In BEPS Action 7 the OECD has recommended changes to Tax Treaties to prevent Artificial Avoidance of Permanent Establishment (PE) Status. Those changes will be made through Multi-Lateral Instrument (MLI). Among other things, the changes make the criteria for formation of Dependent Agency PE stricter.
So now, Post-BEPS and Post-MLI, we are more likely to be confronted with the formation of PE in Host Country, whereas in earlier times we were able to plan for avoidance of PE. When a PE gets formed it becomes necessary to attribute taxable profits to the PE. How do we attribute profits to a PE? That is the subject matter of this Article.
First, a general discussion on how profits are attributed to a PE, on basis of the Authorized OECD Approach, will be made. And then specific discussion on attributing profits to a Dependent Agency PE (DAPE) will be made to examine whether arm‟s length payment of remuneration (e.g. commission) to the Dependent Agent (DA) is enough or whether additional profits need to be attributed to DAPE? Whether we should adopt Single Taxpayer (DA remunerated at ALP) approach or Dual Taxpayer (DA remunerated at ALP + DAPE attributed additional profits) approach? We will examine that by looking at a simple numerical example.
In so doing I will share certain practical approaches. Also, we will look at the OECD 2010 Report on Attribution of Profits to PEs as well as the „Additional Guidance issued by OECD in March 2018 on Attribution of Profits to PEs‟ in the wake of BEPS Action 7.
Under Article 7(2) of Tax Treaties the PE is hypothetically treated as a distinct and separate enterprise dealing independently with the Head Office (HO) or the Parent Enterprise (of which PE is a part). This is a hypothesis because actually a PE is not
legally and economically separate - like a Subsidiary is - and a PE, not being a separate legal entity, actually does not deal independently with the HO.
Because the PE is actually not a separate and independent entity, first we need to construct the PE as a hypothetical distinct and separate enterprise dealing independently with its HO. To do that the Authorized OECD Approach („Step I + Step II‟ prescribed in OECD 2010 Report on Attribution of Profits to PEs) guides us that in Step I we should undertake a Functional and Factual Analysis (FFA), leading to:i. The attribution to the PE of the contractual Rights and Obligations arising out of transactions (evidenced by contracts between the enterprise and external parties) between the enterprise of which the PE is a part and separate external enterprises;
ii. The identification of Significant People Functions relevant to the attribution of economic ownership of Assets to the PE;
iii. The identification of Significant People Functions relevant to the assumption of Risks, and the attribution of Risks to the PE;
iv. The identification of other Functions (or Activities) - in addition to the Significant People Functions relevant to the attribution of economic ownership of Assets and Significant People Functions relevant to the assumption of Risks - of the PE;
v. The recognition and determination of internal Dealings between the PE and other parts of the same enterprise (HO and other parts) that can appropriately be recognised; and
vi. The attribution of Capital based on the Assets and Risks attributed to the PE.
After constructing or setting up the PE as a Hypothetical Separate Enterprise we can then move to Step II of the Authorized OECD Approach to determine the Arm‟s Length Price of Internal Dealings (e.g. purchase of goods from HO for resale, sale of goods to HO, rendering service to HO, etc.) between the PE and the HO or Parent Entity (of which PE is a part).
In Step II the Internal Dealings, between the PE and the HO, recognized in step I, is priced at arm‟s length, assuming the PE and the HO (or rest of the enterprise of which it the PE is a part) to be independent of one another, as if the PE is an Associated Enterprise (AE) of the HO. The arm‟s length price of Internal Dealings is determined using Comparability Analysis applying the Most Appropriate Transfer Pricing Method.
We must keep in mind that in addition to the Internal Dealings with HO the PE may have transactions with other unrelated external enterprises as well as transactions with other related enterprises (AEs). In the case of transactions with unrelated enterprises (Arm‟s Length Parties) the PE‟s profits (or losses) attributable to its participation in those transactions (Arm‟s Length Transactions) can be computed directly. And the pricing on an arm‟s length basis of any transactions with AEs (other than HO), attributed to the PE, can be done separately by performing Transfer Pricing analysis.
The attribution of profits to a PE of an enterprise on an arm‟s length basis will follow from the calculation of the profits (or losses) from all its activities, including transactions with other unrelated external enterprises, transactions with related enterprises (with separate TP analysis) and internal dealings with other parts (HO) of the enterprise (under Step II of the Authorized OECD Approach). So, profits attributable to the PE from all its activities will be –
• Income and Expense with regard to dealings with third parties;
• Income and Expense with regard to dealings with AEs (other than HO) at ALP determined by making a TP analysis; and
• Income and Expense with regard to Internal Dealings with HO/Parent Entity (at ALP by virtue of Article 7 of Tax Treaties and determined by following Steps I and II of the Authorized OECD Approach).
The Functional and Factual Analysis, under Step I of Authorized OECD Approach, will initially attribute to the PE any risks inherent in, or created by, the PE‟s own Significant People Functions relevant to the assumption of risks.
The Significant People Functions relevant to the assumption of risks are those which require active decision-making with regard to the assumption and management of those risks – you may also refer to the „6 Step‟ framework for risk allocation given in OECD BEPS Action 8-10.
We need to determine which assets are “economically owned” and/or used by the PE and in what capacity. The factual position is that no one part (PE or HO) of an enterprise owns assets; they belong to the enterprise as a whole. So, it is necessary to find a means of attributing economic ownership of assets.
Assets generally are attributed to that part (PE or HO) of the enterprise which performs the Significant People Functions relevant to the determination of economic ownership of assets. The Functional and Factual Analysis will examine all the facts and circumstances to determine the extent to which the assets of the enterprise are used in the functions performed by the PE, including the factors to be taken into account to determine which part (PE or HO) of the enterprise is regarded as the economic owner of the assets.
There is broad consensus among the OECD member countries for applying use as the basis for attributing economic ownership of tangible assets. This is regarded as a pragmatic solution for attributing economic ownership of tangible assets.
The attribution of economic ownership of assets will have consequences for the attribution of capital and interest-bearing debt as well as the attribution of profit to the PE.
• Where a PE is treated as the economic owner of a tangible asset, it will typically be entitled to deductions for depreciation (in the case of depreciable assets) and interest (in the case where the asset is wholly or partly debt-financed).
• Where a PE is treated as the lessee of a tangible asset, it will typically be entitled to deductions in the nature of lease-rent.
(i) Internally Developed Trade Intangibles
If the PE performs Significant People Functions related to the internally developed intangibles, then the PE will be treated as economic owner of those intangibles.
The Significant People Functions relevant to the determination of the economic ownership of internally created intangibles are those which require active decision- making with regard to the taking on and management of individual risk and portfolios of risks associated with the R & D of intangible property.
(ii) Acquired Trade Intangibles
Just as with internally developed intangible property, the key question in determining economic ownership of acquired intangibles is where within the enterprise (PE or HO) the Significant People Functions related to active decision-making required for taking on and managing risks are undertaken. With regard to acquired intangibles, these functions might include the evaluating the acquired intangible, analyzing the performance of any required follow-on development activity, and evaluating and managing risks associated with deploying the intangible asset.
(iii) Marketing Intangibles
The principles of the Authorized OECD Approach can also be applied to questions regarding the attribution of income with respect to marketing intangibles. The fundamental principles as regards marketing intangibles are the same as for trade intangibles. The Significant People Functions relevant to the determination of economic ownership are likely to be those associated with the initial assumption and subsequent management of risks of the marketing intangibles. These may include, for example, functions related to the creation of and control over branding strategies, trademark and trade name protection, and maintenance of established marketing intangibles.
(1) Introduction: The importance of ““free” capital
Enterprises require capital to fund day-to-day business activities, to create or acquire assets (tangible and intangible), and as explained in the previous section to assume the risks associated with an ongoing business (e.g. credit or market risk). Broadly, capital comes from three sources: (i) contributions of equity by shareholders; (ii) retained profits (including sometimes reserves, though practices among countries may vary); and (iii) borrowings.
Sources (i) and (ii) are referred to collectively as equity capital and source (iii) is debt capital. Under tax law, deductions are generally not given for payments made to equity holders, whereas deductions are generally available (subject to thin capitalisation rules, etc.) for payments of interest or interest equivalents to the holders of debt capital.
The term “free” capital (sources (i) and (ii)) is defined as an investment which does not give rise to an investment return in the nature of interest that is deductible for tax purposes under the rules of the host country of the PE. Because interest expense is generally deductible for tax purposes, it will be necessary to ensure an appropriate attribution of the enterprise‟s “free” capital to a PE in order to ensure an arm‟s length attribution of profits to the PE on deduction of interest.
Under the Authorized OECD Approach, the economic ownership of assets is attributed to a PE if the Significant People Functions relevant to the determination of economic ownership are performed in PE‟s jurisdiction, and risks are attributed to a PE if the Significant People Functions relevant to the assumption and/or management of the risks are performed in PE‟s jurisdiction. Once the Functional and Factual Analysis (of Step I) has attributed the appropriate assets and risks of the enterprise to the PE, the next stage in attributing an arm‟s length amount of profits to the PE is to determine how
much of the enterprise‟s “free” capital is needed to cover those assets and to support the risks assumed. This process involves two stages. The first is to measure the risks and value the assets attributed to the PE. The second is to determine the “free” capital needed to support the risks and assets attributed to the PE.
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