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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
The OECD released on November 24, 2009, a second version of proposed new language for Article 7 of the OECD Model Tax Convention and its Commentary dealing with the attribution of profits to a permanent establishment (PE). The purpose of this new language is to implement certain conclusions reached in the Report on the Attribution of Profits to Permanent Establishments as adopted by the OECD on July 17, 2008 ("Profit Attribution Report"), and referred to as the Authorized OECD Approach (AOA). The purpose of this article is to highlight the improvements made in the second draft toward the goal of ensuring that international double taxation is relieved when either the residence or source state makes an adjustment to the profits reported as subject to tax in a PE. A subsequent article will comment on the issue raised by this process of how much deference should be shown to the state that first makes an adjustment under the AOA, as a matter of equitable and efficient administration of the international tax system.
Readers who have been following the OECD project to revisit the rules regarding the attribution of profits to PEs under Article 7 of the Model Tax Convention know that this process has been long and has raised many controversial issues. The OECD framed the project as taking a fresh look at PE profit attribution principles; from the beginning, the mandate has been that the relevant bodies would consider and develop an approach, if appropriate, which was not constrained by either the original intent or the historical practice and interpretation of Article 7. Instead, the focus was on formulating the most preferable approach to attributing profits to a PE under Article 7, given modern-day multinational operations and trade.1
It quickly became clear that there was no unanimity of view among the member states on several important issues underlying the developing profit attribution approach. For example, states offered different approaches to attributing "free capital" to a PE, which determines the amount of interest expense which can be deducted for purposes of attributing profits to the PE. In another significant and controversial example, some states argued that the notional payments between a branch and its head office, which are a key element in determining the profits attributable to a PE under the AOA, could be subject to withholding tax, even though the notional payments exist only for the purpose of profit attribution and do not represent actual commercial transactions.
Despite the goal to harmonize interpretations of Article 7 among taxpayers and tax administrations, significant ambiguity of interpretation and application remains around many critical components of the AOA. For example, the AOA requires taxpayers and tax administrations to undertake a functional and factual analysis in order to define hypothetical dealings between the PE and the rest of the enterprise. Part of that functional and factual analysis is identification of the "significant people functions" that may be relevant to the attribution of "economic ownership" of assets by the PE and to the attribution of risks to the PE. Despite the 260 pages of the Profit Attribution Report (including 74 pages in Part I, which sets out the general principles) and the lengthy draft Commentary, significant uncertainty remains over the application of many key concepts. For example, it is not clear what "significant people functions" would cause the "economic ownership" of a marketing intangible to be attributed to a PE, with the result that the profits from the exploitation of that intangible would then be included in the profits to be attributed to the PE.
At the same time, tax authorities around the world have become more aggressive in asserting the existence of PEs of nonresident suppliers based on in-country sales, marketing, service, or other activities performed by agents. The issue of what profits to attribute to a PE creates even more tax (and financial statement) risk for taxpayers when they did not believe that they maintained a PE in the source state in the first place.
The consequence for taxpayers is that the international tax landscape relating to the attribution of profits to PEs looks particularly fraught with uncertainty at the moment. Taxpayers are therefore understandably anxious that the new Article 7 text and the associated commentary be effective in reducing to an absolute minimum the risk of double taxation.
The November 2009 proposed revisions to the Article 7 text and the associated commentary are the OECD's second crack at incorporating the principles of the AOA that differ from the principles of current Article 7 into the Convention and Commentary.2 A prior version had been released for public comment on July 17, 2008. The November 2009 version is a significant improvement over the July 2008 draft in terms of providing more comfort to taxpayers that double taxation will be relieved. The improvements in the November 2009 draft reflect comments from various taxpayers and industry organizations.3
The first discussion draft fell short of the goal of ensuring that taxpayers would not suffer unrelieved double taxation. The second draft has made great improvements toward that goal, but the mere fact that the first draft was so deficient in that area illuminates the fact that profit attribution principles remain a matter of considerable debate among tax administrations.
The current text of Article 7(2) states in relevant part as follows:
…where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.
It seems clear from this text that the two states are expected to agree on the amount of profits to be attributed to the PE, in that the "expected" profits "shall" be attributed to the PE "in each Contracting State." Current Article 7 contains few specific rules about how taxpayers or tax administrations are to determine those "expected" profits, but the general sense (at least among taxpayers) has been that, as with all other areas of treaty interpretation, the tax administrations are expected to endeavor to come to the right result under the applicable profit attribution principles, and that a single amount then will be recognized by both the source and the residence state for purposes of their source taxation and double tax relief provisions.
Perhaps current Article 7(2) assumes too much about the ability of states to come to such determinations. The Profit Attribution Report acknowledged that significant differences have existed among jurisdictions as to how to attribute profits to a PE. Therefore, it was considered that Article 7 itself, and not just the Commentary, needed to be amended to incorporate some of the principles of the AOA.
The July 2008 discussion draft modified somewhat current Article 7(2), principally to incorporate the basic principle of the AOA that the attributable profits are those that the PE would be expected to earn (including through dealings with other parts of the enterprise) if the PE were a separate and independent enterprise, taking into account the functions performed, assets used, and risks assumed by the enterprise through the PE and through the other parts of the enterprise.
The July 2008 draft then added a new Article 7(3), which expressed in the Model Convention itself the possibility that the two Contracting States would not agree on one very significant element of the profit attribution mechanism, namely, the amount of free capital that is to be allocated to the PE and used to determine the amount of interest expense deductible for purposes of computing the profits attributable to the PE. The proposed Article 7(3) essentially then provided that if the states agree that the application of the source state's method produces an "arm's length result" in conformity with Article 7(2) of the Model Convention, then the residence state is obliged to defer to the source state for purposes of calculating the attributable profits for purposes of applying the double tax relief provisions of Article 23.
Taxpayers found this result alarming on several levels. First, the mandate that the residence state defer to the source state was troubling. Some treaty interpretation issues are binary in that, in principle, there is one correct answer. For example, there may be an issue whether a payment constitutes business profits within the meaning of Article 7 or a royalty within the meaning of Article 12. The two tax administrations are expected in principle to agree on a single answer. Other issues, such as the determination of an arm's-length price under Article 9, may be subject to resolution within a range of results. Even in the case of determining an arm's-length price, however, taxpayers certainly have been of the view that the tax administrations are under an obligation to endeavor to determine a mutually acceptable result under the facts of the case, i.e., the most appropriate result under the applicable principles. The thought that the source state tax administration can claim that its adjustment must be sustained, absent a showing by the residence state that the result is so far out of bounds that the adjustment is not in conformity with Article 7(2), is a remarkable departure from the goal that the two states reach a mutually agreeable determination of the most appropriate result. It certainly raised the specter of increased controversies, of residence state tax administrations being held hostage by source states defending aggressive adjustments, and ultimately of increased risks of double taxation as residence states express reluctance to grant relief under those circumstances.
The new Commentary proposed in the July 2008 draft did not give taxpayers any reason to believe that their fears were ill-founded. First, the draft Commentary expressly noted that the attribution of free capital is only one circumstance in which different approaches could be allowed by Article 7(2), so that two states could assert different approaches, both of which would be allowed by the AOA. Second, in light of the various double taxation risks arising when one state makes an adjustment, the draft Commentary provided an optional paragraph which states might include in Article 7 as negotiated bilaterally. That optional paragraph generally would require the state not making the initial adjustment to make an appropriate adjustment to the extent necessary to eliminate double taxation. In an alternative to the primary optional language, the July 2008 draft Commentary also provided another optional paragraph that would reserve for the state not making the initial adjustment the right to address the appropriateness of the initial adjustment through the Mutual Agreement Procedure before granting the corresponding adjustment.
In sum, the most robust defenses against double taxation, or against aggressive source state adjustments, appeared in the July 2008 draft only as optional language for Article 7, not as part of the agreed OECD Model Convention text.
Taxpayers considered this a tepid response to the real dangers of double taxation in this area, and made this point a central issue in comments provided to the OECD and in the public consultation organized by the OECD on September 17, 2009, to address issues raised by commentators regarding the July 2008 draft.
The OECD responded with remarkable speed, releasing a new discussion draft on November 24, 2009. The new draft deleted the proposed special rule dealing with the attribution of free capital, and instead incorporated into the Model Convention as Article 7(3) the most significant operative elements of the primary optional language from the July 2008 draft, as follows:Where, in accordance with paragraph 2, a Contracting State adjusts the profits that are attributable to a permanent establishment of an enterprise of one of the Contracting States and taxes accordingly profits of the enterprise that have been charged to tax in the other State, the other State shall, to the extent necessary to eliminate double taxation on these profits, make an appropriate adjustment to the amount of the tax charged on those profits. In determining such adjustment, the competent authorities of the Contracting State shall if necessary consult each other.
The second alternative, reserving for the state not initiating the adjustment the ability to cause the propriety of the initial adjustment to be reviewed by the Competent Authorities, even if the initial adjustment arguably conformed with Article 7(2), remains as an alternative to the new Article 7(3), as follows:Where, in accordance with paragraph 2, a Contracting State adjusts the profits that are attributable to a permanent establishment of an enterprise of one of the Contracting States and taxes accordingly profits of the enterprise that have been charged to tax in the other State, the other Contracting State shall, to the extent necessary to eliminate double taxation, make an appropriate adjustment if it agrees with the adjustment made by the first-mentioned State; if the other Contracting State does not so agree, the Contracting States shall eliminate any double taxation resulting therefrom by mutual agreement.
Incorporating in Article 7 an obligation to avoid double taxation certainly is a welcome development. The proposed Commentary in the November 2009 draft also places appropriate emphasis on the need to provide mechanisms to avoid double taxation. In fact, there is in the text an air of eagerness to reassure taxpayers, in that the text refers no fewer than eight times in the first nine paragraphs of the new proposed Commentary to the intent to "ensure" or "guarantee" relief from double taxation. Regarding the substantive rules, however, there is no additional guidance on how to apply the AOA; taxpayers will be left with the text of the Profit Attribution Report itself to try to figure out those questions.
The change in the proposed Article 7 text and Commentary between the July 2008 and November 2009 drafts is remarkable. It shows that the OECD can be responsive to taxpayer comments, and can change direction when warranted. The process also shows how contentious some of these issues must have been within the groups debating the PE profit attribution standards. It is understandable, perhaps, that an area as complex and factually nuanced as PE profit attribution is not easily susceptible to specific guidance (in the Commentary or otherwise) that crisply and clearly addresses all factual contexts.
There is still some unease about the results of this project, given the lack of specific guidance as to how to apply the AOA and the expressed expectation that tax administrations will advance differing interpretations on how to apply the AOA in various areas, and not just with respect to the question of the allocation of free capital. In that sense, the AOA project may have opened a period where taxpayers as a practical matter are facing less, rather than more, certainty on how profits will be attributed to their PEs, as international norms develop around some of the open interpretative issues. In this environment, the insistence in the Commentary that double taxation must be relieved in order to allow a smoothly functioning international tax system that does not impede international business is an important message to tax administrations around the world.
A subsequent commentary will address the question of what deference should be given to the state making the initial adjustment, an issue raised by the alternate versions of Article 7(3) presented in the November 2009 draft.
This commentary also will appear in the March 2010 issue of theTax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, and Cole, Kawano and Schlaman, 940 T.M., U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively Connected Income, and ¶7160, U.S. Income Tax Treaties.
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