1 attribution of profits to permanent establishments -recent developments- xiamen university – 18...
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Attribution of Profits to Permanent Establishments
-Recent Developments-
Xiamen University – 18 February 2011
Josine van Wanrooij
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Agenda
1. Article 7 OECD MC in general
2. Article 7(1) OECD MC
3. Article 7(2) OECD MC
4. Article 7(3) OECD MC
5. Example
6. Questions
7. Contact details
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1. Article 7 OECD MC in general
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1.1. Relevance
• Avoidance of double taxation with regard to business profits
• Taxing rights of source state (Article 7 OECD MC)
• Relief obligation of residence state (Article 23A OECD MC)
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1.2. New Article 7 OECD MC as of 2010
• Pre-2010 Article 7 OECD MC: seven paragraphs
• 2010 Article 7 OECD MC: four paragraphs– One new paragraph on relief of double taxation– Four paragraphs deleted
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1.3. Main changes to Model and Commentary
• 2008: Commentary on Article 7 OECD MC amended as such that it does not conflict with the pre-2010 Article 7 OECD MC
• 2010: Article 7 OECD MC and Commentary amended
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2. Article 7(1) OECD MC
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2.1. Article 7(1)1 OECD MC (i)
• Not amended in 2010
• “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”.
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2.1. Article 7(1)1 OECD MC (ii)
• Right to tax
• But!
Article 7(7) OECD MC (pre-2010)
Article 7(4) OECD MC (2010)
Other articles have precedence
• Definition of permanent establishment in Article 5 OECD MC
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2.2. Article 7(1)2 OECD MC (i)
• Slightly amended in 2010
• “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.” (pre 2010)
• “If the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that other State.” (2010)
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2.2. Article 7(1)2 OECD MC (ii)
• Which profits may be taxed?
• No force of attraction
• No link to overall profits of the enterprise
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HO
State R
State S
PE
PE manufactures in State S
HO Sells products in State R
HO sells 1 product in State S
Question: Who may tax what?
2.2. Article 7(1)2 OECD MC (iii)
Force of attraction
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2.2. Article 7(1)2 OECD MC (iv)
Link to profits of the enterprise as a whole
HO
State R
State S
PE PE profits 200
HO Loss (100)
Overall profits 100
Question: Who may tax what?
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3. Article 7(2) OECD MC
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3. Article 7(2) OECD MC (i)• Major changes to the text
• “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.” (pre 2010)
• “For the purposes of this Article and Article [23A] [23B], the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 are the profits it might be expected to make, 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.” (2010)
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3. Article 7(2) OECD MC (ii)
• How to determine which profits may be taxed.
• New:– Reference to dealings– Reference to Article 23A and 23B OECD MC– How to attribute profits: Separate independent entity
approach (arm’s length principle)
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3.1. Arm’s length principle• Laid down in Article 9(1) OECD MC
Whereconditions are made or imposed between two enterprises in their relations which differ from market conditions, then the profits that would be realised under market conditions by an enterprise are to be included in the profits of that enterprise and taxed accordingly.
Need to compare• Fact and transaction• Price
• Additional guidance in the Transfer Pricing Guidelines
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3.1.1. Transfer Pricing GuidelinesTypical process• Determine relevant years
• Broad based analysis of taxpayer’s circumstances
• Understanding controlled transaction as to choose most appropriate transfer pricing method and identify the significant comparability factors
• Review internal and external comparables
• Selection of most transfer pricing method
• Identification of potential comparables based upon the comparability factors
• Comparability adjustments
• Determine arm’s length price
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3.1.2. Comparability analysis (i)
• Characteristics of property or services
• Functionality analysis– Functions– Risks– Assets
• Contractual terms
• Economic circumstances
• Business strategies
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3.1.2. Comparability analysis (ii)
• A permanent establishment does not enter into legally binding contracts with its head office
• For that reason functional analysis most important factor to hypothesise the permanent establishment as distinct and separate enterprise.
• Who does what and who is responsible for what?
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3.1.2. Comparability analysis (ii)
Dealings• Starting point are the accounting records and
available internal documentation
• Real and identifiable events are dealings
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3.1.2. Comparability analysis (iii)
• Functionality analysis Distinguish functions performed by personnel in significant
people functions and other functions and allocate assets and risks upon that basis
• Characteristics of property and services
• Economic circumstances
• Business strategies
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3.2. Major differences pre and post 2010
• Full application of arm’s length principle as of 2010
• Before 2008 amendments of the commentary a few major exceptions to full application of arm’s length principle– Royalties – Provision of services– Transfer of funds
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3.2.1. Major differences pre and post 2010
Royalties
• Pre-2010– No internal royalties– Costs were allocated to the relevant parts
• 2010– Internal royalties should be taken into account
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3.2.2. Major differences pre and post 2010
Internal services
• Pre-2010– No arm’s length price for services that are rendered
within the enterprise but not to other enterprises– Services were remunerated against costs
• 2010– All services should be remunerated with an arm’s length fee
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3.2.3. Transfer of funds (i)
• Relevant for potential interest deductions
• Pre-2010: internal loans were in principle not recognised in non-financial sector
• 2010: Internal loans are recognised
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3.2.3. Transfer of funds (ii)Free capital• Free capital does not give rise to tax deductible interest
• The attribution of free capital based on the assets and risks attributed to the permanent establishment
• Free capital supports the functions, assets and risks of the permanent establishment
• Parts of one enterprise have the same creditworthiness
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4. Article 7(3) OECD MC
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4. Article 7(3) OECD MC• Major changes
• “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.” (pre-2010)
• “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 States shall if necessary consult each other.” (2010)
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4.1. Article 7(3) OECD MC, pre 2010
• Only determines which expenses should be attributed but does not deal with the issue of whether those expenses are deductible
• Same principle as Article 7(2) OECD MC
• For that reason deleted in 2010 OECD MC
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4.2. Article 7(3) OECD MC, post 2010
• Based on corresponding adjustment mechanism of Article 9(2) OECD MC
• Also see Article 25 OECD MC
• All cases of double taxation should be eliminated in the permanent establishment context
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5. Example
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5.1. Example 1• A operates in the container leasing business and its
European sales activities are structured through a PE in the Netherlands.
• The PE employs 8 persons and the following activities are conducted: – European marketing and sales – logistic services
• Question: which questions should be asked in order to determine what kind of profits should be allocated to the PE?
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6. Questions?
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Josine van Wanrooij, Senior Tax Lawyer
Amsterdam Office of Loyens & Loeff
T: +31 20 578 55 88
F: +31 20 578 58 44
Contact