty definition, it is useful
to review, briefly, two early judicial interpretations of the expression “permanent
establishment.” In 1962, the Supreme Court of Canada addressed the meaning of
the term in the domestic context, in determining whether a permanent establishment
exists in a particular province. In the course of deciding that a home office set up in
Quebec by a sales representative of a company was not sufficient to create a
permanent establishment of the company in Quebec, the court noted:
[T]he word “establishment” contemplates a fixed place of business of the corporation,
a local habitation of its own. The word “permanent” means that the establishment is a
stable one, not of a temporary or tentative character.27
In 1957, in the US treaty context, the United States Tax Court provided the
following interpretation:
The term “permanent establishment” normally interpreted suggests something more
substantial than a license, a letterhead and isolated activities. It implies the existence
of an office, staffed and capable of carrying on day-to-day business of the corporation
and its use for such purpose, or it suggests the existence of a plant or facilities
equipped in the ordinary routine of such business activity. The descriptive word
“permanent” in the characterization “permanent establishment” is vital in analyzing
the treaty provisions. It is the antithesis of temporary or tentative. It indicates permanence and stability.28
Turning now to the precise requirements of the treaty definition, there are
three key conditions to the existence of a permanent establishment:29
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1. there must be a place of business;
2. that place of business must be fixed; and
3. the business of the enterprise must be carried on through that fixed place.
Place of Business
The commentary on the OECD model specifically states that machinery and equipment can, on its own, be a place of business.30 It thus leaves open the possibility
that the mere presence of certain equipment might meet this part of the definition.
It seems clear that machinery and equipment of a certain significance is considered a
place of business in most countries.31 It may be wrong to conclude from this
statement that small, portable, or mobile equipment can never constitute a place of
business, although such equipment may be less likely to meet either the requirement that the equipment be “fixed” or the requirement that it be a place through
which the business of the enterprise is carried on.32 In general, it might now be
possible to state that a place of business is any physical object that is commercially
suitable to serve as the basis of a business activity,33 and that the taxpayer has an
appropriate right to use or ability to control, for the purposes of the business.34
The “Fixed” Component
The need for the place of business to be fixed re-emphasizes the general concept of
permanence. There are, in fact, two aspects to the condition of being “fixed”: a
locational or geographical aspect, and a temporal aspect. In respect of the former,
“fixed” generally connotes a link to a geographical point or a distinct place. In the
case of equipment that may give rise to a fixed place of business, it is enough that
the equipment remain at a particular site.35 Traditionally, apart from the special
circumstances of construction enterprises (addressed below), the fact that equipment was moved from place to place within a source state resulted in a finding that
the place of business was not fixed.36 However, the notion that a place of business
must be tied to a specific location has been subject to gradual erosion. There are
now a number of authorities stating that a fixed place can be found to exist even
though the equipment has been relocated from site to site, provided that relocation
takes place under one integrated contract for a single customer and provided that a
rather indeterminate geographical proximity test is met.37 This interpretation is
likely restricted to cases where the activities with which the equipment is associated
are clearly of a peripatetic nature, such as offshore drilling.38 Hence, it is possible
for movable places of business to be treated as fixed if the movable item is used at
fixed points within a proximate area for one customer on a repetitive or continuous
basis for a sufficient period of time, at least where the nature of the business
requires periodic relocation of the equipment.
The temporal element in the concept of “fixed base” emphasizes that the place
of business should not be established for a temporary purpose.39 This requirement
echoes the general comments quoted above from both the Supreme Court of Canada
and the United States Tax Court. In general, therefore, the place of business in the
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source state must exist for a sufficient period of time to give the required degree of
permanence; it need not, however, be everlasting.40 In appropriate circumstances,
owing to the special nature of certain business activities that never achieve a great
degree of permanence, a fixed place can be permanent even if it lasts for a limited
time.41 Hence, in Fowler v. MNR,42 the maintenance of a stand at the Pacific
National Exhibition from which knives were sold for a three-week period annually
over a period of some 16 years was enough to create a permanent establishment.
The court was satisfied that a sales outlet maintained at approximately the same
location over such an extended period possessed the same attributes as an office or
a branch. Given the nature of the business in question, the mobility of the operation did not detract from the existence of a permanent establishment in Canada.
It is not clear how long a place of business must exist before it becomes fixed or
permanent. However, in the absence of a deeming treaty provision, presence in a
source state for a certain period of time will not in and of itself create a permanent
establishment;43 the other requirements of article 5(1) still need to be met. In the
United States, it appears that a presence of less than one year is considered to be
temporary, while periods longer than one year, but generally less than two years,
may, depending on the facts, also qualify as temporary.44 In the construction field
(discussed below), the OECD model fixes a 12-month period of permanence, and
until recently, there appeared to be little support for the application of the 12-month
test to other fields.45
Draft Revisions to the Commentary
Both the temporal and the locational aspects of a fixed base are addressed in the
2002 draft revisions to the OECD commentary,46 in at least three areas.
First, where the business activities are peripatetic and equipment is moved
between neighbouring locations, a single place of business will be considered to exist
where the locations to which the equipment is moved constitute a coherent whole,
commercially and geographically, with respect to the business being conducted.47
Where, however, there is no commercial coherence, the fact that activities may be
carried on within a limited geographical area should not result in that area being
considered a single place of business.48 In the latter case, each separate location will
need to be examined to determine whether any operation constitutes a separate
permanent establishment. While these revisions will extend the current ambit of
the commentary, the amendment reflects the decisions in the cases mentioned
above and therefore does not appear to change the way in which the model has
been interpreted in practice. If the proposed revisions are adopted, it will be clear
that both geographical and commercial coherence are required. The revisions note
that an area in which activities are carried on as part of a single project that
constitutes a commercially coherent whole may lack the necessary geographical
coherence to be considered a single place of business and thus may fail to meet the
“fixed” requirement of a permanent establishment. An example is given: a consultant
travels from bank branch to bank branch at various locations in the source state to
provide training services under a single contract with the bank.49
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Second, the commentary revisions deal with short-term but recurrent activities
taking place over a number of years. In such cases, each period of activity needs to
be considered in combination with the number of times during which the place of
business is used for that activity, which may extend over a number of years.50 This
amendment seems to echo the result in the Fowler decision. In any event, given the
nature of the activities described, it should not have much direct impact on leasing
issues.
Finally, the draft revisions address the issue of the period of time needed to
meet the required degree of permanency under article 5(1), although they do not
propose a clear solution. The draft notes:
While the practices followed by Member countries have not been consistent in so far
as time requirements are concerned, experience has shown that permanent establishments normally have not been considered to exist in situations where a business had
been carried on in a country through a place of business that was maintained for less
than six months. One exception has been where the activities were of a recurrent
nature; in such cases, each period of time during which the place is used needs to be
considered in combination with the number of times during which the place is used
(which may extend over a number of years). Another exception has been made where
activities constituted a business that was carried on exclusively in that country; in this
situation, the business may have a short duration because of its nature but since it is
wholly carried on in that country, its connection with that country is stronger.
Conversely, practice shows that there were many cases where a permanent establishment has been considered to exist where the place of business was maintained for a
longer period. For ease of administration, countries may want to consider these
practices when they address disagreements as to whether a particular place of business
that exists only for a short period of time constitutes a permanent establishment.51
While it is clear from this statement that operations that last for less than six
months should not constitute a permanent establishment (other than in the exceptional cases), the draft revisions fall far short of suggesting that the carrying on of a
business at a fixed place for more than six months automatically creates the required
degree of permanency. In a draft discussion paper on regulation 105 treaty-based
waivers, the Canada Customs and Revenue Agency (CCRA) addressed these aspects
of the draft revisions prior to their release by the OECD.52 The CCRA, while not
purporting to make these statements in the context of when a permanent establishment might be found to exist, suggests that the OECD favours a short (at least
initial) six-month demarcation threshold:
[I]t is apparent that consideration that activities which exceed 6 months in duration
will be indicative of a permanent establishment is supportable under the OECD Model
Convention. Activities which last less than six months but take place on a recurring
basis may also result in a finding that a permanent establishment exists.53
The draft revisions quoted above indicate that there is no clear consensus on a
six-month threshold. To create permanence for business activity of such short
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duration is not in keeping with the approach generally adopted by members of the
OECD, as noted in the draft itself. It appears clear that, if the draft is adopted,
business activities lasting less than six months (excepting those in construction,
where the preferred standard is 12 months, and activities such as recurrent trade
fair attendance, which is inherently temporary) will not be treated as meeting the
required degree of permanence. If the activity lasts longer than six months, it may,
but need not, on the basis of local practice and the kind of business involved, be seen
as permanent. It remains to be seen whether the exceptionally strict approach
outlined by the CCRA in its discussion draft will be supported by the courts, either
in Canada or elsewhere, should the OECD draft revisions be adopted.
The establishment of a time guideline shorter than the standard applied to
construction/installation projects is strange. Such activities are, by their very nature, of limited duration. The time discussion in the OECD commentary generally
tends to suggest that where activities are by nature brief, the time needed to
establish permanence should be shorter than that for activities that in the normal
course of business last for much longer periods. Furthermore, such a general rule
can produce an anomaly in the leasing field. For example, a lessor may lease two
identical pieces of equipment to two customers in the same source state, one of
which is used on a construction site, and the other in a context that clearly does not
fall within article 5(3). If there were a 6-month rule of thumb for activities other than
those in the construction industry, the first equipment lease would not constitute a
permanent establishment if it was needed for only 10 months (subject, of course, to
qualification of the equipment as a construction project under the article 5(3)
provisions, as discussed below), but the second would be a permanent establishment if the lease was scheduled to last only 7 months and the equipment was
returned at the end of that term.
Carrying on Business Through the Fixed Place
To summarize to this point, mobile equipment in a source state may be treated as a
place of business in that state and will be viewed as “fixed” in cases where the
equipment is used at a particular place for more than a temporary period, or where
it is used at a number of sites in a proximate geographical area as part of a coherent
commercial project for a sufficient period of time. In such cases, the permanence
requirements may well be met although, at present, the length of time required for
permanence is far from clear. However, as all three requirements of article 5(1)
must be met before a permanent establishment will be found to exist, a determination of whether leased equipment constitutes a permanent establishment should be
decided on the basis of the final element, namely, whether the business is carried
on wholly or partly through the fixed place of business.54
This determination has a two-part requirement: (1) the business must be carried
on in whole or in part (2) through the fixed place of business. In respect of the latter,
there is little in the current commentary regarding the requirement that the
business must be carried on through the place of business; however, the draft
revisions propose to add a statement that “[t]he words ‘through which’ must be
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given a wide meaning so as to apply to any situation where business activities are
carried on at a particular location that is at the disposal of the enterprise for that
purpose.”55 This addition appears merely to emphasize a requirement that has
always been present in the OECD model, and it should be interpreted in conjunction with the requirement that the business be carried on, in whole or in part, by
the enterprise.
The concept of carrying on business is not defined in the OECD model. Where
a treaty term is not defined, the domestic law—and, in particular, the domestic tax
law—of the contracting states becomes relevant.56 The concept is prevalent in the
domestic law of many states. In the United States, taxing power is significantly tied
to the issue of whether the taxpayer is engaged in a trade or business within the
United States. This is a similar, albeit not exactly comparable, concept to carrying
on a business, and it is settled law that the mere management of investments and
the collection of rents, interest, and dividends is insufficient to constitute the
carrying on of a trade or business.57 In Australia, the fact that a business has to be
carried on connotes the need for repetitive or recurrent, rather than isolated,
activity in the relevant location.58
In Canada, the case law suggests that the determination of whether a business is
being carried on is a factual one. Specifically, it is a determination that appears to
require a functional analysis of the activities that must be conducted in order to
generate the income, so that a decision can be made as to where the operations that
produce the income take place.59 A requirement of recurrence also appears relevant.60
In the leasing context, the courts have indicated that they will review a range of
functions apart from the location of the equipment to determine whether a lessor is
carrying on business in Canada. These factors include the place where the rental
contract is made; the place where the rental rates are determined; the place where
the equipment is delivered and where the rental commences; the place where payment is made or received; the location of employee activities connected with the
rental business; and the place where the equipment is sourced or bought.61 On the
basis of all such factors, the issue is whether, in substance, the business is being
carried on in Canada as opposed to somewhere else. It should be noted that
Canada also statutorily extends the concept of carrying on business in the context
of non-resident activities;62 however, that provision does not expressly deal with
issues relating to the leasing of equipment, and in any event, it would be all but
excluded by the business profits provisions of treaties.
If the test is to examine the totality of the business and decide where the business
giving rise to the income is being carried on, the mere collection of rent from
equipment located in the source state without other activity by the lessor is unlikely
to be viewed as the carrying on of a business through that equipment (assuming
that the equipment in question constitutes a fixed place of business).63 This conclusion is supported by the decision in the Dredging case64 in the Netherlands, where
the court did not allocate to a permanent establishment of a partnership/partners
the rental income derived by a partner from the provision of equipment to the
partnership. The court did not view the rental income in question as being separately
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taxable as business profits derived from the carrying on of a business by the partner
through the equipment itself. Likewise, in the Malaysian case of Walter Wright
(Singapore) Pte. Ltd. v. DGIR,65 the court found that a Singapore company that
provided cranes and trucks under a rental arrangement to a related Malaysian
company did not have a permanent establishment in Malaysia as a result of the fact
that the equipment was located in Malaysia.
Are Employees/Personnel Needed at the Business Location?
Lessors might be tempted to argue that the need to carry on business through a
place of business requires the presence of personnel of the enterprise at that
location for the purpose of conducting and carrying on that business.66 This position is alluded to in several places in the OECD commentary.67 If this reasoning
were correct, the mere presence of leased equipment would never create a permanent establishment. However, as a result of a review of the OECD model and
commentary necessitated by the advent of electronic commerce, and specifically
the question whether a server constitutes a permanent establishment, the position
has emerged that while the presence of personnel is usually required for the
conduct of business, there may well be businesses that may be at least partly carried
on without personnel.68 Therefore, human intervention is not a requirement for
the existence of a permanent establishment.69 It appears that, instead, a functional
analysis is applied in making the determination:
Where an enterprise operates computer equipment at a particular location, a permanent establishment may exist even though no personnel of that enterprise is required
at that location for the operation of the equipment. The presence of personnel is not
necessary to consider that an enterprise wholly or partly carries on its business at
a location when no personnel are in fact required to carry on business activities at that
location. This conclusion applies to electronic commerce to the same extent that it
applies with respect to other activities in which equipment operates automatically, e.g. automatic pumping equipment used in the exploitation of natural resources [emphasis added].70
A functional analysis of this nature will require an examination of the nature of the
activities performed at the location in light of the business that is carried on by the
enterprise,71 to determine whether the functions located in the source state are an
essential and significant part of the business of the enterprise as a whole.72
With this change to the commentary, lessors can no longer argue that the
absence of personnel of the leasing enterprise in the source state means that no
permanent establishment exists. However, the revision does not infringe on the
basic position of the OECD’s fiscal committee, described above, that generally,
leased equipment operated, serviced, inspected, and maintained by the lessee, or
under the direction of the lessee, does not create a permanent establishment for
the lessor. A functional analysis that focused on the activities of the lessee and the
operation of the equipment in the source state would favour a finding that a
business was being carried on in the source state by the lessee, and not by the lessor,
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in such circumstances.73 In this situation, the asset in question is clearly the subject
of the business, and not the place through which the business is carried on.74 This
view is supported elsewhere in OECD documentation:
1. In the context of the leasing of containers, the OECD’s fiscal committee
stated, “[I]t may be doubtful whether there is or is not a permanent establishment in the State of a customer [of a container leasing company] by the
mere fact of the presence of containers there.”75 The committee in that
context reviewed various kinds of activities of leasing companies in the
container field, and it is clear from the discussion that simply having containers in a country would not cause the leasing company to have a permanent establishment there.
2. The OECD commentary considers an example of a company involved in the
supply of gaming machines and concludes, “A permanent establishment
does not exist if the enterprise merely sets up the machines and then leases
the machines to other enterprises. A permanent establishment may exist,
however, if the enterprise which sets up the machines also operates and
maintains them for its own account.”76
3. Elsewhere in the commentary, there is a statement to the effect that “[i]f the
fixed place of business is leased to another enterprise, it will normally only
serve the activities of that enterprise instead of the lessor’s; in general, the
lessor’s permanent establishment ceases to exist, except where he continues
carrying on a business activity of his own through the fixed place of business.”77
4. The new functional analysis described in the quotation above also refers to
the “operation” of the equipment. When equipment is leased to another
party, and the lessee is responsible for all aspects of operation, maintenance,
inspection, etc., the business that is being carried on in the source state is
that of the lessee and not that of the lessor. This interpretation coincides
with the general approach that for a business to be carried on through a
fixed place of business, a degree of active operation78 or active conduct of
the enterprise79 is required.
One Permanent Establishment, Several, or None
It is important to bear in mind that if a lessor has a permanent establishment in the
source state, it does not follow that all of the lessor’s rental income from that state
is taxable to that permanent establishment. Only that portion of the profits of the
enterprise that is attributable to the permanent establishment is taxable in the
source state80 (unless the treaty is based on the UN model, in which case income
from business activities carried on in the other state of the same or a similar kind as
that which is effected through the permanent establishment is also taxable).81
Therefore, where the treaty provisions in question are based on the OECD or US
models, each item of rental equipment, or groups thereof being used in relevant
geographical proximity for a common customer, and the activities associated with
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that equipment, need to be evaluated separately from the perspective of whether a
permanent establishment exists. It is therefore possible to have a situation where
some rental activity is taxed on a permanent establishment basis and some not.
As a result, a distinction must be made between the position that applies when
there is equipment supplied at one location for one customer in the source state,
but the nature of the activity is such that the equipment is moved regularly from
one site to another over the course of the contract, and the position that applies
when the lessor supplies a large number of items to different customers for use at
different sites for different projects in the source state. In respect of the former, the
business is peripatetic, and the permanent establishment issue must be analyzed
from the perspective of whether the movable place of business can be treated as
fixed owing to the long-term use of the equipment on a regular basis at several sites
within a proximate area. In respect of the latter, the leasing of equipment to
different customers at disparate and commercially unconnected sites would traditionally have been analyzed from the perspective of whether any of the separate
sites met the requirements of a permanent establishment and, if so, what profit was
attributable to each such establishment. While the changes made to the OECD
commentary over the years have reflected a gradual relaxation of the thresholds
against which the existence of a permanent establishment is measured, even the
latest 2002 draft revisions to the commentary do not change the need for a separate
permanent establishment analysis in the scattered equipment scenario.82 The
changes, if approved, will confirm that there can be a grouping as regards mobile
equipment used for a coherent commercial whole, but this grouping is examined in
relation to the contract under which the equipment is used, or the customer to
which it is connected. While the rental of equipment to a host of different customers
in various locations in a source state may be commercially coherent for the lessor,
it is not commercially coherent in the way required by the revisions.83 Furthermore, there is likely to be no geographical coherence in such cases. If a lessor can
support such scattered business from locations wholly outside the source state, the
prospect remains that a permanent establishment does not exist.
THE INCLUSIVE PROVISIONS: ARTICLE 5(2)
In article 5(2), all of the three model treaties provide identical listings of places that
are included in the term “permanent establishment.” “Permanent establishment” is
said to include
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a place of management;
a branch;
an office;
a factory;
a workshop; and
a mine, an oil or gas well, a quarry, or other place of extraction of natural
resources.
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The list, being inclusive, provides illustrative examples and not definitive types of
permanent establishment.84 Being inclusive, the article might be taken to mean
that all such operations are automatically permanent establishments, but this is not
so. Instead, an enumerated place will be treated as a permanent establishment only
if it meets the full requirements and conditions of article 5(1).85 In other words, an
office, workshop, factory, etc., is a permanent establishment only if it is also a fixed
place of business through which the business of the enterprise is wholly or partly
carried on. Accordingly, this list might better be viewed as indicative examples of
places of business, rather than of permanent establishments.
The list does not specifically state that pieces of equipment can constitute a
permanent establishment. However, the provisions can be relevant to lessors—for
example, where the lessor maintains a workshop in the source state that is under
the management and control of the lessor and at which the lessor inspects and
maintains the equipment during the lease term. The same situation arises if the
facility is used by the lessor as a centre at which to service the equipment (subject
to the auxiliary activity discussion below) between rental contracts. In such circumstances, the combined effect of the inclusive provision in article 5(2) and the
primary definition in article 5(1) is that this place of business is likely to constitute
a fixed place of business through which the leasing business is carried on in the
source state, creating a permanent establishment. A permanent establishment would
also likely exist if the lessee, on a relatively long-term basis, made space available in
the source state to an employee or employees of the lessor in order for those employees
to supervise and direct the movement of equipment in the source state, to monitor
the need for and arrange repairs, to ensure rents were collected, etc.,86 unless the
lessor’s employees in such a case, while in the source state, were temporarily under
the operational control of and subject to direction by the lessee in respect of those
repairs, etc.
Some care should be exercised to check the precise wording of treaties based on
these models to ensure that they do not add to the list of items treated as permanent establishments. The original treaty between Canada and the United States,
for example, contained a provision that stated that
[t]he use of substantial equipment or machinery within one of the Contracting States
at any time in any taxable year by an enterprise of the other Contracting State shall
constitute a permanent establishment of such enterprise in the former State for such
taxable year.87
This provision not only raised the prospect that the presence of equipment in and
of itself might be enough to constitute a permanent establishment, but also operated as a deeming provision. Therefore, equipment, if substantial and if used by the
taxpayer in the source state at any time in any year, created a permanent establishment even when the main operative provisions of article 5(1) were not otherwise
satisfied. It should be noted that the treaty wording focused on “use” and not
ownership of the equipment.88 However, such a provision need not be determinative
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of the issue for lessors. Where a treaty contains such phraseology, lessors can claim
that equipment that is leased to a lessee, and is maintained, inspected, and operated
by the lessee, is used by the lessee and not by the lessor and therefore should not in
any event create a permanent establishment of the lessor.89 The only Canadian
treaty that retains general provisions of this nature (apart from those treaties that
contain specific provisions to deal with specialized equipment used in the natural
resource field, discussed below) appears to be that with New Zealand. This treaty
contains a provision that deems an enterprise to have a permanent establishment in
the source state if substantial equipment or machinery is, for a period longer than
six months, used or installed by, for, or under contract with that enterprise in that
state.90 As leased equipment rented for more than six months would be equipment
“under contract with that enterprise,” if the test of substantiality is met, the mere
presence of the equipment beyond the six-month time limit would create a permanent establishment for the lessor under that treaty.
BUILDING AND CONSTRUCTION SITES:
ARTICLE 5(3)
Enterprises engaged in building and construction activities present a special problem for tax treaty purposes because these activities are often, by nature, transitory
and impermanent. Once the project is completed, the site is dismantled, and the
enterprise in question moves on. Consequently, the OECD model provides that “a
building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.”91 It is in this context that we
also see the first significant difference among the three major model treaties. The
UN model includes in the list of encompassed activities both an “assembly project”
and “supervisory” activities in connection with any of the listed activities, and in
keeping with the expanded scope of tax authority for the source state, lessens the
required period of presence to six months.92 The US model, by contrast, follows
the OECD model and adopts the 12-month time frame, but includes in the list of
activities “an installation or drilling rig or ship used for the exploration or exploitation of natural resources.”93 In fact, this addition in the US model may not actually
represent an expansion of the OECD and UN provisions, since exploratory drilling
and many other exploration activities can reasonably be characterized as construction activity.94 This characterization is more likely if the 2002 draft revisions to the
commentary are adopted because, under those revisions, the commentary will
confirm that the concept of an installation project is not restricted to an installation related to a construction project, but also includes the installation of new
equipment.95
Under this provision, for enterprises engaged in equipment-leasing activities, it
might be argued that the rental of equipment leased for use in connection with a
“construction” or “installation” activity for a period longer than 12 months causes
that equipment itself to become a building/construction/installation project and
hence a permanent establishment of the lessor, whether or not the lessor operates
the equipment and is in the construction/installation sector of the economy. This
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interpretation might hold if the provisions of article 5(3) are in effect provisions
that deem a permanent establishment to exist provided that the activity in question
is related to construction/installation and provided that it lasts for 12 months or
more. However, article 5(3) of the OECD model is not a deeming provision, and
even here the guiding principles remain those set forth in article 5(1).96 The special
construction provisions were made a separate part of article 5 for systemic reasons.
Article 5(3) was originally part of article 5(2) in the 1963 OECD model treaty, but
was moved to a separate position within the article in 1977 to avoid a claim that the
listed article 5(2) items did not otherwise have to satisfy the full requirements of
article 5(1), including the requirement of permanency.97 Therefore, the relocation
of the construction project provisions to a separate position within article 5(3) does
not change the general need for construction projects, like all other permanent
establishments, to meet the requirements of article 5(1), other than the temporal
aspect of permanence. It is simply the temporal aspect of a fixed base that is abridged
by the stipulated 12-month rule in article 5(3).98
Therefore, if the lessor does not have a fixed place of business through which
the leasing business is carried on in the source state within the meaning of article
5(1), article 5(3) cannot have an impact on the outcome even if the lease extends
for more than 12 months. Where the other article 5(1) provisions are met, as in
situations where the “lessor” is the operator of the equipment at a construction or
installation project site, article 5(3) does come into play to establish the minimum
time period required at 12 months, at least in those cases where it is possible to
claim that the equipment is a construction or installation project in its own right.
Hence, the operation of an anchored semi-submersible drilling vessel at a number
of sites on the US continental shelf for one customer over a two-and-a-half-year
period was held to be a permanent establishment of a Dutch enterprise under the
US-Netherlands tax convention.99 Likewise, rented scaffolding can be a permanent
establishment of the lessor when the lessor is responsible for reconfiguring the
scaffolding to accommodate changes made to the building and for dismantling it at
the end of the project. In the latter case, it appears that a construction or assembly
project would exist under Article 5(3)100 once the 12-month time limit was exceeded.
The significance of article 5(3) therefore rests in the time stipulations: once a
foreign enterprise has a place of business through which its business, in the construction field, is carried on in the source state, and the activities in question extend
beyond the time frame specified, the “permanence” or temporal requirement of a
fixed base is established.101 The provisions do not create a fixed base under the
second, geographical requirement, although, as the commentary makes clear, the
need to move the equipment around within the confines of a coherent single
project does not destroy the existence of an appropriate geographical nexus.102
THE EXCLUSIONARY PROVISION: ARTICLE 5(4)
Where an enterprise has a fixed place of business through which its business is
carried on in the source state, and hence has a permanent establishment there under
articles 5(1) to 5(3), that fixed base will not be treated as a permanent establishment
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if the operations conducted through that base can be brought within one of the
categories of operation expressly excluded under article 5(4). Article 5(4) is a deeming provision, such that a facility is excluded from the definition even if it would
otherwise constitute a permanent establishment under article 5(1).103 In the leasing
context, the relevant provisions of article 5(4) of the OECD model state that the
term “permanent establishment” does not include
a) the use of facilities solely for the purpose of storage, display or delivery of
goods or merchandise belonging to the enterprise;[104]
b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
d) …
e) the maintenance of a fixed place of business solely for the purpose of carrying
on, for the enterprise, any other activity of a preparatory or auxiliary character;
f ) the maintenance of a fixed place of business solely for a combination of activities mentioned in subparagraphs a) to e), provided that the overall activity of the fixed
place of business resulting from this combination is of a preparatory or auxiliary
character.[105]
The first exclusion is perhaps the most significant for a leasing enterprise
because it suggests that a fixed base can be maintained by the enterprise in the
source state for the purpose of effecting delivery of the equipment to customers
and the return delivery thereof at the end of the lease term. Under the second
provision, use of an independent third party for this purpose would also be excluded. If, however, the depot in the source state is also used for the purpose of
maintenance and repair of the goods by the enterprise upon their return to the
depot, the facility is not within the exclusion because the facility is no longer used
solely for storage or delivery. The combination provisions in article 5(3)(f ) appear
to be of little assistance to the lessor in such cases, for the commentary itself states:
A permanent establishment could also be constituted if an enterprise maintains a
fixed place of business in order to supply spare parts to customers for the machinery
supplied to such customers, or to maintain or repair such machinery, as this goes
beyond the pure delivery mentioned in sub-paragraph a) of paragraph 4. 106
Would the situation be different if the lessor engaged an independent third
party in the source state to perform the repair, parts, and maintenance functions?
One might be tempted in that context to call in aid the provisions of article 5(4)(c),
to the extent that such repair activities might be classified as “processing.” As this
term is not defined in the model, reference must be made to the domestic law. In
Canada, at least, repair is unlikely to be classified as “processing” because the
courts look for the goods in question to be changed in form, appearance, or
characteristics, or for the goods to become more marketable as a result of the
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process.107 The same appears to be true in England, where the Court of Appeal has
indicated that a lessor could not be viewed as processing when it cleaned, serviced,
and repaired the leased equipment. Processing under English law requires a substantial measure of uniformity or system of treatment, which cannot be said to exist
when each item of plant and equipment is treated individually according to the
amount of servicing or repair required.108 However, where the lessor’s business is
the leasing of equipment, it can be argued that the service and repair of such
equipment, in preparation for the lease opportunity, is an activity of a preparatory
or auxiliary character within the meaning of article 5(4)(e). Therefore, if a lessor
merely sent its equipment for repair by a third party based in another country, and
the lessor derived no rental revenues from that country, these circumstances should
not create a permanent establishment. The situation should not differ if the lessor
itself is effecting the repair in another country.
If such is the case, why should the presence of both the repair and delivery
function in a source state from which rental income is derived exclude the combined activity provision in article 5(3)(f )? The key here is the requirement in
article 5(3)(f ) that the overall combination of activities in the source state retain the
character of being preparatory or auxiliary. Once again, a functional analysis should
be applied, the decisive criterion being whether the combined activity forms an
essential and significant part of the activity of the enterprise as a whole.109 If the
delivery and return of leased equipment were coupled with its repair and maintenance, even by a third party but under the direction of the lessor, it appears that
these activities would encompass a significant part of the business of an operational
leasing enterprise, such that functionally the combined activities could be viewed
as exceeding the scope of the exclusions in article 5(4).110 However, either activity,
conducted in isolation on its own in the source state, may well be excluded under
the specific provision in question. This interpretation is consistent with the position suggested by the fiscal committee of the OECD, described above.111
SPECIFIC TRE AT Y PROVISIONS DEALING
WITH NATURAL RE SOURCE S
As discussed earlier, the inclusive provisions in article 5(2) state that a permanent
establishment includes a mine, an oil or gas well, a quarry, or other place of
extraction of natural resources. This provision is to be interpreted broadly and
includes all places of extraction of hydrocarbons, both on- and offshore.112 However, from the leasing perspective, these provisions are next to irrelevant, since the
issue here is not whether the operation or development of a mine creates a permanent establishment for the enterprise conducting that activity, but whether the
simple rental of equipment by a non-resident to the enterprise developing or
operating the resource location creates a permanent establishment of the lessor.
The language of article 5(2) does not cover this latter situation.
The more significant issue here, from the perspective of lessors of equipment
used in the exploration for or exploitation of natural resources, is the fact that
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article 5(2) does not deal with exploration for such resources113 or the tax treatment
to be accorded to exploration and exploitation activities, an area where it was not
possible for the OECD member states to develop a common view given their own
divergent practices. It is left to contracting states to negotiate specific provisions in
their treaties.114 Accordingly, in this part of the analysis, it is necessary to focus on
provisions found in a particular treaty network. For this purpose, the discussion
will focus on Canada’s treaties, which embrace a surprising array of options.
Currently, Canada has some 80 treaties in effect or awaiting ratification. Twentynine of these treaties contain specific provisions that deal with exploration activities, although there is little consistency of approach. The most common approach
is to expand the list of places that may be considered a permanent establishment,
set out in article 5(2), to cover “a mine, an oil or gas well, a quarry or other place
relating to the exploration for or the exploitation of natural resources.”115 This
inclusion in the treaties is consistent with a Canadian reservation to the OECD
commentary.116 However, in the leasing context, it is not of much significance
because, as noted above, the article 5(2) inclusions are indicative only, and it
remains necessary to satisfy the primary requirements of article 5(1) before a
permanent establishment will be found to exist. The simple fact that a lessor is
renting equipment to an entity that is engaged in the exploration for or in the
exploitation of a natural resource does not, on its own, create a permanent
establishment for the lessor under these treaty provisions. One approaches this
situation in exactly the same way as any other leasing activity, as addressed above.
The listing approach sometimes takes other forms, such as including in the list
“an installation or structure used for the exploration or exploitation of natural
resources, but only if so used for a period of more than 120 days in any twelve
month period.”117 In other treaties, the wording of article 5(3) of the OECD model
is amended to more closely resemble that of the US model, by including “an
installation or drilling rig or ship used for the exploration or development of
natural resources,” linked with an exclusion if the period of presence is less than a
stated minimum.118 Here, “use” of the installation is not linked to use by the lessor,
and the concept of “installation” may well be wide enough to encompass any item
of equipment.119 There is no direct authority on the latter point; however, a
dictionary reference indicates the breadth of the term, stating that an installation
includes “a mechanical apparatus set up or put in position for use.”120 One commentator has gone so far as to suggest that the US wording results in the existence
of a permanent establishment for every exploration activity after the lapse of the
required time.121 However, as noted above, article 5(3) of the OECD model is not a
deeming provision; and as in the case of article 5(2), anything that falls within its
purview must still meet the conditions of article 5(1). Therefore, these treaty
variants do not change the position in any significant way for lessors, other than to
create temporal permanence via duration of presence where the circumstances are
such that the lessor’s operations otherwise satisfy the requirements of article 5(1).122
Some treaties deal with the matter more directly, by including a specific provision
that deems both the existence of a permanent establishment and the carrying on of
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a business through that establishment. In one variant, the deeming provision
applies where substantial equipment is being used in the source state for more than
12 months by, for, or under contract with the enterprise in the exploration for, or
the exploitation of, natural resources or in activities connected with such exploration
or exploitation.123 This provision is exceptionally broad: in deeming the existence
of a permanent establishment, it displaces the tests in article 5(1); there does not
appear to be a requirement that the equipment be used by the foreign enterprise,
and therefore the use of the equipment by the lessee would be enough to bring the
lessor within the provision (the lessee’s use would be a “use of the equipment under
contract with the lessor enterprise”); and it extends to “connected activities.” If
equipment rented in this industry meets the uncertain concept of being “substantial”124 and is leased and used in the source state for more than 12 months, it
appears that the lessor will have a permanent establishment in the source state,
even if the lessor’s involvement there is restricted to the presence of the equipment
and its use by the lessee in the context of exploration for or exploitation of a natural
resource.
In another variant of this approach, and with even more direct effect for leasing
entities, one treaty deems both the existence of a permanent establishment and the
conduct of business through it if an enterprise supplies on hire plant and machinery used for, or to be used in, the prospecting for, or extraction or exploitation of,
natural resources in the source state.125 A number of treaties apply a similar deeming provision in respect of “activities [carried on in the source state] in connection
with the exploration or exploitation of natural resources, where those activities are
carried on for a period in aggregate exceeding 30 days in any twelve month
period.”126 This approach appears to abandon any requirement for a fixed place of
business and any requirement that a business be carried on through the relevant
base by substituting the simple need that there be an “activity” in connection with
a particular economic sector.
The scope of this last variant is far from clear, and it is consequently uncertain
whether mere leasing from abroad, with limited or no direct involvement by the
lessor or its personnel in the source state, will constitute an activity within the
meaning of the provision. Dictionaries define “activity” as “the state of being
active; the exertion of energy, action,”127 or “the state or quality of being active.”128
The term may thus connote the need for a degree of involvement or presence in
the source state beyond the mere presence of equipment, in a manner not contemplated by the phrase “carrying on a business” in article 5(1). If there is support for
the argument that the use of different wording conveys an intended difference in
meaning, these provisions will not likely encompass passive leasing activity.129
Consequently, the requirements may not differ significantly from the requirement
to carry on business through a fixed place of business. On this interpretation, the
position is not materially different from the general position under article 5(3),
although the time frame within which the degree of permanence is achieved is
much shorter (or non-existent in respect of any treaty that does not specify a
threshold time period).
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CONCLUSION
There appears to be a clear current trend in international tax law toward a lowering of the threshold required to create a permanent establishment in a source state.
As a result, unmanned rental equipment can be a fixed place of business for a
foreign enterprise, provided that the equipment is in place at a particular location
or, if the business is peripatetic, that the equipment is deployed in circumstances
demonstrating an appropriate degree of geographical and commercial coherence,
and further provided in either case that the equipment remains operative in the
source state for a period of time sufficient to create the required degree of temporal
permanence. There is no agreement on a fixed time threshold. In a number of specific
industries (such as construction and natural resource exploration and exploitation),
clear time frames tend to be specified in relevant treaties. In other cases, presence
for a period of less than six months (other than in exceptional circumstances such
as brief but recurring trade fair activity) is insufficient to create a permanent
establishment. Beyond these time frames, there is no consistent approach.
Where a foreign lessor can structure its presence in a source state so as to avoid
having a fixed place of business, that state will not be able to impose tax on a
permanent establishment basis under treaties based on the OECD model. Even
where there is a fixed place of business, a permanent establishment should not be
found to exist if the foreign lessor does not carry on a business through that fixed
place of business. The test for this final requirement now appears to require a
functional analysis to determine the exact scope and breadth of activities conducted
by the lessor in the source state. By contrast, where a treaty departs from the
OECD model and the contracting states retain the ability to tax rents on a gross
basis, a foreign lessor will be inclined to structure operations so as to ensure that
functionally there are sufficient activities attached to a fixed base in the source state
to enable the lessor to claim that a permanent establishment exists there, so as to
be able to pay tax on a net basis.
While there are thousands of specific variants in respect of the manner of
conducting a leasing business, the permanent establishment status can be summarized as follows (recognizing that these conclusions may have shifted from those
stated previously by the OECD itself in the chart reproduced earlier):
1. The mere fact that equipment is present in a source state, where the lessor
carries on no other activity in that state, should not create a permanent
establishment. Here, it is unlikely that the lessor will be viewed as carrying
on the leasing business through that equipment.
2. The maintenance of a base in the source state for the sole purpose of
delivery and return of the leased equipment is not a permanent establishment under the exclusions in article 5(4).
3. However, if the delivery base is also used by the lessor for inspection,
maintenance, and repair of the equipment during or after the relevant lease
term, and those activities are conducted by employees of the lessor, or by a
4.
5.
6.
7.
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third party under the supervision of the lessor, there will likely be a fixed
place of business through which the lessor is carrying on a leasing business
in the source state, provided that the base endures beyond the threshold
time period (whatever that period might be).
Even in the absence of a fixed base in the source state, to the extent that an
item of equipment is now more readily classified as a place of business under
the emerging lower thresholds and is more readily treated as being fixed
owing to the erosion of the geographical and temporal aspects of a “fixed”
presence, there is now a greater risk that a foreign lessor that maintains,
inspects, and repairs that equipment in the source state will be held to be
carrying on a business through a fixed place of business in that state. In light
of the functional analysis that leads to this result, it may now make little
difference whether the lessor’s employees who carry out this activity are
normally based in the source state, in the lessor’s state of residence, or for
that matter in a third state.
However, if the lessor is able to direct such activities from its base outside the
source state, because, for example, the lessee is vested with such responsibility
under the lessor’s direction, the functional analysis seems to suggest that a
permanent establishment of the lessor does not exist in the source state.
Some additional source-state activity might still be added to the last scenario.
For example, a simple right in the lessor to effect a periodic direct inspection of the equipment in the source state might not tip the functional
analysis in favour of a permanent establishment. However, each additional
lessor function in the source state increases the risk of a finding that there is
a fixed place of business through which the lessor is carrying on a business
in the source state, provided that both the temporal and the geographical
requirements of the fixed base are met.
The situation in respect of the scenario outlined in item 5 is far less clear
where the lessor contracts with a third party in the source state to perform
such services. In that case, the functional analysis of the totality of the
lessor’s activities, directly or indirectly, in the source state may well tip the
balance in favour of a finding that the enterprise is carrying on a leasing
business through the equipment located in the source state.
Evidently, there is no clear line by which a lessor can conclude whether a
permanent establishment will be found to exist in a source state, particularly where
more than just the presence of equipment is involved. Any lessor that seeks to rely
on the absence of a permanent establishment in the source state should carefully
examine all aspects of its leasing operations in that state. Conversely, foreign
lessors leasing into countries such as Canada, which tax rentals on a gross basis in
the absence of a permanent establishment, may now find that it is easier to meet
the permanent establishment threshold so as to be able to achieve taxation based
on net income.
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NOTES
1 In CIR v. Hang Seng Bank Limited (1990), 3 HKTC 351, at 360-61 (PC), Lord Bridge noted
that “if the profit was earned by the exploitation of property assets as by letting property . . .
the profit will have arisen in or derived from the place where the property was let.” While he
may have been referring to real property in this context, the result should not be significantly
different in respect of leases of chattels. In the South African case of COT v. British United Shoe
Machinery (1964), 26 SATC 163 (Fed. SC), lease payments from long-term leases were found
to be sourced where the machines were used by the lessee. With respect to short-term leases, a
situation where the lessor needs to undertake more activity in order to generate revenue, the
source focus seems to shift to the question of where the activity that gives rise to the income is
located. Even then, there is still the prospect of a source-based taxation claim by the state in
which the equipment is being used. Many states have statutory provisions that effectively deem
source in respect of lease payments for equipment used in the state, to deal with any
uncertainties linked to the length of time of use that arise from this kind of authority.
2 Organisation for Economic Co-operation and Development, Model Tax Convention on Income
and on Capital (Paris: OECD) (looseleaf ) (herein referred to as “the OECD model”).
3 Amended by the report entitled “The Revision of the Model Convention,” adopted by the
Council of the OECD on July 23, 1992.
4 Article 12(2) of the 1977 version of the OECD model: Organisation for Economic Co-operation
and Development, Model Double Taxation Convention on Income and on Capital (Paris: OECD, 1977).
5 Article 12(2) of the United Nations Model Double Taxation Convention Between Developed and
Developing Countries (herein referred to as “the UN model”), UN publication no. ST/ESA/102,
1980.
6 Article 12(2) of the United States Model Income Tax Convention of September 20, 1996
(herein referred to as “the US model”).
7 Article 12(3) of the OECD model. Under article 12(4) of the UN model, there is the further
possibility that the rent might be connected with the provision of independent personal
services, in which case the issue is whether the rent is connected to a fixed base in the source
state under article 14. In the current OECD model, the concept of independent personal
services is subsumed into the general permanent establishment provisions.
8 Among these countries, Canada continues to reserve its right to impose a 10 percent tax at
source. See paragraph 35 of the commentary on article 12 of the OECD model.
9 Article 12(2) of the UN model.
10 Under article 7(1) of the OECD model, the profits of an enterprise are not subject to tax in the
source state unless the enterprise carries on a business in that state through a permanent
establishment there and the profits in question are attributable to that permanent establishment.
The same result would prevail under article 7(1) of the US model, provided that the rental
income is properly treated as business profits of an enterprise.
11 See paragraph 16 of Organisation for Economic Co-operation and Development, “The
Taxation of Income Derived from the Leasing of Industrial, Commercial or Scientific
Equipment,” in Trends in International Taxation (Paris: OECD, 1985), 9-16. The report was
adopted by the Council of the OECD on September 13, 1983.
12 Ibid., at paragraph 25(b).
13 Gustav Lindencrona and Stephen Tolstoy, “General Report,” in International Fiscal
Association, Cahiers de droit fiscal international, vol. 75a, Taxation of Cross Border Leasing
(Deventer, the Netherlands: Kluwer Law and Taxation, 1990), 21-44, at 36, note that only
Denmark and the Netherlands appear to have followed the recommendation.
14 Paragraphs 38 to 46 of the commentary on article 5 of the OECD model.
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15 Supra note 11, at paragraph 18.
16 Ibid., at paragraph 19.
17 This comment was made by Lindencrona and Tolstoy, supra note 13, at 34.
18 This is the case under a number of Canadian treaties. For example, under the most recent
Canada-Denmark treaty, infra note 126, article 12(6) deems royalties to arise in a contracting
state when the payer is a resident of that state, unless that person can attach that royalty to a
permanent establishment or fixed base elsewhere.
19 This is the pragmatic view, in any event. Charles E. McLure Jr., “Source-Based Taxation and
Alternatives to the Concept of Permanent Establishment,” in Report of Proceedings of the First
World Tax Conference: Taxes Without Borders (Toronto: Canadian Tax Foundation, 2000), 6:1-15,
at 6:11-12, notes that source-based taxation can be justified on either a benefit analysis (the
country where income originates should be compensated for the cost of providing services) or
an entitlement analysis (the country that allows the benefit of economic exploitation should be
able to tax income arising within its borders). An entitlement analysis would justify royalty
treatment for rental payments, whereas a benefit analysis is not as clearcut in this area; but even
where royalty treatment is justified, the justification ultimately remains the need of the source
state to protect its tax base.
20 Supra note 11, at paragraph 24. This recommendation appears to have fallen on deaf ears in
Canada. Of the many treaties and protocols negotiated since the 1992 amendment to the
OECD model, all continue to include rental payments in the definition of royalties, and only
two (the convention with Argentina and the new India treaty) provide a lower withholding rate
for rentals. Some go so far as to provide exemption from, or reduced rates for, certain other
types of royalty payment, while applying the general (and higher) treaty withholding rate to
rental payments: see, for example, the tax convention with Lebanon and the third protocol to
the US treaty, infra note 118.
21 This article will deal only with the concept of the existence of a permanent establishment. The
question of what profit is attributable to a permanent establishment once it exists is a complex
issue that is currently under review by the OECD’s fiscal committee. In 2001, the committee
issued its Discussion Draft on the Attribution of Profits to Permanent Establishments (Paris: OECD,
2001) for review and comment by OECD members.
22 In this case, the branch would clearly be a fixed place of business within the meaning of article
5(1) and a branch within the meaning of article 5(2)(b) of the OECD model.
23 See supra note 11, annex.
24 Citing a Finnish decision, Arvid Skaar, Permanent Establishment: Erosion of a Tax Treaty Principle
(Deventer, the Netherlands: Kluwer Law and Taxation, 1991), 191, indicates that equipment
provided on a finance lease basis, where responsibility for the asset is left entirely to the lessee,
does not constitute a permanent establishment, since in this case the lessor has no right to use
the place of business constituted by the asset.
25 For a review of the most recent authority on this issue generally, see Jack et al., infra note 34, at
15:19-24.
26 Article 5(1) of the OECD model, the UN model, and the US model.
27 Sunbeam Corporation (Canada) Ltd. v. MNR, 62 DTC 1390, at 1393 (SCC).
28 Consolidated Premium Iron Ores Ltd. et al. v. CIR, 57 DTC 1146, at 1162 (US TC), aff’d. on
appeal 59 DTC 1112 (US CA, 6th Cir.).
29 These conditions are separately identified in paragraph 2 of the commentary on article 5 of the
OECD model.
30 Ibid. Klaus Vogel et al., Klaus Vogel on Double Taxation Conventions: A Commentary to the OECD-,
UN- and US Model Conventions for the Avoidance of Double Taxation of Income and Capital, 3d ed.
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(2002) vol. 50, n o 2
(London: Kluwer Law International, 1997), 285, indicates that a place of business means all the
tangible assets used for carrying on the business and that in marginal cases one such tangible
asset would be sufficient.
31 Arvid Aage Skaar, “Commentary on Article 5 of the OECD Model Treaty: The Concept of
Permanent Establishment,” in The Taxation of Permanent Establishments, vol. 1 (Amsterdam:
International Bureau of Fiscal Documentation) (looseleaf ), 13-14. The author notes that this
would clearly be the case with respect to rigs, ships, trucks, buses, and aircraft.
32 Skaar, supra note 24, at 120, drew this conclusion in his initial work on the subject. However,
his analysis makes it clear that the case law on which he relied generally found that no
permanent establishment existed largely because the portable equipment in question was
moved from place to place and hence did not meet the fixed requirement.
33 Skaar, ibid., at 123. While Skaar qualified his statement by adding “substantial” before the
reference to “physical equipment,” in the author’s opinion this does not seem to be justified. As
noted ibid., the cases in the area generally find that no permanent establishment exists due to
movement of the relevant equipment. In this regard, it is significant to note that the 2002 draft
revisions to the commentary, infra note 46, when addressing the specific issues relating to
computer equipment (and particularly servers) and the business Web sites that may be hosted
on that equipment, make a clear distinction between the intangible Web site and the tangible
computer equipment. Draft paragraph 42.2 of the commentary on article 5 notes that “the
server on which the web site is stored and through which it is accessible is a piece of equipment
having a physical location and such location may thus constitute a ‘fixed place of business’ of
the enterprise that operates the server” (but not of the person whose Web site is hosted by the
Internet service provider). As servers need not be “substantial” equipment, this provision
appears to support the statement in the article. It also reconfirms the need to go on to step two
and find that the equipment is also fixed on the basis of both the locational/geographical and
temporal aspects addressed in the discussion below.
34 Sandra E. Jack, D. Blair Nixon, and Wanda L. Rumball, “Permanent Establishment: The
Canadian Perspective,” in International Fiscal Association (Canadian Branch), Special Seminar
on Canadian Tax Treaties: Policy and Practice (Kingston, ON: IFA (Canadian Branch), 2000),
15:1-35, at 15:4. The authors review a number of post-1989 cases on this point at 15:8-10.
35 Paragraph 5 of the commentary on article 5 of the OECD model. Again, the 2002 draft revisions
to the commentary, infra note 46, in the electronic commerce context, reinforce this concept.
Draft paragraph 42.4 of the commentary on article 5 notes that, with respect to the requirement
that a place of business be fixed, in the case of a server, it is not relevant to the determination
that the server might be moved; instead, the question is whether in fact it is moved. The server
will be fixed if it is located in a particular location for a sufficient period of time.
36 See the cases to this effect summarized by Jack et al., supra note 34, at 15:11.
37 IRS ltr. rul. 8526005, March 8, 1985. In this case, the ruling indicated that the use of the rig to
drill 17 wells under a single contract for a single customer in a geographically integrated area
(covering some 200 square miles) of the US continental shelf over a two-and-a-half-year period
was enough to create a fixed base for the purposes of both the construction project provisions
and the general permanent establishment provisions. The Canada Customs and Revenue
Agency (CCRA) appears to support this approach in a technical interpretation (CCRA
document no. 9826935, November 30, 1999) dealing with a seismic ship operating in Canadian
territorial waters for an extended period. The French Conseil d’État, in a decision on June 29,
1981, and reported in “Decision of the Supreme Administrative Court (Conseil d’Etat) of June
29, 1981” (1981) vol. 21, no. 10 European Taxation 324-27, appears to have taken an even wider
view and indicated that the mere drilling of consecutive wells could result in a finding that a
permanent establishment exists if the time frame of work exceeded the 12-month limit for such
activity. However, in light of the statements in the OECD commentary and the bulk of other
authority cited throughout this article, that decision is of questionable validity. Vogel, supra
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note 30, at 286, states his view that these cases are not in accordance with the existing
commentary. This position will, of course, have to be modified if the 2002 OECD draft
revisions to the commentary, infra note 46, are adopted.
38 Skaar, supra note 31, at 17.
39 Paragraph 6 of the commentary on article 5 of the OECD model.
40 No. 630 v. MNR, 59 DTC 300 (TAB).
41 Paragraph 6 of the commentary on article 5 of the OECD model. This is borne out in
Entreprises Blaton-Aubert Société Anonyme v. MNR, 69 DTC 121 (TAB), where the court noted
that permanent did not mean perpetual, but instead had to be determined in the context of the
nature of the business in question.
42 90 DTC 1834 (TCC). The case has been subject to some criticism. See the case comment by
Kathleen S.M. Hanly, “Meaning of Permanent Establishment,” Current Cases feature (1991)
vol. 39, no. 2 Canadian Tax Journal 323-26.
43 See Nathan Boidman, “Does Time Alone Create a Permanent Establishment? The Courts and
Revenue Canada Go Their Separate Ways” (2000) vol. 54, no. 7 Bulletin for International Fiscal
Documentation 339-42.
44 Peter Blessing and Carol Dunahoo, Income Tax Treaties of the United States (Valhalla, NY:
Warren Gorham & Lamont) (looseleaf ), 3-21-22.
45 Skaar, supra note 31, at 25. However, Vogel, supra note 30, at 288, takes a different view to the
effect that a place of business may be treated as fixed in the non-construction field if it is
planned to last fewer than 12 months and that anything in excess of 12 months satisfies the
requirement in any case.
46 On October 2, 2001, the OECD released “Draft Contents of the 2002 Update to the Model
Tax Convention.” The document contains proposed changes to the OECD model and the
commentary, which the Committee on Fiscal Affairs will be asked to review and approve in
2002. The document may be subject to revision during this process, and to further reservations
by member states. The document is available on the OECD Web site at http://www.oecd.org/
pdf/M00018000/M00018559.pdf, and is herein referred to as the “2002 draft revisions to the
commentary.”
47 Ibid., at draft paragraph 5.1 of the commentary on article 5.
50 Ibid., at draft paragraph 6 of the commentary on article 5.
51 Ibid.
52 Parts of the draft paper are quoted by Jack et al., supra note 34, at 15:13-14.
53 Ibid., at 15:13. The Australian tax authorities also appear to have jumped on the bandwagon in
an attempt to create a very short time threshold. On August 15, 2001, the Australian Taxation
Office issued Draft Taxation Ruling TR2001/06, which states, as a rule of thumb, that if a
business operates at or through a place continuously for six months or more, this will be
enough generally to create the required degree of temporal permanence.
54 In The Queen v. Dudney, 2000 DTC 6169 (FCA), the court seemed to tie the concept of the
business being carried on through the fixed place of business to a determination of whether
there is a fixed place in the first instance—albeit in the related context of whether or not
independent personal services are performed through a fixed base available to the individual in
question in the source state under former article 14 of the OECD model. In this respect, the
Dudney decision reflects an unfortunate mixing of separate concepts, and given the clear
wording of article 5, it should not be carried over to interpretation of the permanent
establishment provisions. However, it may well now be the case that one aspect of deciding
518
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whether the permanent establishment threshold has been met is to determine whether the
non-resident has the right to use the fixed place of business as his/her own (Skaar, supra note 31,
at 18-22). The inclusion of this factor fits well with the functional approach outlined below,
which clearly focuses on whose business is being carried on through the place of business in
question. Leave to appeal the Dudney decision to the Supreme Court of Canada was denied on
November 2, 2000 ([2000] SCCA no. 195).
55 Supra note 46, at draft paragraph 4.6 of the commentary on article 5.
56 See article 3(2) of the OECD model; section 3 of the Income Tax Conventions Interpretation
Act, RSC 1985, c. I-4, as amended, which, in the Canadian context, requires a living
interpretation in the sense of looking to the interpretation under the Income Tax Act as
amended from time to time; and Thiel v. FC of T, 90 ATC 4717 (Full HC).
57 Continental Trading, Inc. v. CIR, 265 F.2d 40 (9th Cir. 1959).
58 See the review of Australia’s domestic tax position in Thiel, supra note 56. That case was
actually directed to the issue of whether the taxpayer, who was treated as if he had conducted
an isolated transaction, could be said to be an “enterprise” entitled to claim the benefit of the
permanent establishment provisions. The definition of enterprise in article 3 required the
enterprise to be carried on by a resident of a contracting state. The court concluded that the
words “carried on” in article 3 could have a meaning other than that which they had in other
articles. For article 3 purposes, an enterprise could consist of an isolated activity. As there was
no permanent establishment in Australia, the majority found that there was no tax liability in
respect of that isolated activity. Dawson and McHugh JJ went on to consider the use of similar
words in article 7 and concluded that, in that context, the reference to an enterprise carrying
on business through a permanent establishment required the business to be carried on in the
same way as domestic law required—that is, through the habitual pursuit of business activities.
59 Cutlers Guild Ltd. v. The Queen, 81 DTC 5093 (FCTD); GLS Leasco Inc. et al. v. MNR, 86 DTC
1484 (TCC). A similar approach seems to be inherent in the decision in J. Rutenberg v. MNR,
[1979] CTC 459 (FCA).
60 See the Exchequer Court decision in Tara Exploration and Development Co. Ltd. v. MNR, 70
DTC 6370. The need for recurrence should be subject to the extended meaning definition in
section 253 of the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended, in cases where
there is no treaty protection.
61 GLS Leasco Inc., supra note 59; United Geophysical Co. of Canada v. MNR, 61 DTC 1099 (Ex. Ct).
62 Section 253 of the Income Tax Act, supra note 60.
63 Vogel, supra note 30, at 289, states that at least in respect of real estate, the mere letting by a
non-resident of realty in the source state does not make that property a place of business through
which the lessor’s rental business is carried on. The Canadian revenue authorities appear to
have a different view. Interpretation Bulletin IT-177R2, “Permanent Establishment of a
Corporation in a Province and of a Foreign Enterprise in Canada,” May 4, 1984, as revised on
August 25, 1995, states in paragraph 7 that if a corporation has rental income from real estate
that is income from a business, the corporation will have a permanent establishment wherever
each real property is located because each property will be considered a fixed place of business.
64 As reported in “The So-Called ‘Dredging Case’ Published at Last” (1986) vol. 26, no. 8
European Taxation 259-62.
65 [1990] 2 MTC 115 (HC). The Special Commissioners of Income Tax (as reported at [1988]
MTC 282) had held there was no permanent establishment, and the appeal to the High Court
maintained that in the absence of a permanent establishment, no tax was payable in Malaysia.
While this position appears to be consistent with authority elsewhere, it should be noted that
the High Court did not consider in this case the fact that the Singapore-Malaysia tax treaty
excluded from business profits treatment certain forms of income, including income in the
form of rents and royalties, or the fact that the definition of royalties in the treaty (albeit for
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the purposes of the royalty article only) included consideration provided for the use of or the
right to use industrial, commercial, or scientific equipment. Had the court considered those
provisions, it might have concluded that the rentals were taxable under the treaty as royalties
and not as business profits.
66 The Exchequer Court of Canada in Tara Exploration, supra note 60, at 6378, indicated that a
“permanent establishment” in Canada referred to an establishment in Canada where there
were persons with authority to carry on some part of the taxpayer’s money-making activities. As
all that was present in that case was a formal registered office at which minimal activity occurred,
no permanent establishment was found to exist. On appeal (72 DTC 6288), the Supreme Court
of Canada appeared to confirm this result, although it did not expound on the reasons why
there might not have been a permanent establishment on the facts of the case. In any event, the
court was of the view that even if there were such an establishment, the profits in question
would not be attributable to it.
67 Paragraphs 2 and 10 of the commentary on article 5 of the OECD model.
68 Organisation for Economic Co-operation and Development, Clarification on the Application of
the Permanent Establishment Definition in E-Commerce: Changes to the Commentary on the Model
Tax Convention on Article 5 (Paris: OECD, December 2000), paragraph 12. These revisions
have now been incorporated into the 2002 draft revisions to the commentary, supra note 46.
69 Clarification on the Application of the Permanent Establishment Definition, supra note 68, at
paragraph 9.
72 Ibid., at draft paragraph 42.8 of the commentary on article 5. This functional analysis appears
consistent with the result in Tara Exploration, supra notes 60 and 66 (although the Supreme
Court did not expand on its reasons in this case).
73 Skaar, supra note 24, at 112, notes that while leasehold assets can obviously be a place of
business for someone, this someone need not always be the owner of the assets. Later, at 194,
he refers to a number of decisions relating to bareboat versus time charters, and gaming
machines, to make essentially the same point.
74 Ibid. In respect of a distinction between an asset that serves a business and an asset through
which the business is conducted, see Marc Lampe, “Broadening the Definition of a Permanent
Establishment: The Pipeline Decision” (1998) vol. 38, no. 2 European Taxation 67-71, at 68.
75 See paragraph 18 of Organisation for Economic Co-operation and Development, “The
Taxation of Income Derived from the Leasing of Containers,” in Trends in International
Taxation, supra note 11, 17-28. This report was adopted by the Council of the OECD on
September 13, 1983.
77 Paragraph 11 of the commentary on article 5 of the OECD model. This position is bolstered
by a number of court decisions. In Sunbeam Corporation, supra note 27, the Supreme Court of
Canada notes (at 1393) the need for the place of business to be that of the taxpayer alleged to
have a permanent establishment at that location. This requirement suggests that the operation
conducted through that place of business must be that of the taxpayer’s enterprise as well. See
also Shahmoon v. MNR, 75 DTC 275 (TRB).
78 See United Dominions Trust Ltd. v. CIR, [1973] 2 NZLR 180 (SC).
79 Inez de Amodio v. Commissioner, 34 TC 894 (1960).
80 Article 7(1) of the OECD model; article 7(1) of the US model.
81 Article 7(1)(c) of the UN model.
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83 It may well be that the CCRA takes a more expansive view of the result of a series of shortterm contracts. See the discussion of its position in respect of management consulting services
as set out by Jack et al., supra note 34, at 15:14-15. Such linking of contracts that are not part
of a coherent commercial whole, or tied to an otherwise fixed place of business, is clearly
inconsistent with both the current commentary and the 2002 draft revisions.
84 IRS ltr. rul. 8526005, supra note 37.
85 Paragraph 12 of the commentary on article 5 of the OECD model. See also Vogel, supra note
30, at 295.
86 This situation would be similar in many ways to the Norwegian case of Johanson and Scanwell
AB v. Stavanger Municipality, September 5, 1989, Utv. 1989, at 720 (Stavanger City Court),
aff’d. March 15, 1991 (CA), where the provision of space to a contractor on a drilling platform
(namely, a desk in a room with 25 desks) was enough to give the contractor a permanent
establishment in Norway when the operations of the contractor were directed from that
location: reported in Donald H. Watkins, Judith M. Woods, Michael A. Hiltz, and C. Brian
Darling, “Recent Cases: The View from Revenue Canada,” in Report of Proceedings of the FiftyFirst Tax Conference, 1999 Conference Report (Toronto: Canadian Tax Foundation, 2000),
47:1-21, at 47:13-14. Canadian courts might well be more narrow in their approach; for
example, in the recent Federal Court of Appeal decision in Dudney, supra note 54, the court
seems to be emphasizing the need for more control over the location and the identification of
it with the business of the taxpayer before the location can become a fixed base/place of
business of the taxpayer. This position directly counters that of the CCRA to the effect that
control over premises and identification of them with the taxpayer’s business are not relevant to
the existence of a permanent establishment. (The CCRA position is set out in Shannon L.
Baker and Dale S. Meister, “Non-Residents Rendering Services in Canada: Regulation 105 and
Other Issues,” International Tax Planning feature (1999) vol. 47, no. 5 Canadian Tax Journal
1321-41, at 1325-26.) While the Dudney case refers to the concept of a fixed base in the context
of former article 14 of the OECD model, that concept is very similar to concepts relating to a
fixed place of business, as noted by the Tax Court of Canada in the trial decision in Dudney (99
DTC 147). In fact, as a result of subsequent amendments to the OECD model, the former
article 14 provisions are now subsumed into the permanent establishment provisions.
87 Paragraph 3(f ) of the protocol to the Income Tax Treaty Between Canada and the United
States of America, signed in Washington, DC on March 4, 1942.
88 No. 630 v. MNR, supra note 40.
89 Halsbury’s Laws of England, 4th ed., reissue, vol. 2 (London: Butterworths, 1991), section 1850,
notes that a lease (hire) is a contract by which the hirer obtains the right to use the chattel hired
in return for the payment to the owner of the price of the hiring. Rev. rul. 73-278, 1973-1 CB
336, indicates that rent (in this case, a per diem fee paid for the use of rail cars) is consideration
paid for the use or occupancy of property; clearly, in such context, the use is by the lessee, not
the lessor. Lindencrona and Tolstoy, supra note 13, at 22, define a lease as a contract whereby a
separation of ownership of an asset and its usage is established for a certain period of time. As
well, there is reference to a German case dealing with a manufacturing arrangement under
licence, which would be comparable to a leasing situation described in Jack et al., supra note 34,
at 15:8-9. In the German case, the court held that there was no permanent establishment on
the basis that the Swiss licensor lacked control over the facilities and machinery supplied to the
German manufacturer and accordingly had no place of business in Germany.
90 Article 5(4)(b) of the Convention Between the Government of Canada and the Government of
New Zealand for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with
Respect to Taxes on Income, signed at Wellington on May 13, 1980.
91 Article 5(3) of the OECD model.
92 Article 5(3) of the UN model.
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93 Article 5(3) of the US model. See also Vogel, supra note 30, at 307.
94 IRS ltr. rul. 8526005, supra note 37. However, in an editorial comment, Michael Edwardes-Ker,
The International Tax Treaties Service (London: In-Depth Publishing) (looseleaf ), questions
whether drilling activities are encompassed by the construction and assembly project
provisions. See also Blessing and Dunahoo, supra note 44, at 3.02[2][b][ii].
95 Supra note 46, at draft paragraph 17 of the commentary on article 5.
96 Skaar, supra note 31, at 36. One caution, however, is that individual treaties based on the
OECD model can change the wording of the article to create a deeming situation, as has
happened in the natural resource field, discussed below.
97 Vogel, supra note 30, at 305-6.
98 For an apparently contrary view, see a report by Pieter M. Smit of a Netherlands Supreme
Court decision in respect of a pre-1963 tax treaty provision, “Supreme Court Rules on
Construction Permanent Establishment” (1999) vol. 39, no. 3 European Taxation 137-41, which
suggests that the combination of time with a connection to a construction project is enough to
result in the deemed existence of a permanent establishment. Smit’s view is that the decision
misapplies the position taken in the OECD commentary on article 5(3).
99 IRS ltr. rul. 8526005, supra note 37.
100 This interpretation arises from a European tax case cited by Vogel, supra note 30, at 289.
101 Ibid., at 307. This position is also taken in IRS ltr. rul. 8526005, supra note 37, and is echoed
by the statement of the Federal Court of Appeal in Dudney, supra note 54, at 6174—albeit in
the context of a fixed base for independent personal services—where the court noted that the
duration of the contract at issue was relevant to the permanence of a fixed base only if one had
existed in the first place.
102 Paragraph 20 of the commentary on article 5 of the OECD model. This position now applies
to non-construction-related but otherwise peripatetic activities, as addressed in notes 37 and
38, supra, and will be reinforced by the 2002 draft revisions to the commentary, supra note 46,
at draft paragraphs 5.1 to 5.4 of the commentary on article 5.
104 While article 5(4) of the US model contains similar language, subparagraphs (a) and (b) of
article 5(4) of the UN model do not include the word “delivery.” Therefore, for treaties based
on the UN model, there is less scope for reliance on these provisions to avoid the creation of a
permanent establishment in situations where a lessor maintains a depot in the source state at
which customers return the equipment for subsequent delivery to another customer in the
source state.
105 The UN model omits this paragraph in its entirety. Consequently, a combination of activities
may well exclude the application of the provisions under treaties based on that model. In the
US model, there is no express caveat requiring combined activities to be of a preparatory or
auxiliary nature.
106 Paragraph 25 of the commentary on article 5 of the OECD model. Under the 2002 draft
revisions to the commentary, supra note 46, paragraph 25 will be amended to refer to “a fixed
place of business for the delivery of spare parts to customers for machinery supplied to those
customers, where, in addition, it maintains or repairs such machinery” (emphasis in the original).
107 Tenneco Canada Inc. v. The Queen, 91 DTC 5207 (FCA); MNR v. Federal Farms Ltd., 67 DTC
5311 (SCC); Cintas Canada Limited v. The Queen, 99 DTC 926 (TCC).
108 Vibroplant Ltd. v. Holland, [1982] 1 All ER 792 (CA).
109 Paragraph 24 of the commentary on article 5 of the OECD model. The 2002 draft revisions to
the commentary, supra note 46, will also add a statement in paragraph 27.1 of the commentary
on article 5 to the effect that an enterprise cannot fragment a cohesive operating business into
522
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(2002) vol. 50, n o 2
several small operations at different locations within a source state in order to argue that each
is merely engaged in a preparatory or auxiliary activity.
110 Given the absence of the proviso in the US model, as noted supra note 105, it could perhaps be
argued that in treaties based on that model, the combined activities should not be treated as a
permanent establishment. On the other hand, if the overriding purpose of the provisions is to
deal with matters of a preparatory or auxiliary nature, the omission of the caveat may not
actually affect the way in which they will be applied in practice.
111 Supra note 11, annex.
113 On this point, however, Canada has reserved its right to replace the words “of extraction” in
article 5(2)(f ) with the words “relating to the exploration for or the exploitation.” See
paragraph 63 of the commentary on article 5 of the OECD model.
115 There are provisions to this effect in 19 of Canada’s treaties—those with Argentina, Chile,
Croatia, Estonia, Iceland, Jordan, Kazakhstan, the Kyrgyz Republic, Latvia, Lebanon (not yet
in force), Lithuania, Luxembourg, Portugal, the Russian Federation, South Africa, Sweden,
Ukraine, Uzbekistan, and Vietnam. The treaty with France, through a second protocol signed
on November 30, 1995, does not use this language but notes that it is understood that a place
of exploration is considered a permanent establishment if it meets the requirements of article
5(1) of that treaty.
116 Supra note 113.
117 Article 5(2)( j) of the Agreement Between the Government of Canada and the Government of
the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with Respect to Taxes on Income and on Capital, signed at New Delhi on January 11,
1996. Similar, but not identical, wording is included in article 5(3)(b) of the Convention
Between the Government of the Republic of Kazakhstan and the Government of Canada for
the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes
on Income and on Capital, signed at Almaty on September 25, 1996. In article 5(2)(i) of the
Convention Between the Government of Canada and the Government of the Republic of
Trinidad and Tobago for the Avoidance of Double Taxation, the Prevention of Fiscal Evasion
with Respect to Taxes on Income and the Encouragement of International Trade and
Investment, signed at Toronto on September 11, 1995, again there are similar inclusions but no
time period is specified.
118 Article 5(3) of the Agreement Between Canada and the Republic of Malta for the Avoidance of
Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on
Capital, signed at Valetta on July 25, 1986 (the time frame specified is 183 days in any 12-month
period); article 5(4) of the Convention Between Canada and the United States of America with
Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26,
1980, as amended in respect of this particular provision by the first protocol to that convention
signed on June 14, 1983 (the time frame specified is 3 months in any 12-month period), and as
further amended by the protocols signed on March 28, 1984, March 17, 1995, and July 29, 1997.
119 One author has suggested a narrower interpretation to the effect that it is probable that
equipment such as service rigs and seismic equipment will not fall within the same net as ships
and drilling rigs—perhaps on the basis that “installation” will be qualified by the subsequently
listed words. See Gary J. Webb, “The Canada-U.S. Tax Treaty: Implications for Canadians
Carrying on Business or Investing in the United States,” in Report of Proceedings of the Thirty-Sixth
Tax Conference, 1984 Conference Report (Toronto: Canadian Tax Foundation, 1985), 269-90,
at 277. This interpretation is not supported by the United States, Treasury Department,
Technical Explanation of the Convention Between the United States of America and Canada
■
523
with Respect to Taxes on Income and on Capital, April 26, 1984, which, in explaining article V,
refers to “an installation or drilling rig or drilling ship.”
120 Oxford English Dictionary, 2d ed.
121 Vogel, supra note 30, at 310.
122 But see comments by Blessing and Dunahoo, supra note 44, at 3.02[2][b][ii], suggesting that at
least the need for a geographical site/project is removed by the focus on the equipment itself as
a site. They take the view later (at 3-52) that the US offshore activities article does not apply to
passive activities such as leasing, a view that supports the position stated.
123 See article 5(4)(b) of the Convention Between Canada and Australia for the Avoidance of
Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income,
signed at Canberra on May 21, 1980.
124 In Sunbeam Corporation, supra note 27, the Supreme Court’s only comment in this respect (at
1394) is that the adjective “substantial” is intended to mean substantial in size, and that the use
in question must be that which would arise in the course of operation. In No. 630 v. MNR,
supra note 40, equipment costing more than $600,000 (in the 1950s) was held to be substantial.
125 Article 5(3) of the Convention Between Canada and the Hashemite Kingdom of Jordan for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on
Income, signed at Amman on September 6, 1999.
126 Articles 5(8)(a) and (b) of the Agreement Between Canada and Papua New Guinea for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on
Income, signed at Vancouver on October 16, 1987; article 27A of the Convention Between the
Government of Canada and the Government of the United Kingdom of Great Britain and
Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion
with Respect to Taxes on Income and Capital Gains, signed at London on September 8, 1978,
as amended by the protocols signed on April 15, 1980 and October 16, 1985; article 27 of the
Convention Between Canada and the Kingdom of Denmark for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on
Capital, signed at Copenhagen on September 17, 1997 (although the wording here refers to
“exploration or extraction of hydrocarbons”); article 29 of the Convention Between the
Government of the Republic of Lithuania and the Government of Canada for the Avoidance of
Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on
Capital, signed at Vilnius on August 29, 1996 (again with variant wording but to substantially
the same effect); article 23 of the Convention Between Canada and the Kingdom of the
Netherlands for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with
Respect to Taxes on Income, signed at The Hague on May 27, 1986, as amended by the
protocol signed on March 4, 1993. The Dutch treaty goes further and, under article 23(4),
excludes certain activity from the application of the deeming provision. It is interesting to note
that similar provisions appear in article 21 of the Convention Between the Government of the
United Kingdom of Great Britain and Northern Ireland and the Government of the United
States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion
with Respect to Taxes on Income and on Capital Gains, signed at London on July 24, 2001.
The Papua New Guinea and Denmark treaties are not restricted, like the others noted, to
offshore activities.
127 Oxford English Dictionary, 2d ed.
128 Random House Webster’s Dictionary, 2d ed.
129 See supra note 122.

Leased Equipment: When Does a Permanent Establishment Exist?

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