Attribution of Profits to a Permanent Establishment – A brief note on the new U.S. Model

This note on the issue of attribution of profits to a PE is part of a forthcoming wider analysis to the 2006 U.S. Model.

U.S. tax policy choices may be said to reflect not only on its tax legislation but also on its tax treaties. After a decade where the US Treasury Department has revamped key treaties of its treaty network, it was expected that the newly released 2006 update to the U.S. Model Income Tax Convention and Model Technical Explanation, would take into account some of the tax treaty policies well-established on the recently concluded treaties.

Taking into account that the U.S. Model and Technical Explanation are used as a starting point in bilateral treaty negotiations, it is a good window to understand certain treaty policy choices, derived form interaction of foreign legislation with domestic rules, and its recent evolution since its last update in September 1996 (See 1996 United States Model Income Tax Convention).

One of the novelties of the 2006 US Model is the addition, in line with the ongoing OECD project on attribution of profits to a PE(*), of a new language on the business profits article. In anticipation of the OECD findings, paragraph 2 of Art. 7 includes a last sentence referring that business profits to be attributed(**) to the PE shall include only the profits derived from the assets used, risks assumed and activities performed by the PE. This terminology of assets, risks and activities resembles the functional analysis approach used in the OECD PE drafts.

Paragraph 2 reads as follows: “Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits that it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions. For this purpose, the profits to be attributed to the permanent establishment shall include only the profits derived from the assets used, risks assumed and activities performed by the permanent establishment.”

The technical explanation was adequately expanded to take account recent developments. For example, the new technical explanation now refers that the language of paragraph 2 (combined with paragraph 3) incorporates the arm's-length standard, which is interpreted by the US in a manner consistent with the OECD Transfer Pricing Guidelines. Nevertheless, such consistency, including the application of the transfer pricing profits methods, should take into account the different economic and legal circumstances of a single legal entity (as opposed to a separate enterprise).

In addition, paragraph 3 is also amended to conform to the current OECD Model Tax Convention. The more detailed references included in the 1996 Model were simply eliminated, namely that the expenses considered to be incurred for the purposes of the PE were expenses for research and development, interest and other similar expenses.

Paragraph 3 reads as follows: “In determining the profits of a permanent establishment, there shall be allowed as deductions expenses that are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.”

The new language of Paragraph 3 is coupled with an interpretative note to be included in the protocol of the US treaties to be signed. In first place, the technical explanation refers that the rule provided by the interpretative note is that internal dealings may be used to allocate income (even though U.S. domestic regulations generally do not recognize them) in cases where the dealings accurately reflect the allocation of risk within the enterprise.

Secondly, the technical explanation mentions that the principles of the OECD Transfer Pricing Guidelines are considered to apply by analogy for purposes of determining the profits attributable to a PE. In that regard, the technical explanation refers that the amount of expense allowed as a deduction is determined by applying the arm's length principle, which means that a PE may deduct payments made to its head office or another branch in compensation for services performed for the benefit of the branch. The method to be used in calculating that amount will depend on the terms of the arrangements between the branches and head office and the technical explanation includes an example of legal services performed by the head office.

The interpretative note also mentions that a PE cannot be funded entirely with debt, but must have sufficient capital to carry on its activities. As such, in determining the amount of profits, the PE 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. This means that an interest deduction may be denied to the extent necessary to reflect such capital attribution.

Taking into account the restrictions for capital attribution found under U.S. domestic law, the interpretative note allows a taxpayer to apply a more flexible approach. For financial institutions (excluding the insurance sector) such amount of capital may be determined by allocating the institution’s total equity between its various offices on the basis of the proportion of the financial institution’s risk-weighted assets attributable to each of them. As regards insurance companies, it is mentioned that premiums earned through the PE and the portion of the insurance company's overall investment income from reserves and surplus that supports the risks, are attributable to a PE.

Comment: It is a fact that the U.S. plays a major role in setting the pace on international tax developments and that its treaty policies, reflected on US Model and treaties, are important to understand the so-called consensus mode of a wider forum, such as the OECD. The U.S. Model, on the issue of the attribution of profits, demonstrates that the U.S. is pushing ahead with the problematic OECD project by trying perhaps to find a middle ground (between the status quo and complete revamping of Art. 7) where business and tax administrations may agree to go forward. This is an example where the U.S. model is in fact ahead of the OECD Model, but other examples could also be mentioned, such as pension fund entitlement and hybrid entities. The slight amendments to Art. 7 may prove the support of the U.S. to the OECD PE project but the cautious wording found on the technical explanation also demonstrates that work needs still to be done in areas such as capital allocation.

(*) 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).

(**) It should be mentioned that the term "attributable to" provides an alternative to the analogous "effectively connected" term used under US section 864(c). This is an important point since the PE income determined by applying U.S. effectively connected income rules and the amount determined under Article 7 may well be different. In light of extensive litigation in US Courts, the technical explanation sets out rules for the interaction of those two results.