The Attribution Of Profits To Permanent Establi...
Currently, there is a lack of consensus amongst OECD Member countries as to how profits should be attributed to a permanent establishment (PE). As a first step in remedying this situation a working hypothesis has been developed as to the preferred approach for attributing profits to the PE. The basis for the working hypothesis is to examine how far the approach of treating the PE as a hypothetical distinct and separate enterprise can be taken and how the guidance in the OECD Transfer Pricing Guidelines could be applied, by analogy, to attribute profits to a PE. This discussion draft contains the results of testing the working hypothesis in general (Part I) and to PEs of banks (Part II). Public comments are invited in order to assist in the development of an OECD consensus on the attribution of profits to a PE.
The Attribution of Profits to Permanent Establi...
This material was first published by Sweet and Maxwell Limited in the British Tax Review as Celeste M Black, 'The Attribution of Profits to Permanent Establishments: Testing the Interaction of Domestic Taxation Laws and Tax Treaties in Practice' (2017) 2 British Tax Review 172 and is reproduced by agreement with the Publishers. The adoption of the "authorised OECD approach" to the attribution of profits to a permanent establishment (PE) under the business profits article of the OECD Model Tax Convention on Income and on Capital has failed to produce uniformity given the persistence of the alternative relevant business activity approach. Through the analysis of a hypothetical case study involving asset dealings between a foreign PE and the enterprise head office, this article examines the interaction of the domestic law and treaty practice of two jurisdictions that are representative of different approaches to PE profit attribution, the UK and Australia. This study of intra-enterprise dealings involving inventory, depreciating assets and capital assets reveals the potential for mismatches in taxation outcomes, both overlaps and gaps, even in relation to these relatively straightforward transactions.
The Committee on Fiscal Affairs has undertaken to adopt a two track approach to implementation of the Report in order to provide tax administrations and taxpayers with maximum certainty as to how profits should be attributed to permanent establishments under both existing and future treaties. In order to provide improved certainty for the interpretation of existing treaties based on the current text of Article 7, a revised Commentary on the current version of Article 7, which includes those conclusions of the Report that do not conflict with the prior Commentary, has been included in the 2008 update to the Model Tax Convention. In order to reflect the full conclusions of the Report, work has also begun on a new version of Article 7, to be included in the next update to the Model Tax Convention and to be used in the negotiation of new treaties and of amendments to existing treaties. A discussion draft of the new Article 7 was released on 7 July 2008.
The determination of a treaty permanent establishment is based on the facts and circumstances related to activities in each country, which are often fluid. If a permanent establishment exists, an enterprise is taxable on the business profits attributable to it.
General treaty approach: A foreign corporation with a permanent establishment under a treaty generally computes its income under the "business profits" article of the treaty. The foreign corporation generally is subject to U.S. tax only on business profits that are attributable to the permanent establishment. In certain treaties, the attributable concept of a treaty may be similar to the Code's effectively connected concept, with certain modifications. However, a treaty may completely override the Code with its own concept of income attributable to a permanent establishment, such as the authorized OECD approach described below.
Tax professionals generally believe that a treaty requires a direct attribution of profits to a permanent establishment, which seems to eliminate the residual-force-of-attraction principle found under the Code. In the wine sale example above, it is difficult to see how the foreign corporation's home office income from vintage wine sales may be attributable to any permanent establishment that purchases and sells electronic equipment. Note that a few older treaties do use the residual-force-of-attraction principle, and thus the wine sale example may result in the same or similar income as with the Code.
The OECD has adopted an authorized approach to computing business profits attributable to a permanent establishment, based on its transfer-pricing guidelines. Additionally, the 2006 and 2016 U.S. Model Treaties use the authorized OECD approach, as do the U.S. treaties with Belgium, Bulgaria, Canada, Germany, Iceland, Japan, and the United Kingdom. Under the authorized OECD approach, a permanent establishment is treated as a "functionally separate entity" for purposes of attribution of business profits. To put that another way, business profits are determined not based on apportionment or allocation but rather based on the arm's-length standard (i.e., transfer pricing). In its simplest terms, the authorized OECD approach applies transfer-pricing principles to branch operations to determine a foreign corporation's U.S. business profits.
Note that the foreign corporation may choose to forgo a permanent establishment limited-risk model under the authorized OECD approach and use a full risk-bearing entrepreneurial model for transfer pricing that is similar to the Code's effectively connected income standard, which may result in losses for U.S. federal income tax purposes during the market penetration or startup phase. However, the foreign corporation's use of an entrepreneurial transfer-pricing model may result in significant U.S. profits becoming attributable to the U.S. permanent establishment in future years, thus increasing taxes in such years as compared with profits that would be attributable under a limited-risk distributor model.
In this guideline, the attribution of income is addressed in accordance with the principles presented in the attribution report by the OECD. The functional and factual analysis is reviewed on a general level, as well as the preparation of a comparability analysis. At the end of the guidelines, the attribution of income to a permanent establishment is demonstrated through simple examples.
According to the OECD attribution report, the economic ownership of tangible assets can be defined in accordance with the significant people functions or use of assets. According to the significant people function specification, that part of the enterprise where decisions concerning the procurement and the use of assets are made can be regarded as specific to the economic owners of the assets. Economic ownership defined in accordance with the use of assets refers to the fact that the economic owner of production machinery, for instance, is a permanent establishment in the event that the machine concerned is used at the permanent establishment for the manufacture of products. In this respect, the permanent establishment can deduct depreciation from the production machinery in the permanent establishment's taxation, and the capital gain obtained from selling the machine can be regarded as belonging to the permanent establishment.
The question of whether intangible property is to be attributed to the permanent establishment should also be determined in the functional and factual analysis. The attribution of intangible property to various parts of the company is also based on the determination of economic ownership with respect to property. Economic ownership is determined on the basis of significant people functions. The financial owner of intangible property represents that part of the enterprise where decisions on the development and procurement of intangible property are actively made, as well as the related risk-taking and administration.
The OECD Attribution Report does not separately mention how subsidiary shares are attributable to the branch. However, the attribution of shares as assets of the PE is mentioned in the Supreme Administration Court yearbook resolution KHO:2016:71. That decision concerned whether the subsidiary shares could be attributed to the Finnish branch of a foreign company, and if the interest on the procurement debt of these shares could be deducted from the profits of the branch.
According to the resolution, the functions and personnel of the subsidiary were transferred to the branch only to a minimal extent. Moreover, it was established that the representatives of the branch did not wield the authority of the subsidiary. Rather, it was concluded that this authority belonged to the board of directors of the head office or the parent company of the corporation. The shares of the subsidiary could not be allocated to the permanent business activities of the branch, and thus could not be regarded as funds belonging to the branch. Therefore, nor the debt from the share acquisition or the deductions on the interest rate of the debt could be allocated to the subsidiary. This being the case, the attribution of subsidiary shares as assets of the permanent establishment is performed in compliance with the same principles as the attribution of other assets, and significant people functions play a significant role in this attribution. As a starting point, the attribution of subsidiary shares to a permanent establishment thereby requires that the significant people functions linked with the ownership of the shares are located in the permanent establishment. When assessing the attribution of subsidiary shares to a permanent establishment, the regulation on tax evasion in section 28 of the Act on Taxation Procedure should also be taken into consideration in the matter (see, e.g. SC 2016:72).
The attribution of free capital to a permanent establishment occurs in two stages. In the first stage, the risks are measured and the assets valued which are attributed to the permanent establishment. In the second stage the amount of free capital to support the risks and assets is determined. In the attribution report, various methods are described for the attribution of free capital in the permanent establishment. According to the attribution report, each method has its own strengths and weaknesses, which should be taken into account when selecting the method; no one method can be indicated as being applicable to all situations. 041b061a72