Dependent agent and a permanent establishment of the represented entity

9. September 2019

If a foreign company is using an entity on our market, which mediates sale of products of this foreign company directly to clients in the Czech Republic (CR), a permanent establishment of this foreign company may be formed in CR, or rather a duty may emerge to submit income tax return and to tax a part of its worldwide income here. The tax consequences are influenced by specific activities performed by the entity in CR and the conditions set up for cooperation. Practice tends to be very rich in this respect. From mere promotion and marketing events, to product trainings and to negotiations of conditions of sale, entering into contract, accepting orders, solving unpaid invoices etc. The entity may be a person (such as an entrepreneur (self-employed), an employee) or a legal entity, and it may engage in activities actively for several clients or only work for one and be forbidden to enter into competition.

In this article, we would like to briefly point out the conditions of creating a permanent establishment on grounds of a dependent agent (the so-called “agency” permanent establishment), a recent judgment of the Supreme Administrative Court (SAC) in this matter and the expected development. Although in some situations, a permanent establishment may be created on other grounds, in this article we will only focus on the agency permanent establishment. In case of a specific situation, we always recommend discussing it with an expert.

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The current version of the Czech Income Tax Act

According to article 22 of the Income Tax Act, a permanent establishment arises in CR for a tax non-resident, if an entity is authorised and usually uses the authorisation to enter into contracts here that are binding for this non-resident, acts on his behalf in CR. A permanent establishment then emerges for all activities, which the entity performs for the taxpayer on the territory of the Czech Republic.

The definition in the law is a relatively broad one. It covers not only situations of a representative, who arranges sale for a tax non-resident, but also the situation of purchase. It covers the situation of a dependent as well as an independent agent. Unlike the treaty for avoidance of double taxation, see further.

In practice, the treaty for avoidance of double taxation still has a say in the creation of a permanent establishment, giving the tax non-resident an option to achieve a more favourable tax regime. What does the treaty say, then?

Treaty for avoidance of double taxation (DTT)

The regime in a DTT depends on the particular definition. Most treaties CR has entered into are based on the definition of an agency permanent establishment from the Model Double Taxation Convention in its version valid until the most recent update in the year 2017. This most recent update has significantly broadened the definition following a recommendation under Action 7 from the Base Erosion and Profit Shifting (BEPS) project of fight against tax evasions at OECD. This broadened definition will not have much effect on practice, though, for the time being, because within the Multilateral Convention to Implement Tax Treaty (MLI), CR has only committed to the minimal standards. We will not come across the new definition, unless a bilateral protocol is negotiated, which will change the respective treaty, or unless a new treaty including the new definition is negotiated.

According to the model convention of the OECD valid until 2017, an agency permanent establishment of a company from the other Contracting State is established, if an entity – other than an independent agent – acts on behalf of this company from the other Contracting State and is authorised and usually uses the authorisation to enter into contracts on behalf of this company. In such a case, this company has a permanent establishment on the territory of CR in relation to all activities, which this entity performs for the company, unless the activities of this entity are not limited to activities belonging to an exception from a permanent establishment. The model convention also rules out creation of a permanent establishment at an independent agent. This is because the company is not deemed to have a permanent establishment in the Contracting State only because it performs its activity via a broker, general commission agent or any other independent representative, if these persons are acting within the scope of their regular activity.

As we have already mentioned, the DTT excludes creation of a permanent establishment, if the activities of the agent are limited to activities belonging to an exception from creation of the permanent establishment. These typically include preparatory and auxiliary activities with regard to the main activity of the company, i.e. purchase, marketing and promotion, and also in case when the agent has the status of an independent agent. An agency permanent establishment then arises in case the agent is independent and at the same time he is authorised and usually uses the authorisation to enter into contracts on behalf of the represented entity.

When an agent is an independent one is specified in greater detail in the Commentary to the Model Double Taxation Convention. Evaluation always depends on the conditions and circumstances of a specific case. An entity will be independent, if it is independent of the represented entity both legally and economically, and when acting on behalf of the represented entity, it is acting within its regular activity. Whether or not an entity is independent depends on the scope of obligations the entity has in relation to the represented entity. If the business activities of the agent performed for the represented entity are subject to detailed instruction and wide control on the part of the represented entity, the agent cannot be considered as an independent one. Another question is the distribution of business risk, the number of represented entities, a non-competition clause etc. An agent cannot be considered as an entity acting within its regular activity, if performing activities in the place of the represented entity, which from the economic perspective belong to the scope of activity of the represented entity rather than the agent's own business activity. When assessing the question if certain activities represent common activities of an agent or not, the business activities usually performed within the activity of an agent as a broker, commission agent or another independent representative should be examined.

The treaty further stipulates as a condition for the creation of an agency permanent establishment that the agent is authorised and usually uses the authorisation to enter into contracts on behalf of the company (the represented entity). In case of an explicit power of attorney or signing of contracts with clients, there will probably be no doubt about the existence of this authorisation. In this context, the Commentary explicitly mentions that the person, which is authorised to negotiate about all elements and details of a contract in a way binding for the company, may be considered a person applying this authorisation “in this state”, even if the contract is signed by a different person in the country, in which the company is located, or if the first person is not formally authorised to present the given company. As well according to the Commentary, a representative can be considered as an agent with an actual authorisation to negotiate contracts in cases, when he receives and accepts orders (despite not formally completing them), which are being sent directly to a warehouse, from which goods are supplied, and when the foreign company approves transactions in a routine way.

A recent judgment of the SAC in the matter of an independent agent

In a recent dispute, the case of a local company was handled, which was fully owned by German partners, and due to the place of actual management being in Germany it was a German tax resident. The company therefore taxed its worldwide income in Germany, in compliance with the valid DTT. The object of its business was the sale of work clothing and equipment in CR. This company had no employees in CR, but had office premises permanently available here as part of “corporate service”, which another local company provided to it as part of its services for foreign entities (virtual office address rental, the option of office or meeting room rental and administrative services). The company also used the services of a client service from a professional call centre, which handled requests from potential clients and clients, who called the telephone numbers published on its website.  The call centre passively accepted orders from clients and entered them in the information system of the company. The call centre did not have any option to influence or negotiate about elements and details of contracts with the clients, nor did it have any authorisation to decide about non/acceptance of an order from a client. The call centre only recorded complaints, but did not handle them. Orders (supplies) were being sent directly from Germany, and any potential exchange of goods or complaints also took place directly from Germany. The question was, if this local company with German tax residency (i.e. it taxed its worldwide revenues in Germany) has created a permanent establishment in CR (on grounds of which it should then tax the income attributable to this permanent establishment in CR). The tax authority stated that the call centre is a dependent agent, due to the fact that it deals with complaints for the company in CR and returned goods are sent to its address in CR by clients, among other things. And further also due to the fact that the company is a significant and substantial purchaser of services for the call centre and other activity of the call centre was negligible. Based on this, the regional court decided that the company has a permanent establishment in CR on grounds of a dependent agent via the call centre (contracts of purchase for the sale of work clothing were made in CR via the centre).

The Supreme Administrative Court (SAC) noted that in some respects, the regional court decided  incorrectly and did not sufficiently evaluate the content of the administrative file, and disagrees with the opinion of the financial directorate that the call centre can be considered as dependent agent of the company, but its activity rather qualifies as an activity of an independent agent, because the activities the call centre provides to the company in CR are mainly of administrative nature and due to the fact that the company has no employees in CR and the employees of the call centre speak Czech, this language skill can be considered a special skill/ knowledge of the agent, which supports the conclusion of its independence in the sense of the Commentary to the Model Double Taxation Convention. Another fact in favour of independence was the fact that the call centre had a number of other large clients in CR. The activity of the call centre was more of an administrative nature, when decisions about accepting an order and its realisation were performed in Germany. The SAC thus cancelled the judgment of the regional court as well as the decision of the tax administrator and returned the matter to the tax administrator for further proceedings, and the tax administrator must abide by the legal judgment of the SAC.

According to the opinion of the SAC, the agent was independent in this case and his authorisation to enter into contracts (reception of orders) was largely unproven. What is very important from the judgment for practice, though, is that in its reasoning, the SAC drew significantly on the Commentary to the model convention of the OECD, whereby it significantly increases legal certainty and has increased application of the Commentary in practice.

New development – BEPS

The current rules for creation of a permanent establishment are certain to change over time. The OECD BEPS project recommended in Action 7 to broaden the definition of a permanent establishment of a dependent representative. A permanent establishment will thus not only be created in case a dependent representatives enters into contracts on behalf of the company (the represented), but it will also be created in situations, when the agent usually plays the main role leading to the making of contracts, which are then ordinarily made without any significant adjustment by the company. The aim of this change was to handle the bypassing of creating a permanent establishment by means of using commission agents or similar structures. The changes have also very much narrowed down the situations, when an agent will be considered “independent”. An independent position is less likely if the agent negotiates exclusively or almost exclusively for one of more closely related companies. Exceptions from the definition of a permanent establishment are also being reduced (there is no more dispute that all exceptions must be of preparatory and auxiliary nature from the perspective of the main activity of the taxpayer, including purchase, maintaining stocks of goods etc.) and rules against artificial fragmentation of activities for avoiding a permanent establishment or reduction of allocated profit by using for example exceptions from a permanent establishment.

These changes do not apply in CR, though. They will only apply, if a change occurs in one of the current treaties (such as renegotiation or a new DTT) or in case of a change of the position of CR within the MLI from its current minimalist version in the case of articles relating to permanent establishments.

Take-away

Although the effects of the change of definition of an agency permanent establishment from the BEPS project are not topical in CR, even the current definition already covers a number of cases, when a permanent establishment may be formed. With regard to changes in the Commentary to the model convention and outputs from the BEPS project, we recommend focusing on the form of organisation of sale on our market and its tax maintainability. Special caution suggests itself in situations, when a foreign company has employees in CR or a contractor, who is in charge of providing sale and market development. Location of the warehouse and the form of its control may intensify the risks further. Setting up a suitable way of allocating income in a potential permanent establishment and administration of the tax obligations need not be a nightmare if handled by an expert. In case you have any doubts regarding the tax setup of your system of sale or our article has caught your attention, we will be happy if you contact us.

Štěpán Osička & Daniela Riegel

In case of queries, please contact us

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