Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
"Songs of Innocence and Experience": Changes to the Scope and Interpretation of the Permanent Establishment Article in U.S. Income Tax Treaties, 1950-2010
J. Ross Macdonald*
The permanent establishment concept has been an integral element of U.S. income tax treaties since the first U.S. income tax treaty in 1932. Although the specific language used to define a permanent establishment has undergone change and elaboration over the years, until relatively recently many of its underlying conceptual precepts have remained comparatively stable. As discussed below, some portion of the recent erosion in the permanent establishment concept can be attributed to the actions of the Treasury and the Service (the U.S. tax authorities). Since 1950, the Treasury has repeatedly acquiesced in expanding the scope of source-country taxation in more and more permanent establishment areas. In addition, the erosion is inextricably tied to the way in which the permanent establishment definition has been interpreted.
This Article reviews the history of the permanent establishment provision as contained in a number of representative early U.S. income tax treaties and compares its underlying conceptual underpinnings to those contained in more recent U.S. treaties that are based on the permanent establishment definition contained in the OECD Model Treaties (and, to a lesser extent, the U.N. Model Treaties). Because the permanent establishment articles in most current U.S. treaties are based on the OECD Model Treaty definition, one may question the need for such a review and comparison, particularly now that most of the early U.S. treaties have been superseded. There are a number of responses to that question.
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Bayless Manning’s article, Hyper Lexis and the Law of Conservation of Ambiguity: Thoughts on Section 385, pointed out the trap that lawyers (a category which would typically include those drafting treaties, legislative history, or commentaries explicating model treaties) tend to fall into:
Elaboration in drafting does not result in reduced ambiguity. Each elaboration introduced to meet one problem of interpretation imports with it new problems of interpretation. Replacing one bundle of legal words with another bundle of legal words does not extinguish debate, it only shifts the terms in which the debate is conducted. In physics, we are all familiar with the Law of Conservation of Energy; in law, there is an analogous Law of Conservation of Ambiguity.
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. . . [T]he Law of Conservation of Ambiguity tells us that the draftsman can control and select what will be left ambiguous, but he cannot banish or control the aggregate amount of ambiguity.
The OECD Model Commentaries have grown like Topsy over the years. As we will see, at least some of the additions have been a reaction to legal developments. Nonetheless, as this Article suggests, the increase in detail has not significantly clarified the interpretation of the permanent establishment concept—at best, the changes have simply shifted the terms of the debate in the manner described by Manning; at worst, the continuous increase in and elaboration of explanatory material has often led to increased uncertainty and ambiguity. Accordingly, an understanding of the permanent establishment article in U.S. income tax treaties cannot begin and end with the OECD Model Treaties and Commentaries. The proper interpretation of U.S. permanent establishment articles also requires a knowledge of prior model treaties as well as of a body of prior U.S. income tax treaties, legislative history, case law, and rulings.
*Of Counsel, Baker & McKenzie LLP.