Allocating profits to permanent establishmentsSeptember 26, 2013
In response to uneven treatment and uncertain results arising from different interpretations of Article 7 (“Business Profits”) of its Model Tax Convention, the Organisation for Economic Co-operation and Development (OECD) issued a Report on the Attribution of Profits to Permanent Establishments. The report, published in 2008, established what is today called the Authorized OECD Approach (AOA) for the allocation of income to permanent establishments.
Once the 2008 Report was issued, the OECD recognized the need to make amendments to the Commentary to Article 7 and harmonize the guidance issued in the 2008 Report with the interpretation of Article 7 contained in the Commentary.
Therefore, in 2010, Article 7 itself was amended to reflect the principles contained in the 2008 Report. In addition, a report was issued in 2010 on the Attribution of Profits to Permanent Establishments (the 2010 Report).
The Authorized OECD Approach (AOA)
The 2010 Report confirms the authorized OECD approach (AOA) set out in the 2008 Report, establishing a single standard of analysis when dealing with allocating profits between a head office and a foreign permanent establishment.
The necessity to allocate profits originates from the conflict that, in case of a permanent establishment, both the source country of the permanent establishment as well as the residence country of the headquarters company may claim the right of taxation for the profits realized by the permanent establishment – thus creating double taxation.
Therefore, setting clear rules on how to allocate profits to a permanent establishment is a critical step to avoiding double taxation.
For this purpose, the AOA treats head office and permanent establishment as if they were functionally separate entities and presents a two-step analysis to arrive at a profit allocation between head office and permanent establishment.
An analysis of the functions, assets, risks and other unique facts associated with the permanent establishment is conducted, driven significantly by where the acting persons are located (“significant people functions”). It is then determined where, in a deemed third-party situation, so-called dealings (assumed contractual relationships) between the permanent establishment and the head office would exist.
Where dealings can be recognized, transfer pricing methods, as set out in the OECD Transfer Pricing Guidelines, are applied to determine transfer prices for the dealings between head office and permanent establishment.
The risk of inconsistent versions and applications of Article 7
Article 7 of thepre-2010 OECD Model Convention based the allocation of profits to permanent establishments on assigning individual income and expense items to either permanent establishment or head office, and refrained from realizing profits between head office and permanent establishment.
However, the 2010 Model Tax Convention, in its AOA, allows exactly that: profits are realized between head office and permanent establishment on non-existent transactions. However, a new OECD report, a change in a model tax convention or the related Commentary does not change existing individual treaties or their domestic tax law interpretation.
Against this backdrop, almost all countries are faced with the reality that their network of bilateral double tax treaties most likely includes both pre- and post-2010 language, or that their tax treaty networks contain largely pre-2010 language, but domestic law incorporates post-2010 principles. The question then becomes: how are countries dealing with the variances in treatment?
China – no formal position taken to date
Pricing Practical Manual for Developing Countries (UN Manual), China’s State Administration of Taxation (SAT) has released the China Country Practices report. In the report, China establishes its position that while the OECD Guidelines may be applicable to developing countries, the UN Manual offers more realistic and practicable solutions for the issues faced by developing countries.
Accordingly, it is not surprising that the SAT has not formally taken a position on whether it endorses or will adopt the AOA.
The SAT has provided limited guidance on attributing profits to permanent establishments. It is, however, worth noting that while China has not adopted a formulary apportionment approach to cross-border transactions, under domestic rules, allocation of provisional tax among branches in different locations takes into account allocation keys, such as operating revenue, employee remuneration and total assets of the branches.
Germany – delayed legislation, definitive treatment
Germany planned to incorporate the AOA into German domestic law. But for reasons not related to the AOA, the legislative process stalled and most likely will only be resumed in 2014. Despite this, the German example offers a valuable insight into a possible approach to addressing the uneven implementation of the post-2010 Article 7 across a country’s treaty network.
First, the German draft legislation aligned closely to the two-step analysis set out in both the 2008 and 2010 Reports. Second, in an effort to deal with the fact that the majority of Germany’s treaties still include pre-2010 Article 7 language, the domestic rule proposed to employ a reciprocal approach. It planned to stipulate that Germany would generally tax a permanent establishment’s profits under the AOA principles.
If, however, the taxpayer could establish that the other State that is a party to the double tax treaty does not apply the AOA, Germany would be willing to refrain from applying it and to apply pre-2010 principles as contained in the relevant treaty’s language.
United States — conforming provision in model tax treaty
The US has not adopted new legislation or regulations in response to the AOA. In addition, the current US Model Income Tax Treaty was issued in September of 2006 and has not been updated to reflect the AOA. Nevertheless, the US is a member of the OECD, and generally takes the position that its transfer pricing policies are fully consistent with OECD principles.
Further, Article 7 of the US Model Income Tax Treaty is generally consistent with the AOA, and thus, US tax treaties are generally consistent with the AOA. However, in the event of a dispute involving the US and a treaty partner, the taxpayer will wish to consult the applicable tax treaty for the specific treatment.
The full version of this article is published in EY´s Global Tax Policy and Controversy Briefing, issue 12 (PDF, 7.39 MB)
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