Transfer pricing and attribution of profits to PEs

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Attribution of profits to dependent agent PEs – Perspective of the OECD

Introduction

Article 7 of the OECD Model Tax Convention determines the profits that are to be attributed to a PE.90 This Article has been subject to various interpretations with double or non-taxation as possible consequences.91 The CFA has over time been acting in order to provide a common interpretation of the Article.92 Most recently the work of the CFA has lead to the publication of the OECD Report.93 This Report contains according to the OECD the internationally agreed principles for attribut-ing profits to PEs and constitutes guidance on the application of the arm’s length principle in Article 7 of the OECD Model Tax Convention.94
The concept of dependent agent PEs is based on the same principles as the concept of other PEs.95 The reasoning behind the concepts is to involve a foreign enterprise in the taxation of the host state when the enterprise conducts economic activities in the host state, regardless of whether the activities are carried out through a physical PE or a dependent agent PE.96 According to the OECD Report the attribu-tion of profits to dependent agent PEs is not to differ from profit attribution to other types of PEs.97 Consequently, this chapter contains both general information concerning profit attribution to PEs and information specifically applicable regard-ing dependent agent PEs.
The chapter firstly gives a historical development of Article 7 of the OECD Model Tax Convention. Secondly, the current wording of the article is presented, together with the Commentary on the article. Thirdly, the chapter contains a section con-cerning the OECD Report.

Development of Article 7 of the OECD Model Tax Con-vention up to date

In the 1920s the League of Nations started the work on what now constitutes Arti-cle 7 of the OECD Model Tax Convention.98 In the 1927 League of Nations Draft Bilateral Convention for the Prevention of Double Taxation, Article 5 held the provi-sion for allocating income based on source. According to the article only the exis-tence of a PE in a state could lead to the taxation of income derived through trade or profession by a non-resident.
The 1933 League of Nations Draft Convention on the Allocation of Business Income was issued by the Fiscal Affairs Committee of the League of Nations.100 This Con-vention treated the PE as an independent enterprise for tax purposes.
Furthermore, both the Mexico Model Convention of 1943 and the London Model Convention of 1946 contained a provision holding that each state, in which a PE was located, had the taxing rights over income arising within respective states ter-ritory.102 Both of the Conventions treated the PE as a separate part of the general enterprise.
The successor of the League of Nations, the Organisation for European Economic Cooperation (OEEC), issued in the 1960s a report regarding the attribution of prof-its to PEs and associated enterprises.104 The OEEC stipulated a draft provision in the report concerning the attribution of profits to PEs, which was incorporated in the 1963 OECD Draft Convention. The 1963 OECD Draft Convention implemented the separate entity approach.105 A change was made to the wording and instead of treating the PE as dealing quite independently it was to be treated as dealing wholly independently with the general enterprise.106 The wording of Article 7 of the OECD Draft Convention of 1963 is to a large extent identical to the current wording.107
The OEEC reorganised itself and adopted the name OECD.108 As a result of a pro-posal published by the OECD in 1974, minor changes were made to the provisions on business profits. The changes were incorporated in the 1977 and 1992 OECD Model Tax Conventions.
In 1994 the OECD released a report on the attribution of profits to PEs.110 The Re-port resulted in significant changes of the Commentary on Article 7 of the OECD Model Tax Convention.111 The new Commentary on Article 7 was incorporated in the 1994 OECD Model Tax Convention.112
In July 2008 the OECD published the OECD Report concerning the attribution of profits to PEs. The OECD Report acknowledges that parts of the conclusions of the report deviate from the historical interpretation of the current Article 7 of the 2005 OECD Model Tax Convention and the associated commentaries.113 In order to implement the conclusions of the OECD Report fully, the CFA decided upon a two-step strategy.114 The first step of the implementation process resulted in the issu-ing of an updated Commentary on Article 7 of the OECD Model Tax Convention. The updated Commentary takes into account conclusions of the OECD Report that are in line with the current wording of Article 7 of the OECD Model Tax Conven-tion. The second step of the implementation process is to result in the adoption of a new Article 7 of the OECD Model Tax Convention, which will be included in the next version of the Convention.115

Article 7 of the OECD Model Tax Convention

The wording and interpretation

The current wording of Article 7 of the OECD Model Tax Convention is expected to be changed by the year 2010 as well as the Commentary on the Article in order to fully adopt the conclusions of the OECD Report.116 In the meantime the Commen-tary has been changed to a temporary version and incorporated in the 2008 update of the OECD Model Tax Convention.117 Below follows a presentation of the ex-isting wording of Article 7 of the OECD Model Tax Convention and the interpreta-tion according to the updated Commentaries on the Article. Furthermore, the attri-bution of profits according to the OECD Report is presented.

Paragraph 1

Along with Article 7, paragraph 1, of the OECD Model Tax Convention the right to tax the profits of an enterprise are reserved for the home state. However, provided that the enterprise carries out business through a PE in the host state, the host state may tax the amount of profits attributable to the PE.118
The Commentary states that the paragraph gives rise to two principles.119 The first principle stipulates that an enterprise is not to be taxed in another state unless it carries out business in that state through a PE situated therein.120 The second prin-ciple lays down that the taxing rights of the host state only regard the profits at-tributable to the PE.121
The first mentioned principle is an expression of a generally accepted standard of double taxation conventions.122 According to this standard the host state does not have taxing rights over the enterprise until it plays a proper part of the economic life of that state.123
The second principle incorporated within the paragraph prohibits a force of attrac-tion approach when attributing profits to a PE.124 According to this approach the host state taxes the enterprise for all of its income derived within the territory of the host state, even when the income is not attributable to the PE. Instead of apply-ing the force of attraction principle, the tax authorities of the host state are to see to the separate sources of income that a foreign enterprise derives from the state.125
Furthermore, Article 7, paragraph 2, of the OECD Model Tax Convention gives guidance on how to determine the profits that are attributable to the PE.126 Therefore, the second sentence of paragraph 1,127 shall be read as directly referring to paragraph 2. Consequently, the first paragraph is not to be interpreted in a way that may contradict the subsequent paragraph.128 This means that profits may be attributed to a PE even if the general enterprise as a whole does not make any profits. Equally, situations might occur in which the enterprise as a whole makes profits without any part of them being attributable to the PE.129

Paragraph 2

Article 7, paragraph 2, of the OECD Model Tax Convention states that the profits that are to be attributed to a PE are those that the PE could have been expected to make ‘if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.’130 This paragraph corresponds to the arm’s length principle stated in Article 9 of the OECD Model Tax Convention.131 The paragraph states that the profits attributable to the PE are those that the PE would have made were it dealing independently according to the conditions set by the market.132
For the purpose of establishing the profits that are attributable to a PE, the trading accounts of the PE are recognised as a starting point.133 Further the Commentary on Article 7, paragraph 2, of the OECD Model Tax Convention stipulates that the so called two-step approach described in the OECD Report is to be used regarding the profit attribution.134
The first step in the above mentioned approach is a functional and factual analysis in order to identify activities carried out through the PE in relation to activities un-dertaken by the whole enterprise, especially the parts of the enterprise that par-ticipate in dealings with the PE.135 Guidance on how to perform the functional and factual analysis is given in the OECD TP Guidelines.136
The second step of the two-step approach results in the determination of the arm’s length price of the dealings between the PE and the general enterprise.137 The OECD TP Guidelines are also relevant as guidance under the second step as they are to be applied by analogy for the determination of the arm’s length price, in re-lation to the functions performed, assets used and risks assumed of the general en-terprise through its PE.138
The Commentary on Article 7, paragraph 2, of the OECD Model Tax Convention states that the same approach for attributing profits to PEs in general is to be used when attributing profits to dependent agent PEs.139 When applying the above de-scribed two-step approach in relation to dependent agent PEs, the functional and factual analysis is to result in the determination of functions undertaken by the de-pendent agent as well on its own account as on the account of the general enter-prise.140
Furthermore, the Commentary establishes that the dependent agent and the gen-eral enterprise in the favour of which the agent is acting are two different taxpay-ers.141 This means that the agent is to be taxed for the profits it derives when act-ing on its own account for the enterprise, simultaneously as profits may be attrib-uted to the dependent agent PE of the general enterprise. In the last mentioned case the PE is to be ascribed the assets and risks of the general enterprise, with the addition of sufficient capital to support these risks. Thereafter, profits are to be at-tributed to the dependent agent PE on the basis of the assets, risks and capital. These profits are distinct from the ones derived by the dependent agent enterprise. Further, the profits of the dependent agent PE are not to include the profits of the dependent agent enterprise.142

Paragraph 3

Article 7, paragraph 3, of the OECD Model Tax Convention allows a deduction of expenses arising in connection to the PE when determining the profits of the PE. The right to deduct the expenses is neither dependent on whether they constitute executive or general administrative expenses nor in which state they are oc-curred.143 The expenses are deductable to the extent that they have actually in-curred.144

Paragraph 4

According to Article 7, paragraph 4, of the OECD Model Tax Convention some Member States are allowed to determine profits attributable to a PE by allocating the total profits of the whole enterprise to its different parts irrespective of paragraph 2. This is true for Member States in which it has been customary to pursue this method of profit attribution.145 The result of profit attribution is not to contra-dict principles set forth in Article 7 of the OECD Model Tax Convention.146
The method for profit attribution set out in Article 7, paragraph 4, of the OECD Model Tax Convention does not have the separate enterprise approach as a basis and only considers the activities of the PE.147 Therefore, this method differs from the one prescribed under paragraph 2. It is recommended that only Member States in which it historically has been accepted by the tax authorities and taxpayers to allocate profits based on this method, to apply it.148

Paragraphs 5 – 7

In accordance to Article 7, paragraph 5, of the OECD Model Tax Convention, profits are not to be attributed to a PE due to the mere purchase of goods or merchandise that the PE performs on behalf of the enterprise. This paragraph refers to a PE that, in addition to carrying on other business, also undertakes purchasing for the gen-eral enterprise.149
Furthermore, Article 7, paragraph 6, of the OECD Model Tax Convention prescribes that the same method for profit attribution is to be used year by year. The purpose of this paragraph is to ensure a continuous and consistent tax treatment.150 Fur-thermore, the paragraph precludes the changing of method with the purpose of achieving a more favourable result.151
Finally, Article 7, paragraph 7, of the OECD Model Tax Convention, states that other Articles in the Convention that separately deal with categories of income included in the profits of the enterprise, are not to be affected by Article 7. Thus, if an item of income is governed by special Articles, for example Articles on dividends or inter-est, these Articles are applicable prior to Article 7 of the OECD Model Tax Conven-tion.

The OECD Report

The background to the authorised OECD approach

The lack of current consensus regarding the interpretation of Article 7 of the OECD Model Tax Convention increases the risk of double or non-taxation.153 With the in-tention of minimising this risk the CFA has been working to provide a common in-terpretation of the Article by establishing an authorised approach for profit attri-bution.154
The authorised OECD approach for attribution of profits to PEs was established as a formulation of a Working Hypothesis, by the CFA’s Working Party No. 6 on the Taxation of Multinational Enterprises (WP).155 The foundation for developing the Hypothesis was to observe to which extent a PE could be treated as a hypotheti-cally distinct and separate entity.156 Furthermore, the Working Hypothesis exam-ined in which way the OECD TP Guidelines could be used when attributing profits to PEs in accordance with the arm’s length principle set out in Article 7 of the OECD Model Tax Convention.157
It should also be pointed out that the WP was neither constrained by the original intent nor the historical practice and interpretation of Article 7 of the OECD Model Tax Convention when developing the authorised OECD approach.158 The objective has been to develop the most appropriate method for profit attribution to PEs, having in mind current characteristics of the multinational operations and trade.159
Furthermore, it is emphasised in the OECD Report that the Report does not deal with the issue of the existence of a PE.160 This means that Article 5 of the OECD Model Tax Convention is not affected by the OECD Report.161

The relevant business activity approach and the functionally separate entity approach

One of the issues addressed in the OECD Report concerns the question on what constitutes the profits of an enterprise.162 According to the OECD Report, Member States have developed two main interpretations of this phrase; the relevant business activity approach and the functionally separate entity approach.163 This vari-ance in interpretation can lead to double taxation or non-taxation.164
In accordance to the relevant business activity approach, the ‘profits of an enter-prise’ merely include the profits relating to business activities in which the PE is engaged.165 According to the OECD Report, the phrase relevant business activity cannot be derived from the OECD Model Tax Convention.166
Along with the relevant business activity approach, the profits that are to be at-tributed to a PE under Article 7, paragraph 2, of the OECD Model Tax Convention, are limited by paragraph 1.167 The approach sets that the maximum amount of profits attributable to the PE are the profits that the whole enterprise makes from the relevant business activity. These profits are made from transactions with third parties and with associated enterprises.168
However, under the functionally separate entity approach the profits attributable to a PE are not restricted to the amount of profits made by the enterprise as a whole.169 Hence, this approach allows profits to be attributable to a PE even if the enterprise as a whole has not realised any profits.170 This is possible for example when the PE produces goods that are transferred to a different part of the enter-prise.171
According to the OECD Report the functionally separate entity approach reflects the wording of Article 7, paragraph 2, of the OECD Model Tax Convention.172 This is due to the fact that this provision prescribes the treatment of a PE as a distinct and separate entity which deals independently with the general enterprise.173 There-fore, the functionally separate entity approach is adopted as the authorised OECD approach for attributing profits to PEs.

Table of Contents
1 Introduction 
1.1 Background
1.2 Purpose and approach
1.3 Methodology
1.4 Delimitations
1.5 Terminology
1.6 Outline
2 Transfer pricing and attribution of profits to PEs
3 Dependent agent PE
3.1 Introduction
3.2 Perspective of the OECD
3.3 Swedish perspective
4 Attribution of profits to dependent agent PEs –Perspective of the OECD 
4.1 Introduction
4.2 Development of Article 7 of the OECD Model Tax Convention up to date
4.3 Article 7 of the OECD Model Tax Convention
4.4 The OECD Report
5 Attribution of profits to dependent agent PEs –Swedish perspective 
5.1 Introduction
5.2 Functionally separate entity approach
5.3 Determining the profits
5.4 Dependent agent PEs
6 Dual taxpayer approach versus single taxpayer approach 
6.1 Introduction
6.2 Business circles
6.3 Academic circles
7 Analysis
7.1 Introduction
7.2 Swedish definition of dependent agent PE in relation to the OECD Model Tax Convention
7.3 Profit attribution to dependent agent PEs – Swedish perspective in relation to the authorised OECD approach
7.4 Dual taxpayer approach versus single taxpayer approach
8 Conclusion
List of references
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Attribution of Profits to Dependent Agent Permanent Es-tablishments The dual taxpayer approach versus the single taxpayer approach