Attributing Profits To A Permanent

Attributing Profits to a Permanent Establishment

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Abstract The permanent establishment concept has a history as long as the history of double taxation conventions. Currently, the international tax principles for attributing profits to a permanent establishment are provided in Article 7 of the OECD Model Tax Convention on Income and on Capital, which forms the basis of the extensive network of bilateral income tax treaties between OECD Member countries and between many OECD and non-OECD member countries. There is considerable variation in the domestic laws of OECD member countries regarding the taxation of permanent establishments. In addition, there is no consensus among the OECD Member countries as to the correct interpretation of Article 7. This lack of common interpretation and consistent application of Article 7 can lead to double, or less than single, taxation. This paper begins by explaining the importance and the need to have clearly defined rules with regard to the attribution of profits to a permanent establishment. It then analyzes the Discussion Draft released by the OECD on August 3, 2004, changes made and very specific issues that need to be resolved in the said draft. It also examines the various issues that may arise while implementing the said draft from both business and country perspectives. Finally, the paper goes on to discuss the implications of the draft on existing rules for profit attribution rules existing in different countries like the U.S., Canada, Switzerland and India.

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Contents 1 Introduction 1.1 A Brief History of the Permanent Establishment Principle . . 1.2 Purpose of profit attribution provisions . . . . . . . . . . . . 1.3 Importance of the New Discussion Draft . . . . . . . . . . . .

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2 Basic Approach

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3 First Step: Determining the activities and conditions hypothesized distinct and separate enterprise 3.1 Functions . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Assets used . . . . . . . . . . . . . . . . . . . . . . . . 3.3 Risks assumed . . . . . . . . . . . . . . . . . . . . . . . 3.4 Attributing capital to the permanent establishment . . 3.5 Determining funding costs . . . . . . . . . . . . . . . .

of the . . . . .

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4 Second step: Determining the profits of the hypothesized distinct and separate enterprise based upon a comparability analysis 4.1 Applying Transfer pricing methods to attribute profits . . . . 4.2 Comparability analysis . . . . . . . . . . . . . . . . . . . . . . 4.3 Capital assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4 Intangible Property . . . . . . . . . . . . . . . . . . . . . . . . 4.5 Treatment of Dependent Agent Permanent Establishments . . 4.6 Key Entrepreneurial Risk-Taking Functions . . . . . . . . . . 4.7 Documentation . . . . . . . . . . . . . . . . . . . . . . . . . .

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5 Changes made by the revised Draft 5.1 Dealings: . . . . . . . . . . . . . . . . . . . . . . 5.2 Allocation of Capital . . . . . . . . . . . . . . . . 5.3 Determining funding costs . . . . . . . . . . . . . 5.4 Intangible property . . . . . . . . . . . . . . . . . 5.5 Notional Interest . . . . . . . . . . . . . . . . . . 5.6 Dependent Agent Permanent establishments . . . 5.7 Symmetrical Application of the authorized OECD

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6 Practical implementation issues 20 6.1 Issues for governments . . . . . . . . . . . . . . . . . . . . . . 21 6.2 Issues for taxpayers . . . . . . . . . . . . . . . . . . . . . . . . 21

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7 Apparent tensions in the Discussion Draft 7.1 Documentation . . . . . . . . . . . . . . . 7.2 Separate and Distinct Entity Approach . . 7.3 Functional analysis in general . . . . . . . 7.4 Assets used and conditions of use . . . . . 7.5 Capital Allocation . . . . . . . . . . . . . 7.6 Application of Guidelines . . . . . . . . . . 7.7 Absence of a definition for “profits” . . . . 7.8 Dependent Agent Permanent establishment 7.9 Deference to Host Country Determinations

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8 Impact of the Draft Convention on the existing practices relating to the attribution of profits to a Permanent Establishment 8.1 Issues regarding US bilateral treaty provisions . . . . . . . . . 8.2 Impact of the Discussion Draft on Canada . . . . . . . . . . . 8.3 Swiss approach to the allocation of profits to Permanent Establishments . . . . . . . . . . . . . . . . . . . . . . . . . . 8.4 Taxation of Business Process Outsourcing Units in India . . . 9 Conclusion

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Introduction

1.1

A Brief History of the Permanent Establishment Principle

An early version of the permanent establishment principle has been traced to the late 1800s when European nations negotiated bilateral tax treaties to govern the tax treatment of cross-border economic activity1 . The modern version of the rule arose after World War 1 when nations became concerned that international double taxation was inhibiting international trade and investment. After the War, for example, Canadian tax authorities attempted to tax incoming mail order sales of a U.S. firm despite the fact that this firm only advertised its goods in Canada2 . The Americans maintained that the United States should have the exclusive right to tax these earnings, creating potential double taxation of the same business activities. As a result of growing concern, the League of Nations commissioned a group of tax experts to come up with a mechanism to ensure that double taxation would be avoided. The group arrived at a consensus and developed the permanent establishment concept that became enshrined in a 1927 model tax convention and later adopted in the 1963 Organisation for Economic Cooperation and Development (OECD) model tax treaty (as well as subsequent revisions of this model treaty in 1977 and 1992) 3 . The OECD Model Tax Convention on Income and on Capital (hereinafter referred to as the Model Treaty) provides the basis for most of the existing bilateral income tax treaties, especially those among developed countries. These treaties generally try to prevent double taxation by assigning priority rights of taxation between the tax authorities of the two countries. Although the treaties generally confer on the country of residence the priority right to tax the income of an enterprise, they create a number of exceptions pursuant to which the country of the source of the income has the priority right of taxation. One of these exceptions is the right of the country in which an enterprise maintains a permanent establishment to tax the business profits 1

The requirement for a fixed place of business within source countries is typically traced back to the tax treaty between Austria-Hungary and Prussia in 1899. See Arvid A. Skaar, Permanent Establishment: Erosion of a Tax Treaty Principle 65-101 (1991). 2 See Michael J. Graetz & Michael M. O’Hear, The ”Orginal Intent” of U.S. International Taxation, 46 Duke Law Journal 1021, 1088 (1997) (arguing the original intent of U.S. international income tax policy favored source-based taxation). 3 Reforming the permanent establishment principle through a quantitative economic presence test, Arthur J. Cockfield; See also, ”Commentary on Article 7 of the OECD Model Treaty: Allocation of Profits to a permanent establishment”, in Taxation of Permanent establishments, IBFD online publication.

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attributable to that permanent establishment. Once a permanent establishment exists, Article 7 of the OECD Model Treaty and the comparable article in most bilateral tax conventions permit the taxing authority of the country in which the permanent establishment is situated to tax the profits attributable to the permanent establishment. The expanded concept of permanent establishment increases the ability of tax authorities to conclude that a non-resident has an actual or deemed permanent establishment in a jurisdiction and therefore the need for there to be a uniform set of principles and procedures for determining the portion of an enterprise’s profits that are attributable to a permanent establishment. In the absence of such uniformity, the risk of both taxing authorities imposing tax on the same income is likely to become a barrier or certainly a disincentive to cross-border operations.

1.2

Purpose of profit attribution provisions

A: Limitation of source-based taxation The provisions of Article 7 have long been viewed as designed to prevent taxation of the profits of a non-resident enterprise, except to the extent that they are attributable to a permanent establishment of the enterprise. The OECD Commentary on Article 7, endorses: “the generally accepted principle of double taxation conventions that an enterprise of one state shall not be taxed in the other State unless it carries on business in that other State through a permanent establishment situated therein...the second and more important principle is that, when an enterprise carries on business through a permanent establishment in another State, that State may tax the profits of the enterprise but only so much of them as is attributable to the permanent establishment, in other words that the right to tax dose not extend to profits that the enterprise may derive from that State otherwise than through the permanent establishment.”4 The limitations provided by Article 7 reflect the view that the host country should be permitted to tax the profits of a non-resident enterprise only if it has substantial connection with that country. Even where it is agreed that an enterprise has a local permanent establishment, the determination, allocation and verification of income and expenses attributable to the permanent establishment often normally are more difficult for the host country to ascertain than for the residence country. 4

OECD Commentary on Article 7, paras 3 and 5. See also 1996 US Model Technical Explanation of Article 7, para 1.

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B. Minimization of double or inappropriate taxation By minimizing the exposure of non-resident enterprises to taxation in jurisdictions with which they have limited contact, the provisions of Article 7 have helped to avoid overlapping claims of jurisdiction to tax. Global businesses are encountering increased examination activity on permanent establishment issues in many countries, typically involving the attribution of substantial profits. Their primary concerns regarding the attribution of profits to a permanent establishment are that: • A consistent approach be applied internationally. • Adequate certainty be provided in advance regarding the interpretation and implementation of the agreed approach. • Associated compliance burdens not exceed an administrable level. Each of these goals must be satisfied if the primary purpose of tax treaties - the avoidance of double or inappropriate taxation, is to be achieved. In recent years, a growing focus on permanent establishment issues led to the conclusion that the OECD member countries needed to reach a greater consensus on the principles to be applied in attributing profits to permanent establishments. Accordingly, beginning in 1998, the OECD undertook an effort to reconsider the interpretation of Article 7 with a view towards achieving consensus among the member countries on its correct interpretation. The Working Party published an initial discussion draft in February 2001 that focused both on general issues (Part1) and issues relating to the banking sector (Part II). This has been followed by drafts relating exclusively to banking and global dealing issues (Parts III and IV) In 2 August 2004, the OECD published a revised version of Part I of its “Discussion Draft on the Attribution of Profits to Permanent Establishments”, The new Discussion Draft revises and updates the description of the key building blocks and general principles to revise the rules on income attribution applicable under Article 7 of the OECD Model Tax Treaty (the “Model Treaty”).

1.3

Importance of the New Discussion Draft

Revised Part I of the Discussion Draft is an extraordinarily important document. The OECD suggests that the thinking reflected in this document is now sufficiently far advanced that it represents the “authorized OECD approach” to attributing profits to permanent establishments. The 7

implication is that, OECD member country competent authorities will in all likelihood immediately begin to apply the principles contained in the August 2, 2004 Discussion Draft in resolving cases involving permanent establishments. The OECD suggests that any future changes to this document will be only for the purpose of clarification and should not be expected to change the substance of the tax rules set out in the August 2 draft. The rules of the Discussion Draft apply principally to companies that operate in branch form in treaty jurisdictions. However, because this document is issued at a time when tax authority assertions of the existence of permanent establishments are proliferating in transfer pricing and other tax audits around the globe, the rules for attributing income to permanent establishments contained in the Discussion Draft may often be relevant to those operating in subsidiary and partnership form 5 .

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Basic Approach

The starting point of the OECD analysis is that the income of a permanent establishment should be determined on the basis of an assumption that the permanent establishment should be viewed as a “functionally separate entity.” 6 . Under this approach, paragraph 1 of Article 7 is interpreted as not affecting the determination of the quantum of the profits that are to be attributed to the permanent establishment, other than providing specific confirmation that, “the right to tax of (the host country) does not extend to profits that the enterprise may derive from that State otherwise than through the permanent establishment. The terms ‘profits of an enterprise’ and ‘only so much of them’ in Article 7 are interpreted as referring only to the profits of the business activity in which the permanent establishment has participated 7 . The treatment of a permanent establishment as a distinct and separate 5 Attributing Income to Permanent Establishments, By Joseph Andrus, Adam Katz, Richard Collier, Annie Devoy, and Isabel Verlinden (PricewaterhouseCoopers) 6 Under this approach, paragraph 1 of Article 7 is interpreted as not affecting the determination of the quantum of the profits that are to be attributed to the PE, other than providing specific confirmation that, the right to tax of the host country does not extend to the profits that the enterprise may derive from that state otherwise than through the permanent establishment. (See Para 19 of the Discussion Draft) 7 Tax Treatment of “Dealings” Between different parts of the same enterprise under Article 7 of the OECD Model: Almost a century of uncertainty; Raffaele Russo, Official Journal of the International Fiscal Association Volume 58 Number 10, October 2004.

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enterprise has both a strong base in historical international practice as well as in a theoretical foundation that will serve well in ensuring that the taxation of permanent establishments comes within the purview of the arm’s length standard8 . Consistent with the basic methodology set out in earlier versions of the Discussion Draft, income is then attributed to a permanent establishment by applying the following steps: 1. A detailed functional analysis must be undertaken in order to identify the location of key entrepreneurial risk-taking functions in the permanent establishment and its home office9 . 2. Assets and risks of the business are attributed to the permanent establishment and home office based on the location of the performance of the key functions as identified in the functional analysis10 . The part of the enterprise attributed the asset will also be attributed any associated profit. 3. Free capital is allocated to the permanent establishment in proportion to the assets and risks allocated to the permanent establishment. 4. income is allocated to the permanent establishment by applying the OECD Transfer Pricing Guidelines to the notional separate legal entity assuming it has the assets, risks, and capital determined under the first three steps and deals with its home office on an arm’s-length basis. 8

Letter dated 11th October 2004 from the BIAC (Business and Advisory Committee to the OECD) on the Discussion Draft to the OECD on the Discussion draft. 9 The determination should be on a case by case basis as the key entrepreneurial risktaking functions and their relative importance will depend on the particular facts and circumstances. 10 The functional analysis will examine all the facts and circumstances to determine the extent to which the assets of the enterprise are used in the functions of the PE and the conditions under which the factors are used, including the factors to be taken into account to determine which part of the enterprise is regarded as the economic owner of the assets, See Para 58 of the Discussion Draft.

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3.1

First Step: Determining the activities and conditions of the hypothesized distinct and separate enterprise Functions

The first step of the authorized OECD approach determines the activities and conditions of the hypothesized distinct and separate enterprise. The functional and factual analysis takes account of the functions performed by the personnel of the enterprise as a whole including the permanent establishment-“people functions” 11 and assesses what significance if any they have in generating the profits of the business. The functional analysis needs to be carried out in a thorough and detailed manner in order to establish the exact nature of the function being performed. This is because where the functional analysis has determined that the permanent establishment has performed key entrepreneurial risk taking functions, the permanent establishment will be attributed the assets and risks associated with those functions. This in turn leads to the attribution to the permanent establishment of the income and expenses associated with those assets and risks.

3.2

Assets used

To the extent that assets are used in the functions performed by the permanent establishment, the use of those assets should be taken into account in attributing profit to the functions performed by the permanent establishment. Regard has also to be given as to the conditions under which the asset is used; the capacity in which the permanent establishment uses the asset will have an impact on the amount of profits attributed to it.

3.3

Risks assumed

The division of risks and responsibilities within the enterprise will have to be, “deduced from conduct of the parties and the economic principles that govern relationships between independent enterprises” 12 . This deduction must be 11

People functions can range from the routine to the key entrepreneurial risk taking functions of the business. The latter are those which require active decision making with regard to the most important profit generators of the business and so it will be particularly important for these to be identified under the functional analysis. 12 Discussion Draft Para 25.

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accompanied by analyzing the internal practices of the enterprise, by making a comparison with what similar enterprises would do and by examining any internal documentation showing how the attribution of risk has been made.

3.4

Attributing capital establishment

to

the

permanent

Under the authorized OECD approach1. The permanent establishment is treated as having an appropriate amount of capital in order to support the functions it performs, the assets it uses and risks it assumes. 2. An arm’s length amount of “free capital”13 is attributed to the permanent establishment. The Discussion draft provides several alternative methods for attributing an arm’s length amount of capital to a permanent establishment. It indicated that this was done because it was not possible to obtain an international consensus on a single allocation method, which it suggests was due to the fact that “there is no single approach which is capable of dealing with all circumstances” 14 . The Discussion draft accordingly endorses four alternative approaches, which differ substantially: • The capital allocation approach, which involves allocating an enterprise’s actual ’free capital’ in accordance with the attribution of assets owned and risks assumed. • The economic capital allocation approach, which involves allocating economic capital based on all economic risks. • The thin capitalization approach, which requires the permanent establishment to have the same amount of ‘free capital’ as an independent enterprise would have if it were carrying on the same or similar activities under the same or similar conditions in the host country. • The safe harbour approach, a quasi-thin capitalization approach, which requires the permanent establishment to at least have the same 13

The term “free capital” is defined as an investment which does not give rise to an investment return that is deductible for tax purposes under the rules of the host country of the PE. 14 See Discussion Draft Para 142

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amount of ‘free capital’ required for regulatory purposes as would an independent enterprise operating in its sector in the host country, potentially combined with a safe harbour. To the extent that taxpayers are allowed to choose from among the alternative methods, the resulting flexibility may assist them in applying the authorized OECD approach. However, it is not entirely clear from the Discussion draft whether taxpayers are free to make this choice, or whether it is a decision to be made by each OECD member state.

3.5

Determining funding costs

Once the amount of “free capital” has been determined, the balance of the funding requirement is the amount by reference to which the interest deduction is calculated. There is more than one authorized approach to attributing interest bearing debt and to determining the rate of interest to be applied to that debt. • Treasury Dealing: While movement of funds between parts of the enterprise do not necessarily give rise to dealings, there are circumstances under which they could be recognized as internal interest dealings within non financial enterprises, for the purposes of rewarding a treasury function. • Tracing approach: Under this approach, any internal movement of funds provided to a permanent establishment are traced back to the original provision of funds by third parties. • Fungibility approach: Where, money borrowed by a permanent establishment of an enterprise is regarded as contributing to the whole enterprise’s funding needs, and not particularly to the permanent establishment’s funding needs. This approach ignores the actual movement of funds within the enterprise and any payments of interbranch or head office/branch interest. Each permanent establishment is allocated a portion of the whole enterprise’s actual interest expense paid to third parties on some pre-determined basis.

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Second step: Determining the profits of the hypothesized distinct and separate enterprise based upon a comparability analysis

The authorized OECD approach is to undertake a comparison of dealings between the permanent establishment and the enterprise of which it is a part, with transactions between independent enterprises. By analogy with the Guidelines15 , comparability in the permanent establishment context means either that there are no differences materially affecting the measure used to attribute profit to the permanent establishment, or that reasonably accurate adjustments can be made to eliminate the material effects of such differences.

4.1

Applying Transfer pricing methods to attribute profits

A permanent establishment differs from a subsidiary and is not legally or economically separate from the enterprise. Therefore, dealings between a permanent establishment and the enterprise of which it is a part normally don’t have legal consequences for the enterprise as a whole implying a greater need for scrutiny16 of dealings between a permanent establishment and the rest of the enterprise. The starting point for the evaluation of a potential “dealing” will normally be the accounting records of the permanent establishment showing the purported existence of such a ”dealing”. Under the authorized OECD approach that “dealing” as documented by the enterprise will be recognized for the purposes of attributing profit, provided it relates to a real and identifiable event17 . A functional analysis should be used to determine whether such an event has occurred and should be taken into account as an internal dealing of economic significance. One of the relevant 1995 Guideline principles requires that “dealings” of an enterprise with its permanent establishments are to be respected in 15

OECD Transfer Pricing Guidelines for multinational enterprises and tax administrations, 1995. 16 This greater scrutiny means a threshold needs to be passed before a dealing is accepted as equivalent to a transaction between independent enterprises acting at arm’s length and placing the onus on the taxpayer to demonstrate that it would be appropriate to recognize the dealing. 17 For example, the physical transfer of stock in trade, the provision of services, use of an intangible asset, a change in which part of the enterprises using a capital asset, the transfer of a financial asset, etc

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much the same way as transactions between members of a multinational group, provided that such dealings are not inconsistent with the substance of the particular business transactions or activities. The tax authorities must, therefore, refrain from restructuring actual transactions and documented dealings of the two parties involved.18 A second relevant 1995 Guideline principle is the recognition that transfer pricing is not an exact science and that, therefore, as long as transfer prices are within a range of comparable prices, no adjustment is necessary. In this respect, it is very important, that the enterprises are given sufficient flexibility.19 These two important principles protect taxpayers against unwarranted adjustments of transfer prices by taxing authorities. In competent authority cases, the burden of proof lies with the country that proposes an adjustment, which is important in the interest of minimizing the likelihood of double taxation.

4.2

Comparability analysis

According to the guidelines there are five factors determining comparability between controlled and uncontrolled transactions; characteristics of property or services, functional analysis, contractual terms, economic circumstances and business strategies. The comparability analysis might determine that there has been a provision of goods, services or assets between one part of the enterprise and another that is comparable to a provision of goods, services or assets etc. between independent enterprises. Accordingly, the part of the enterprise making such a “provision” should receive the return, which an independent enterprise would have received for making a comparable “provision” in a transaction at arms length. Notwithstanding the fact that the permanent establishment is not a distinct and separate legal entity from the rest of the enterprise, the same economic goals can nonetheless be replicated as between a permanent establishment and the rest of the enterprise as a notional construct to assist in the attribution of profits to a permanent establishment.

4.3

Capital assets

Here the first step would be to determine whether the enterprise itself owns the assets, leases it or rents it from an independent enterprise. In this 18 19

See Paras 1.36 and 1.37 of the 1995 Guidelines. See Para 4.17of the 1995 Guidelines.

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respect documentation of the arrangement will be of assistance, however, if the documentation does not reflect the true conduct of the parties, the actual conduct of the permanent establishment and the enterprise will need to be considered in order to establish the true nature of the arrangement. The Functional analysis will determine where the economic ownership of an asset belongs depending upon which part or parts of the enterprise perform the key entrepreneurial risk-taking functions in respect of that asset.

4.4

Intangible Property

The draft begins from the position that existing guidance under Article 5 and 7 is minimal and further states that the position reached in the 1994 Report is defective in many respects. According to the Draft, the economic ownership of intangible property should be made on a similar basis as the attribution of assets; that is, on the basis of where the key entrepreneurial risk-taking functions were performed. For example, a transfer may be documented as a “rental”, but the permanent establishment is in fact responsible for its regular maintenance, recruits personnel to conduct unforeseen repairs and further decides whether to continue use or replace the asset. In the said circumstances economic ownership of the asset appears to have been transferred to the permanent establishment 20 . With respect to internally developed trade intangibles, the revised Discussion draft takes the position that the key entrepreneurial risktaking functions are those functions related to the development of the intangible. Active decision-making and day-to-day management of research and development programs would, in most instances, be the key factors. The Discussion draft states: “it is not so much the intention to use the intangible per se that should be a factor in determining economic ownership of an intangible, but the extent to which the intended user performed the key entrepreneurial risk taking functions, e.g., by taking (or taking part in) the initial decision to develop the intangible or undertaking the day to day management of the research and development program.” Under the OECD methodology applicable to permanent establishments, economic risks cannot be separated from functions, so that a permanent establishment could not become the economic owner of intangibles merely by virtue of paying the bills for research, unless it also participates in the management and performance of the research. With regard to marketing intangibles the Discussion draft admits that it 20

See Para 204 of the Discussion Draft.

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may be more difficult to identify which functions and risks actually relate to the creation and ongoing maintenance of the global marketing intangibles. However, it states that the same principles should apply to determine the sole or joint ”economic” ownership of marketing intangibles as trade intangibles.

4.5

Treatment of Establishments

Dependent

Agent

Permanent

According to the Discussion draft in cases where a permanent establishment arises from the activities of a dependent agent, the host country will have taxing rights over two different legal entities- the dependent agent enterprise (which is a resident of the host country) and the dependent agent permanent establishment (which is a permanent establishment of a nonresident enterprise) The host country can only tax the profits of the non-resident enterprise where the functions performed in the host country on behalf of the nonresident enterprise meet the permanent establishment threshold as defined under Article 5. Further, the quantum of that profit is limited to the business profits attributable to operations performed through the dependent agent permanent establishment in the host country. The same principles that are used for other types of permanent establishments will be used to attribute profits to the dependent agent permanent establishment. The dependent agent permanent establishment will be attributed the assets and risks of the non-resident enterprise relating to the functions performed by the dependent agent permanent establishment on behalf of the non-resident, together with sufficient free capital to support those assets and risks. The OECD approach then attributes profits to the dependent agent permanent establishment on the basis of those assets, risks and capital. The analysis would also focus on the nature of functions carried by the dependent agent on behalf of the non-resident enterprise and in particular whether it undertakes key entrepreneurial risk-taking functions. Here, an analysis of the skills and expertise of the employees of the dependent agent enterprise is to be considered, in order to determine whether the dependent agent acts on behalf of the non-resident enterprise in performing negotiating or risk-management functions. In practice, the dependent agent enterprise may not perform key entrepreneurial risk taking functions and if it does not then the attribution of the assets, risks and profits to the dependent agent permanent establishment, are correspondingly reduced or eliminated. 16

The authorized OECD approach recognizes that it is possible in appropriate circumstances to attribute profits in addition to the arm’s length reward that has been

4.6

Key Entrepreneurial Risk-Taking Functions

As noted above, the entire scheme for allocating income to permanent establishments turns on identifying the geographic location of the performance of key entrepreneurial risk-taking functions. The Discussion Draft defines key entrepreneurial functions as “those which require active decision making with regard to the most important profit generators of the business.” The identification of these factors is a highly factspecific exercise. The Discussion Draft suggests that key entrepreneurial risktaking functions will not necessarily be the same in any two analyses, even for enterprises in the same industry.

4.7

Documentation

The Discussion Draft suggests that taxpayers should prepare documentation supporting their application of the Discussion Draft rules in accordance with the Transfer Pricing Guidelines.

5 5.1

Changes made by the revised Draft Dealings:

Various commentators found fault with the 2001 Draft for not providing a sufficiently clear explanation of the concept of “dealings”21 . In particular, to what extent would the tax authorities be bound by the characterization of dealings by the taxpayer? The Discussion draft now provides further guidance on this issue. It states that, because the dealings between a permanent establishment and the rest of the enterprise normally have no legal consequences the onus is placed on the taxpayer to demonstrate that it would be appropriate to recognize the dealings22 . 21

”Summary of the Proceedings of an invitational seminar on the attribution of profits to permanent establishments.”, B.J. Arnold & M.Darmo, (2001), vol. 49, no.3 Canadian Tax Journal, 525-549 (The OECD uses the term “dealings” as being analogous to the concept of transactions taking place between separate enterprises: i.e., a dealing is a “transaction” that takes place between the PE and another part of the same legal enterprise.) 22 Discussion draft Para 174.

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5.2

Allocation of Capital

The new draft continues to provide that a portion of the enterprise’s capital must be attributed to the permanent establishment to support the functions it performs, the assets it uses and the risks it assumes, but provides additional guidance on how this is to be done “to ensure that a fair and appropriate amount of profits is allocated to the permanent establishment.” In particular, the new draft significantly modifies and expands the discussion of capital allocation, rejecting the previous preference for a single method in favor of providing several alternative methods for determining an arm’s length amount of capital to be attributed to the permanent establishment23 .

5.3

Determining funding costs

The application of the authorized OECD approach represents a significant departure from the existing commentary by authorizing an approach to attributing interest expense based on the recognition of internal interest dealings in non-financial enterprises in appropriate circumstances. The authorized OECD approach is able to do this because it is rooted in a detailed functional and factual analysis, which attributes functions, assets and risks to the permanent establishment, then attributes a sufficient amount of “free capital” to support the assets used and the risks assumed.

5.4

Intangible property

The Discussion draft discusses the determination of the “economic owner” of intangible property, for both internally developed and acquired intangibles and for trade and marketing intangibles. This is a modification from the original draft which provided that that it might be appropriate to allocate intangible assets between a permanent establishment and the home office by reference to the place where the intangible was used or intended to be used. The ownership and use of trade intangibles are said generally to depend on which part of the enterprise undertakes the “active decision-making” relating to the development or acquisition of the intangible and the “day-to-day management” of the risks associated with its development or use. In the case of marketing intangibles, the revised draft concludes that it generally is not possible to identify one part of the enterprise as the owner of the 23

OECD Revises Proposed Changes on the attribution of Profits to a Permanent Establishment, as Examination Activity Increases, Mary C.Bennett and Carol A. Dunahoo, Washington D.C.

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global marketing intangibles, although this may sometimes be possible for marketing intangibles specific to the permanent establishment’s host country. The shift of the focus from potential use to participation in development as the key factor to consider is a welcome development.

5.5

Notional Interest

The existing Commentary to Article 7 does not authorize a deduction in respect of internal debts and receivables in computing the profits of a permanent establishment generally, except for payments of interest actually made for different parts of a financial enterprise. Thus, making a distinction between financial and non-financial enterprises. The 2001 Draft proposed to continue the approach of not recognizing internal “interest” dealings for non-financial enterprises. The Discussion draft significantly departs from this approach by allowing the recognition of internal interest dealings in non-financial enterprises in appropriate circumstances24 .

5.6

Dependent Agent Permanent establishments

The 2001 Draft did not address the specific issues that might arise in the context of dependent agent permanent establishments. But the Discussion draft added a separate section examining the special considerations applicable to dependent agent permanent establishments. This section provides “specific guidance on the attribution of profits to a dependent agent permanent establishment that is consistent with the arm’s length principle in addition to the arm’s length price for services performed by the agent”. As a result of this approach, a dependent agent permanent establishment can be allocated income over and above the arm’s length fee already due to the dependent agent permanent establishment .25 In an earlier draft of Part III of the Discussion Draft, relating to global dealing in financial products, the OECD had suggested that compensation in addition to the arm’s-length fee to the dependent agent should be attributed to the permanent establishment. This was by far the most intensely debated point at the recent public consultation in Geneva, Switzerland held to discuss the OECD income attribution project with affected businesses. Notwithstanding the adverse comments from affected businesses in Geneva, revised Part I clearly takes the position that a dependent agent permanent establishment can, under appropriate circumstances, be allocated income 24 25

Discussion draft Paras 149 and 167. Discussion draft Para 267.

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over and above the arm’s-length fee due to the dependent agent that gives rise to the permanent establishment. This income arises when employees of the dependent agent perform key entrepreneurial risk-taking functions and therefore attract to their location assets and risks under the methodology summarized above. The assets and risks belong to the principal, not the agent, but because the functions giving rise to those assets and risks occur in the agent’s country, they should properly be allocated to the permanent establishment in that country, not to the home office.

5.7

Symmetrical Application of the authorized OECD approach

One consequence of the authorized OECD approach is that the “functionally separate entity” approach is used irrespective of whether a country is the host country or the home country, or whether it gives relief from double taxation by exemption or credit methods. This common interpretation of Article 7 should reduce the incidence of double taxation because of the differences in the way countries compute the quantum of profit to be attributed to a permanent establishment under the arm’s length principle. The development of the authorized OECD approach therefore represents a clear improvement over the existing situation, even if it does not address all issues. In situations where the host country applied one method of attributing profits and the home country applied another approach, taxpayers who prepared symmetrical accounts 26 in the way recommended by the commentary were, in the past, exposed to the risk of double taxation. This problem has been solved under the authorized OECD approach whereby, taxpayers who apply symmetrical accounts applying the functionally separate entity approach should, in principle, be able to satisfy both tax administrations that an arm’s length amount of profits have been attributed to the permanent establishment.

6

Practical implementation issues

The new approach as provided under the Discussion draft will create a major change in the way profits must be attributed to permanent establishments, and relief from double taxation must be provided. To ensure successful 26

Symmetrical preparation of accounts means that “the values of transactions or the methods of attributing profits or expenses in the books of the permanent establishment corresponded exactly to the values or methods of attribution in the books of the head office.

20

implementation of the Draft, domestic laws of most OECD countries must be amended to conform to the new approach. There are questions concerning how the residence country can relieve double taxation based on either the exemption or the credit method (article 23 A, or 23B): 1. Whether, the relief must be based on the profits that have effectively been taxed, or on the profits that would result from the application of the new approach 2. Whether relief must be based upon the taxable profits calculated under the rules of the residence country or the source country. Where the bilateral rules are clear in that respect, the question remains as to whether or not a residence country is prepared to accept the allocation made by the host country or vice versa. To ensure the consistent and fair application of the authorized OECD approach to taxpayers, adequate guidance must be provided in advance regarding the operation of that approach both to governments and to taxpayers.

6.1

Issues for governments

Tax administrations can expect to experience an increased demand for examination and other resources to administer the complexities of the authorized OECD approach. Similarly, they should expect an increased demand for competent authority resources to address the increased number of cross-border disputes that will arise upon implementation of that approach.

6.2

Issues for taxpayers

The Discussion draft places increased emphasis on documentation and makes it clear that the onus will be on the taxpayers to provide the requisite documentation of the manner in which they attribute profits to their permanent establishments. This will require the documentation in many cases of internal dealings for which no documentation is currently maintained or required, especially in the case where the taxpayer did not intend to create a permanent establishment.

21

7

Apparent tensions in the Discussion Draft

7.1

Documentation

One obvious conflict present in the Discussion draft exists between the OECD’s emphasis of the need for taxpayers to document their dealings and the warning that any such documentation will be relied upon only to a limited extent. For instance, the OECD insists on determining the economic ownership, as opposed to simply accepting the legal ownership (in this context, determined by how the ownership of the assets is recorded in the books of the enterprise) of a capital asset. It is true that an enterprise cannot enter into legally binding agreements with itself, as can be accomplished between related companies. But if a hypothetical separate entity is subject to tax, then hypothetical agreements giving effect to various intra-company arrangements that are documented in advance should also be the basis of evaluation by the tax authorities of the bona fides of such arrangements. The Discussion draft presumes that such documentation is inherently suspicious and will require cautious reassessment by tax administrators to determine whether it reflects the economic reality. Further, there are situations where documentation is not commonly prepared by taxpayers, yet the preferred OECD approach requires that such documentation be prepared on a goingforward basis.

7.2

Separate and Distinct Entity Approach

The basic premise of the Discussion draft is that the permanent establishment should be hypothesized as a separate and distinct entity for the purposes of attributing profits to that permanent establishment. However, some of the OECD positions, as outlined in the Discussion draft, seem to be inconsistent with this general hypothesis. This situation arises in the context of attributing credit rating to the permanent establishment. The OECD suggests that in attributing “free capital”to a permanent establishment, the credit-worthiness of the enterprise as a whole should be attributed to the permanent establishment. This appears contradictory with hypothesizing the permanent establishment as a separate and distinct entity. The OECD suggests that the “factual situation of the enterprise” is such that the synergies and risks generated by the enterprise, resulting in the credit rating, cannot be assigned to a particular part of the enterprise, as these things are “fungible”27 ; however, this is precisely what the OECD approach requires, 27

Discussion Draft Para 93.

22

i.e., the execution of a functional and factual analysis to identify what considerations should be associated with a particular part of the enterprise.

7.3

Functional analysis in general

The 2004 Report does not provide adequate guidance regarding the manner in which activities are to be taken into account in attributing profits to the permanent establishment. It focuses heavily on where the ‘key entrepreneurial risk taking functions’ are performed and what their relative importance is. It notes, however, that these key functions will vary from sector to sector and even from enterprise to enterprise and concludes that the determination must be made on a case-by case basis because it ‘will depend on the particular facts and circumstances’ The Draft further requires analysis of all activities performed on behalf of the permanent establishment, and of all activities performed by the permanent establishment on behalf of other parts of the enterprise. It fails to give practical guidance on how to deal with situations where key functions that are closely related are carried out partly within and partly outside the host country, or to acknowledge that, where some or all of the relevant activities occur outside of the host country, the necessary information may not be readily available 28 . For instance, suppose an enterprise resident in Country A sells its products to customers in Country B through a permanent establishment located in Country B where the enterprise has a dependent agent who regularly negotiates and concludes contracts on behalf of the enterprise. Suppose further that the result of such sales is that the enterprise holds receivables from its customers. In that case, the enterprise would have to determine where the ‘key entrepreneurial risk taking functions’ are performed that relate to the holding of those receivables. Should these functions be viewed as attributable to Country B, because that is where the sales are concluded that give rise to the receivables? Should they be viewed as attributable to Country A, on the grounds that the enterprise’s head office personnel there set the criteria for extending credit to customers in Country B? Should it matter whether the enterprise records bad debts on the books of its Country A head office or Country B permanent establishment? The Discussion draft does not provide much in the way of guidance for resolving these very practical issues. This is merely an example of one of the several situations that may arise while attempting to identify the ‘key entrepreneurial risk taking functions’ associated with the activities of 28

Supra note 23.

23

the permanent establishment. What is clear is that the profit attribution exercise outlined in the Discussion Draft will always be extraordinarily fact intensive, that primary weight is placed on the functional analysis, and that, as with all fact-intensive exercises, this process will be one open to substantial disagreement and dispute.

7.4

Assets used and conditions of use

According to the draft, the economic ownership of an asset ‘belongs with the part or parts of the enterprise performing in particular the key entrepreneurial risk taking functions in respect of that asset, and that the actual acquisition of an asset by one part of the enterprise is not determinative in assigning its economic ownership within the enterprise’29 . What is not clear from this language is whether the focus is intended to be on the key entrepreneurial risk taking functions in respect of the acquisition of the asset or in respect of its use. Further, the draft provides little practical guidance to the taxpayers or tax authorities on the types of evidence that would be sufficient to demonstrate that assets (including, e.g. financial assets and intangible assets) used by a permanent establishment are properly considered loaned, leased or licensed to the permanent establishment, rather than owned by it, for purposes of determining the amount of profits attributable to the permanent establishment.

7.5

Capital Allocation

To the extent that taxpayers are allowed to choose from among the alternative methods the differences among the methods of capital allocation and their numerous weaknesses are likely to give rise to disputes between taxpayers and authorities and even among authorities. Although the Discussion draft provides a certain amount of detail and states an intention to ‘set forth a clear principle and provide practical guidance on how to apply that principle in practice’, it does not furnish adequate guidance to ensure clear and consistent application 30 . The approach in the discussion draft according to which, the host country can choose an allocation of capital, which then has to be accepted by the home country when providing relief from double taxation is neither supported 29

Discussion draft Para 199. See, The attribution of profits to a permanent establishment: Issues and recommendations, Mary C. Bennett and Carol A. Dunahoo, Baker & Mckenzie LLP, Washington, INTERTAX Volume 33 Issue 2, Kluwer Law International 2005. 30

24

by the OECD Model Convention nor the Commentary, and is contrary to the arm’s length principle. It is difficult to conceive that any country would be prepared to accept the proposition that the host country will have the right to determine not only the attribution of capital, but also the place at which key entrepreneurial risk-taking functions are located and the manner in which the assets, risks and functions are to be allocated 31 .

7.6

Application of Guidelines

The conceptual link between attribution of profits to a permanent establishment and the arm’s length principle is apparent; it must be implemented in practice. The Discussion draft is headed in the proper direction in this regard32 . The Discussion draft calls for the imputation of contractual terms to internal dealings within the enterprise, by analogy to the contractual terms of comparable transactions between independent enterprises33 . This will require a series of subjective determinations that will inevitably lead to disagreements at least in some cases. Further, the absence of contracts in the permanent establishment context, and of documentation especially in the case of dependent agent permanent establishments, will make the application of a proper comparability analysis very difficult. The Discussion draft contains very little discussion on which transferpricing method is to be chosen, besides indicating that the transfer pricing guidelines are to be applied by analogy. A more detailed discussion is required in this regard thereby providing guidance to taxpayers on this issue and confirming an adequate level of agreement on it among tax authorities.

7.7

Absence of a definition for “profits”

The Discussion draft acknowledges that problems may arise where the host country’s domestic rules prescribe one authorized approach for attributing capital and the domestic rules of the home country prescribe a different approach. The OECD suggests that a solution to this problem can be found in the existing Commentary to Article 23 of the convention, where the home country is supposed to compute “profits” as defined by its domestic law. Further, there is no definition of the term ”profits” in article 7, the host country may apply the relevant formulation found in its domestic law. The 31

See Letter dated 11th October 2004 from the BIAC (Business and Advisory Committee to the OECD) on the Discussion Draft to the OECD on the Discussion draft. 32 Ibid. 33 Discussion draft para 179.

25

OECD then acknowledges that the amount of profits calculated by the home and host countries could very well be different, but notes that it thought it inappropriate to address this issue, as this would require changes to member countries’ domestic laws dealing with double taxation. As pointed out by some commentators, the words of Article 7(2) expressly mandating that the profits attributable to a permanent establishment should apply in each contracting state would be virtually meaningless if the home and host countries determined the profits of a permanent establishment under their respective domestic laws.34

7.8

Dependent Agent Permanent establishment

Revised Part I of the Discussion Draft clearly states intent to apply its provisions to dependent agent permanent establishments (i.e., permanent establishments created when one entity operates in a country on behalf of a nonresident legal entity by habitually exercising the authority to contract on behalf of that entity). In a global dealing context this analysis would have the effect of assigning to the dependent agent permanent establishment part of the return to the capital of the enterprise. In the context of a sales agent relationship (or perhaps a commissionaire) functions that could attract income to the host country of the dependent agent permanent establishment might be holding or managing inventory in that country (causing inventory risk to take its situs in the permanent establishment), conducting research, or other key entrepreneurial functions. One very serious potential concern seems to have been allayed in the Discussion Draft, however. There had been some suggestion that in certain circumstances under the OECD methodology the selling activities of a sales agent or commissionaire could cause marketing intangibles (and the returns on those intangibles) to be allocated to the host country of a dependent agent permanent establishment. However, paragraph 272 of revised Part I of the Discussion Draft contains the following statement: In particular, it should be noted that the activities of a mere sales agent may well be unlikely to represent the key entrepreneurial risk-taking functions leading to the development of a marketing or trade intangible so that the dependent agent permanent establishment would generally not be attributed profit as the “economic owner” of that intangible. This statement should limit the ability of tax authorities to assert that marketing intangible related returns can be allocated properly to an alleged dependent agent permanent establishment. This, in turn, will significantly 34

Supra note 26 at Para. 12.

26

reduce the leverage that a taxing authority can potentially create by asserting the existence of a dependent agent permanent establishment in the context of a normal transfer pricing audit of a sales agent or commissionaire. The narrow focus on ‘key entrepreneurial risk taking functions’ ignores the value of capital raising and capital and risk management as well as other significant functions typically undertaken in the home office or another centralized location of a securities firm and thus results in an overallocation of profits (or loss) to the dependent agent permanent establishment35 . The Discussion draft states that it does not intend to expand or otherwise modify the existing dependent agent permanent establishment definition, but does make it clear that a related entity acting as a sales agent in a country may give rise to a dependent agent permanent establishment. Under these circumstances, the question arises as to whether any income in addition to the arm’s-length fee to the sales agent for its services, determined under normal transfer pricing principles, should be allocated to the permanent establishment so created.

7.9

Deference to Host Country Determinations

While it is clear that free capital must be allocated among branches based on a functional analysis, it has been impossible for the OECD member countries to finally agree on a single detailed method for making these allocations in a banking context. This has led to the articulation of an interesting canon of treaty interpretation, which is elaborated in revised Part I. Essentially the position is that where more than one method of attributing income and deductions is “approved” or “appropriate” under a treaty, the host country may apply any of the approved methods. The taxpayer’s home country is then obligated to grant relief from double taxation, even though its own domestic tax rules are different and acceptable under the treaty. An unfortunate consequence of this approach is that a global enterprise may find that it needs to undertake allocation exercises in different ways in different countries and its home country may be obliged to provide relief from double taxation for all of them. What remains somewhat unclear is the extent to which foreign tax credit limitation and sourcing rules in the home country’s domestic law and preserved under Article 23 of the Model Treaty, may operate to prevent full double tax relief in situations in which host countries follow different approved rules. 35

Letter dated 27th April 2005 from the Securities Industry Association to Mr. Jeffrey Owens, Director, Centre for Tax Policy and Administration, OECD.

27

8

8.1

Impact of the Draft Convention on the existing practices relating to the attribution of profits to a Permanent Establishment Issues regarding US bilateral treaty provisions

To date, the US has agreed in only two recent treaty agreements - those with the UK and Japan - to the application by analogy of transfer pricing principles to attribute profits to a permanent establishment36 . The 24 July 2001 exchange of notes accompanying the treaty with the UK provides in relevant part, in connection with Article 7, that: ‘It is understood that the OECD Transfer Pricing Guidelines will apply, by analogy, for the purposes of determining the profits attributable to a permanent establishment. Accordingly, any of the methods described therein-including profits methods-may be used to determine the income of a permanent establishment so long as those methods are applied in accordance with the Guidelines. In particular, in determining the amount of attributable profits, the permanent establishment shall be treated as having the same amount of capital that it would need to support its activities if it were a distinct and separate enterprise engaged in the same or similar activities’. The notes subsequently exchanged on 6 November 2003 in connection with the signature of the US-Japan Treaty state this point somewhat differently: ‘It is understood that the principle as set out in paragraph 1 of Article 9 of the Convention may apply for the purposes of determining the profits to be attributed to a permanent establishment. It is understood that the provisions of Article 7 of the Convention shall not prevent the Contracting States from treating the permanent establishment as having the same amount of capital that it would need to support its activities if it were a distinct and separate enterprise engaged in the same or similar activities.’ There is a substantive difference in these formulations. The UK language is mandatory (’shall’), while the Japanese language appears to be discretionary (‘may’, ‘shall not prevent’). The Japanese language is puzzling, considering that the 2001 Draft does not characterize the application of the authorized OECD approach in the treaty as optional. The attribution of capital appears to be left to the discretion of the Contracting States, however, 36

See, The attribution of profits to a permanent establishment: Issues and recommendations, Mary C. Bennett and Carol A. Dunahoo, Baker & Mckenzie LLP, Washington, INTERTAX Volume 33 Issue 2, Kluwer Law International 2005.

28

it is not clear whether the application of Article 9 (transfer pricing principles) is meant to be at the discretion of the Contracting States, of the taxpayer, or both. This creates a risk of disputes between the tax authorities, and between the taxpayer and tax authorities, regarding the approach to be followed in a particular case. Given the significance of the change and the need to ensure symmetrical approaches in the residence and source jurisdictions, it is appropriate to amend treaties where application of the authorized OECD approach is desired. Confirmation of the US Treasury Department of its position in this regard would provide taxpayers with greater guidance and certainty37 . The following implications of applying the authorized OECD approach under US bilateral treaties should be clarified:38 • Will parallel application of the ‘old’ and ‘new’ profit attribution approaches create new risks of double taxation for global companies, in addition to increased administrative burdens for taxpayers that must apply parallel sets of rules? • Is this a transitional issue and if so how urgent is its resolution? Given the present insufficiency of guidance on the application of the authorized OECD approach, efforts to reach an international consensus through the OECD, in consultation with business, should be broadened and redoubled. To minimize confusion during the transition period, adequate training should be provided to tax administrators and counsel.

8.2

Impact of the Discussion Draft on Canada

It is not clear whether the Canadian courts have whole-heartedly accepted the separate entity notion approach of Article 7 that is the authorized OECD approach. Although some have argued that this concept is alive and well in Canada39 , the publicly stated positions of the Canada Revenue Agency, in particular in denying the deduction of notional expenses, might suggest otherwise. This position is based on the Tax Court of Canada decision in Cudd Pressure40 . In Cudd Pressure, the issue was whether a non-resident could deduct a notional rent charge in computing the income attributable to its permanent 37

Supra Note 22. Ibid. 39 D.A. Ward, “Attribution of Income to Permanent Establishments,” (2000), vol. 48, no.3 Canadian Tax Journal, 559-576. 40 Cudd Pressure Control Inc. v. R., 98 DTC 6630 5Fed.CA), 1995 2 CTC 2382 (TCC). 38

29

establishment in Canada. The Tax Court of Canada suggested that the concept of notional expenses is not recognized in Canada and that the profits of the permanent establishment should be determined pursuant to the domestic law. The Court then noted that paragraph 4(b) of the Income Tax Conventions Interpretation Act was intended to ensure that Canadian permanent establishments could not deduct amounts that were unavailable to Canadian taxpayers as deductions in calculating their business income when calculating the profits attributable to the permanent establishment41 . Justice McDonald, dissenting in part, determined that because the Canada- U.S. Treaty allowed for the deduction of notional expenses in the computation of profits attributable to a permanent establishment, recourse to domestic principles was not essential, and therefore such notional expenses could be deducted in appropriate cases. Although the decision of Justice McDonald is seen by many as an authority supporting the concept of deducting notional expenses on the grounds that such deductions are supported by the application of the separate entity approach for the purposes of computing profits attributable to a permanent establishment in Canada, the Canada Revenue Agency disagrees with this proposition. Instead the Canada Revenue Agency supports the tax court’s analysis, which relies on the Income Tax Conventions Interpretation Act for the proposition 42 that, “where a term is not defined in the treaty, the term has the meaning that it has for the purposes of the Act from time to time”. On the basis of the Discussion draft, the working hypothesis will very likely require changes to the Commentary, and possibly the actual wording of Article 7, to the effect those notional expenses will expressly be allowed. Although it is expected that Canada will accept the new provisions of Article 7 without reservation43 , the question as to what changes to Canada’s laws will be necessary to give effect to these new provisions remain open. It is not clear whether any Canadian court would allow international treaties to “trump” domestic law in situations involving the computation of the profit to be attributed to the permanent establishment. In accordance with the Tax court of Canada’s interpretation of paragraph 4(b) of the 41

The tax treaty under consideration was the Canada-U.S. Reciprocal Tax Convention (1942), the ”Canada-U.S. Treaty. 42 See, for example, Income Tax Technical News - No. 18, dated 16 June 2000 (“Technical News No. 18”). 43 To date Canada has accepted the provisions of Article 7 without reservation. In addition, Canada has not noted any observation with respect to the Commentary to Article 7. As a result, in accordance with paragraphs 28 to 32 of the introduction to the OECD Model Convention, Canada should be considered as accepting both.

30

Income Tax Conventions Interpretation Act in Cudd Pressure, some might argue that the domestic law can override the separate entity concept of Article 7. As a result changes to the Act and/or the Income Tax Conventions Interpretation Act may be necessary to remove potential conflicts between the changes to Article 7 and the domestic statutory provisions44 .

8.3

Swiss approach to the allocation of profits to Permanent Establishments

According to Swiss Law, the main methods used for the allocation of profits to a permanent establishment are the direct and indirect methods: Under the direct method, the profits which are to be attributed to each permanent establishment are those which it would have made if the permanent establishment had been a separate, unrelated and distinct enterprise engaged in the same or similar activities under the same or similar circumstances. Income is therefore determined on the basis of separate accounts pertaining to the permanent establishment. In other words, the permanent establishment is treated as a separate entity. This method is in conformity with the authorized OECD approach of treating the permanent establishment as a “functionally separate entity”. Under the indirect method, the income of the permanent establishment is calculated as a fraction of the total profits earned by the enterprise. The permanent establishments participation in the total capital is quantified by applying coefficients based on a comparison of assets, turnover, and number of hours worked or other appropriate factors. The U.S.- Switzerland tax treaty specifically mentions that the direct method of allocation must be applied. This is a result of Article III, paragraph 3 which states as follows: “Where an enterprise of one of the contracting States is engaged in trade or business in the territory of the other contracting State through a permanent establishment situated therein, there shall be attributed to such permanent establishment the industrial or commercial profits which it might be expected to derive if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing at arm’s length with the enterprise of which it is a permanent establishment.” Pursuant to the introduction of the new Swiss Federal Tax Law in 1995, some commentators argue that the rules for the prohibition of intercantonal 44

OECD Revised Discussion Draft on Attribution of Profits to a PE: Commentary and Canadian Implications; Carrie D’Elia and Maria Tatarova, Osler, Hoskin & Harcourt LLP, Canada.

31

double taxation, should only be applicable to Swiss residents with enterprises, permanent establishments or real estate situated abroad. Hence, the direct method of allocation would be applicable to foreign residents with enterprises, permanent establishments or real estate situated in Switzerland45 . This interpretation is questionable and has not been confirmed by the Supreme Court as yet. If Switzerland has to conform to the new provisions of the OECD Draft, they have to begin by applying the direct method consistently.

8.4

Taxation of Business Process Outsourcing Units in India

Although India is not an OECD member country, it is interesting to observe the growing trends in India with regard to the attribution of profits to permanent establishments. India has witnessed a steady growth of outsourcing of business processes by foreign entities to business process outsourcing units situated in India. Business process outsourcing in India is carried out either by captive service providers such as branches or whollyowned subsidiaries of the foreign parent or through independent business process outsourcing companies. The tax implications of such foreign entities outsourcing activities have been a matter of debate. On January 2, 2004, the Central Board of Direct Taxes issued a Circular regarding the taxability of income in the hands of foreign entities outsourcing business processes to Indian entities. The circular differentiated between ‘core activities’ and ‘incidental activities’ carried out by the business process outsourcing unit, in order to evaluate if they constitute a permanent establishment in India of the foreign entity. This resulted in controversies because of the differentiation between ‘ core activities’ and ‘incidental activities’. On August 9, 2004 the Central Board of Direct Taxes issued a new (draft) circular which deals with taxation of foreign entities outsourcing their activities to business process outsourcing units in India. The said circular has the following implications: (a) If there is no connection between the foreign entity who is outsourcing certain services and an Indian business process outsourcing unit to whom it has been outsourced, the Indian business process outsourcing unit will not be a permanent establishment of the foreign entity. Further, the Indian business process outsourcing unit would be assessed to tax as a separate entity. (b) If foreign entities have a business connection/permanent establishment in India 45

Ibid.

32

by way of a branch, sales office, dependent agent, only so much of the profits are attributable to the activities carried out in India by such permanent establishment would be liable to be taxed in India. The Circular refers to Article 7 of the OECD Treaty and observes that the profits attributable to the permanent establishment are those which the permanent establishment would have made as if it had been dealing with an entirely separate entity, instead of dealing with its head office, under conditions and prices prevailing in the ordinary market, which corresponds to the arm’s length principle. It is evident that the new draft circular issued by the Central Board of Direct Taxes in India is in line with the hypothesis suggested by the OECD on the attribution of profits to a permanent establishment.

9

Conclusion

As observed in the OECD’s November 19, 2004 statement, it is clear that many issues remain to be resolved. The OECD summarized these issues as follows: Timing issues The timing originally envisaged to finalize Parts I to III was too optimistic Transition Issues Questions were asked about the legal status of the current drafts pending finalization of the work on changes to the OECD model. On the practical side the Report developed an approach for determining which part(s) of an enterprise owns intangibles developed by the enterprise, which raises issues on how to deal with an intangible developed in the past. Outstanding issues needing clarification Clarification was sought on the meaning and role of the key entrepreneurial risk taking functions in the OECD approach. Another key issue was the scope for double taxation that may arise from the Report’s conclusion that there was more than one valid approach for attributing capital to a permanent establishment. Clarification was sought on how the Report’s proposed solution to this problem- the symmetrical application of the approved approaches-would work in practice.

33

The Discussion draft suggests that, once finalized, its conclusions will be ‘implemented’ through amendments to the Commentary on Article 7, and supplemented with ‘further practical guidance’ in the OECD Transfer pricing guidelines. However, from the discussion above, we may conclude that additional steps are required before the discussion draft can truly be viewed as having reached the stage of providing a legal and administrable framework for the attribution of profits to a permanent establishment. There is a concern on the part of the business community that mere finalization of the discussion draft will cause some countries to believe that there are now well-developed rules for attributing profits to permanent establishments, which will likely lead to more ready assertions of permanent establishment status. In reality, the discussion draft falls short of creating a zone of certainty about the ultimate result. Several further steps will be required to approach that goal, including amendment of the Article 7 Commentary and refinement of the transfer pricing guidelines to better illustrate how they should be applied by analogy to the permanent establishment situation. Further, the final report should provide that the OECD views the new approach as a significant change and recommends that member countries implement the new approach with the same types of transitional measures that would accompany a change in law 46 . The OECD should produce practical examples to ensure that the new, somewhat theoretical, approaches of the Discussion draft will work as expected in practice. The questions of whether tax authorities and taxpayers will be able to reach common conclusions on typical cases concerning the “key entrepreneurial risk taking function”, or in the allocation of assets, risks and capital in specific situations has to be tested against realistic examples before the new approach is formally approved by the OECD for implementation in the Convention, commentary or in the Guidelines. The overall assessment by the business community of the workability of the new approach in the Discussion draft, will depend upon the acceptance by the OECD that profit attribution to a permanent establishment is not an exact science. From that perspective, it is important that it is crucial that tax examiners understood that business decisions of an enterprise must be respected, and that all results within a reasonable arm’s length range should be acceptable. Under these circumstances, the multiple approaches under the Discussion draft can be quite useful, but only if both the home and host countries are prepared to respect the commercial practices of the enterprises as to structuring and pricing of their dealings. 46

Supra note 35

34

The new Approach should only become effective after its adoption by a large majority of member countries. They should also be given a sufficient period to allow for the adjustment of their national tax systems and for the implementation of the newly created rules both by the enterprises and the tax authorities. Without a thorough discussion of the necessary adjustments required under domestic law and the change of many domestic regimes, it can be anticipated that the new rules will not be applied consistently in practice, with the result that the new approach will lead to general confusion and additional cases of double taxation 47 . It is anticipated that the proposed review of the Model convention to identify changes to Article 7 arising from the Discussion draft could take eighteen months to two years. Given the uncertainties relating to the implementation and impact of changes to the OECD’s preferred approach (which are bound to exist until some time after changes are made to the Commentary and Model Convention), the international community could face years of uncertainty in terms of identifying the parameters for attributing profits to a permanent establishment.

47

Letter dated 11th October 2004 from the BIAC (Business and Advisory Committee to the OECD) on the Discussion Draft to the OECD on the Discussion draft.

35