Getting closer to the finish line: The first step to revise the Commentary on Article 7 of OECD Model

The OECD Committee on Fiscal Affairs (CFA) has issued on 10 April 2007 a highly expected discussion draft on a revised Commentary concerning Article 7 (Business profits) of the OECD Model Tax Convention. The discussion draft, which follows the release on 21 December 2006 of a revised Report on the Attribution of Profits to Permanent Establishments, is essentially designed to improve certainty on the interpretation of existing treaties based on the current text of Art. 7. This draft represents the first of the last steps of the OECD in developing an authorised OECD approach (AOA) to the attribution of profits to permanent establishments (PEs).

Historical background
The topic of attribution of profits has been in the OECD agenda already for more than 6 years and the more attentive readers may well recall that it was also one of the general topics of the 2006 IFA Congress in Amsterdam. During the Conference, Prof. Philip Baker presented the conclusions of the IFA General Report which highlighted that on the countries surveyed domestic law and treaty law are largely in conformity, but that no consensus was found as to the correct interpretation of Art. 7. Accordingly, 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.

The First step
Taking into account the many areas covered by the PE Reports, the OECD concluded that it would perhaps not be necessary to make substantial changes to the Commentary. The idea of rewriting the existing Commentary is to provide clarification, without fundamentally altering the basic principles on which it is founded. As such, the proposed Commentary incorporates several of the conclusions of the 2006 Report that according to the CFA, “would not conflict with previous versions of the commentary”. A question remains as to whether we are faced with a major change of the Commentary disguised of clarification.

In fact, OECD member countries should follow the Commentary on the Articles of the Model Tax Convention, as modified from time to time [emphasis added], when applying and interpreting the provisions of their bilateral tax conventions that are based on these Articles. Commentaries made after a treaty is concluded may be considered not be in the same category as Commentaries in place at the time the treaty was concluded. But that is not to say that later Commentaries are to be excluded altogether from the interpretation process.

The following are arguments in favour of using later Commentaries when interpreting a treaty concluded. First, there is no rule that anything that happens after the treaty is concluded is irrelevant. Secondly, refusing to take later Commentaries into account can result in such Commentaries being frozen in time and therefore failing to adapt to changes in business or technology. Thirdly, it is common for national legislation to be interpreted to take account of later developments. There is no rule that the same should not apply in interpreting tax treaties. Finally, if later Commentaries are not used, the result could be a different interpretation of identical wording in treaties entered into at different times.

In determining the use of later Commentaries in any particular circumstances, it is important to differentiate between (substantial) changes that fill gaps in the existing Commentaries or amplify the existing Commentaries and changes that simply record a treaty practice or clarify an already existent element. It is therefore expected a period of uncertainty as to whether the courts of OECD member countries will accept that the AOA (as included in the draft) is consistent with the wording of existing articles based on Art. 7.

The step still ahead
The step still ahead consists of an alternative form of wording for Art. 7 (and commentary), which is expected to be released shortly. This option, which supports more clearly the adoption of the AOA across the board, has its disadvantages and advantages.

A problem remains that once adopted it will still be a question of years to such text (i.e. new wording of Art. 7) is incorporated into the real treaties, unless a practical solution is found.

In a recent article, Avery Jones and Philip Baker discussed the possibilities to devise a simple system for amending the wording of many tax treaties in a short period of time. In “multiple amendment of bilateral double taxation conventions” (BIFD -2006 no. 1 ; p. 19-22), the authors look at some possible solutions to the problem of the bilateral nature of tax treaties and how to overcome some constitutional limitations of the procedure of concluding tax treaties. In that regard, the authors propose that the OECD adopts multilateral framework agreements for amending existing treaties. Interestingly, the authors refer to the adoption of the AOA as a “good example of the need for a method to amend the wording of large numbers of tax treaties”. Time will tell if new developments will arise in this area.

The proposed Commentary and the interpretation of paragraph 1 of Art. 7.
It has been long acknowledged that current Commentary provides little guidance on how to interpret the term “profits of an enterprise”, beyond rejecting of the force of attraction principle. Two broad interpretations of the term “profits of an enterprise” were developed in that regard, namely the “relevant business activity” and the "functionally separate entity” approach.

In this regard, the proposed Commentary adopts the later approach by stating that Art. 7 should not be interpreted as restricting the amount of profit that can be attributed to a PE to the amount of profits of the enterprise as a whole. Under the proposed Commentary, the application of paragraph 2 may result in profits being attributed to a PE even though the enterprise as a whole has never made profits.

The proposed Commentary and the interpretation of paragraph 2 of Art. 7.
The proposed commentary indicates that in order to attribute profits to a PE it will be necessary to determine the profits that would have been realized if the PE had been a separate and distinct enterprise engaged in the same or similar conditions under the same or similar conditions and dealing wholly independently with the rest of the enterprise. This is achieved by using a two-step approach.

The first step requires a functional and factual analysis, identifying the economically significant activities carried through the PE. The second step requires to determine the remuneration for such activities by applying by analogy the transfer pricing principles with reference to the functions performed, assets used and risks assumed by the enterprise through the PE and through the rest of the enterprise [emphasis added].

The proposed commentary also points out that the same two-step approach should be used to attribute profits to a an Agency PE under Paragraph 5 of Art. 5 (this point will deserve a more detailed analysis in a future post).

The proposed Commentary and the interpretation of paragraph 3 of Art. 7.
With regards to expenses attributed to a PE, the proposed Commentary clarifies that Paragraph 3 only determines which expenses should be attributed to a PE for purposes of determining its profits. The proposed Commentary clearly refers that the issue of whether those expenses, once attributed to the PE, are deductible is a matter to be determined by domestic law of the PE State.

Interestingly, in recent days I came across an Indian ruling from the Mumbai bench of the Income Tax Appellate Tribunal (ITAT) , which determined that the deductibility of travel and entertainment expenses incurred by foreign companies which are attributable to its PE in India must be limited as per the Indian domestic law (Income-Tax Act). In Mashreqbank psc (ITA No. 2153/Mum/01), the ITAT considered that the limitations under the domestic tax laws are to be taken into account for the purposes of computing profits of a PE under Article 7(3) of the India UAE tax treaty.

The proposed Commentary and the issue of finding a consistency between paragraph 2 and 3 of Art. 7.
Paragraphs. 2 and 3 of Art. 7 provide the rules on how profits should be attributed to a PE. Art. 7(2) is the main rule which determines that the profits to be attributed to a PE are those which the PE would have made if, instead of dealing with its head office, it had dealt with an entirely separate enterprise under conditions and at prices prevailing in the ordinary market (i.e. the Arm’s length principle). Art. 7(3), on the other hand, states that, in calculating the profits of a PE, allowance is to be made for (certain) expenses incurred for the purposes of the PE.

At first glance, it seems that no major problems should exist when attributing profits to a PE on the basis of this two paragraphs. The only thing to do is to treat (for the purposes of the PE State) the PE as a subsidiary and apply the arm’s length principle. The first problems arise when one looks with more attention to the Commentary and identifies several limitations to the “deemed independence rule”, embodied in Art. 7 (2). This apparent inconsistency between 7(2) and 7(3) has created a major controversy, extensively analysed both by commentators, OECD and jurisprudence.

The proposed Commentary eliminates some of the controversial passages of the Commentary (para. 12 and following) that may be said to contain the existing exceptions to the arm's length principle. On the related issue of whether a PE may deduct its interest expense on intra-entity loans, the OECD maintains however the ban on deductions for internal debts and receivables, with the exception of financial enterprises such as banks.

Capital attribution and funding of a PE
It is acknowledged that companies require capital to support their activities and that such capital might be raised as equity capital (e.g. issue of shares) or as loan capital (e.g. issue of debt). The proposed Commentary considers that a PE would require certain amount of funding made up of "free capital" and interest bearing debt in order to support the functions performed, assets used risks assumed. The proposed Commentary accepts however that different approaches for attributing “free” capital are capable of giving an arm’s length result.

In fact, it should be mentioned that the amount of income attributable to the PE does not concern only the source jurisdiction (PE State). The attribution of profits has consequences also on the non-resident taxable base in his state of residence, namely in determining the amount double taxation relief to be granted under Art. 23 of the OECD Model.

In that regard, the proposed Commentary recognizes that the use of different capital attribution methods by the PE State and the State of Residence of the enterprise may give rise to double taxation. In that regard, the proposed Commentary refers that the OECD Member States agreed to grant double taxation relief for the amount of interest deducted (which is derived from the application of the capital attribution approach used in the PE State), if the following conditions are met:
(i) the difference in capital attribution results from conflicting domestic laws regarding the chosen capital attribution method ; and (ii)the approach used to determine the attribution of the capital is accepted in the PE state and produces a result consistent with the arm's length principle in that particular case.

The new approach does not mean, of course, that the Residence State must automatically give relief based on whatever capital attribution results the PE chooses to assign. There is always the fundamental arm’s length principle that should be complied with, in all stages of the attribution process. Nevertheless, since transfer pricing is far from being an exact science the symmetry issue may well become a future problem.

See related posts:
2007 Tax Agenda: What to expect from the usual suspects? View

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

The attribution of profits to permanent establishments during the 2006 IFA Congress View

Again Agency PEs (but this time Secret Agents) View

Attribution of Profits to an Agency PE: finding a middle ground View

Indian outsourcing activities: from finding a PE to determining its remuneration View

India: telecommunications, PE issues and attribution of profits View

The NatWest Saga continues - NatWest III View

ATO Guidelines on the Attribution of Profits to an Agency PE View

The Attribution of profits to PE - saga continues View