COVID-19 and tax treaties: the updated OECD guidance

By Parwin Dina, Lead Client Service Partner and Global Tax Leader, GTS (Global Tax Services), UAE

The rapid spread of the COVID-19 pandemic has dramatically affected how businesses are conducted. For example, many more people work now from home.

The new situation has created questions about the application of the existing tax treaty rules. For example, new taxing rights over an employee’s income may arise in a jurisdiction if an employee changes work location because of the COVID-19 restrictions.

The OECD Secretariat initially issued guidance in April 2020 on applying international tax treaty rules in circumstances where cross-border workers or individuals were stranded in a jurisdiction that was not their jurisdiction of residence as a result of this pandemic. T

This guidance was updated on 21 January. It appears that the goal of the updated guidance is to suggest ways that governments can best address these tax treaty issues through legislation, regulations, guidance, and best practices.

The creation of permanent establishments

The updated OECD guidance notes that when employees are relocated to jurisdictions other than those they regularly work in because of the COVID-19 pandemic, this could create “permanent establishments” in those jurisdictions for tax treaty purposes under existing rules.

The types of permanent establishments that can be created are fixed (where the home office may be seen as a fixed place of business), agency, and construction permanent establishments. All could lead businesses to have new filing requirements and tax obligations.

A number of tax authorities have issued guidance on whether changes in work practices prompted by the COVID-19 pandemic can result in the creation of a permanent establishment. Such guidance seems to have provided greater certainty to businesses.

A fixed permanent establishment

In determining the existence of a permanent establishment, we would generally look at the facts and circumstances. Typically, a place must be permanent and be at the disposal of an enterprise for that place to be considered a fixed place of business through which the business of that enterprise is wholly or partly carried on, the updated OECD guidance states.

Under Paragraph 18 of the Commentary on Article 5 of the OECD Model Tax Convention on Income and on Capital (OECD Model), even though part of the business of an enterprise may be carried on at a location, such as an individual’s home office, that should not lead to the conclusion that that location is at the disposal of that enterprise simply because an individual uses that location (e.g., an employee) who works for the enterprise.

The question arises as to whether carrying on intermittent business activities at the home of an employee makes that home a place at the enterprise’s disposal, the updated OECD guidance notes.

A home office may be a permanent establishment of an enterprise if used continuously for carrying on a business of that enterprise. The enterprise generally must require the individual to use that location to carry on the enterprise’s business, the updated OECD guidance notes.

If an individual continues to work from home after the cessation of the public health measures imposed or recommended by the government, the home office may be considered to have a certain degree of permanence.

However, that change alone will not necessarily result in the home office giving rise to a fixed place of business permanent establishment, the OECD updated guidance observes. A further examination of the facts and circumstances will be required to determine whether the home office is now at the disposal of the enterprise following this permanent change to the individual’s working arrangements.

Under Paragraphs 18 and 19 of the Commentary on Article 5 of the OECD Model, whether the enterprise requires an individual to work from home or not is an important factor in determining whether a home office is considered to be at the disposal of the enterprise.

As an example, Paragraph 19 of the OECD Commentary notes that where a cross-border worker performs most of their work from their home situated in one jurisdiction rather than from the office made available to them in the other jurisdiction, one should not consider that the home is at the disposal of the enterprise because the enterprise did not require that the home be used for its business activities.

Individuals teleworking from home (i.e., the home office) as a public health measure imposed or recommended by at least one of the jurisdictions’ governments to prevent the spread of the COVID-19 virus would not create a fixed place of business permanent establishment for the business/employer, the OECD guidance observes.

Agency permanent establishment

Under Article 5(5) of the OECD Model, a dependent agent’s activities, such as those of an employee, will create a dependent agent permanent establishment for an enterprise if the employee habitually concludes contracts on behalf of the enterprise establishment. Here the concern is whether the activities of an individual temporarily working from home for a non-resident employer could give rise to a dependent agent permanent establishment.

Thus, to apply Article 5(5) in these circumstances, it is important to evaluate whether the employee performs these activities in a “habitual” way.

As a result of an extraordinary event or public health measures imposed or recommended by the government, an employee’s or agent’s activity in a jurisdiction is unlikely to be regarded as habitual, the updated OECD guidance observes.

We note that in Paragraph 6 of the 2014 Commentary on Article 5, a permanent establishment should be considered to exist only where the relevant activities have a certain degree of permanency and are not purely temporary or transitory.

Paragraph 98 of the 2017 OECD Commentary on Article 5 explains that an enterprise’s presence in a jurisdiction should be more than merely transitory if the enterprise is to be regarded as maintaining a permanent establishment in that jurisdiction under Article 5(5).

If the employee continues to work from home for a non-resident employer after the COVID-19 pandemic, on a habitual basis and continues to conclude contracts on behalf of the enterprise, it would be more likely that the employee would be considered to habitually conclude contracts on behalf of the enterprise, the updated OECD guidance explains.

In accordance with the Commentary on Article 5 of the OECD Model, the extent and frequency of activity necessary to treat an agent as acting “habitually” depends on the nature of the contracts and the business of the enterprise.

Therefore, the agent’s activity in a jurisdiction should not be regarded as “habitual” if they have exceptionally begun working at home in that jurisdiction as a public health measure imposed or recommended by at least one of the governments of the jurisdictions involved to prevent the spread of the COVID-19 virus and, therefore, would not constitute a dependent agent permanent establishment, the updated OECD guidance concludes.

Construction site permanent establishment

In general, a construction site will constitute a permanent establishment if it lasts more than 12 months under the OECD Model or more than six months under the UN Model.

The question that arises for a construction permanent establishment in the context of COVID-19 is whether it would cease to exist when work on the site is temporarily interrupted. Examples of temporary interruptions given in the OECD Commentary are interruptions caused by bad weather, a shortage of material, or labour difficulties.

We find that many activities on construction sites are temporarily interrupted by the COVID-19 pandemic. In accordance with Paragraph 55 of the Commentary on Article 5(3) of the OECD Model, the duration of such an interruption of activities should be included in determining a site’s life and, therefore, will affect the determination of whether a construction site constitutes a permanent establishment.

A construction site permanent establishment would not be regarded as ceasing to exist when work on the site is “temporarily” interrupted concludes the updated OECD guidance. However, in light of the extraordinary circumstances of the COVID-19 pandemic and based on the facts and circumstances, operations prevented as a public health measure constitute a type of interruption that should be excluded from the calculation of time thresholds for construction site permanent establishments, the updated OECD guidance states.

Potential change of the residence of a company

Another question concerns the company’s residence under the relevant domestic laws, which could affect its residency for tax treaty purposes as a result of the COVID-19 pandemic. There could be a potential change in the “place of effective management” of a company due to relocation, or inability to travel, of board members or other senior executives.

A change in board members’ location should not lead to a shift in treaty residence because the COVID-19 pandemic is an extraordinary and temporary situation, the updated OECD guidance states.

A number of jurisdictions have issued guidance on whether temporary changes in work and company management practices prompted by the COVID-19 pandemic can trigger an issue of dual residence (in cases where the change in the place of effective management results in a company being considered a resident of two jurisdictions simultaneously under their domestic laws).

Even if there are cases of dual residence of an entity, tax treaties provide tiebreaker rules ensuring that the entity is resident in only one jurisdiction.

Some treaties contain tiebreaker clauses similar 2017 OECD Model tiebreaker rule, whilst others have provisions pre 2017 OECD Model tiebreaker rule. It is also expected that competent authorities will deal with the dual residence issue on a case-by-case basis by mutual agreement.

For tax treaties based on the 2017 OECD Model, the updated OECD guidance illustrates the range of factors that the competent authorities are expected to consider in order to make their determination.

These factors include where the meetings of the company’s board of directors or equivalent body are usually held; where the chief executive officer and other senior executives usually carry on their activities; where the senior day-to-day management of the company is carried on; where the person’s headquarters are located; etc.

Where the treaty contains the pre-2017 OECD Model tiebreaker rule, the place of effective management seems to be the only criterion used to determine the residence of a dual-resident entity for tax treaty purposes.

According to the Commentary on Article 4 of the 2014 OECD Model, the place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity’s business as a whole are in substance made.

Some jurisdictions interpreted the concept of “place of effective management” as being ordinarily the place where the most senior person or group of persons (for example, a board of directors) made the key management and commercial decisions necessary for the conduct of the company’s business.

All relevant facts and circumstances should be examined to determine the “usual” and “ordinary” place of effective management, and not only those that pertain to an exceptional period such as the COVID-19 pandemic.

An entity’s place of residence under the tax treaty tiebreaker provision is unlikely to be affected by the fact that the individuals participating in the management and decision-making of an entity cannot travel as a public health measure, the updated OECD guidance concludes.

A change to the residence status of individuals

When it comes to determining the change to individuals’ residence status, the rules can become quite complex.

The important question here is whether tax administrations and competent authorities must consider a period where public health measures imposed apply when assessing a person’s residence status.

For the purpose of a tax treaty – which governs the allocation of taxing rights over employment income – an individual can be resident of only one jurisdiction at a time (their “treaty residence”). 

The first starting point is to look at the domestic law. If the person is resident in only one jurisdiction, no further analysis is required. If he is resident in both jurisdictions being tested, the tiebreaker rules in Article 4 of the OECD Model are applied.

There is a hierarchy of tests, starting with the question in which jurisdiction does the person have a permanent home available to him.

The updated OECD guidance looks at two scenarios: Scenario 1, where a person is temporarily away from his home (for example, to work for a few weeks) and gets stranded in the host jurisdiction because of the COVID-19 pandemic and attains domestic law residence there.

In Scenario 2, a person is working in his current home jurisdiction and has acquired residence status there, but he temporarily returns to his previous home jurisdiction because of the COVID-19 situation. He may never have lost his status as a resident of his previous home jurisdiction under its domestic legislation, or he may regain residence status on his return.

Under Scenario 1, the question that arises is whether residence status can be acquired in the jurisdiction where the person is temporarily present because of extraordinary circumstances.

There are, however, domestic rules causing a person to become a resident if he is present in the jurisdiction for a certain number of days. But even if the person becomes a resident under such rules, if a tax treaty is applicable, the person is unlikely to be a resident of that jurisdiction under the treaty’s tiebreaker rule. Such a temporary dislocation should therefore have no tax implications in the vast majority of cases, the updated OECD guidance states.

In Scenario 2, the question is whether the person would regain residence status for being temporarily and exceptionally in the previous home jurisdiction. But even if the person is or becomes a resident under such rules, if a tax treaty is applicable, the person is unlikely to become a resident of that jurisdiction under the tax treaty. This is because the person’s connections to the current home jurisdiction are stronger than those to the previous home jurisdiction. Here, although the same treaty rules apply as the first scenario, the criteria in the second scenario determines the habitual abode of the person. “Habitual abode” refers to the frequency, duration, and regularity of stays that are part of the settled routine of an individual’s life.

Generally, the habitual abode of a person is where he is customarily or usually present; the test will not be satisfied by simply determining which of the two contracting jurisdictions the individual has spent more days during that period.

The mere dislocation because a person cannot travel back to their home jurisdiction due to a public health measure involved, should not by itself impact the person’s residence status for purposes of the tax treaty, the updated OECD guidance concludes.

Income from employment

The rules for income from employment are found in Article 15 (Income from employment) of the OECD Model. which governs the distribution of the right to tax between the employee’s jurisdiction of residence and the place where the employment is performed.

The starting point for Article 15 of the OECD Model is that “salaries, wages and other similar remuneration” are taxable only in the person’s jurisdiction of residence unless the “employment is exercised” in the other jurisdiction.

The other jurisdiction (the source jurisdiction) may exercise a taxing right only if the employee is there for more than 183 days. In this case, we would expect that where the source jurisdiction has a taxing right, the residence jurisdiction must relieve double taxation under Article 23 of the OECD Model, either by exempting the income or taxing it and providing a credit for the source jurisdiction tax.

The updated OECD guidance discusses the application of Article 15 to two situations including amongst others, the treatment of wage subsidies to employers for payment to their employees and the case where stranded workers exceed the 183 day-test.

Treatment of wage subsidies to employers to pay for their employees

There are many jurisdictions where governments have stepped in to subsidise for keeping an employee on a company’s payroll during the COVID-19 pandemic despite being unable to work, the updated OECD guidance notes.

The employee’s income from the employer, which is in the form of government subsidy, should be attributable to the place where the employment used to be exercised, the updated OECD guidance concludes.

Stranded workers

The updated OECD guidance mentions two situations whereby individuals who are resident in one jurisdiction and employed in another to become stranded in that other jurisdiction as a result of the pandemic.

First, the employee could be prevented from leaving that other jurisdiction by COVID-19 restrictions. Second, the employee could leave the other jurisdiction and qualify for the exemption from source taxation in Article 15(2).

The question that arises is whether, given the exceptional circumstances, one should disregard days under the above-mentioned situations when asserting a taxing right under the 183-day test.

Paragraph 5 of the Commentary on Article 15 explains that all days of presence count (working days or not) and provides several examples, one of which is “days of sickness.” But this paragraph contains an exception: if those days of sickness “prevent the individual from leaving, they do not count towards the days of presence test.

The updated OECD further explains that the exception may cover situations where employees are prevented from traveling because they are in quarantine due to exposure to the COVID-19 virus, where the government has banned traveling, and where it is, in practice, impossible to travel due, for example, the cancellation of flights.

The updated OECD guidance concludes that, if an employee is prevented from traveling because of COVID-19 public health measures and remains in a jurisdiction, the additional days spent in that jurisdiction could be disregarded for purposes of the 183-day test in Article 15(2)(a) of the OECD Model,

The consequence for disregarding days spent in a source jurisdiction due to COVID-19 restrictions may result in the source jurisdiction not exercising taxing rights allocated to it under the terms of a double tax treaty.

Hence, it is in the interest of businesses to check with their local tax authority to determine whether t to disregard the additional days spent in the jurisdiction for purposes of the 183-day test, the updated OECD guidance notes.

–Parwin Dina is Lead Client Service Partner and Global Tax Leader, GTS (Global Tax Services), UAE.