OECD issues welcome guidance on tax treaty issues arising from the COVID‑19 crisis

Jian Cheng Ku

Gabriel van Gelder

Mehdi el Manouzi

DLA Piper

By Jian‑Cheng Ku, Gabriël van Gelder, & Mehdi el Manouzi, DLA Piper Nederland N.V., Amsterdam

On 3 April, the OECD released guidance addressing how governments should apply standard tax treaty provisions when multinational group taxpayers or their employees are forced to change their behavior to comply with coronavirus (COVID‑19) travel restrictions and quarantines.

In the fight to control the spread of the COVID‑19 pandemic, governments have implemented unprecedented measures such as travel restrictions, banning of public gatherings, and quarantine rules. These measures are severely limiting the mobility of workers and could have significant adverse tax consequences in cross‑border situations.

For example, if companies can not hold board meetings due to travel restrictions, this could change the location of a company’s place of effective management and therefore result in a change in the company’s residency under relevant domestic tax laws and for tax treaty purposes. Please see our earlier MNE Tax article addressing tax issues relating to the change of domestic residency from a Dutch tax perspective.

Furthermore, individuals that live in one country but work in another country may be unable to physically perform their duties in their country of employment. This may change the tax treatment under the applicable treaty due if, for example, the number of days that a worker may work outside the country of employment is reduced.

The OECD report tries to address the many tax issues arising from the COVID‑19 crisis and provides recommendations for countries that can be taken into account when applying their tax treaties.

The report is based on a careful analysis of the international tax treaty rules, and it addresses concerns about the following issues: creation of permanent establishments, residence status of a company (place of effective management), cross‑border workers, and residence status of individuals.

Creation of permanent establishments

Tax treaties operate to qualify one state as the residence state of the taxpayer and the other state as the source state (where the income has arisen) and then allocate taxing rights between the residence and source states.

The most common type of source income is from trade or business activities conducted by a nonresident within the source country.

The trade or business activities in the source country should exceed a minimum threshold of (physical) presence for the source country to have a taxing right under international tax law. Under the OECD Model Tax Convention on Income and on Capital 2017 (OECD Model), exceeding this threshold leads to what is called a permanent establishment.

To qualify as a permanent establishment, certain conditions must be met with respect to the activities in the source state.

It follows from the OECD Commentary on Article 5 of the OECD Model that the main requirement for a permanent establishment is the existence of a “place of business,” i.e., a facility such as premises or, in certain instances, machinery, or equipment.

This place of business must be “fixed,” i.e., it must be established at a distinct place with a certain degree of permanence. Also, the carrying on of the business of the enterprise must be accomplished through this fixed place of business. This usually means that persons who, in one way or another, are dependent on the enterprise (personnel) conduct the business of the enterprise in the state in which the fixed place is situated.

As cross‑border employees are restricted from leaving their country of residency due to the COVID-19 emergency and may have to continue their work from home, their activities may be sufficiently substantial to create a taxable presence in their state of residence, in the form of a permanent establishment.

The OECD report states that a taxable presence in the form of a permanent establishment requires the permanent establishment to have a certain degree of permanency (part of the condition of fixedness) and to be at the disposal (part of the condition of place of business) of the enterprise.

Referring to the OECD Commentary (paragraph 18 of the Commentary on Article 5 of the OECD Model), the OECD report states that even though an enterprise may carry out part of its business at a location, such as an employee’s home office, that alone should not lead to the conclusion that the location is at the disposal of that enterprise.

Referring to the OECD Commentary (paragraph 18 of the Commentary on Article 5 of the OECD Model), the OECD report states that even though an enterprise may carry out part of its business at a location, such as an employee’s home office, that alone should not lead to the conclusion that the location is at the disposal of that enterprise.

A final argument the report presents is that the employee that works from home does so as a result of government instructions and not the enterprise’s instructions, and thus no permanent establishment is created by the COVID‑19 measures.

The report concludes that the exceptional and temporary change of the location, where employees physically exercise their employment resulting from the COVID‑19 measures, should not lead to the creation of new permanent establishments for the enterprise.

Source countries also have a taxing right under international tax rules if a person acting for the enterprise has the authority to conclude contracts in the name or on behalf of the enterprise and the person uses this authority habitually and not merely in isolated cases (agency permanent establishment).

With respect to a permanent establishment in the form of a dependent agent (agency permanent establishment), the report refers to the OECD Commentary on Article 5 of the OECD Model, which states that the presence of an enterprise in a country should be more than merely transitory. The OECD comments that exercising the authority to conclude contracts might not be habitual considering the short period of the current COVID‑19 crisis.

Source countries also have taxing rights if a permanent establishment is present within their borders in the form of a building site, construction, or installation project that lasts more than 12 months (6 months under the United Nations Model Double Taxation Convention 2017).

The report refers to the OECD Commentary (paragraph 55 of the Commentary on Article 5 of the OECD Model), which explains that a construction site should not be regarded as ceasing to exist when work is temporarily discontinued. The OECD concludes that the duration of interruptions should be taken into account when assessing the threshold period of 12 months.

Residence status of a company (place of effective management)

Article 4 of the OECD Model defines a resident for tax treaty purposes and, therewith, the state of residency for the allocation rules.

Companies are considered to be a resident of a treaty state if a company is taxed by that treaty state on the basis of domicile, residence, place of effective management, or any other criterion of similar nature. Furthermore, if a taxpayer is considered to be a tax resident of more than one jurisdiction, tax residency for treaty purposes is determined on the basis of the effective place of management under the corporate tie‑breaker rule contained in most tax treaties, or for tax treaties that are covered under the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), on the basis of a mutual agreement procedure between the competent authorities.

COVID‑19 measures could potentially lead to a change in the place of effective management of a company as a result of travel restrictions imposed on the board directors. A change of tax residency could affect the place a company is regarded to be resident for domestic tax purposes and/or tax treaty purposes.

The OECD report states that the treaty tie-breaker rule should ensure that a company is resident in only one of the treaty states if issues may occur regarding dual residency.

Reference is made to the tie-breaker rule, as included in the OECD Model 2017, where the competent authorities enter into a mutual agreement procedure and deal with the dual residency issue on a case‑by‑case basis, where all the facts and circumstances should be taken into account.

The report takes the position that it is unlikely that the COVID‑19 crisis will create any changes to an entity’s residence status under a tax treaty considering the temporary change in location of one or more board directors and the extraordinary and temporary nature of the situation.

Cross‑border workers

International tax law allocates the right to tax income from cross‑border employment between the employee’s state of residence and the state in which he or she physically works.

The OECD Model stipulates that income derived from employment is taxable in the person’s state of residence unless the employment is (physically) exercised in the other state.

Under the place of exercise test, the country of employment may exercise a taxing right if the employee is present for more than 183 days (within a period of 12 months), the employer is a resident of the source state, or the employer has a permanent establishment in the source state that bears the remuneration.

Under the current circumstances, cross‑border workers may be unable to physically perform their duties in their country of employment, which may lead to a different tax treatment (status) under the applicable tax treaty due to not meeting the number of days that a worker may work outside the country of employment.

The OECD report identifies these tax issues but does not give recommendations on how countries should cope with them. The OECD mentions that it is working to help countries mitigate the unplanned tax implications and potential new burdens arising from the COVID‑19 crisis.

The OECD report identifies these tax issues but does not give recommendations on how countries should cope with them. The OECD mentions that it is working to help countries mitigate the unplanned tax implications and potential new burdens arising from the COVID‑19 crisis.

The report also addresses the issue of how income that workers receive under government schemes as compensation for an enterprise’s inability to pay salaries should be treated under tax treaties.

The report states that these payments most closely resemble termination payments and, therefore, should be attributable to the place where the employee would otherwise have worked before the COVID‑19 crisis.

Residence status of individuals

With respect to a change of an individual’s tax treaty residence position, the OECD report gives some concrete examples of issues arising from double residency.

The report states that the current tie-breaker test, which consists of a hierarchy of tests, should be sufficient to determine the treaty residence of an individual. The report concludes that it is unlikely that the COVID‑19 crisis will affect the tax treaty residence position of individuals.

Mutual agreements

Some jurisdictions have taken swift action in an early stage to tackle cross‑border tax issues for workers that cannot physically perform their duties in the country of employment.

The Netherlands and Germany have concluded a mutual agreement, with respect to the interpretation and application of the treaty provision on income from employment, the days that an employee physically works from home due to the COVID‑19 crisis are deemed to be days of work spent in the state of employment.

Furthermore, Belgium and Germany have likewise agreed to lenient rules for taxing cross-border workers

Moreover, Luxembourg, France, Belgium, and Germany have communicated that they expect to conclude more mutual agreements to mitigate adverse tax consequences for cross-border workers.

Our assessment

The OECD recommendations are very welcome and provide practical guidance on how to handle tax issues arising from the COVID‑19 crisis when applying tax treaties.

However, although the OECD guidance states that it is “based on a careful analysis of the international tax treaty rules,” the legal status of the report is most likely limited. Therefore, taxpayers should not expect to obtain legal certainty from this report.

Considering that the current Commentary on the OECD Model provides little guidance on the tax implications of exceptional circumstances, like force majeure, we expect that the OECD will take the new guidance into account for their next update of the OECD Commentary.

Next steps

We expect governments to shortly publish their assessment of the OECD guidance, including whether they will apply the guidance when interpreting their tax treaties.