Tax Treaty Series

ITQ T-

015

September 27, 2019

Question

ACO is a company which is resident in country A. ACO carries on a dredging business. ACO was interested in bidding for a dredging contract in regard to a harbour in country B. As ACO had no office or employees in country B, ACO engaged a third party consulting firm resident in country B (BCO) to study, and prepare a report on, the density of the sediment in the country B harbour. Based on that report, ACO prepared and submitted its bid (to the harbour authority) for the dredging contract. As ACO’s bid was the lowest price, it won the contract. According to ACO’s budget, it expected to derive a small profit from the project.

The performance of the dredging contract was expected to take 3 months. ACO identified a team of senior, skilled employees in its country A headquarters to lead the dredging project “on the ground” in country B. Those employees relocated to country B for the duration of the contract. Those employees hired additional employees in country B to supplement the project team. The necessary dredging equipment was hired (by the relocated employees in country B) from third party providers in country B.

After the dredging work commenced, it became obvious that the BCO report was deficient in many respects. The report grossly underestimated the density of sediment in the harbour. As a result, ACO was required to perform a significant amount of additional work to complete the contract. It took 2 years for the work to be completed. Instead of achieving the budgeted profit, the dredging contract caused ACO to suffer a significant loss (due to unbudgeted salaries and hiring charges, and penalties levied by the harbour authority in accordance with the contract).

ACO could not seek redress from BCO, as BCO had become insolvent, and its directors and employees could not be found.

What will be ACO’s tax treatment in countries A and B, under the A/B treaty (which is identical to the 2014 OECD model treaty, with Art. 23A)?

Answer

B tax :

ACO has a PE in B, at the dredging site in the harbour: Art. 5(1) & (3), A/B treaty.
B is permitted to tax the profits attributable to ACO’s PE: Art. 7(1).
Determining the profits attributable to ACO’s PE (in accordance with 2010 OECD Art. 7 report):
1. Merely because ACO has derived a global loss on the contract does not mean that a profit cannot be attributable to the PE.
2. The PE and HQ are assumed to be separate and independent enterprises: Art. 7(2).
3. Functions allocated to HQ: decision-making in regard to the bid.
4. Functions allocated to PE: recruitment of B employees, hiring of equipment, and performance of dredging contract.
5. Significant risks allocated to HQ: risk involved in engaging BCO for report on sediment, risk in bidding too low.
6. Significant risks allocated to PE: risk in performing contract in inefficient manner.
7. Significant assets allocated to HQ: technical knowhow in regard to bidding for contract, technical knowhow / skills of HQ employees relocated to B.
8. Significant assets allocated to PE: technical knowhow / skills of PE employees who were relocated from HQ.
9. A likely characterisation of the PE is a service provider, due to the fact that its role was limited to performing a contract which was won by the HQ.
10. The key issue to determine is to what extent the loss incurred on the contract was due to the low bid price (which, in turn, was caused by the incorrect report from BCO), or alternatively was due to the inefficient performance of the contract by the PE employees.
11. If it is clear that the loss was wholly or substantially due to the low bid price, then (to that extent) the loss should be allocated to the HQ. That would mean that a profit should be attributed to the PE, to reward it for the efficient performance of the contract (within the context of a low bid price).

A tax :

If a profit is attributed to the PE, that profit should be exempt from B tax: Art. 23A(1).

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