Article 7: profits of a permanent establishment

Question 1

What are the general features of the old approach of article 7?

Answer 1

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Article 7(1): 2 principles:

1. Enterprise only taxable in State where activity is carried on:
   
   • Except when PE in other state.
2. If the enterpise has a PE in the other state, then “the profits of the enterprise” may be taxed in the other State “but only so much of them as is attributable tot that PE” (no “force of attraction”)
   
   • PE has to have an active realisation in the profits for it to be attributable to the PE
   • Difficult issues of profit allocation
   • No force of attraction principle = if PE in other State, profit not derived through PE activity is not taxed there

Question 2

How is the approach for deductions of costs under the old art. 7?

Answer 2

• Deductions for costs allowed if: “incurred for the purposes of the PE”, regardless whether incurred in PE State or in HQ State

Question 3

What are profits according to article 7?

Answer 3

• No definition: left to domestic laws of Contracting States: article 3(2)
• Art. 7 (7) specific treaty rules override the general rules of art. 7 both where foreign enterprise has PE in other State or not = lex specialis
  
  • Eg.: State A bank without PE in B grants loans to residents of B –> Art. 11 (interest)
  • Eg. independent sportsperson resident of A performs in state B: article 17: athletes & entertainers.
• Art. 6 (4): income derived by company resident of State A from immovable property situated in B always taxable in B, even if immovable property is not a PE

Question 4

What are “profits attributable to a PE”?

Answer 4

• Key question: to what extent the “profits attributable to a PE” are restricted by or linked to “the profits of the enterprise” as a whole (Art. 7 (1) first and second sentence)?
• 2 approaches:
  
  1. Single enterprise approach
  2. Separate entity approach

Question 5

What is the single enterprise appraoch?

Answer 5

• Profits of the enterprise as a whole have a restrictive effect on the profits attributable to the PE
• No profits can be attributed to the PE until they are realized by the enterprise as a whole
  
  • Example 1: German PE produces shoes and transfers them to the Belgian HQ in year one. Shoes are sold by Belgian HQ in Y2. No profit attributable to German PE in Y1.
  • Example 2: If enterprise as a whole is loss making no profit attribution to PE

Question 6

What is the separate entity approach?

Answer 6

• Art. 7 (2) there shall be attributed to that PE, the profits it might be expected to make if it were a distinct and separate enterprise engaged in same or similar activities in same or similar circumstances and dealing wholly independently with the enterprise of which it is a PE
• “Profits of the enterprise” as a whole have no restrictive effect on the “profits attributable to the PE”
• Profits can be attributed to the PE even if they are not realized by the enterprise as a whole
  
  • Example 1: German PE produces shoes and transfers them to the Belgian HQ in Y1. Shoes are sold by Belgian HQ in Y2. Profits for manufacturing activity attributable to German PE in Y1
  • Example 2: Enterprise makes losses on shoe sales, still profit attributable to PE for manufacturing activity

Question 7

Which of the 2 approaches does art. 7 of pre OECD take?

Answer 7

• Intermediate position:
  
  • Features of a single enterprise approach due to the interaction between art. 7(1) and art. 7(3) (“single enterprise”) and art. 7 (2) (“separate enterprise”)
  • Features of a separate entity approach (art. 7 (2) OECD MC)
• Absence of clear treaty rules/principles
  
  • Reference to domestic law “unless the context otherwise requires” (cfr. art. 3(2) OECD MC
  • Dominant role of the accounts of the PE and domestic General Accepted Accounting Principles (GAAP)

Question 8

What is the new approach of article 7 of the OECD?

Answer 8

• Authorized OECD Approach (AOA): 2010 OECD MC
• New Art. 7 (1) OECD MC (idem as old approach)
  • Taxation in residence State unless PE in other State – no force of attraction-principle
• Term “profits” (idem as under old approach)
  
  • New Art. 7 (4) specific treaty rules override the general rules of art. 7 both where foreign enterprise has PE in other State or not (= old Art. 7 (7))
• The “profits attributable to a PE” are not restricted to the “profits of the enterprise as a whole”:
  
  • Changes to old art. 7(1) OECD MC (“only so much of them”: deleted!)
  • Art. 7 (2) is the key provision
  • Deletion of old art. 7 (3) OECD MC on costs deductible by PE and consequentional changes to art. 7 (2) (“subject to provision of paragraph 3”).
  • No need to reconcile new art. 7 (2) with new art. 7 (1) 2010 OECD MC.
• Clear “treaty rules” - limited relevance of domestic law and GAAP

Question 9

How do we calculate profits of the PE under the AOA?

Answer 9

1. Step 1: drawing up tax balance sheet and P&L accounts of PE
   
   • No reference to PE accounts (GAAP) but application of transfer pricing principles
   • Factual & functional analysis
     • Identification of significant people functions (SPF)
     • Allocation of economic ownership of assets based on SPF
     • Identification & allocation of risk based on SPF
     • Attribution of “free capital” based on assets and risks
     • Recognition of internal dealings
2. Step 2: determination of arm’s length remuneration: article 9

Question 10

How do we draw up a tax balance sheet and P&L for the PE?

Answer 10

• Absence of legally binding contracts between HQ and PE and no primary reliance on the accounts of the PE (GAAP) so
• Requirement for an approach applicable in the PE context to attribute risks, economic ownership of assets and capital to the PE. Solution:
• Recourse to functional analysis, i.e. people functions as basis for hypothesising the PE as distinct and separate enterprise and determining the profits of the PE
• Identification of functions:
  
  • The more functions PE = the more profit attributable
  • PE: significant people’s functions: many employees = attribute economic ownership of lots of assetss

Question 11

Do we need to attribute marketing intangibles?

Answer 11

• Depends if it is used for a long period = long term investment exclusively = on balance sheet
• If not: not on balance sheet PE = marketing intangibles = will be used by lots PE

Question 12

What can a PE do with excess cash?

Answer 12

• If PE has excessive cash = retained earnings –> buys shares = dividends are attributable to PE
• But the excess cash is not legally owned by PE = cannot legally own anything
• Property entity as a whole but can be economically attributable = taxed in CS of PE!

Question 13

What is the identification of functions?

Answer 13

• Functional and factual analysis should:
  
  • Identify functions performed by personnel and distinguish between significant people functions and other functions
  • Identify characteristics of property and services
  • Identify economic circumstances and business strategies
• (People) functions can range from support or ancillary functions
  
  • Eg. branch carrying out auxiliary activities for entire group = PE over routine functions (e.g. PE toll manufacturer for entire group) to significant (people) functions relevant to the attribution of economic ownership of assets and/or the assumption of risks
    
    • Eg. production or sales PE, retail office of a non-resident bank)

Question 14

What is the attribution of assets?

Answer 14

• The identification of significant people functions relevant to the attribution of economic ownership of assets
• “Economic ownership” is the equivalent of ownership for income tax purposes, with attended benefits and burdens, i.e.:
  
  • Right to the income attributable to the ownership of assets
  • Right to depreciate the asset
  • Attribution of capital gains and losses relating to the asset
  • Investment in financial assets (shares, debt claims): entitlement to dividend and interest income (art. 7 (4) jo. Art. 10 (4) and art. 11(4) OECD MC)
• Rejection of mere “booking location” approach (limited relevance of GAAP)
• “Owning” a tangible asset does not automatically result in the attribution of the goods produced with it ((see next slides)
• Determination generally based on where the significant people functions relevant for the determination of economic ownership have been performed
• AOA differentiates between tangible and intangible assets

Question 15

What is the difference of the attribution of assets wrt tangible or intangible?

Answer 15

1. Tangible assets:
   
   • Broad consensus to generally apply use as a basis for attributing economic ownership, in the absence of circumstances in a particular case that warrant a different view
2. Intangible assets
   
   • Determination of economic ownership based on where the relevant significant people functions in connection to the intangible have been performed
   • Trade intangibles and marketing intangibles
   • Manufacturing intangibles
   • Newly developed and acquired intangibles

Question 16

What is the example of attribution of assets of debt claims?

Answer 16

• If PE: negotiates the terms of the loan, checks the credit rating and risks of Belco, makes the decision to grant the loan and closes the contract, subsequently administers, controls and monitors the risk associated with the loan

Question 17

What is the example of attribution of assets to toll/contract manufacturing PE?

Answer 17

• HQ: buys the raw materials and holds title to the goods until they are sold; HQ decides which goods are to be manufactured by the PE and sets the quality and quantity levels; Bears all inventory and sales risk
• Belco = customer
• Toll/contract manufacturing PE:
  
  • Economic ownership, plant/machinery/intangible (unless license on intangible)
  • “Economically owns” plant and machinery
  • Employs labour force
  • Manufactures the raw materials into semi-finished goods on the request and
  • Specifications of the HQ
  • Needs intangible to be able to produce (manufacturing formula & specifics)
    
    • Or at least a license to use the intangible

Question 18

What is the attribution of risks?

Answer 18

• No contractual arrangements for the attribution of risks in the PE context
• Enterprise as a whole legally bears the risk
• Range of potential risks depending upon PE and HQ activities: not legal understanding = more economical understanding
  
  • Market risk
  • Inventory risk
  • Credit risk
  • Operational risk
  • Product liability risk
  • Currency risk

Question 19

What is the signficiant people functions?

Answer 19

• The PE should be considered as assuming any risks for which the significant people functions relevant to the assumption of risks are performed by personnel of the PE at the PE’s location
• Significant people function for the assumption of risk = Active decision making function with regard to the acceptance of risk. To be distinguished from:
  
  • Strategic functions
  • Functions performed as a service
• Risks can not be segregated from functions
• But risks may be related to economic ownership of assets

Question 20

What are the consequences of bearing risk?

Answer 20

• Attribution of the attendant benefits and burdens (exposure to gains or losses, including bankruptcy)
• Affects the attribution of free capital under step one of the approach
• Affects the selection and application of a “transfer pricing method” under step two of the approach

Question 21

What is the attribution of capital?

Answer 21

• Really important: capital needs to be allocated to PE: the amount of capital is determined by SPFs of PE = risks assumed by PE.
• The attribution of free capital based on the assets and risks attributed to the PE
• Free capital is funding that does not give rise to a tax deductible return in the nature of interest
• Purpose: supporting the functions the PE undertakes, the assets economically owned and risk assumed to provide a cushion against crystallisation of risk
• General assumption of the same creditworthiness for all parts of the enterprise
  
  • No provision of capital from one part to another, no guarantees
  • Basis for determining funding costs
• Several methods are allowed to allocate “free” capital to a PE

Question 22

What is the recognition of internal dealings?

Answer 22

• The recognition and determination of the nature of dealings between PE and the rest of the enterprise
  
  • “Transactions” between the hypothesised parts of a single enterprise that can be recognised under the provisions of the AOA. Although they have no legal consequences, they are inferred for the purpose of determining PE profits
• Starting point: accounting records/internal documentation + functional analysis
• But only “recognition” if it is based on a real and identifiable event, i.e. economically significant transfer of risks, responsibilities and benefits
  
  • Determination by a functional and factual analysis

Question 23

How do we handle the determination of arm’s length remuneration?

Answer 23

• Notional transfer of goods
• Comparability between dealings and uncontrolled transactions by applying the TPG’s comparability factors
• Applying the TPG’s methods to arrive at an arm’s length pricing for the dealings between the PE and the rest of the enterprise (CUP, RPM, Cost plus, transactional method)

Question 24

What is the symmetrical application of the new approach?

Answer 24

• Profit attributed to PE & TP used = accepted by both parties as being the same price.
• Combination of art. 7 and art. 23 OECD MC requires each state to conform to the arm’s length principle:
  • Art.7 (2) allows each State to adjust profits if HQ and/or PE have not respected Art. 7 (2) and the arm’s length principle
  • Art. 7 (2) also applies “For the purposes of Art. 23 A and B”, i.e. profit determined by PE State must get relief for double taxation in State of HQ

Question 25

What is the new art. 7(3)?

Answer 25

• If one CS adjust profits upwards, other CS must make corresponding downwards adjustment (compare to art. 9 (2) OECD MC) to the extent necessary to relief double taxation
• In case of dispute: Art. 25 MAP + mandatory binding arbitration (Art. 25 (6) OECD MC)
• Within EU: Arbitration Convention and the 2017 Dispute Resolution Directive
• To avoid litigation: enter into APA with local tax authorities at both ends (see Art. 9)!

Question 26

What are the differences between old & new approach?

Answer 26

• Differences:
  
  • Restricted independence (old) vs. absolute independence (new)
  • Reliance on domestic law & GAAP (old) vs. independent treaty principles (new)

Question 27

What are the similarities between old & new approach?

Answer 27

• Both rely on the separate entity and the arm’s length principle but the scope of these principles is significantly wider under new art. 7 (2) 2010 OECD MC

Question 28

Can we apply the new approach to existing treaties?

Answer 28

• Update of the commentary in 2008 (rejection of the single enterprise approach, preparation of TP documentation, capital allocation approaches, construction PE’s etc.)
• The OECD position: yes we can
• OECD position is rejected by international case law (ex. the Natwest II - case in the US and the Morgan Stanley-case in India)