In cases where South Africa has concluded an agreement with another country for the avoidance of double taxation, a critical issue is the circumstances under which the business profits of a person who is a resident of that country may be taxed in the Republic. The right to tax is linked to whether the activities of that person give rise to a permanent establishment (PE). Where a permanent establishment is found to have been created, South Africa may tax the income attributable to that permanent establishment.
Every double-taxation agreement (DTA) contains an article in which the term “permanent establishment” is defined. The definition commences with a basic statement of principle:
For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.
The article then lists specific inclusions for what constitutes a PE (office, place of management, factory, warehouse, etc.). Depending on the agreement between the negotiating parties, two special circumstances where a PE will be found to arise may be listed as part of the specific inclusions or as a separate sub-article. These circumstances are construction or assembly projects, and the provision of services.
Finally, certain activities may be regarded as not giving rise to a PE. These are listed separately. Even though these activities may be undertaken through a fixed place of business, they are insufficient to justify a conclusion that there is a PE.
Income Tax Case No 13276
In May 2015, the Tax Court in Johannesburg gave judgment in a matter in which the critical issue was whether there was a PE. This is the first judgment on PE in South African reported law in almost 40 years.
The appellants were two entities (limited liability companies or LLCs), resident in the United States (US), which were part of a global advisory group specialising in the airline industry. The dispute in question related to a consulting contract that the LLCs had with a South African client.
In terms of the consulting contract, the advisory services were delivered in South Africa (SA), at the client’s premises, over a 16-month period (between February 2007 and May 2008). In total, 17 of the LLCs’ employees worked on the project. Three formed the core of the team and were present in SA on a rotational basis; the others were sent to SA only as required. In carrying out the consulting activities, the physical “engine room” (as described by one of the witnesses) of the consulting work was the client’s boardroom. The consultants were generally based in the boardroom and occasionally needed to work with the client’s staff in other parts of the client’s premises. The consultants did not work in the boardroom after hours or on weekends.
The fees paid to the LLCs consisted of fees paid during the currency of the contracts in 2007 and 2008, plus a success fee that was paid in 2009, after the impact of the services on the client’s performance could be identified and quantified.
The South African Revenue Service (SARS) considered that the activities of the LLCs were such that they had created a PE in the Republic. SARS therefore assessed the LLCs to be taxed on their consulting income and imposed additional tax equal to 200% of the amount assessed.
The LLCs had objected to the assessment and additional tax. The objection against the additional tax was disallowed, although the additional tax was reduced to 100% of the tax assessed. The LLCs appealed against both the assessment to tax and the additional tax.
The legal issues
The DTA between SA and the US defines PE in Article 5.
Article 5(1) contains the standard description that a PE is a fixed place of business through which the business of an enterprise is wholly or partly carried on.
Article 5(2) lists the specific inclusions. For the most part, these describe types of places or structures. However, the list also includes oil-drilling or exploration vessels (paragraph (i)), certain construction or assembly projects (paragraph (j)) and the performance of services, including consultancy services (paragraph (k)). The dispute related to the special inclusion Article 5(2)(k), which provides that the term “permanent establishment” includes especially:
[The] furnishing of services, including consultancy services, within a Contracting State by an enterprise through employees or other personnel engaged by the enterprise for such purposes, but only if activities of that nature continue (for the same or a connected project) within that State for a period or periods aggregating more than 183 days in any twelve-month period commencing or ending in the taxable year concerned.
The LLCs argued that before the special inclusion could be dealt with it first had to be established that there was a PE as described in Article 5(1). They argued that there was not a PE as contemplated in Article 5(1).
SARS argued that the existence of a PE as contemplated in Article 5(1) was not required for the special inclusion to be enforceable. In any event, SARS argued, there had indeed been a PE as contemplated.
Application of the special inclusion
In his judgment, Vally J considered the guidance published by the Organisation for Economic Development and Co-operation (OECD) in its Commentary on the Model Tax Convention (“Commentary”). This Commentary indicated that for inclusions to apply there still has to be compliance with Article 5(1). This, the Judge found (at paragraph  of the judgment):
…takes no account of the phrase “includes especially”.
The question to be considered was whether the term “includes” indicates an illustration or an extension of Article 5(1). The Commentary suggests that the term is used in an illustrative sense. However, Vally J pointed out (at paragraph ) that it was well established that our courts have recognised that the term “includes” is sometimes employed as an exhaustive list, but “as a general rule, it is a term of extension”. In other words, it brings within the ambit of a term circumstances that would ordinarily not be regarded as falling within its scope. After reviewing the history of the use of the term, Vally J concluded (at paragraph ):
Thus, the word ‘include’ used in a statute is often used to extend or enlarge the meaning of a thing or concept. It brings within the scope of the thing or concept others that are not ordinarily or naturally part of the thing or concept.
Moving then to consider whether Article 5(2)(k) should be interpreted as part of, or separately from, Article 5(1), Vally J considered that they should be considered as separate forms of PE. In this respect, he referred (at paragraph ) to the Technical Explanation given by the Internal Revenue Service (IRS) to the US Congress on the application of the DTA, in which the IRS explained:
As indicated in the OECD Commentaries …, a general principle to be observed in determining whether a permanent establishment exists (except with respect to the furnishing of services under subparagraph (k)) is that the place of business must be “fixed” in the sense that a particular building or physical location is used by the enterprise for the conduct of its business. (Emphasis added)
Finding support in this explanation by South Africa’s treaty counterparty for the interpretation that he had suggested, Vally J concluded (at paragraph ):
Thus, once the provisions of article 5(2)(k) are met, there is no need to further examine whether the provisions of article 5(1) have also been met to determine whether the existence of a permanent establishment has been proved.
Had Article 5(1) been satisfied?
The judgment also considered whether the requirement of Article 5(1) had been met. That is, if the ruling on Article 5(2)(k) was incorrect, was there in any event a PE under Article 5(1)?
In argument, the LLCs had referred Vally J to a Canadian decision The Queen v Dudney WA (2000) DTC 6169, which considered the question of whether a US resident person engaged to perform services for a Canadian client of his principal had created a PE in Canada. The following facts were found by the Canadian Federal Court of Appeal (FCA):
The work was done on the premises of PanCan in Calgary. The Appellant was at first provided with a small room from which to work. After three months, he was moved to a larger room, which he shared with a number of other consultants. Later he was moved to another room in a different building, also occupied by PanCan. For the most part, the actual training, or mentoring, of the PanCan personnel took place in the offices of the people being trained, or in a conference room. Sometimes there would be meetings or consultations in the space provided to the trainers. Their use of that space was strictly limited, however. It was available to them for the purpose of the contract only.
Interpreting Article XIV of the US–Canada DTA, the FCA held that the facts did not support a conclusion that Dudney had a fixed base from which he conducted his operations in Canada. Thus, the FCA concluded:
Although Mr Dudney had access to the offices of PanCan and he had the right to use them, he could do so only during PanCan’s office hours and only for purpose of performing services for PanCan that were required by his contract. He had no right to use PanCan’s offices as a base for the operation of his own business. He could not and did not use PanCan’s offices as his own.
Vally J was quick to point out that while the Dudney judgment did not affect his interpretation of the application of Article 5(2)(k), he found that it was relevant to the assertion of whether Article 5(1) was applicable. Applying the decision to the facts before him, the judge stated (at paragraph ):
There is no doubt that the appellant had a fixed base in the boardroom of X. Throughout its stay in South Africa it had a presence in the boardroom of X even though at times some of its employees moved to other areas of the X premises. This, it must be remembered, is very different from the factual situation in Dudney, where Dudney, who was a sole individual providing services, moved from one area to another. In our case, while some employees moved from one area to another the appellant was, at all times, present in the boardroom during the tenure of the contract. It had exclusive use of this space for the entire duration of the contract. To put it differently, it had at its disposal constant access to the boardroom during working hours. Access during nonworking hours was neither necessary nor requested. This flows directly from the fact that compliance with its obligations in terms of the contract required regular intensive interaction with employees of X, which, it goes without saying, was most suitable during normal working hours. There can therefore be no doubt that the appellant had established “a fixed place of business” in South Africa while carrying out its obligations in terms of its contract with X.
The LLCs had therefore, on their own interpretation, been found to have established a PE in the boardroom.
Vally J was unsympathetic to the argument that the additional tax of 100% was excessive. The LLCs claimed that they did not realise that they would be found liable for the tax and that they had already been taxed on the income derived in their country of residence. These arguments were considered inadequate, Vally J holding (at paragraph ):
The appellant unilaterally decided that it is not liable for taxation in South Africa and did not bother to clarify the issue with anyone, least of all the respondent. In this, the appellant’s conduct falls short of what is expected of a reasonable international corporation operating on the scale it does. The fact that it paid tax to the USA authorities for the income or profits generated in South Africa (in circumstances where it held a permanent establishment in South Africa) is of no moment to the determination of the issues in this case. That was a unilateral decision that has no bearing on whether it was liable to the respondent in terms of South African law, which, of course, includes giving effect to the DTA.
This matter was determined on the wording of a specific sub-paragraph in an article in the DTA (Article 5(2)(k)). This sub-paragraph is not generally found in the DTAs that SA has concluded, although it is frequently found in those concluded more recently.
Of greater general interest was the interpretation applied in relation to Article 5(1). The acceptance by Vally J of the principles applied in the Canadian judgment in Dudney is not inconsistent with the view expressed some 40 years earlier by Corbett JA in SIR v Dowling 37 SATC 249 (A) at 257, in which it was stated:
I incline to the opinion that, whatever the precise scope of art 5(1), read with art 5(2), may be, it contemplates the situation where, by reason of factors such as occupation and control, the fixed place of business can be said to be the taxpayer’s place of business …
The intention behind Article 5(1) is clear, and was appropriately dealt with by Vally J. The mere presence of person A, performing work at the premises of person B, does not make B’s premises the place of business of A. For this to be so, A must exercise both occupation and control over the premises for the purposes of carrying on their own business.
It is no secret that SARS considers that there has been inadequate reporting of PE income by non-resident entities. Thus, it may be expected that there will be a surge in inquiries into the activities of non-residents (the draft of a proposed reportable arrangement notice relating to services by non-residents bears testimony to this intent).
Non-residents that have been engaged to perform services in the Republic have a duty to acquaint themselves with the applicable law and, where appropriate, register for the payment of tax. Failure to do so may result in their incurring unwelcome liability for tax, penalties and interest.
This article first appeared on pwc.co.za.