Substance over form: where is the Permanent Establishment?

Cross-border taxation

Mauritius cannot be a tax libertarian under the cloak of tax arbitrage to take care of foreign corporate interests first and foremost

By Prakash Neerohoo

After the Panama Papers and Paradise Papers, the International Consortium of Investigative Journalists (ICIJ) has published the “Mauritius Leaks”, a report on alleged harmful tax practices in the Mauritian Offshore Financial Centre (OFC) to the detriment of African countries that have signed a Double-Tax Avoidance Treaty (DTAT) with Mauritius. Since the publication of the report in the international media, there has been a passionate debate about the merits and demerits of the OFC with a consensus emerging among mainstream political parties (which, by the way, have high-profile members operating in the offshore business sector) about the need to defend the OFC against any critique, whether legitimate or not.

It is very important to have an objective debate on the issues raised because (a) there is a high dose of subjectivity from operators in global business who want to be judge and party at the same time, and (b) the nexus between politics and global business does not allow an impartial analysis of controversial tax issues. Offshore business operators are living in a bubble that precludes them from properly processing what has transpired outside and now the bubble threatens to prevent them from seeing just how significant the effort will be to shed off the perception (right or wrong) of a tax haven that hovers over the OFC.

The debate so far has focused on legal arguments and overlooked fundamental principles of cross-border taxation. One argument is that African countries were willing parties to the DTAT they have signed at arm’s length with Mauritius and they knew the risks and rewards of receiving foreign investment from non-resident companies routed through the OFC. This argument is quite legalistic and it is analogical to the reasoning underlying a contract between two parties, which is supposed to be sacrosanct although it might subsequently turn out to be flawed in some respects.

Another argument is that companies in the OFC are entitled to do tax planning to minimize their tax liability, including using tax-avoidance tools within the parameters of tax legislation and tax treaties. However, tax avoidance is a grey area between compliance and evasion. Tax avoidance, however legal, may lead to tax evasion when it is predicated on a systemic effort to escape tax liability in the countries where income-generating activities are conducted and profits are derived.

Double non-taxation

Cross-border investment is a strategy used by multinational corporations who incorporate separate business entities in an OFC (a low-tax jurisdiction like Mauritius) to serve as a conduit for investment in third countries (India or Africa) instead of setting up subsidiaries in those countries where they would be subject to a higher corporate tax rate. Mauritius is indeed an attractive OFC for foreign corporations looking for profitable investment opportunities in developing nations with its (a) economic stability, (b) low taxes (a tiered corporate tax structure with 15% tax rate for domestic companies and 3% tax rate for offshore companies, coupled with no tax on dividends and capital gains), (c) social stability, (d) legal framework, and (e) secure property rights.

The DTAT is meant to avoid double taxation of profits from income-generating investment by sharing the taxing rights between the source jurisdiction (recipient of investment) and the resident jurisdiction (where the offshore company is registered). However, in some cases, the resident jurisdiction ends up getting most of the taxes and tax benefits for investors while the source jurisdiction gets a measly pittance. That was the complaint from India under the former DTAT with Mauritius and now it seems that some African countries have the same grievance under their tax treaties with Mauritius.

In some cases, the agreement to avoid double taxation has become an agreement to ensure “double non-taxation” in both the source jurisdiction (recipient of funds) and the resident jurisdiction (provider of funds). That was the case with the DTAT between Mauritius and India where the former had all the taxing rights (corporate tax on profits and Capital Gains Tax on transfer of assets and shares). Mauritius had the right to levy Capital Gains Tax on offshore companies investing in India but never exercised that right as its statutory Capital Gains Tax rate is zero. As a result, those companies escaped tax liability in both India and Mauritius. Deprived of substantial tax revenue, India negotiated successfully a review of the DTAT (Article 13) to obtain taxing rights over capital gains realized on transactions occurring in India, effective April 1, 2017.

At that time, some vested interests lambasted the government for surrendering its unexercised taxing rights to India in exchange for generous compensation and financial assistance through loans. They predicted that all hell would break loose over the OFC with the flight of offshore companies to greener pastures, but that did not happen. Actually, nobody can blame India for its move because it is a country that has enormous public expenditure needs for a large population and it needs to raise sufficient tax revenue to fund public services and infrastructure development in order to raise the standards of living of the poorest segments of society.

Permanent establishment

One basic principle of corporate taxation is that tax is levied on profits derived from income-producing activities conducted in the source jurisdiction where substantial economic activity occurs. It is based on the concept of permanent establishment (PE) as defined in article 5 of the OECD Model Tax Convention (reflected in most double tax treaties) and expanded in corporate tax legislation in some countries.

Article 5 (1) of the Convention defines a PE as “a fixed place of business through which the business of an enterprise is wholly or partly carried on.” Under article 7 of the Convention, a Contracting State to a tax treaty (e.g. Senegal) cannot tax the profits of an enterprise of the other Contracting State (e.g. Mauritius) unless it carries on its business through a PE situated therein (Senegal). In short, profit should be taxed where value is created, which makes business sense.

The investor corporation is liable for tax in the source jurisdiction where the income-producing PE is based. If the corporation is generating revenue from activities (production or sales) conducted through a PE in India or African countries, then it makes sense that corporate tax and Capital Gains Tax should be payable in those source jurisdictions. The corporation cannot transfer its profits to the resident jurisdiction to pay tax at a lower rate (3% in Mauritius). The definition of a PE favours substance (economic activity) over form (incorporation).

Substance implies that the PE must have substantial economic activity. An offshore company that has only a letterbox or a bank account, or is a shell company holding intellectual property rights only, has no PE as such in the country of residence as it is not engaged in income-producing activity there. Holding annual board meetings or hiring accounting and legal services in the country of residence are not the hallmarks of a PE. Where the economies of both Contracting States to a tax treaty contribute to the business profits, there exists sufficient economic justification for profits to be allocated among them in a manner that avoids double taxation.

General Anti-Avoidance Rules

The OECD is implementing an action plan to combat Base Erosion and Profit Shifting (BEPS) activities undertaken by multinational enterprises to shift profits to low-tax or no-tax jurisdictions by incorporating business entities in OFCs, which are then used to invest in third countries. The BEPS activities have deprived OECD countries as well as India and Africa of substantial tax revenue, which impacts their ability to fund public services (education and health) and invest in infrastructure needs. BEPS Action 6 states that tax treaties are not intended to create opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping).

Most OECD countries have General Anti-Avoidance Regulations (GAAR) enshrined in their statute books to combat aggressive tax planning and tax treaty abuse by corporations looking for undue tax benefits. India has followed suit with a set of regulations that came into effect on April 1, 2017. Indian GAAR is intended to deal with the taxation of non-resident transfer of assets, among other purposes.

In May 2019, the Indian Tax Administration issued a proposal to amend Income Tax Law (ITL) rules on profit attribution to a PE in line with OECD guidance, including attribution of profits to a “significant economic presence” based on the source principle of taxing profits. In a nutshell, it is proposed that the profits that may be taxed in India are limited to income which is reasonably attributable to operations in India if a business connection exists under Indian ITL or, as the case may be, profits attributable to the PE under a tax treaty.

A win-win

The tax treaty has to be a win-win formula where both Contracting States share taxing rights based on the PE’s location. It cannot be a jackpot for the resident jurisdiction and its offshore companies. The argument that the source jurisdiction (recipient of investment) should be content with the inward investment and give up all taxes on income-producing activities does not hold water. India did not buy it. Africa would not buy it any longer.

It’s time for Mauritius to reassess its OFC’s tax policies and practices in order to ensure that African countries are treated fairly and are not subject to exploitation at the hands of profit-maximizing corporations in a new variation of past economic relationships that were skewed in favour of foreign entities. Mauritius cannot be a tax libertarian under the cloak of tax arbitrage to take care of foreign corporate interests first and foremost. It needs to step up to ensure tax fairness to its African partners in cross-border transactions.

* Published in print edition on 2 August 2019