Short-term assignments, hiring-out of labour and the OECD Model

Not so long ago, I was introduced to an expression that I came to associate with abuse, employment income and tax treaties. The expression is "international hiring-out of labour" and I have to admit it was fairly unknown to me (as many other things) before I studied in Leiden.

The use of such expression in the field of tax treaties dates back to 1985, when the OECD issued a report addressing the treaty problems of arrangements of hiring out labour. Basically those arrangements consist on a local employer wishing to use short-term foreign labour and avoid taxation of employment income in his state by recruiting the labour force through an intermediary (lessor) established abroad. The relationship is characterized by the fact that, although there is a contract of employment between the lessor and the employee and a special contract between the lessor and the lessee (local employer), no contract exists between the employee and the lessee.

In terms of tax, a problem started to arise in cases of international hiring-out of labour. Since the right of the state of the temporary employment to tax employment income was limited by the provisions and conditions of Art. 15, the tax administrations were not happy to notice that non-resident labour was easily entering their boundaries and as easily avoiding source country taxation.

As a possible contribution to solving problems of abuse, the 1985 OECD report suggested interpreting the notion of employer through a factual analysis for treaty purposes of the employment relationship. In fact, as part of the 1992 update to the OECD Model, the Commentary was amended to clarify situations covered by the exception Art. 15(2). In particular, the concept of material employer in hiring-our of labour situations and the formal criteria for a substance over form approach were inserted in paragraph 8 of the OECD Commentary.

Nevertheless, experience demonstrated that applying the criteria mentioned in paragraph 8 of the OECD Commentary only to abusive cases was a difficult task and that its practical application could easily target bona fide companies and employees. Recognizing the difficulty in certain cases of establishing which enterprise is the employer, the OECD initiated a revision of the Commentary to address this particular problems.

This introduction serves to make the bridge with the OECD most recent public discussion draft with revised changes to the Commentary on paragraph 2 of Art. 15 of the OECD Model Tax Convention. This is a very interesting report that slightly updates a previous 2004 draft version, which has been extensively discussed with the tax community. Basically, the OECD seems to be extending the cases of material employer even to situations where there are no indications of abuse (the so-called short-term assignments). For that purposes the OECD proposes, new paragraphs 8 and 8.1 to 8. 21 to the Commentary.

But to understand the issue in question is important to clarify the basic rules:

Under the general rule of paragraph 1 of the Art. 15, the residence country of the employee has the exclusive right to tax the income from employment, unless the employment is exercised in the other treaty country (i.e. country of activity). In the latter case, paragraph 2 allows the country of activity to tax the remuneration if the employee is present in the country of activity for a less than 183 days, the remuneration is paid by a resident employer or it is borne by a permanent establishment situated in the country of activity.

The purpose of the new Commentary is thereby to resolve interpretation issues concerning the concept of "employer" for purposes of paragraph 2 of Art. 15. The conflicts increasingly arise because some countries disregard the formal employment relationship in order to assess whether the income derived by short-term assignees is also taxable in the country of activity. In fact, over the last years, a body of case law and rulings from countries such as Australia, Netherlands and Belgium have proven the tendency towards a more economical employer approach.

In that regard, the draft distinguishes between countries adopting a formal approach of employer under their domestic law and countries taking the view that "employer" should be given a more material or economic emphasis (e.g. applying substance over form approaches). This material interpretation may be achieved on the basis of domestic law of the country of activity or on the basis of the object and purpose of Art 15. According to the OECD, both approaches must be applied on the basis of objective criteria.

In determining the employer, the draft attaches importance to the nature of the services rendered, in order to determine whether the services rendered by the individual constitute an integral part of the business of the enterprise to which these services are provided. In cases where the nature of the services rendered point to an employment relationship different than the one of the formal employer, the draft suggests objective criteria to determine the employer, namely:
− who has the authority to instruct the individual regarding the manner in which the work has to be performed;
− who controls and has responsibility for the place at which the work is performed;
− the remuneration of the individual is directly charged by the formal employer to the enterprise to which the services are provided;
− who puts the tools and materials necessary for the work at the individual’s disposal;
− who determines the number and qualifications of the individuals performing the work.

As a consequence, instead of being regarded as non-resident employee of a non-resident employer rendering services on a temporary basis, individuals may, if certain objective criteria are met, be deemed to be the employees of the service recipient in the other country (i.e. source country), and therefore, taxable in the source country where they are performing their services.

Since the draft includes several practical examples, lets use one of them (which by coincidence or not is also found in a ruling from the Australian Tax Authorities).

Example (form ATO ruling):
Cco is a company resident in State C. It carries on the business of filling temporary business needs for highly specialised personnel. Dco is a company resident in Australia which provides engineering services on building sites. (..) In order to complete one of its contracts in Australia, Dco needs an engineer for a period of 5 months. It contracts Cco for that purpose. Cco recruits Y, an engineer resident of State Y, and hires him under a 5 month employment contract. Under a separate contract between Cco and Dco, Cco agrees to provide the services of Y to Dco during that period. Under these contracts, Cco will pay Y's remuneration, social contributions, travel expenses and other employment benefits and charges. Dco will pay Cco this amount plus 10% for Y's services.

Possible Solution:
Y provides engineering services while Cco is in the business of filling short-term business needs. By their nature, the services rendered by Y are an integral part of the business activities of Dco, an engineering firm, but not of his formal employer. Under and could come to the conclusion that the exception of paragraph 2 of Article 15 does not apply on the basis that Dco is more in an economic employment relationship with Y than the formal employer Cco.

As a final point it is interesting to note that to the extent that the residence country (Y in the example above) acknowledges that the source country (Australia) taxed in accordance with the convention, the new proposed Commentary also provides that the resident country (Y) must grant relief for double taxation.

It is no surprise that there are critics out there, which consider that if countries would follow the new approach, the limitation of Article 15(2) would, in most cases, become meaningless. Nevertheless, not all is bad in the "wonderland" and the new commentary (which probably is now very close to its final stage) has interesting features that deserve further study and analysis.