Permanent Establishment and ITC 13276

Author: Nico Theron (Tax Consulting South Africa)

Nico Theron looks at the recent judgement of ITC 13276 and its wider implications for Permanent Establishment in relation to the double tax treaty between South African and the United States of America. 

In the recent seminal judgement of ITC 13276, the Tax Court was faced with the daunting task of interpreting the definition of "Permanent Establishment” as contained in the double tax treaty concluded between South Africa and the United States of America ("the treaty”). 

The facts

Briefly, the facts of the case are that employees of a non-resident advisory company ("the appellant”) came to South Africa during 2007 on a rotational basis to provide certain strategic and financial advisory services to a South African-based company. During the 2007 calendar year, employees of the appellant were in South Africa for a period exceeding 183 days while rendering services to the South African based company.

The South African Revenue Service (SARS) assessed the appellant to tax it for each of its 2007-to-2009 years of assessment on the basis that the appellant had a permanent establishment in South Africa as envisaged in the treaty.

The dispute

In arriving at its conclusion that the appellant had a permanent establishment in South Africa, SARS contended that the appellant had satisfied the requirements of paragraph 2(k) of article 5 of the treaty, and that this fact automatically resulted in the appellant having a permanent establishment in South Africa. SARS further contended that, even if the application of article 5(2)(k) alone could not create a permanent establishment, it was the SARS’ view that a permanent establishment will in any event also exist under article 5(1) of the treaty. 

On the other hand, the appellant  contended that article 5(2)(k) of the treaty alone cannot create a permanent establishment. Rather, the appellant contended that article 5(2)(k) of the treaty can only create a permanent establishment if the requirements of article 5(1) of the treaty are also satisfied. In this case the appellant submitted that the requirements thereof were not satisfied. 

The appellant sought to support its arguments by placing reliance on, inter alia, the Organisation For Economic Cooperation and Development’s (OECD) Commentary ("the Commentary”) on the OECD model tax treaty.

The appellant argued that, in terms of the Commentary, article 5(2)(k) of the treaty cannot operate independently from article 5(1) of the treaty as the Commentary quite clearly states that items listed under paragraph 2 of article 5 will only create a permanent establishment if these items "… meet the requirements of paragraph 1.” 

The question before the court

The binary issue that formed the subject matter of the appeal was (a) whether or not sub-paragraph 2(k) of article 5 of the treaty should be interpreted in line with the Commentary, or if some other interpretation should be afforded thereto,; and (b) if sub-paragraph 2(k) does not operate independently from article 5(1), whether a permanent establishment will exist under article 5(1). 

We shall only deal with the court’s decision to question (a) - whether or not sub-paragraph 2(k) of article 5 of the treaty should be interpreted in line with the Commentary on the model tax treaty, or if some other interpretation should be afforded thereto. 

The court’s conclusion

Vally J, in delivering the judgment of the Tax Court, plainly disagreed with the interpretation proffered by the Commentary stating that:"This interpretation, in my view, takes no account of the phrase ‘includes especially’.” Vally J then went on to analyse the term "includes especially” with reference to various authorities and concluded that: 

"It therefore has to be interpreted that the contents of article 5(2)(k) must be read to mean that they  are an integral part of article 5(1). On this analysis, as soon as an enterprise’s activities fall within the ambit of article 5(2)(k) it becomes liable for taxation in the non-resident country. There is no need for a further or separate enquiry as to whether the requirements of article 5(1) have been met. The two articles cannot be read disjunctively. The definition, by virtue of the bridging phrase "includes especially”, is a composite one. This clearly expresses the purpose of the treaty. To break it up and treat the two articles separately would be to ignore the natural and ordinary meaning of the phrase "includes especially”. (Our emphasis). 

While this interpretation stands in direct contrast to the Commentary, Vally J made quick work of finding support for the court’s controversial conclusion. Vally J stated that firstly, there is no counterpart of article 5(2)(k) in the model tax treaty on which the Commentary is based and secondly, the nature of article 5(2)(k) of the treaty is of a different specie to those contained in sub-paragraphs (a) to (f) of paragraph 2 in the model tax treaty. For these reasons, the court found that it cannot simply accept the interpretation proffered by the Commentary in relation to how article 5(2)(k) of the treaty in question should be interpreted.  

The interpretation favoured by the court in casu is that paragraph 5(2)(k) operates independently from article 5(1) of the treaty. Since the appellant satisfied the requirements of article 5(2)(k) in this case, the court found that the appellant had a permanent establishment in South Africa  and was therefore indeed subject to tax on its business profits, attributable to such South African based permanent establishment.  

It would be interesting to know whether or not the SARS, at any point in this dispute, placed reliance on the requirements under section 23 of the Companies Act to register an external company where certain activities are conducted in South Africa for more than 6 months. 

The take away

Arguably, the judgement casts the permanent establishment net wider from a South African tax perspective than what the Commentary may have led some to believe. Where article 5(2) of a treaty between South Africa and another country contains examples not listed in article 5(2) of the model tax treaty and which is of different specie to those listed in the model tax treaty, the impact of ITC13276 should be considered.  

Example of treaties where this may be the case are those concluded between South Africa, and, amongst others:

• Botswana;
• Lesotho;
• Mauritius (the treaty with effect from 28 May 2015);
• Mozambique;
• Namibia;
• Uganda;
• Canada; and
• Italy.

There may very well be various non-resident companies operating in South Africa in such a manner so as to avoid creation of a fixed place of business as required under article 5(1) of the relevant treaty. Following ITC13276, these efforts may have turned out to be futile.  

Depending on how business structures have been set up, non-resident and resident taxpayers will be well advised to reconsider whether or not a permanent establishment may be said to exist following the judgment in ITC 13276. 

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This article first appeared on the September/October 2015 edition on Tax Talk.