International Law Office, April 11, 2011 – By Anthony V Raftopol
Numerous companies located outside Iraq, but providing goods and services into the country (either on a single project basis or through a consistent stream of business), are grappling with the idea that Iraq may tax at least some of their business profits. This is true even where such companies are not registered in Iraq or do not maintain a local office or local employees. The Iraqi authorities are managing this by applying a tax to the value of the supply contract upon entry of goods into the country, as a kind of guarantee deposit. This is released only once the foreign supplier has submitted a tax clearance letter, issued by the General Commission for Taxes, confirming settlement of its tax liability on the supply contract in question.
The fact that Iraq permits the taxation of business profits of foreign-registered entities should be of no surprise. This practice is employed by many countries, provided that a sufficiently close nexus exists between the taxing jurisdiction and the foreign entity. In developed countries, especially, this ‘nexus’ is crystallised under the ‘permanent establishment’ analysis, subject to numerous tax treaties and the Organisation for Economic Cooperation and Development (OECD) Model Tax Convention. However, the Iraqi authorities have adopted a much simpler formula for determining which foreign suppliers should be taxed, by considering whether suppliers are doing business in Iraq or doing business with Iraq. Given the significant distinctions between the approach under the OECD model and that adopted by Iraq, companies supplying goods and services into the country should familiarise themselves with the Iraqi approach in order to limit their tax exposure while doing business.
Permanent establishment under the OECD Convention
The guidelines adopted by many countries under tax treaties modelled after the OECD Convention revolve around whether a subject business has created a permanent establishment within a country’s jurisdiction. Under the OECD Convention, the existence of a permanent establishment must be accompanied by the following factors:
There must be a link between the place of business and a specific geographic point, as well as a degree of permanence with respect to the taxpayer;
The company must have a place of business; and
The business of the enterprise must be carried out wholly or partially at the fixed place.
Accordingly, a permanent establishment must comprise a fixed and commercially coherent space which the foreign enterprise uses to carry out its business. Mere presence is not enough as that does not necessarily translate into doing business within the space. The facilities need not be used exclusively by the foreign enterprise or for the business subject to taxation. Rather, the facilities must belong to the foreign enterprise and not to another unrelated entity.
Many treaties explicitly exclude from the definition of ‘permanent establishment’ places where certain activities are taking place. Generally, these exclusions apply to activities conducted at the fixed place of business, such as activities related to the storage, display or delivery of goods, merchandise or other so-called ‘preparatory or auxiliary activities’, as well as purchasing or information-gathering activities.
Taxation of foreign suppliers
The authority of the General Commission for Taxes to tax an entity located outside Iraq is set forth in Article 21(7) of Law 113/1982, which establishes the principle that non-residents may be taxed in cases where:
“the trade, commercial business, vocations or any other transaction of a commercial nature from which the gains and profits have arisen is carried on in Iraq. The financial authority shall differentiate between trading in and with Iraq.” (emphasis added)
Accordingly, Iraq law distinguishes between ‘doing business in Iraq’ and ‘doing business with Iraq’, and the tax regulations set forth the principle that non-residents are not liable for tax unless trade, commercial business, the provision of services or any other transaction of a commercial nature are carried on in Iraq. Under Tax Instruction 2/2008, the Iraqi tax administration has attempted to delineate further the distinction between business in Iraq versus business with Iraq. For example, under Article 2, trading with Iraq will be assumed (and Iraq tax liability will not apply) where the supplier has its place of business outside Iraq, the contract was signed outside Iraq and all legal and handling activities (eg, issuing letters of credit or shipping, paper handling, customs and similar processes) are performed by Iraq-registered entities. Trading with Iraq will also be assumed where all of the services and expert activities are performed and paid for outside Iraq.
However, a foreign supplier will be deemed to be doing business in Iraq (and will be subject to tax, irrespective of whether such services were performed under the same or a separate contract) to the degree that it provides complementary services inside Iraq, including installation, supervision, maintenance and engineering works.
Under this analysis, significant tax savings under any particular supply arrangement may be made by relocating outside Iraq the most important actions to be taken by the foreign supplier or subcontracting those actions to an Iraqi party. Significantly, tax savings could ensue if such foreign suppliers were to use two separate contracts with the Iraqi beneficiary: one for services performed outside Iraq and the other for services performed within the country.
This model of taxation, which is centred around the concept of doing business in Iraq, appears to have a broader and more simplified application than the ‘permanent establishment’ criterion adopted by the OECD Convention. The OECD Convention focuses on the location and the nature of the place of business, which requires a somewhat sophisticated understanding of the business itself in order to determine whether a permanent establishment exists. On the other hand, the Iraqi authorities appear to be more interested in the location of the most important actions taken by the foreign supplier. So long as many of the key actions taken to conduct business are located outside Iraq or are assigned to Iraq-registered actors, the business profits of the foreign supplier are considered as doing business with Iraq and are not otherwise subject to tax. No further analysis of the business itself need be undertaken.
The OECD Convention specifically excludes the taxation of preparatory or auxiliary services conducted within a particular tax jurisdiction (as this would not necessarily lead to a conclusion that a place of business has been established), whereas the same services would lead to taxation in Iraq for the foreign supplier, as this would be considered as doing business in Iraq (the actions themselves are being performed in Iraq, regardless of their nature). Thus, under Iraqi tax law, there may be a significant economic connection between a business and Iraq; but if the supplier performs its most important operations from outside the country or by using in-country agents, it is unlikely to incur income tax liability in Iraq.