Tax court rules on creation of permanent establishment in South Africa

taxation 6Author: Dr Beric Croome – ENSafrica Tax Executive

Where a foreign company renders professional services to a South African company in South Africa, it is important that the foreign entity considers whether, as a result of rendering such services, the foreign company will create a permanent establishment in South Africa. The reason why this becomes important is that where a foreign company creates a permanent establishment in South Africa, this country will under the provisions of a Double Tax Agreement (“DTA”) concluded with another country, be entitled to subject that foreign entity to tax on the profit attributable to that permanent establishment created in South Africa.

In the case of AB LLC and BD Holdings LLC (“AB and BD”), case number 13276 heard in February 2015, as yet unreported, the Tax Court had to determine whether AB and BD had created a permanent establishment in South Africa, and as a result thereof, was liable to tax in South Africa. The case involved two corporations incorporated in the United States of America and the court therefore had to consider the provisions of the DTA concluded by South Africa and the United States of America.

Article 7(1) of the DTA concluded by SA and the USA provides that the profits of an enterprise of the USA shall be taxable only in the USA, unless that enterprise conducts business in South Africa through a permanent establishment located in South Africa. Furthermore, the DTA provides that where business is carried on through a permanent establishment, the profits of the enterprise may be taxed in South Africa, but only to the extent that they are attributable to that permanent establishment.

Article 5(1) of the DTA in turn provides as follows:

“for the purpose 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.”

In addition thereto, Article 5(2) of the DTA provides that the term ‘permanent establishment’ includes especially-

“(k)   the furnishing of services, including consultancy services, within a contracting state by an enterprise through which employees or other personnel engaged by the enterprise for such purposes, but only if activities of that nature continue (for the same or connected project) within that state for a period or periods aggregating more than 183 days in any 12 month period commencing or ending in the taxable year concerned.”

The court had to decide how the DTA should be interpreted and whether it was necessary for AB and BD to have met the requirements of both Articles 5(1) and 5(2)(k) of the DTA.

The taxpayer contended that it is necessary that a permanent establishment be created first under Article 5(1) and only once that has occurred, is it then necessary to take account of the provisions of Article 5(2)(k) of the DTA. SARS on the other hand, argued that if AB and BD fell within the provisions of Article 5(2)(k), a permanent establishment exists and it is not necessary that AB and BD meet the requirements of Article 5(1) of the DTA.

The court also had to consider the manner in which the 183 days in any 12 month period commencing or ending in the taxable year concerned should be determined under Article 5(2)(k). AB and BD contended that the 183 requirement found in Article 5(2)(k) must be for a “12 month period commencing or ending in the taxable year concerned”. Thus, when an entity spends less than 183 days in any 12 month period commencing or ending in a taxable year in South Africa, then that entity cannot be said to have created a permanent establishment in this country. AB and BD were present in South Africa from February 2007 and the third phase of the consulting assignment ended during May 2008. The Judge made the point that since 1 May 2008, no employees of AB and BD were present in South Africa and that the Appellant’s financial year commenced on 1 January 2007 and ended on 31 December 2007. AB and BD accepted that it had been present in South Africa for more than 183 days during the 2007 tax year. The taxpayers argued that insofar as the 2008 tax year is concerned, SARS could not count any of the days already taken into account when determining the days that it was present in South Africa during the 2007 tax year. On the basis that AB and BD were only in South Africa from 1 January 2008 to 1 May 2008, it was not in South Africa for 183 days during that tax year. It was therefore argued that SARS could not tax the profits derived during that tax year. As far as the 2009 tax year is concerned, the court made the point that it was common cause that AB and BD had no presence in South Africa during that year. The taxpayers therefore argued that it was only in 2007 that it met the 183 day rule as set out in Article 5(2)(k).

SARS contended that the presence of AB and BD in South Africa for the 2008 and 2009 years was established beyond doubt. SARS contended that as the Appellant was in South Africa during the calendar year 1 January 2007 to 31 December 2007 and 1 January 2008 to 31 December 2008, it was in South Africa for two tax years, that is 1 March 2007 to 28 February 2008 in respect of the 2007 tax year and 1 March 2008 to 28 February 2009, that is the 2008 tax year. At paragraph 47, the court indicated that the 183 day period should be calculated forwards from 1 March 2007 to 28 February 2008 as this is the commencing of the fiscal year and then again backwards from 28 February 2009 to 1 March 2008, as that is in respect of the ending of the fiscal year. SARS conceded that this results in some days being double counted. SARS’ counsel contended that SARS is not only allowed by the treaty to double count the days, but that it was actually contemplated by the parties to the DTA and in support thereof drew attention to the OECD commentary which deals with this point. Unfortunately, the commentary referred to deals with Article 15 of the Model Tax Convention on Income and on Capital which deals with income from employment and does not in any way refer to the determination of whether a permanent establishment has been created as envisaged in terms of Article 5(2)(k). It is therefore questioned whether it is appropriate to rely on commentary dealing with income from employment in determining how Article 5(2)(k) should be interpreted.

Vally J in his judgment handed down on 15 May 2015 reached the conclusion at paragraph 30 that Articles 5(1) and 5(2)(k) cannot be read disjunctively. He expressed the view that as a result of the usage of words ‘includes especially’ Article 5(2)(k) of the DTA should be read as specifying those specific activities which will be regarded as creating a permanent establishment in South Africa. The Tax Court reached the decision that taking account of the number of days spent by AB and BD’s staff in South Africa, it met the time requirement specified in Article 5(2)(k) of the DTA and for that reason a permanent establishment had been created in South Africa. The court also reached the conclusion that AB and BD had a fixed base in the boardroom of its client in South Africa, and had therefore established a fixed place of business in South Africa while rendering services to its client in South Africa.

At paragraph 37 of the judgment, the court refers to the interpretation of Articles 5(2)(k) and 5(1) as set out in the Technical Explanation, which document the court viewed as offering an insight into the understanding of the signatories to the DTA, namely South Africa and the United States. It is important to note that the Technical Explanation issued on the South African / United States DTA is not available on the SARS website and can only be located on the website of the Internal Revenue Service. There is no indication in the Technical Explanation itself or in any other documentation that the Technical Explanation has been accepted or adopted by the Commissioner: South African Revenue Service. The introductory paragraph of the Technical Explanation states as follows:

“the Technical Explanation is an official guide to the Convention. It reflects the policies behind particular Convention provisions, as well as understandings reached with respect to the application and interpretation of the Convention.”

The court refers to the fact that the Technical Explanation makes it clear that in considering the furnishing of services by an enterprise as dealt with in Article 5(2)(k) the analysis or interpretation accorded to the place of work set out in Articles 5(2)(a) to 5(2)(f) is not applicable. It indicates further that the Technical Explanation states that “in the case of furnishing of services this does not have to occur within a ‘fixed place of business’ (Article 5(1)). 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.”

It would appear that the court took the view that the Technical Explanation on the DTA under consideration is binding in South Africa, but this does not appear to be the case in other countries. In the Canadian case of Haas Estate v The Queen 1999 53 DTC 1294 Margeson JTCC states at paragraph 30 as follows:

“[30] The Federal Court of Appeal [in Canada (Attorney General) v Kubicek Estate 1997, 51 DTC 5454] observed that:

‘There  is no international tradition or procedure for an exchange of subsequently bargained documents as determinative of treaty interpretation. The Technical Explanation is a domestic American document. True, it is stated to have the endorsation of the Canadian Minister of Finance, but in order to bind Canada it would have to amount to another convention, which it does not. From the Canadian viewpoint, it has about the same status as a Revenue Canada interpretation bulletin, of interest to a Court but not necessarily decisive of an issue.”

It is unfortunate that the court did not deal with the status of the Technical Explanation in South Africa and on what basis the interpretations set out therein should bind the courts of this country. Furthermore, the court did not refer to the rules of interpretation of treaties as set out in the 1969 Vienna Convention on the Law of Treaties. It is clear that the Technical Explanation has not been adopted as part of the DTA concluded with the United States in conformity to the provisions of the Constitution or the provisions of the Income Tax Act itself. The question that does arise is how many similar documents or memoranda of understanding exist between SARS and other revenue authorities insofar as the interpretation of DTA’s are concerned.

In the case of Ben Nevis Holdings (Ltd) and Another v Commissioner for HM Revenue and Customs [2013] EWCA CIV 578, the court there indicated that memoranda of understanding concluded by contracting states may have an important bearing on the position of taxpayers and that it is in interest of fairness to taxpayers that such memoranda of understanding should be readily available to the public.

As indicated above, the Technical Explanation is only available on the website of the Internal Revenue Service and not SARS’ web pages, and if SARS wishes the public of South Africa to be aware of the Technical Explanation, that note should as a minimum be published on the SARS website with a clear indication as to the status that that document has in the law of South Africa.

It must be remembered that Article 5(1) of the DTA, in defining a permanent establishment, refers to a ‘fixed place of business through which the business of an enterprise is wholly or partly carried on’. The court expressed the view that it is not necessary that the non-resident carries out all of its business from the fixed place of business which is established in South Africa. The court reached the conclusion that a permanent establishment is created where AB and BD performs only some of its obligations in terms of a contract concluded with its client, and even if it concluded part of its business from its client’s boardroom.

The court also referred to the manner in which the 2009 assessment should be dealt with. The court accepted that AB and BD did not have a presence in South Africa during any part of the 2009 calendar or fiscal year. The point was made that the amount it earned in 2009 related to a success fee which it received in accordance with the particular clause of the contract concluded with its client. The court reached the view that the success fee constituted deferred income for the February 2007 to May 2008 period and that that was therefore covered by Article 7(1) of the DTA, which provides that the profits of an enterprise made in the state where it held “a permanent establishment shall be taxable in that state if the profit was attributable to that permanent establishment”. The court therefore reached the conclusion that the success fee was directly related to the permanent establishment and was therefore correctly assessed to tax thereon.

In assessing AB and BD to tax in South Africa, SARS levied tax on the fees derived by AB and BD in South Africa, after deducting therefrom attributable expenditure and imposed additional tax of 100% and levied interest on the underpayment of provisional tax in accordance with section 89quat(2) of the Income Tax Act. The court reached the decision that the additional tax was not disproportionately punitive and therefore dismissed the appeal against the additional tax.

Insofar is the imposition of interest is concerned, the court expressed the view that AB and BD should have familiarised itself with the taxation laws of the country within which it conducts its operations, and for that reason it was decided that AB and BD had been negligent in not seeking advice regarding the tax consequences of the contract concluded with its client. The court therefore came to the conclusion that SARS was correct in imposing interest on the underpayment of provisional tax.

Based on the above case, which admittedly deals with the interpretation of articles contained in the SA and USA DTA, it is important that non-residents rendering services to clients in South Africa evaluate whether they will create a permanent establishment in South Africa, thereby triggering income tax on the profit attributable to the services rendered in South Africa.

Furthermore, if the non-resident creates an enterprise as envisaged under the provisions of the VAT Act, it would also be necessary to register for VAT purposes, and charge VAT on the fees received from the resident client and pay that to SARS. Furthermore, where persons from abroad are sent to South Africa to render the services that may, depending on the circumstances and the provisions of the DTA in question, give rise to the non-resident entity being required to register as an employer in South Africa with the obligation to withhold and deduct PAYE from amounts paid to persons sent to South Africa to render services here.

Clearly, any South African tax paid by the non-resident entity, would under the terms of the DTA be recognised as a credit claimable against tax paid in the home jurisdiction of the entity rendering the services in South Africa. Non-resident employees who become liable to tax in South Africa should also be entitled to claim such tax as a credit in their home jurisdiction under the DTA in question.

It is important therefore that non-resident entities rendering services in South Africa carefully consider how to plan and structure their affairs in South Africa, so that they do not fall foul of the provisions of the Income Tax Act read together with any applicable DTA.