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By Gary D. Sprague, Esq. Baker & McKenzie LLP Palo Alto, California
On July 4, 2016, the OECD issued a Discussion Draft on Additional Guidance on the Attribution of Profits to Permanent Establishments as part of the OECD/G20 BEPS Project (“Discussion Draft”). This is a welcome development, in light of the significant changes made to Article 5 of the OECD Model Tax Convention (MTC) under Action 7 of the BEPS Project. It seemed to many commentators that sound international tax policy analysis would require considering the profit attribution consequences of changing the permanent establishment (PE) standard at the same time as proposing changes to MTC Art. 5. That work has now progressed, with the express purpose of providing the additional guidance by the end of 2016, at which point governments will take up whether to implement the PE changes through the Multilateral Instrument (MLI).
The Discussion Draft addresses these complex issues in a thoughtful and balanced manner. The application of the profit attribution rules under MTC Art. 7 can be very complex and nuanced, especially in the case of deemed PEs arising under Art. 5(5), where the nonresident enterprise does not actually conduct any activities in the market state through its own personnel. The Discussion Draft does a good job of presenting examples that demonstrate how the rules could apply in different factual situations. This commentary will briefly identify some of the important issues raised by the Discussion Draft relating to deemed PEs created through selling activities.
The Discussion Draft presents seven situations creating a PE in the market state, four based on sales activities and three based on the operation of a warehouse. One of the sales examples deals with a sales person employed by the nonresident enterprise who performs full-time selling activities for the nonresident in the market state, but who does not operate through a fixed place of business in the market state. Accordingly, all of the examples dealing with PEs arising from sales activities relate to deemed PEs arising under MTC Art. 5(5), while the three warehouse examples involve fixed place of business PEs arising under MTC Art. 5(1).
The Discussion Draft analysis is firmly grounded in the Authorised OECD Approach (AOA), as expressed in the 2010 Report on the Attribution of Profit to Permanent Establishments (“2010 Report”). The 2010 Report included only a few paragraphs dealing with the attribution of profit to PEs created under Art. 5(5), but those few paragraphs set out some important basic principles which have been followed in the Discussion Draft.
In general, the AOA adopts the “functionally separate entity approach” to define the PE and then to attribute profits to that PE. The general principle is stated as follows:
The authorised OECD approach is that the profits to be attributed to a PE are the profits that the PE would have earned at arm's length, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.
This rule is applied through a two-step analysis. In the first step, a functional and factual analysis is applied to hypothesize appropriately the PE and the remainder of the enterprise as if they were associated enterprises, each undertaking functions, owning and/or using assets, assuming risks, and entering into hypothesized transactions (“dealings”) with each other. In the second step, the remuneration of any dealings between the hypothesized enterprises is determined by applying by analogy the Article 9 transfer pricing tools (as articulated in the Transfer Pricing Guidelines for separate enterprises) by reference to the functions performed, assets used, and risks assumed by the enterprises under the hypothesized dealing.
This approach is easier to understand in the case of a normal PE, i.e., a branch that actually employs personnel and thus can be regarded as performing functions. It is harder to apply when the PE in question is only a notional one, created through the deeming rule in MTC Art. 5(5).
The AOA notes that if an Art. 5(5) PE exists, the host state will have tax jurisdiction over two different legal entities, the dependent agent enterprise itself, for which the arm's-length remuneration will be governed by Art. 9 and the arm's-length principle, and the nonresident by virtue of the PE, for which the remuneration will be governed by Art. 7 and the AOA. The AOA describes the separate analysis applicable to the dependent agent enterprise itself and the deemed PE as follows:
On the one hand the dependent agent enterprise will be rewarded for the service it provides to the non-resident enterprise (taking into account its assets and its risks (if any)). On the other hand, the dependent agent PE will be attributed the assets and risks of the non-resident enterprise relating to the functions performed by the dependent agent enterprise on behalf of the non-resident, together with sufficient free capital to support those assets and risks. The authorised OECD approach then attributes profits to the dependent agent PE on the basis of those assets, risks and capital.
The Discussion Draft does a good job of adhering to these principles. In particular, the Discussion Draft presents an example where no profits are attributable to the PE, and one where losses are attributable to the PE. Other examples result in profits attributable to the PE, as appropriate to the assets and risks allocated to the PE. These results follow from the normal application of the AOA. In the case where the nonresident enterprise doesn't have its own employees engaged in sales activity in the territory, then the PE dealing will be hypothesized on the basis only of asset ownership and risk assumption, as the nonresident would not in fact perform any relevant people functions in the market state. If the dependent agent enterprise also does not perform significant people functions that are relevant to the economic ownership of assets, or the assumption or management of commercial risks, then there will be no assets or risk attributed to the PE. In this case, the result is no profit or loss attributed to the PE.
The Discussion Draft also presents examples where certain assets and risks are attributed to the PE. In that case, profits (or losses) may be attributed to the PE, based on the nature of the dealing between the head office and the PE.
There are some elements where the analysis of the Discussion Draft could be elaborated to clarify how the AOA is being applied. Most importantly, the examples don't crisply articulate the “dealings” that are hypothesized between the nonresident and the PE. Defining the notional dealings is the essential foundation to the second step of the AOA analysis, as it is that notional dealing which is the transaction to which normal transfer pricing principles are applied to determine the profits attributable to the PE. In most of the examples, it can be inferred from the calculations of the profit attribution result what the dealing must have been, but it would be preferable for the guidance to describe the dealing more transparently.
Taxpayers certainly are aware that, in most cases in practice, tax administrations that have asserted a PE under MTC Art. 5(5) have started the profit attribution process by attributing to the PE the entire gross revenue from sales to customers that are facilitated by the sales activity giving rise to the PE. That would be a correct application of the AOA only if the dealing between the head office and the PE is a hypothetical buy-sell transaction. The Discussion Draft implies that a reseller dealing is not always the appropriate hypothesized transaction. In one of the four cases, it appears that the gross customer revenue is not attributed to the PE. The fact that the fourth case is different demonstrates that circumstances can exist where a different dealing would be more appropriate. In the absence of a clear statement of the “dealing” in any of the four examples, however, the Discussion Draft does not give clear guidance as to when a buy-sell dealing would, and would not, be appropriate.
It can be anticipated that many circumstances that may result in PEs under the revised PE standards from Action 7 will not best be described by a reseller dealing. This would most commonly exist in cases where concluding purchase contracts or “the principal role” activities that do not include concluding contracts form the basis for the Art. 5(5) PE. In these cases, the more appropriate “dealing” frequently will be some type of service transaction rather than a purchase and sale of property. Where only modest assets or risks are attributed to the PE, a dealing other than a hypothesized reseller transaction might be a better hypothetical on which to base the search for comparables.
One major issue left unresolved by the Discussion Draft is the degree to which this guidance will be applied by tax administrations around the world. As noted, the guidance is issued under the 2010 Report. There is significant uncertainty as to how many jurisdictions will regard this guidance as controlling, as the large majority of bilateral treaties around the world have not yet been updated to incorporate the MTC Art. 7 changes based on the 2010 Report. The MLI, regrettably, does not include a provision by which the Contracting States can capitalize on this unique opportunity to update Art. 7 of their bilateral treaties.
As a technical matter, the interpretations expressed in the Discussion Draft should be equally applicable to treaties entered into pre-2010, as the examples explored in the Discussion Draft do not address cases where there may be profits attributable to the PE arising from the use of intangibles, which is the most significant technical advance in the 2010 Draft over its 2008 predecessor that may be regarded as inconsistent with pre-2010 treaties. Virtually all OECD countries agreed that the 2008 AOA Report represented internationally agreed principles and, to the extent that it did not conflict with the 2008 Commentary, provided guidance to the application of the pre-2010 version of Art. 7. Accordingly, it can be hoped that the OECD/G20 governments will confirm their consensus on this point, and will encourage as wide an adoption of the principles in the final guidance as possible, both by expressly noting that the examples in the Discussion Draft are equally applicable to pre-2010 treaties, and encouraging jurisdictions to update their treaties to incorporate the 2010 version of Art. 7. This would ensure that this guidance will have the widest possible application in the international treaty network.
Finally, in several places the Discussion Draft requested comment on the appropriate order of application for MTC Art. 9 (related to applying the arm's-length principle to transactions between associated enterprises) and MTC Art. 7 (applying the PE profit attribution rules). This is an important issue, as it will be important to ensure that a function, asset, or risk cannot be double counted. This issue arises because the same economic activity potentially could underlie either a transfer pricing adjustment under Art. 9 or a PE profit attribution under Art. 7. As a mechanical matter, the hypothesized P&L of a PE in many cases will include a deduction for the actual payment made to an associated enterprise also operating in the market jurisdiction. The need to make that calculation also makes the order of application important.
It could be argued that the order should not matter, as long as the two respective analyses make it clear that there is no double counting. If the Art. 9 analysis followed an Art. 7 analysis, however, the Art. 7 analysis might have to be redone if an asset or risk that was taken into account in the PE profit attribution was then allocated to the market jurisdiction entity under Art. 9. Accordingly, in order to make the issue clear, to have a uniform rule, and to simplify the application of these rules, it seems preferable to have a clearly agreed order of application. The logical order of application would be as follows. After the accurate delineation of the transaction, Art. 9 should apply first to determine whether the price charged is arm's length; second, the jurisdictional issue of whether the nonresident is also subject to tax in the host state by virtue of Art. 5 would be addressed; and third, if so, then Art. 7 would apply to attribute profits to that PE. This priority rule would avoid double counting income arising from assets or risks that might be attributed to the local entity under Art. 9, including by applying the revised principles now expressed in the Transfer Pricing Guidelines by virtue of the work undertaken in Actions 8–10 of the BEPS Project, and minimizes the complexity involved in making these determinations.
A public Consultation has been scheduled on this Discussion Draft for October 11–12, 2016. Interested taxpayers should pay close attention to the further work on this issue, as other discussion drafts issued as part of the OECD/G20 project indeed have been significantly revised after input provided through public Consultations.
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