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International Taxation
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Background
This topic concerns the situation where an
enterprise carried on by a resident of one State operates in a host State
through a permanent establishment (“PE”): how should the profits be attributed
to the PE both under the domestic law and under the double taxation convention
(“DTC”) between the State of residence and the host State?
This attribution is necessary both in the host state to determine the profits
taxable there, and in the State of residence of the enterprise for purposes of
relief from international double taxation.
The topic focuses, therefore, on the interpretation and application of the
provisions in the Business Profits Articles 7(1) to 7(3) of relevant DTCs.
which generally provide as follows (other than in treaties based on UN Model)
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The profits of an enterprise of a Contracting State shall be taxable only in
that State unless the enterprise carries on business in the other Contracting
State through a permanent establishment situated therein. If the enterprise
carries on business as aforesaid, the profits of the enterprise may be taxed in
the other State but only so much of them as is attributable to that permanent
establishment.
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Subject to the provisions of paragraph 3, 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.
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In determining the profits of a permanent establishment, there shall be allowed
as deductions expenses which are incurred for the purposes of the permanent
establishment, including executive and general administrative expenses so
incurred, whether in the State in which the permanent establishment is situated
or elsewhere.
A number of different theories are followed in different countries regarding
this topic. For example, a distinction is sometimes made between the “separate
enterprise approach” (under which the PE is treated as a separate enterprise)
and the “single enterprise approach” (under which the PE and its head office are
all part of the same, single enterprise). The difference is significant: under
the single enterprise approach, a profit is only recognised for tax purposes
when there is a transaction with a third party, whilst this is not the case
under the separate enterprise approach (i.e., taxation of notional profits is
possible).
Within the separate enterprise approach, there are also different theories as to
how far one can construct the PE as a separate enterprise (separate from the
remainder of the enterprise of which it is part). For example, can one assign to
the PE the “ownership” of assets and risks which are in fact owned or borne by
the enterprise as a whole? Broadly, the current interpretation of Article 7, as
reflected in the Commentary, is based upon a limited recognition of the PE as a
separate enterprise. There is an important conflict here between the fiscal
fiction (under which the PE is treated as a separate enterprise) on the one hand
and the legal fact (according to which the PE is part of a single enterprise and
cannot own assets or bear risk separately from the remainder of the enterprise)
on the other.
This topic has recently been the object of attention by the OECD, and four
Discussion Drafts have been published which develop an “Authorised OECD
Approach” (“the AOA”).
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Salient features of the AOA
In an extremely simplified form, the AOA requires a two step approach namely
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hypothesis the PE as a “functionally separate enterprise” with its own functions
performed, assets used and risks assumed; and
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the arm’s length principle (as elaborated in the OECD Transfer Pricing
Guidelines) is then applied by analogy to the dealings between this functionally
separate enterprise and the enterprise of which it is part (although a
limitation still exists as regards the credit worthiness of the enterprise).
The AOA also discusses the need to attribute profits to a dependant agency PE
over and above the payment of arm's length compensation to the dependant agent
and suggests methodology of arriving at such attribution.
How to do Step one
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Hypothesising the PE as a separate enterprise
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Functions and risks: what are the activities of
PE?
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Attributing economic ownership of assets
(tangible and intangible): drawing up a “tax balance sheet” for the PE under the
authorised OECD approach
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Capital: attributing free capital” and
interest-bearing capital
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Risks follow functions
Under the OECD approach, risks cannot be segregated from associated functions
within a single legal entity; i.e., risks inherent in, or created by, the
functions performed by the PE are attributed to the PE
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Attribution of assets
As legally assets belong to the whole enterprise, “economic ownership” of assets
are attributed to one part of the enterprise generally by reference to
significant people functions relevant for this purpose (in financial sector,
KERT functions)
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Intangible assets
Though paragraph 17.4 of the current Commentary does not recognise intra-entity
royalties or mark-up for the use of intangible property by one part of the
enterprise, under the AOA there is a clear implication that arm’s length
notional payments between different parts of the enterprise may be allowed under
certain conditions.
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Tangible assets
Broad consensus to attribute based on place of use, unless circumstances warrant
different conclusion
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Capital follows functions, assets and risks
Under the arm’s length principle, a PE should have sufficient capital (“free
capital” + debt) to support the functions it undertakes, the assets it uses, and
the risks it assumes. The functional and factual analysis will attribute “free
capital” (i.e. funding that does not give rise to a tax deductible return) to
the PE for tax purposes.
The draft report examines the following three approaches to attributing “free
capital” to the PE :
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The Capital Allocation Approach
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The Thin Capitalization Approach
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The Safe Harbour Approach—quasi thin capitalization/regula-tory minimum
capital approach.
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Determining the funding costs of the PE
Under the AOA, attribution of capital can imply, in appropriate circumstances,
the recognition of internal Interest” dealings. By contrast, in the current
‘Commentary to paragraph 3 of Article 7 there is a ban on deductions for
internal debts generally (subject to special problems for financial activities)
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Attributing creditworthiness to
the PE
Under the AOA, generally, the same creditworthiness is attributed to a PE as is
enjoyed by the enterprise as a whole. Consequently, there is no scope for the
rest of the enterprise guaranteeing the PE’s creditworthiness, or for the PE to
guarantee the creditworthiness of the rest of the enterprise (no intra-entity
guarantee fee)
How to do the Second Step
Once hypothesised as a functionally separate enterprise, the PE must be
attributed profits that it would have earned at arm’s length if it were a
legally distinct and separate enterprise performing the same or similar
functions under the same or similar conditions. This determination will be done
by applying the Guidelines by analogy
The Report provides guidance on:
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when to recognise and how to characterize intra-entity “dealings” between the
PE and other parts of the enterprise of which it is a part and
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how to price those internal “dealings” by
applying the arm’s length principle
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Issues concerning the AOA
General
First, the functionally separate enterprise
approach assumes that a profit can be generated on a dealing between the PE and
the general enterprise (or its head office), even if there is no transaction
with an outside party, so no “real” profit. Certain countries would regard this
as conflicting with established principles of tax law or even constitutional
principles.
Secondly, the recognition of notional (internal) payments of interest, royalties
or rent by a PE raises the question as to whether such notional payments (which
would be deductible in computing the profits attributable to the PE) should be
subject to withholding tax in the country of source: and if they are subject to
withholding tax, at what rate (is it the domestic rate or the treaty rate – and
if so, which treaty?).
Thirdly, there are technical issues with the AOA, for example in its emphasis on
Key Entrepreneurial Risk Taking (“KERT”) functions.
Fourthly, assuming that the AOA is adopted, a major issue is whether it should
be adopted for all businesses, or for financial sector activities only. In
recent years, most of the issues that have arisen with regard to the attribution
of profits to PEs have arisen in the financial services sector. Arguably,
extending the AOA beyond this sector imposes major documentation and transfer
pricing issues which did not exist previously and have not previously given rise
to any significant problems.
A fifth issue is how far the AOA could be consistent with the UN Model, and
could be adopted by jurisdictions which favour that Model. In particular,
Article 7(3) of the UN Model contains wording which would not be compatible with
the AOA.
Specific issues
The OECD discussion has highlighted two specific issues:
First, the attribution of profits where there is an agency permanent
establishment.
Where there is a non-independent agent (who habitually exercises authority to
conclude contracts in the name of the enterprise), there will be an agency
permanent establishment. The issue which arises then, is whether there is any
profit to attribute to this form of permanent establishment, when the agent’s
remuneration already reflects the remuneration an independent agent would have
derived on an arm’s length basis.
The second issue concerns the symmetrical
application of the attribution of profits in both the host State and the State
of residence of the enterprise. If the state of residence relieves international
double taxation by the exemption method, then that State will need to attribute
profits to the PE for the purposes of computing the amount of profits to be
exempted. On the other hand, if the State of residence relieves international
double taxation by the credit method, then that State will need to attribute
profits to the PE for the purposes of computing the maximum amount of foreign
tax credit. However, there is a danger that the host State and the residence
State might adopt a different approach to the attribution of profits, and this
may lead to unrelieved double taxation. This possibility has been heightened in
the banking sector by the failure of the OECD to agree upon a single method of
capital attribution to a PE, so that the host State and the State of residence
may adopt a different approach to the allocation of capital to the PE. The OECD
has suggested a symmetrical approach under which the state of residence accepts,
to a certain extent, the attribution approach adopted by the host state. It is
not fully clear, however, whether this should apply only to determine the free
capital of the PE or also to all dealings between the PE and the enterprise of
which it is a part.
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Issues in the implementation of the AOA
A major practical issue arises from the possible implementation of the AOA. Even
assuming that the AOA represents a correct interpretation of the current wording
of Article 7, elements of the current Commentary clearly do not support the AOA,
but rather support a limited recognition of the PE as a separate enterprise.
Were an international consensus to develop in favour of adopting the AOA, the
question arises whether this could be implemented simply by changes to the
Commentary, or whether it would be necessary to change the wording of Article 7
itself.
The danger is that, if the wording of the Article is not changed, a period of
uncertainty will follow when it is not clear whether the tax administration or
judiciary in certain countries would apply the revised Commentary or not. In a
worst option scenario, one might end up with case law supporting the revised
Commentary and the AOA in some countries, but not in others.
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