TALK TAX: The attribution of profits to permanent establishments during the 2006 IFA Congress

The International Fiscal Association (IFA) held its 60th Congress in Amsterdam, the Netherlands from 17 to 22 September 2006. Following the tradition of past congresses, the IFA delegates debated two main topics, namely, the tax consequences of restructuring of indebtedness (subject I) and the attribution of profits to permanent establishments (subject II).

The two main subjects were complemented by seven specific seminars covering the following topics:
- Seminar A: Indirect tax aspects of cross-border services
- Seminar B: IFA/OECD – Do enterprises mean business?
- Seminar C: International cooperation in countering tax avoidance
- Seminar D: The effect of regional and global trade agreements on domestic tax law and bilateral tax conventions
- Seminar E: Recent developments in international tax
- Seminar F: IFA/EU: the need and scope for coordination of tax policies in the EU
- Seminar G: Tax accounting versus commercial accounting

Although it was the second main issue, the attribution of profits to a permanent establishment (PE) attracted large attention from both practitioners and academics. It is important to recall that permanent establishments were already the main topic of discussion in Vienna (1957), Stockholm (1967), Lausanne (1973) and more recently Geneva (1996).

The topic recently gained new interest with the recent OECD Discussion Drafts on the Attribution of Profits to Permanent Establishments: Part I: General Considerations (2001 and 2004); Part II: Banks (2001 and 2003); Part III (Enterprises Carrying on Global Trading of Financial Instruments) (2003); and Part IV (Insurance) (2005).

Taking into account the ongoing OECD work on this topic, now nearly approaching its completion, the first panel discussion, following the general report and the accompanying IFA branch reports, was aimed at analysing the main problem areas arising from the adoption of the so-called authorised OECD approach (AOA) to the attribution of profits to PEs. The Panel discussion also involved implementation issues and difficulties for particular countries (such as non-OECD members) in adopting the AOA.

The plenary session was complemented with a two break-out sessions specifically covering issues for financial institutions and non-discrimination issues from both the perspective of EC law and tax treaties.

General issues on the attribution of Profits to PEs (2)

The discussion of this topic took place at an important point in time, since the six-year OECD work on this same topic is now closely approaching its completion (3)

The Chair, Prof. Kees van Raad, initiated the plenary session by introducing the subject matter, namely the interpretation and application of Art. 7(1) to (4) of the OECD Model Tax Convention (the business profits provision). After briefly describing the introductory example, where an enterprise carried on by a resident of one state is operated in a host state through a PE, Prof. van Raad briefly outlined the current rules for taxing business profits under the OECD Model. This introduction was followed by an overview given Raffaele Russo on the history of the business profits provision, from the 1927 and 1928 Drafts of the League of Nations until the current 2005 OECD Model and Commentary on Art. 7.

Prof. Richard Vann discussed the current views on Art. 7. In this respect, Prof. Vann identified the two different interpretations of Art. 7(1) to (3), namely the relevant business activity approach (also called single enterprise approach) and the functionally separate enterprise approach (also called the separate enterprise approach). Prof. Vann also addressed the various approaches to the conceptualisations of the separate enterprise and focused on the potential conflict between the fiscal fiction (under which the PE is treated as a separate enterprise) and the legal facts (according to which a PE cannot own assets or bear risk separately from the remainder of the enterprise), when characterizing the so-called internal dealings.

Prof. Philip Baker (IFA General Reporter on subject II) presented the main issues and conclusions of the General Report. Prof. Baker started by highlighting that domestic law and treaty law are either largely in conformity, but that no consensus was found as to the correct interpretation of Art. 7. According to Prof. Baker, this lack of consensus is further emphasized by the absence of guidance, and also by the abundance of disputes and attribution theories in the countries surveyed. Prof. Baker also called upon the attention to the widespread use of presumptive taxation and discussed whether the attribution of profits to branches can be said to be entirely an issue for financial institutions.

The panel discussion continued with the presentation of the main issues, stemming from the future adoption Authorized OECD Approach (AOA). This was followed by an overview given by Mary Bennett of the ongoing OECD PE profit attribution project. Mary Bennett started by mentioning that the aim of the OECD project was in fact to seek to eliminate the current lack of consensus on how to hypothesize the PE as a distinct and separate enterprise, and to apply the Transfer Pricing Guidelines by analogy. Mary Bennett went on to briefly describe the AOA two-step approach and focused her additional remarks on the first step, which involves applying principles of the 1995 transfer pricing guidelines by analogy to perform a factual and functional analysis in order to analyse what is part of the PE and what is not. Mary Bennett mentioned that the first step involves addressing the question of economic ownership of assets, attributing adequate free capital to the PE in light of its risks, and attempting to identify any "dealings" between the PE and the enterprise of which it is a part. Mary Bennett explained that under the AOA risks should follow functions, the attribution of assets should follow where the people functions are performed and finally the attribution of capital should follow risks.

As regards the current state of play of the AOA, Mary Bennett announced that the OECD/CFA decided in June 2006 to publish by the end of 2006 new versions of Parts I – III of the Discussion Drafts, to finalize the Part IV draft report on insurance during the first months of 2007 and to publish during 2007 a draft implementation package, which will include the changes to the Model and Commentary. Mary Bennett also mentioned that the controversial key entrepreneurial risk-taking (functions) terminology would be retained only for specific sectors and no longer would appear in the general part. In addition, Mary Bennett stated that the symmetrical application of profit attribution methods was considered to be an issue more related to Art. 23, and that the proposed changes to the text of Art. 7 would not address the concept of symmetry.

The panel discussion continued with the presentation of five examples, which involved (i) the transfer of inventory, (ii) the transfer of an asset, (iii) debt financing (including withholding tax on notional payments), (iv) self-developed intangibles, and (v) head office expenses. Under each example, the various panel members confronted the current approach and the AOA approach, and highlighted specific issues that need to be resolved or clarified.

Following the discussion of the examples, Radhakishan Rawal addressed the extent the AOA is consistent with the UN Model Convention (2001), and whether it could be adopted by jurisdictions that follow the UN Model. Taking into account the wording of Art. 7(3), Radhakishan Rawal considered that it would not be possible to adopt AOA for treaties based on the UN Model and that such adoption would be possible only if Art. 7 of such treaties would be amended.

Meinhard Remberg presented the position of the business community on the AOA, with particular comments concerning the activities of engineering and construction companies. Meinhard Remberg noted that the integration of activities gives rise to differences regarding construction and engineering activities, and that such difference should be considered by the OECD on the preparation of Part I of the OECD PE project.

The panel continued with a discussion on the specific issue of the attribution of profits where there is an Agency PE, namely whether there may be an additional profit attributable to an Agency PE over and above the arm's length reward paid to the agent. After Prof. Van Raad outlined the issue in question, Prof. Baker highlighted several arguments in favour of the nil sum approach, while Prof. Vann exposed opposing arguments for determining a taxable profit at the level of the Agency PE. The discussion was followed by a vote by the delegates.

The final topic addressed future policy and implementation options arising from an adoption of the AOA by OECD Member States. The panellists discussed the advantages and disadvantages of adopting the AOA for all businesses, adopting the AOA only for the financial sector, not adopting the AOA but maintaining the existing wording of Art. 7 and Commentary, and finally deferred a decision and continue researching alternative solutions. As regards implementation options, the panellists discussed the advantages and disadvantages of changing only the OECD Commentary versus changing the OECD Model and Commentary.

Selected issues for financial institutions (4)

The financial industry, which usually operates through branches, is in the forefront of the debate as to how profits are attributable to a PE and the first break-out session focused on the key practical issues in determining how profits are attributed under the AOA.

The Chair, Dr Richard Collier initiated the break-out session by outlining the specific issues related to attribution of profits to PEs in the financial sector, namely key entrepreneurial risk-taking (functions), capital allocation and symmetry issues, specific issues of the insurance sector and Agency PE considerations.

Before addressing the specific issues, Angelo Digeronimo outlined the historical issues that serve as a background to the ongoing OECD work. Angelo Digeronimo started by mentioning the 1994 OECD report on the attribution income to PEs and its aim to remove uncertainty about the interpretation of Art. 7 of the OECD Model and also remove all differences between Art. 7 and Art. 9 of the OECD Model. However, due to the conservative majority opinion at that time, the report failed to address any differences between Art. 7(2) and 7(3). Although the ban on notional payments between the head office and branch was maintained, Angelo Digeronimo mentioned that the report had its merits. In addition, Angelo Digeronimo mentioned the external and internal drivers to the current OECD work, such as the adoption of the 1995 Transfer Pricing Guidelines and the OECD work on global trading. On this subject, Dr. Collier pointed out that there has been notably little controversy in the approach to the allocation of profits to financial PEs, largely due to the influential 1984 Guidance from the OECD.

Jean-Charles Balat addressed the topic of Key Entrepreneurial Risk Taking (KERT) functions in the framework of the financial industry. Jean-Charles Balat noted that KERT approach can be seen as a concrete application of the functional analysis and that such approach is positive, taking into account the goal of attributing profits to where the key profit drivers are located. Jean-Charles Balat also listed the various practical and theoretical remarks on the KERT concept and highlighted potential compliance issues for taxpayers. Jean-Charles Balat concluded that although it can be said that the KERT approach is too theoretical and has to become more flexible, it can be said that it generally improves the application of the profit split.

Peter Van Dijk commented on the KERT concept from the insurance industry perspective, where risk management is generally the key profit driver. Peter Van Dijk started by welcoming the initiative of the OECD on the attribution of profits to PEs but expressed that in a regulated industry, such as the insurance industry, it may raise more problems than solve the existing ones. Peter Van Dijk also mentioned that there is an uncertainty of what KERT means (for example for underwriting and general management functions) in the insurance business and that may probably give rise to double taxation.

Bas De Mik provided an overview of the issues of capital attribution arising from the AOA and the related issue of symmetry in the capital allocation method used by the residence state. On this topic, David Grecian highlighted that the CFA recently decided to remove the symmetry issue from the draft reports, although there is an agreement as to the inclusion of a policy statement in the draft implementation package, which will include the changes to the Model and the OECD Commentary.

Angelo Digeronimo commented on the status and major points of the draft report on insurance (Part IV) and mentioned that a public release is expected during the beginning of 2007. Peter Van Dijk commented on the specific problems arising from the insurance sector that need to be addressed in the forthcoming draft report.

The break-out session also addressed specific issues concerning Agency PE in the framework of the financial sector. Richard Collier, after providing an overview of the issues, questioned whether the KERT approach, which s focused on Art. 7(2), has an indicative or determinative influence when considering the existence of an Agency PE under Art. 5(5). On this issue, David Grecian started by describing the OECD approach on Agency PE under the AOA and highlighted that the AOA does not make any distinction between different types of PE. David Grecian mentioned that although the OECD did not originally see the Agency PE considerations as a controversial issue, it has became one of the more controversial issues of the AOA. In that regard, David Grecian outlined some of the concerns raised by the business sector and highlighted the importance of the principle that an Agency PE can receive an arm's length reward above the remuneration paid to the dependent agent. Finally, David Grecian concluded that KERT approach hypothesizes the PE and serves to allocate the financial assets and its attached risks to identify a PE, and that such analysis is different than the set of tests under Art. 5(5) and (6). Bas De Mik suggested that the are two hurdles to overcome regarding the Agency PE. The first is the text of Art. 5(5) and the second is the lack of symmetry on capital attribution.

As a conclusion, each of the panel members offered a final comment on important issues coming out of this session. Peter Van Dijk started by mentioning that as long as PEs are not treated as subsidiaries the problems will continue and therefore recommended further study of the issue. David Grecian, considered that the OECD project brought the treatment of the PEs further and will help to achieve greater consistency between the approaches currently in place in the OECD member countries. Anuschka Bakker noted that the regulatory issues of the insurance industry should be further addressed. Richard Collier stressed that further work should be done on Art. 5(5), as a financial sector imperative. Angelo Digeronimo mentioned that the implementation of the AOA introduces the functional analysis, and that with the AOA, we are moving closer to not having differences between Art. 7 and Art. 9. Bas De Mik highlighted symmetry as an important point to reach a solution. Finally, Jean-Charles Balat suggested that the OECD changes the text of Art. 7, so that Anglo-Saxon countries give up the practice of non-recognition of intra-group branch transactions.

EC law and non-discrimination issues(5)

Since most tax treaties contain a non-discrimination article, it is important that any approach to the attribution of profits to PEs is consistent both with the provisions of the Art. 24(3) and its Commentary.

In addition, the current member states of the EU are also subject to the constraints of Community law, which may also impact their position on the attribution of profits to PEs. In fact, although several decisions of the European Court of Justice (ECJ) have dealt already with the taxation of PEs, several EC law aspects still need to be resolved, such as exit taxes, notional income and capital allocation. In that regard, the second break-out session discussed in detail the non-discrimination implications of the OECD Discussion Drafts on the attribution of profits to a PE.

The Chair, Prof. Lang, initiated the session by introducing the subject matter, i.e. non-discrimination issues in respect of the proposed authorized OECD Approach (AOA) arising from the EU fundamental freedoms and Art. 24 of the OECD Model. The session covered five case studies, concerning a head office in State A with a PE in State B.

The first case study dealt with the issues of transfer of assets from the head office to the PE and issues of exit taxation. Prof. Kroppen outlined the main facts and issues, i.e. whether or not the resident state is allowed to tax the transfer of assets from a head office to a PE and whether or not the source state is required to provide a step-up in value when the assets are transferred to the source state.

Prof. Pistone started by exploring the fundamental freedoms, relevant for direct taxation purposes and the four steps that the ECJ uses when applying them to judicial cases. Starting from the state of residence, Prof. Pistone analysed which fundamental freedoms would apply (the freedom of establishment or the free movement of capital) and whether or not that would raise any difference, such as in situations involving third countries. With regard to the correct comparison to determine whether or not discrimination exists, Prof. Pistone submitted the scenario of a head office and a PE in the state of residence. Assuming a difference in treatment exists, Prof. Pistone addressed possible justifications, i.e. territoriality and internal market tax cohesion. From the perspective of the state of source, Prof. Pistone referred to the conclusions of the ECJ in the "N" case (C-470/04) and stated that it may be relevant to determine if the state of source also grants a step-up for EU resident subsidiaries or takes into account if the source state taxes (with deferral) outgoing transfers.

Prof. Gutmann raised additional questions as to whether or not there is a problem under EC law. In doing so, Prof. Gutmann first questioned, from the perspective of the state of residence, if a transfer of assets would be covered by the freedom of establishment. Second, Prof. Gutmann questioned if there would be discrimination, as it is not clear if the residence state has to treat the foreign PE as a foreign subsidiary. Prof. Gutmann also discussed whether or not the EC law solution depends on the features of the domestic tax system of the resident state, e.g. the territorial system. With regard to the state of source, Prof. Gutmann remarked that if no step-up is given in a situation of a domestic head office and PE, why would it be required to do so in this case? Prof. Kroppen drew attention to an ongoing discussion in Germany as to whether or not a discrimination and/or infringement can be justified on the grounds that the EU systems for exchange of information do not work in practice.

Prof. Lang addressed tax treaty law issues by determining the right term of comparison under Art. 24 (3). Taking into account that a step-up in the PE state could raise a double deduction issue, Prof. Lang said that such double dips would not, in principle, be a problem, as Art. 24 only deals with the state of source. Prof. Garcia Pratz also defended the position that there is no problem for the residence state. With regard to the state of source, Prof. Garcia Pratz said that, depending on the comparable enterprise treatment, Art. 24(3) could be said to force (under the traditional and AOA approach) this state to give a step-up to PE in order to avoid discrimination treatment.

The second case study dealt with a scenario involving a notional royalty income from a PE to the head office. Prof. Pistone outlined the main facts and issues, i.e. whether or not a notional royalty payment should be deductible in the source state, what is the right comparison and whether or not a withholding tax levied only at the level of a subsidiary affects the outcome of the case.

Prof. Garcia Pratz, who dealt with the source state EC law issues, said that this case would fall under freedom of establishment. As to the right comparison, and as ECJ case law offers many valid possibilities, it could be possible to compare the present case with the situation of a parent company in the residence state and a subsidiary in the source state. Nevertheless, Prof. Garcia Pratz pointed out that it is important to determine if the notional payment and the real payment would be in a comparable situation. With regard to a possible justification to non-deductibility, Prof. Garcia Pratz stated that, following ECJ case law, the compensation with other advantages, such as the withholding tax levied on subsidiaries, would probably not be allowed as a justification. Prof. Lang dealt with the residence state issues and said that, if the outcome of this case would result in the residence state being precluded to tax such a notional royalty, this could again result in a double benefit. In this regard, Prof. Lang pointed out the recent tendency of the ECJ to look together at both source and residence and the use of the fundamental freedoms to a certain extent as a policy tool.

Prof. Kroppen said that, from a tax treaty law perspective, the right comparator under Art. 24(3) could be a subsidiary of the source state. Accordingly, the fact that a subsidiary would be granted a deduction, whilst no deduction would be available to a PE, amounted to a breach of Art. 24(3). Prof. Kroppen also highlighted that only under the AOA notional payments would be deductible and, therefore, a PE and subsidiary would be treated equally. David Rosenbloom, who offered the US perspective on the non-discrimination article, considered that the correct comparison under Art. 24(3) should be a standalone company and not a subsidiary. In addition, David Rosenbloom said that the concept of intra-entity notional royalty is not recognized, which makes the comparison more difficult. Finally, David Rosenbloom stated that the issue of deduction of development costs could be resolved under Art. 7 and possibly Art. 24(3).

The third case study dealt with a scenario involving a supply of services between head office and PE. Prof. Lang outlined the main facts and issues, i.e. whether or not an equal treatment of a foreign PE and a foreign subsidiary would remove possible problems under Art. 24(3) and EC law.

Prof. Kroppen, considering the residence state EC law issues, stated that the correct comparison would be with a head office and a PE in the residence state. A difference in treatment could amount to discrimination under the freedom of establishment, but in such case possible justifications would need to be evaluated. Prof. Garcia Pratz, considering the source state EC law issues, said that the correct comparison could be with a parent company in the residence state and a subsidiary in the source state. With regard to the outcome of the case, Prof. Garcia Pratz submitted that, provided that domestic law allows deduction of the expense, the current approach and the AOA would not raise EC compatibility issues.
From a tax treaty perspective, Prof. Gutmann considered that a discrimination issue can be raised under the current OECD approach, whilst under the AOA it would cease to exist. David Rosenbloom pointed out that the application of the US transfer pricing rules would result in the arm's length remuneration most likely being the cost for these services. David Rosenbloom stated that this case is similar to the notional royalty case, i.e. no discrimination, with the only difference that in this case there is no timing mismatch.

The fourth case study dealt with the issue of capital allocation to a PE under the AOA. Prof. Lang outlined the main facts and issues, i.e. how much capital is needed to cover the assets and support the risks assumed by the PE and how to deal with the situation when the amount of capital attributed to the PE is higher than the minimum amount attributed to a local subsidiary.

Prof. Gutmann started by pointing out that there is an EC Law issue if a PE in the source state is worse off than a domestic subsidiary. In this regard, three sub-issues need to be resolved. First, whether minimum legal capital is relevant for tax purposes in cases where the PE free capital is higher. Second, what happens in cases where no thin capitalization rule exists in the PE state or transfer pricing rules apply? Third, what happens where free capital is also required for a PE and there is a thin capitalization rule for subsidiaries? Prof Garcia Pratz, defending the point that no EC law problems are raised, stated that the correct comparability depends largely on which "capital allocation model" is followed.
Prof. Pistone, addressing the treaty law issues, said that the comparability of a PE with a subsidiary is strengthened by the AOA. Prof. Pistone also said that, in cases where thin capitalization rules do not exist, the AOA may lead to discrimination. David Rosenbloom commented from a US perspective and referred that no discriminatory treatment should be found. In this regard, David Rosenbloom offered four possible scenarios for comparison under Art. 24(3).

Finally, the fifth and last case study dealt with documentation requirements for a PE of a third country national. Prof. Gutmann outlined the main facts and issues, i.e. the application of EU freedom of capital in a scenario involving third countries instead of intra-EU, the legitimacy to impose more burdensome requirements on a PE and whether or not the assessment of procedural and substantive rules differs.

Prof. Pistone, started by determining the scope of free movement of capital and payments in relation with non-EU countries by referring to a recent ECJ Advocate General's opinion in the Fidum Finanz case. Prof. Pistone also said that, from an EU perspective, procedural obstacles are obstacles and may create EU problems. With regard to the correct comparison, Prof. Pistone referred to a head office in a third country with a profit-making PE in the source state. Prof. Pistone also pointed out that different standards for justifications and proportionality may be envisaged in third country situations. Prof. Kroppen, questioning if there is an EC law problem, said that a restriction (instead of discrimination) could be found, as such a rule could deter the formation of PEs. Since the mutual assistance directive would not apply, Prof. Kroppen discussed the issue of if there would be a practical difference under a tax treaty exchange of information clause.

David Rosenbloom questioned if Art. 24 would apply to procedural restrictions and said that the key enquiry in this case would be if the source state applied a similar rule as to where the accounting takes place as regards a resident company. Finally, Prof. Lang followed the approach that both substantive and procedural rules may affect Art. 24. With regard to the correct comparison, if the comparable situation in this case would be with an enterprise carrying out activity in the source state, Prof. Lang submitted that there would be no discrimination.

Final Comment

There have been during this past years several calls of scepticism, namely of the extension of the already complex and difficult transfer pricing rules to the situation of the branch or to an Agency PE. Critics mentioned, amongst others that the practical application of this process of applying transfer pricing rules by analogy raises a number of difficult issues, which in the end will not make life easier to taxpayers. The increased pressure in the Agency PEs side is perhaps a visible element of those difficult issues. Nevertheless, the OECD has demonstrated its resilience and (as announced during the IFA Congress) will apparently bring this project to an end by 2007/2008. The implementation package announced by the OECD, the discard of the KERT terminology (at least for general PEs) and the postponement of the debate on the symmetry issue were the most recent OECD news announced during the IFA Congress. The question remains as to whether “calm seas” lie ahead or some of the voiced concerns during the Congress will bring some "turbulence" into the project. One thing appears more certain, the attribution of profits project will set anchor in 2007 and we expect changes into the OECD Model (and not only to the Commentary).

Endnotes

(1) The IFA, which is headquartered in the Netherlands, is the leading non-governmental international organisation dealing with tax matters and comprises more than 11,000 members worldwide. The objects of IFA are the study and advancement of international and comparative tax law through specific research, holding of congresses and publications. In 2007, the Annual Congress will be held in Kyoto (Japan). For further details, visit www.ifa.nl

(2) The plenary panel was composed by Prof. Kees van Raad (Netherlands) as the chair, Prof. Philip Baker Q.C. (United Kingdom) as the General Reporter and: Mary Bennett (OECD), Radhakishan Rawal (India), Meinhard Remberg (Germany) and Prof. Richard Vann (Australia) as panel members. Raffaele Russo (Italy) served as secretary.

(3) OECD Discussion Draft on the Attribution of Profits to Permanent Establishments: Part I: General Considerations (2001 and 2004); Part II: Banks (2001 and 2003); Part III (Enterprises Carrying on Global Trading of Financial Instruments) (2003); and Part IV (Insurance) (2005).

(4) The panel of the first break-out session was composed by Dr Richard Collier (United Kingdom) as the Chair and Jean-Charles Balat (France), Bas De Mik (Netherlands), Angelo Digeronimo (Switzerland, OECD – WP6), David Grecian (OECD – WP6) and Peter Van Dijk (Canada) as members. Anuschka Bakker (Netherlands) served as secretary.

(5) The panel of the second break-out session was composed by Prof. Dr Michael Lang (Austria) as the Chair and Prof. Alfredo Garcia Pratz (Spain), Prof. Daniel Gutmann (France), Prof. Dr Heinz-Klaus Kroppen (Germany), Prof. Dr Pasquale Pistone (Italy) and David Rosenbloom (United States) as panel members. Patrick Plansky (Austria) served as secretary.