Working Party No. 1 on Tax Conventions and Related Questions Working Party No. 6 on the Taxation of Multinational Enterprises

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1 Unclassified CTPA/CFA/WP1/WP6(2009)8 CTPA/CFA/WP1/WP6(2009)8 Unclassified Organisation de Coopération et de Développement Économiques Organisation for Economic Co-operation and Development 07-Aug-2009 English - Or. English CENTRE FOR TAX POLICY AND ADMINISTRATION COMMITTEE ON FISCAL AFFAIRS Working Party No. 1 on Tax Conventions and Related Questions Working Party No. 6 on the Taxation of Multinational Enterprises CONSOLIDATED VERSION OF THE DISCUSSION DRAFT ON THE NEW ARTICLE 7 AND THE COMMENTS RECEIVED Joint Drafting Group on Attribution of Profits to Permanent Establishments 17 September 2009 This note is a consolidated version of the July 2008 Discussion Draft on the new Article 7 and of the comments that have been received on that draft. These comments have been included under the relevant parts of the Discussion Draft to which they relate. That document has been prepared solely to facilitate the discussions and is not intended to be a substitute to the full and official version of the comments received, which are available at Contact: Jacques Sasseville; jacques.sasseville@oecd.org; English - Or. English JT Document complet disponible sur OLIS dans son format d'origine Complete document available on OLIS in its original format

2 TABLE OF CONTENTS 1. NEW ARTICLE COMMENTARY ON THE NEW ARTICLE I. Preliminary remarks II. Commentary on the provisions of the Article Paragraph Paragraph Paragraph Paragraph CONSEQUENTIAL CHANGES TO OTHER PARTS OF THE MODEL TAX CONVENTION.. 70 Introduction Article Article Paragraph Paragraph Article Article Article Article Article Article Article Article Paragraph Paragraph Article

3 CONSOLIDATED VERSION OF THE DISCUSSION DRAFT ON THE NEW ARTICLE 7 AND THE COMMENTS RECEIVED 1. NEW ARTICLE 7 1. The following is the draft new Article 7 that the Committee has drafted in order to fully implement the conclusions of the Report on Attribution of Profits to Permanent Establishments. GENERAL COMMENTS AND COMMENTS NOT DIRECTLY RELATED TO THE DRAFT COMMENTS FROM BIAC We commend the OECD on the general quality of the Discussion Draft. It presents a far more internally consistent interpretation of Article 7, and application of the July 17, 2008 Report on the Attribution of Profits to Permanent Establishments (the "Final Report"), than does the partial implementation contained in the 2008 revision to the Model Treaty Commentary. We urge that, with the modifications suggested below, the revised Article 7 and Commentary be quickly adopted and that OECD member states make every effort quickly to incorporate the new understandings of Article 7 reflected in the Discussion Draft in bilateral treaties. In providing comments on the Discussion Draft, BIAC has assumed that the Final Report is indeed now in final form. We have refrained from any comments suggesting changes to the principles contained in the Final Report even though we continue to disagree with certain elements of the Final Report as suggested in our previous comment letters dated 3 November 2005 and 8 August Accordingly, we limit ourselves herein to comments intended to assure that the Final Report is appropriately and clearly implemented in its entirety in Model Treaty language and in the associated Commentary and to assure that a foundation of appropriate procedural principles for dispute resolution is established. To be specific, BIAC believes that the optimal way to resolve disputes in transfer pricing is through the inclusion in tax treaties of workable concepts relative to avoiding double taxation that can be effectively applied in arbitration in addition to the mutual agreement procedures. It is crucial to the achievement of this aim that all revisions in Model Treaty language facilitate the resolution of disputes through the mechanisms of mutual agreement and arbitration and we urge that this objective is implicit in any changes to Article 7. COMMENTS FROM EBF (European Banking Federation) We appreciate the opportunity to comment on the Discussion Draft for a new Article 7 of the OECD Model Tax Convention. In general, we think that the proposals need to be clarified. 3

4 Text of report Both the update on the new Commentary on Article 7 and the discussion draft contain only a reference to part II (banks) and part III (global trading) of the final report on Attribution of Profits to Permanent Establishments instead of a summary [or extracts] of its contents. This concerns above all the attribution of income and (dotation) capital of banks and consequently the functional analysis, including the determination of assets used and conditions of use and risks assumed by banks, "internal loans" and "free capital". We recommend including a summary [or extracts] of the content of part II and part III of the final report on Attribution of Profits to Permanent Establishments. Other issues Inconsistent reporting As far as the points about dotation capital are concerned, we would like to suggest future discussion about a supplementary point on the determination of dotation capital on going back to the regulatory basis of the risk weighted assets when using a so-called waiver regulatory regulation by the bank in accordance with Article 69 of the EU Directive 2206/48/EC of the European Parliament and the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast). The waiver enabled a reduction in the regulatory burden on banking groups by partially waiving the prudential requirements on a solo basis. (Art. 69 para 1 sentence 1: The Member States may choose not to apply Article 68 para. 1 to any subsidiary of a credit institution, where both the subsidiary and the credit institution is included are subject to authorisation and supervision by the Member State concerned, and the subsidiary is included in the supervision on a consolidated basis of the credit institution which is the parent undertaking, and all of the following conditions are satisfied, in order to ensure that own funds are distributed adequately among the parent undertaking and the subsidiaries. Article 68 para. 1: Credit institutions shall comply with the obligations laid down in Articles 22 and 75 and Section 5 on an individual basis.) Banks which use the socalled waiver could have the problem of a lack of data for calculating the appropriate dotation capital of a PE. Income and items of income Furthermore we suggest a supplementary point with regard to "items of income" of a PE and concerns the connection of Article 7 an 23 of the Convention, especially points 32.2, 32.6 and 32.7 of the Commentary: If a so-called "switch-over" clause is applied in a double taxation convention, the interpretation of the word "income" could differ between the contracting states, as is the case e. g. in the new treaty between the United States of America and Germany. The so-called "switch-over" clause is intended to deal with cases of double exemption of income. In Article 23 para. 4(b) of the Treaty between the USA and Germany, It is stated that "income" is not to be exempt but only credited if the USA applies the provisions of the Convention to exempt such income or capital from tax, or applies paras 2 or 3 of Article 10 (dividends) to such income, or may under the provisions of the Convention tax such income or capital but is prevented from doing so under its law. It is stated in the Technical Explanation of the US Treasury Department (July 17, 2007 page 26 concerning dividends) that it was not intended to apply this to cases where profits have been subject to the general US corporate-level taxing regime, and that, for example, the fact that an US corporation pays a reduced level of US corporate-level tax because of the nature or source of its income (e.g. because it is entitled to a dividends received deduction, a net operating loss carry forward, or a foreign tax credit) will not entitle Germany to switch from exemption to credit. In the German Finance Ministry s view, the so-called "switch-over" clause is already applicable if "items of income" of an US-PE of a German enterprise/bank are not to taxed in the USA - even if the "income" as a whole is taxed in the USA. 4

5 The OECD should take into account and clarify that the switch-over-clause is not applicable in cases where profits have been subject to the general corporate-level taxing regime of a PE and that the fact the PE pays corresponding to an national enterprise in the country of the PE a reduced level of corporate-level tax because of the nature of source of its income (e.g. because it is entitled to a dividends received deduction, a net operating loss carry forward, or a foreign tax credit). COMMENTS FROM EVCA (European Venture Capital Association) Private equity and venture capital investments are long-term by nature, providing equity capital to companies across all stages of their development. The industry continuously looks to expand into new markets, often across national borders. In this context, the private equity and venture capital industry and more specifically the funds which are used as investment vehicles (which are either opaque or transparent for fiscal purposes 1 ) for their institutional investor base, are often confronted with the issue of a possible presence of a permanent establishment and the discussion on the income to be allocated to such a permanent establishment. Some tax authorities approach the permanent establishment issue for private equity and venture capital funds very severely whilst others do not. Further difficulties arise for the industry when not all OECD countries interpret the principles of the Model Tax Convention in the same way. Such uncertainty not only makes the whole investment process more burdensome but moreover might lead to double taxation. The issue on the presence of a permanent establishment, which belongs to the application of Article 5 of the OECD Model Tax Convention, and the issue of income allocation, which belongs to Article 7 and is the subject of this consultation, are inherently connected. In this respect, EVCA would like to take the opportunity to invite the Committee of Fiscal Affairs of the OECD to further dialogue on these related issues based on, amongst others, interaction with its Tax and Legal Committee. In terms of Article 5, the main issue seems to be whether the fund managers are capable of creating a permanent establishment of the investors or of the fund in the different countries where the management activity is carried out. In our understanding the fund managers should generally be viewed as independent agents acting in the ordinary course of their business, similarly to what happens to investments in public equities on the basis that, whilst they may be managing just one or a small number of funds, those funds generally comprise the investments from a broad spread of investors. However, currently in some jurisdictions the risk exists that the fund managers would create a permanent establishment to foreign investors or the fund. Turning specifically to Article 7, the key element should be the allocation of income deriving from the management activity carried out in different countries when a permanent establishment of the management company is created. In our understanding, while on the one hand it is evident that an arm s length compensation for the management activity should be allocated to the permanent establishment, it should on the other hand be clarified that the management income to be allocated never includes the investment proceeds (which are referable to the fund and to the investors). One suggestion for future discussion could be the inclusion of specific paragraphs for fund managers in the commentary on Article 7 and (possibly) on Article 5 in order to give the tax authorities of the different OECD countries clear guidelines and have univocal interpretation as far as possible. Inconsistent interpretation of the Articles in different jurisdictions limits the eagerness of investors to participate in funds which reduces the assets available in the private equity and venture capital markets. If the Committee 1. The most common fund vehicle in Europe is the limited partnership. 5

6 of Fiscal Affairs of the OECD would be open to such an addition, the EVCA Tax and Legal Committee would be prepared to actively participate in the analysis and to assist in the provision of relevant information. To conclude, in this current period of financial instability, private equity and venture capital can play a particularly important role in providing an alternative route to capital and access to management expertise that can help companies overcome deteriorating market conditions. Furthermore, with the reticence from the banking industry to provide finance (including equity and debt) for business acquisition and growth, the private equity and venture capital industry might therefore have to play a crucial role in the global economic recovery in general and more specifically the financial system. With private equity and venture capital firms typically investing for five or six years and often longer, the industry offers an antidote to the short-termism which has contributed to the current problems, and will also be able to support viable businesses that may be sold off by large corporations in the short term as they focus on core activities. To enable the industry to fulfil its potential, addressing the issues contained within the current implementation of both Article 7 and Article 5 as outlined above will prove highly useful. COMMENTS FROM ICAEW (Institute of Chartered Accountants in England and Wales) We welcome the discussion draft which represents a more internally consistent interpretation of Article 7 and the July 2008 Report on the Attribution of Profits to Permanent Establishments. COMMENTS FROM RSM RICHTER CHAMBERLAND (Chartered Accountants) As a general comment, we agree with the OECD s revision of Article 7 following the release of the Report on the Attribution of Profits to Permanent Establishments (the Report ). The revised Article 7 is the reflection of the OECD s functionally separate entity approach (the authorized OECD approach ) for attributing profit to a Permanent Establishment ( PE ). As the main purpose of the OECD Model Tax Convention (the Model Treaty ) is to serve as a model for tax treaties entered into by OECD member countries, it is very important to ensure that its language is clear and unambiguous. We believe that the OECD has achieved this goal by revising Article 7. COMMENTS FROM TEI (Tax Executives Institute) TEI commends the OECD s efforts to update Article 7 of the Model Treaty and the related commentary. References to the OECD s 1995 Transfer Pricing guidelines throughout the revised article s commentary underscore the OECD s commitment to the principled and uniform treatment of associated enterprises (i.e., subsidiaries) under Article 9 and Permanent Establishments (PEs) under Article 7. In addition, efforts to close the gap between the theoretical concepts in the commentary and the effective application of the rules by OECD and non-oecd countries are welcome. Finally, the new article and commentary firmly reject the force of attraction rule applied by some countries for determining the profits of a PE. By rejecting that rule, the number of instances of double taxation should be reduced. As a representative of large, complex multinational enterprises (MNEs), TEI supports the development of effective rules to govern international taxation. In order to be effective, the Model Treaty and its commentary should reflect sound tax policy principles, be as simple as possible, easy to administer, and eliminate double taxation. Where the rules reflect these principles, the interpretations by tax administrations, taxpayers, and ultimately the courts will be more consistent. As important, the Model Treaty and its commentaries should, where practicable, align with common business practices by 6

7 respecting the taxpayer s books and records where (1) they are consistent with the functional and factual analysis and (2) the profit attributed to the PE falls within the range of results of comparable separate and distinct enterprises. We offer a number of specific recommendations to clarify the proposed commentary and make the rules more effective. Is there a PE? The attribution of profits under Article 7 can and should only be undertaken after the existence of a PE has been established under Article 5. Regrettably, in proposing optional articles, paragraphs, and commentary in respect of Articles 5 and 7 that satisfy the desires of member and non-member taxing authorities, the OECD is creating substantial uncertainty for businesses and exacerbating the potential for double taxation. TEI believes the OECD should strive to develop uniform rules so that similar situations are treated consistently. Where countries have fundamental objections to specific articles or paragraphs, the countries should use the formal objection or reservation procedures to note their differences with the OECD s Model Treaty. Multiple Versions of Article 7 Commentary Creates Confusion Currently, there are three versions of commentary on Article 7 of the Model Treaty: the pre-2008 commentary, the 2008 revised commentary approved by the CFA and incorporated in the 2008 version of the Model Treaty, and the new proposed commentary that would be released along with the revisions to Article 7. The pre-2008 commentary should apply to treaties ratified prior to 2008 and may continue to apply unless superseded by a new agreement. The new proposed commentary would seemingly only apply to treaties that adopt the new Article 7. The legal effect of the 2008 revised commentary on treaties with the existing Article 7 is problematic. The OECD is of the view that the 2008 revised commentary is effective immediately since it is part of an agreed OECD process, but it is unclear whether Member States or their courts will agree about its application to extant treaties. At a minimum, member countries should specifically indicate the degree to which they will follow the interim, 2008 revised commentary. In addition, where the new proposed commentary is silent on issues and examples that were addressed in the pre-2008 commentary to old Article 7, we believe it would be beneficial to permit taxpayers and tax administrators to cite the pre-2008 commentary as persuasive and take it into account. TEI urges the OECD to confirm this as well as to clarify the application of the pre-2008, revised 2008, and new proposed commentaries to existing and new treaty provisions in order to ensure more uniform and consistent interpretation of the new Article 7 and its commentary. Dependent Agent PEs Paragraph 26 of the new Commentary to Article 7 in the 18 July 2008 Update to the Model Treaty incorporates the principles relating to Dependent Agent PEs set forth in Section D-5 of the Report on the Attribution of Profits to Permanent Establishments. As noted in TEI s 12 October 2004 comments in respect of the OECD s discussion draft on Part I of the Attribution of Profits Report, we are concerned that the application of the principles in Article 7 to an unplanned, deemed dependent agent PE under Article 5(5) may result in excessive compensation to the source country because it is difficult to distinguish between the provision of services to the principal/foreign company for a fee and the provision of services on behalf of a principal/foreign company. 7

8 COMMENTS FROM VNO-NCW Netherlands Employers Federation VNO-NCW, the Netherlands Employers Federation, representing the large majority of small, medium and large enterprises in The Netherlands is pleased to send their comments as requested (on OECD website) on the Discussion draft on a new Article 7 (Business Profits) of the OECD Model Tax Convention. VNO-NCW observes in the Draft a number of generally supportable principles as outlined below but is particularly concerned about the trend, again confirmed in this Draft, to increase the administrative burden and costs of complying with international tax rules. This is especially disturbing when one realises that The Netherlands is front runner in the OECD concept of Enhanced relationship between taxpayer and Revenue where both Revenue and taxpayer aim to reduce their compliance burden by increased transparency. Moreover, VNO-NCW is more than concerned about the lack of consensus between OECD Members in this Draft resulting in the likelihood that no access can be obtained to the MAP procedure if we follow the wording in article 25-1 of the Model Tax Convention ( Model ). After all, art.25-1 does not refer to actions of States resulting in double taxation but rather to taxation not in accordance with the provisions of this Convention. Consequently, non-alignment of interpretation of the Model means simply no access to dispute resolution; a highly undesirable result in times of rapidly increasing globalisation. Such consequence can be avoided by inserting a reference to avoidance of double taxation in article 25-1 as a result of different interpretation of the Model terms by the Contracting States. VNO-NCW has the following more detailed comments on the Draft. OPENING REMARKS The Discussion draft on a new Article 7 (Business Profits) of the OECD Model Tax Convention, dated 7 July to 31 December 2008 (the Draft) contains a number of generally supportable principles, such as the preference for the separate entity approach, the move toward alignment with general transfer pricing principles, and the OECD's clear rejection of the Force of Attraction principle. There are, however, areas of significant concern arising from this Draft and earlier OECD papers. The Draft follows on from the Report on the Attribution of Profits to Permanent Establishments, dated 17 July 2008, which discussed the application of the Authorized OECD Approach (AOA) to transfer pricing on Art. 7 of the Model Treaty. The text of Article 7 was considered to be inconsistent with the AOA in certain areas, and the Draft was released with the aim of aligning Art. 7 of the Model Treaty with the AOA. Given the historical context for the Draft, what follows is therefore an overview of significant concerns which remain from the Draft, the AOA and the Report on the Attribution of Profits to Permanent Establishments, dated 17 July 2008 (collectively the OECD Papers) in relation to Art. 7 of the Model Treaty. Indeed, it is worth noting specifically at this juncture that concerns remain with parts of the AOA, and that certain principles contained therein will have be subjected to further scrutiny before agreement is reached that the AOA is truly workable at a practical level. Before turning to specific examples, it is worthwhile noting some of the key uncertainties that exist from a commercial perspective as a result of the OECD Papers. 2 The extent to which fiscal authorities will adopt the AOA and the nature of any reservations which may be incorporated in treaties as a result; how domestic law of particular countries may be amended, and the transitional provisions, if any, which may be incorporated. There could be 2. One fundamental which is worth bearing in mind for the purposes of what follows is that, from a commercial standpoint, a single enterprise will often have various PEs located in a number of different jurisdictions. 8

9 additional complications where an enterprise has more than one PE, as the changes made by different fiscal authorities are unlikely to be synchronised. The nature of unforeseen tax charges which may arise as a result of the transition from existing practice to the AOA; and the impact past conduct/ documentation may have in formulating the profit profile/ opening balance sheet of a PE under the new regime. The practical question of the level of historical evidence that is available to support the businesses view of profit attribution under the new regime (particularly in regard to the economic ownership of intangibles). Indeed, the level of historical evidence sought looks likely to not only significantly increase the compliance burden for business, but to also add to the uncertainty around whether the business has done enough to be adjudged compliant. Funding issues for PEs will be exposed to more uncertainties, as no single preferred methodology has been identified by the OECD. OECD model treaty commentary changes in regard to the new approach are supposed to not conflict with the previous commentary, but rather to reflect modern day multinational operations and trade 3. However, where the existing commentary no longer reflects modern day multinational operations and trade which is bound to happen in certain circumstances due to the time differential between when the existing commentary was drafted and the state of play in the current commercial market it is possible that some changes will in fact impact on the current tax treatment. There is also the issue of ambulatory tax interpretation in instances, for example, where significant people function was not such a significant factor in the past. The result of the issues noted above, coupled with the comments below, will be a significant increase in transfer pricing work, especially but not only in the initial period when functional and factual analysis is undertaken to establish the economic ownership of various assets etc. An element of uncertainty has also been introduced due to the lack of specific guidance in certain areas. This increased work and level of uncertainty, and corresponding probable requirement for additional resources, is expected to necessitate additional costs for business, a not an insignificant concern in times of economic growth but especially in the current economic climate. Moreover it is likely that review of the compliance documentation requires significant additional and highly skilled staff for Revenue Authorities of OECD Members. Below we present an overview of specific examples of the more problematic issues identified as a result of the changes outlined in the Draft and the associated OECD Papers. The examples have been broadly split into three parts, issues arising in the areas of Transfer Pricing Methodology, Funding Concepts and Intangibles/ Royalties. TRANSFER PRICING METHODOLOGY Retrospective nature of the required analysis A functional and factual analysis is required for implementation of the functionally separate entity approach. It appears that this analysis will need to be retrospective in order to impute commercial terms of dealings in order to ascertain, for example, the economic ownership of intangibles at the date of transition from the previous treatment to the AOA. 3. Clause 4; Report on the Attribution of Profits to Permanent Establishments, dated 17 July

10 There are no guidelines as to how far back a functional analysis would extend in order to determine an appropriate starting position from which to determine economic ownership and such matters under the new approach. Presumably each case will be judged on its merits, and ultimately the evidence will need to be sufficiently robust for all relevant tax authorities to take the same view on matters such as dealings, allocation of risk, value and profit attribution. The difficulty of this should not be under estimated. Under English law, for example, contracts between two legal entities may sometimes be established in the absence of a written contract by deducing risks and responsibilities from the conduct of the parties and other such factors. However, such contract proceedings can be very difficult, as a court needs convincing evidence in order to determine that there was a meeting of the minds on key terms. Even greater difficulties will be faced by business in regard to the transition to a functionally separate entity approach where no written legal agreements exist and the parts of the enterprise dealt with each other on a non-contractual basis. The functional and factual analysis is the foundation of the new authorised OECD approach to profit attribution. However the challenges include the absence of written contracts and a contractual mindset, only one party and also that the arrangements between Head Office and the PE were probably largely focussed on compliance with prevailing tax law (e.g. apportionment of costs etc rather than a full transfer pricing approach). For these and other reasons it might not be possible to compile a compelling functional analysis to support the future profit attribution methodology in spite of significant resources being deployed. There will also be the need to convince at least two tax authorities to take the same view on whatever evidence is available in respect of supporting the proposed starting position. (Note there may often be more than one PE and the allocation of economic ownership etc may therefore involve several tax authorities.) Previous experience of discussions with tax authorities (e.g. during audits and for APAs) shows that this is a potentially contentious area, even when the functional and factual analysis is based on an existing legal framework. Where no contracts underpin the transaction it is to be expected that there will be even more debate. In particular there may be little evidence about which part of an organisation bore risk as this is an issue that had little relevance. The rule of law had to be complied with; attribution and determination of risk was not really relevant in the area we discuss in the Draft. The functional analysis may therefore need to make a retrospective case for where risk was borne based on few facts and little evidence. The new approach links risk to significant people functions whereas it might have been assumed by business and tax authorities in the past that the Head Office substantially bore the risk in past years because it supplied funding to the PEs and employed senior management who were responsible for strategies (though not necessarily for local decision making in accordance with head office guidelines, often made in conjunction with discussions with head office i.e. active decision making 4 ). Separation of business components The new approach seems to separately deal with Risk (including significant people functions relating to risk), Assets (including significant people functions relating to assets), Funding 4. Clauses 25 and 27; Report on the Attribution of Profits to Permanent Establishments, dated 17 July

11 In practice there are links between them. For example although capital might follow risks the net assets position seems a better starting point. Other factors Although the report notes that it is not the intention to impose more burdensome documentation, significant resources will be required to establish initial positions and that the robustness of the analysis might be called into question by tax authorities if the evidence is not compelling. This will especially be the case where it is necessary to retrospectively deduce the substance of a dealing e.g. is the transfer of an asset a sale, lease or licence 5. Conclusions will need to be drawn about whether part of the organisation has been acting in a support or other role. For example, whether the conditions were comparable to, say, those of a contract researcher or owner. As noted, it may be, in practical terms, an insurmountable challenge to unearth sufficient evidence to ensure that the retrospective functional and factual analysis is carried out in a sufficiently thorough and detailed manner as is required. 6 In this respect VNO-NCW suggests that in case OECD decides to accept retroactivity, the period of such look back is at least defined to a limited number of years (eg. 3 years). Funding Turning now to a prime example of an area where significant ambiguity exists under the proposals, namely funding and the resulting attribution of profits to a PE. It seems a safe assumption that the goal of any enterprise is to achieve consistency between the aggregated position under the various new methods and the funding levels shown in the statutory accounts. However, this is probably not possible where an enterprise has a number of PEs in a variety of jurisdictions. It is difficult, without working through a number of detailed scenarios, to determine whether or not the guidance on funding can actually produce an integrated and workable solution for the following reasons: There is no single agreed approach for several key issues e.g. the attribution of free capital or interest bearing debt of an enterprise A number of standalone rules, such as those in the PE host tax authority s local legislation, can impact the way that statutory capital is structured Differences exist in how adjustments may be made for disallowed interest etc The potential flow through impact of a tax adjustment on one part of the enterprise on the other parts of that enterprise will need to be understood in variety of potentially complex scenarios. A key commercial question is whether the aggregated position of the PEs/ branches and Head Office can be reconciled to the statutory accounts/ profit position of the enterprise as a whole, how uncertain the outcome might be, and how much effort will be involved to achieve this. 5. Clause 234; Report on the Attribution of Profits to Permanent Establishments, dated 17 July Clause 96; Report on the Attribution of Profits to Permanent Establishments, dated 17 July

12 Regardless of the existence of any statutory branch accounts that might be in existence, effectively a new tax balance sheet will need to be drawn up at the time of transition. This will be based on the retrospective functional and factual analysis that is undertaken in accordance with Part I, and appears unlikely to correspond with the existing branch accounts because the AOA assumptions used for the new tax balance sheet will differ from the historical tax approach used for statutory reporting purposes. Capital Attribution and funding the operations of the PE Whether a PE is considered under or over capitalised will depend on the rules and practices in the host country. First the tax balance sheet is determined following the retrospective functional and factual analysis and the resulting functions, assets and risks are valued, subsequnetly the arm s length amount of free capital needs to be determined for each PE. The level of free capital will vary assuming different parts of the enterprise conduct different businesses, perform different functions, carry different risks (as a result of significant people functions). It is also unclear at this time how valuations under the AOA, of goodwill for example, will fit with accounting standards and whether a tax authority would base its funding approach on accounting standards or the economic approach used under the AOA? The consultation process was not able to determine a single agreed approach for attributing free capital. A number of methods were considered (and each can be appropriately applied in certain circumstances). The report therefore simply articulates guidelines as there is no agreed approach for attributing free capital. Because no single method has been agreed, business is left with a high degree of uncertainty. The use of the relevant Mutual Agreement Procedure (MAP) to resolve such issues is suggested, however, apart from the resources required to take advantage of this process, the outcomes might be uncertain, and may also have flow through effects for the allocation process for other PEs in the enterprise, an effect which may not be acceptable to the host country fiscal authority for the other PE. (We may see the emergence of more triangular cases.) Each attribution method in isolation can possibly achieve the result of splitting the funding consistently between the Head Office and the PE. However different methods can be agreed by business and the relevant tax authorities for each of an enterprise s PEs. Thus the aggregated position of the PEs and Head Office will not reconcile for the purposes of a single tax balance sheet, nor the statutory accounts. Unless there is an integrated solution, the taxpayer will likely incur double taxation. Additional Funding Points The report also notes that there is more than one method to attributing the interest bearing debt of the enterprise and to determining the rate of interest to be applied to the debt (i.e. in establishing the arm s length amount of interest in the PE). Neither the tracing approach nor the fungibility (allocation of a proportion of funding) approach is fully endorsed as neither is recognised as providing a total solution. Again there is no single approach; it is recognised that some countries might apply tracing, others fungibility, others a mixture of these two methods e.g. tracing for big-ticket items. Interest bearing debt can include internal interest treasury dealings (assuming this is not in relation to free capital) assuming the retrospective functional and factual analysis shows that there are related significant people functions relevant to determining the economic ownership of the cash or financial asset. INTANGIBLES/ ROYALTIES The proposals for determining the ownership of shares in, or rights to use of, intangible assets seem likely to provoke significant disagreement between countries. Intangibles are often seen as a noteworthy driver 12

13 when attributing profits and their allocation has therefore become an increasingly sensitive issue. The treatment of intangibles was not discussed in the early drafts of the Report on the Attribution of Profits to Permanent Establishments. Although a commentary is now included in the final report, establishing the need to retrospectively determine the economic ownership interest of intangibles within a single company will be a challenge for many companies. Again a (retrospective) functional and factual analysis will be required and this no doubt will be influenced by the relatively recent focus on the creation of marketing intangibles. The emerging view appears to be that economic ownership may be influenced by functions performed not at the level of senior management 7 rather at the level of active management. However, it might not be sufficient to merely determine the economic owner. It appears likely that a valuation of intangibles interests might be required (e.g. for opening balance sheet purposes in assessing financing and for buyin/buy-out purposes pursuant to a deemed cost contribution arrangement where there are several PE or other economic owners of that intangible). The tax impacts of the acquisition or recognition of intangibles by a PE will depend on the relevant tax laws and is therefore not addressed in the report. Again, where an enterprise has a number of PEs in a variety of countries, there is a likelihood that different views will be taken by the relevant tax authorities such that the consolidated value for the entity as a whole, whether or not reflected in the balance sheet, might differ from the aggregate of the amounts in the various tax balance sheets. Different treatment under the relevant tax laws may in turn lead to double taxation. It is notable that withholding tax and similar implications of imputed royalties are outside the scope of the report. The report only considers the amount of profit to be attributed, rather than the tax nature of the profit components 8, but this leaves a significant level of ambiguity for business at this time. CLOSING REMARKS There is much to be supported in the general approach taken by the OECD, however significant, basic and detailed review needs to take place. Furthermore, VNO-NCW urge OECD to seek consensus in detail on all issues before finalising and publishing a new commentary to article 7 in particular and to the OECD Model in general. This Draft requires a significant change to avoid deterioration of the tax climate by increased the compliance costs for the taxpayer and the review and assessment costs for the Revenue Authorities amongst OECD Members. The additional costs, plus the inevitable uncertainty of outcome in respect of many issues, will undoubtedly cause commercial harm going forward; this is structural and not limited tothe current financial climate. There is a real risk that the proposals in their current form will result in increased double taxation, which fundamentally brings into question the scope of the obligation to relieve double tax. After all, paragraph 6 of the Introduction in the July 2008 version of Model Tax Convention refers as the aim of the Model to effectively resolve the double taxation problems existing between OECD Member countries. The current Draft has set a first step in a long journey to achieve consensus and clarity. We trust it will not be a journey leading to double taxation. VNO-NCW is much prepared and willing to work together with the OECD to undertake the review and work together to achieve a lasting result: providing clarity, reduced occurrences of friction between OECD 7. Clause 118; Report on the Attribution of Profits to Permanent Establishments, dated 17 July Clause 238; Report on the Attribution of Profits to Permanent Establishments, dated 17 July

14 Members and most noteworthy, no double taxation at lower compliance costs than taxpayer and Revenue have today. COMMENTS FROM TREATY POLICY WORKING GROUP Treaty Policy Working Group member companies appreciate the obvious care and thought with which the Discussion Draft was prepared. We share the OECD s goals, expressed in the Discussion Draft, of providing consistency, maximum certainty regarding the manner in which profits are to be attributed to a permanent establishment, and relief from double taxation. The Discussion Draft does not fully address our underlying concerns regarding the 2008 Report or the twophase process recommended by the OECD for its implementation. However, the Discussion Draft clearly reflects the principles set forth in the 2008 Report more clearly and coherently than did the 2008 Commentary. It confirms some important points and would do more to advance the goals of certainty and consistency. Its approach is, therefore, preferable on balance to interpretations based on the 2008 Commentary alone, which could produce anomalous positions inconsistent with key principles of the 2008 Report. Article 7 BUSINESS PROFITS 1. Profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 may be taxed in that other State. [Existing paragraph 1: The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.] COMMENTS FROM CIOT We suggest that in paragraph 1 the word instead is inserted in the final sentence, so that this reads the provisions of paragraph 2 may instead be taxed in the other State. 2. For the purposes of this Article and Article [23 A] [23B], the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise. [Existing paragraph 2: 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 14

15 which it might be 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.] COMMENTS FROM BIAC The Language of Article 7, Paragraph 2 Recommendation for More Comprehensive Text Article 7, paragraph 2, as revised in the Discussion Draft is the critical Model Treaty provision controlling determinations of the amount of profit that should be attributed to a permanent establishment. Under the Final Report, four critical principles are to be applied in attributing profits to a permanent establishment. These are: (i) the permanent establishment is to be treated as a functionally separate entity dealing independently with other parts of the enterprise and with third parties; (ii) a detailed functional analysis focusing on key people functions must provide the foundation for all profit attribution determinations; (iii) attribution of assets and risks to the permanent establishment should be premised on the functional analysis; and (iv) principles of arm's length dealing should be applied to allocate profits between the permanent establishment and other parts of the enterprise. We believe each of these four fundamental principles should be more fully reflected in the language of Article 7, paragraph 2. Acknowledging the difficulty of synthesizing the details of the Final Report into concise Model Treaty provisions, we think that Article 7, paragraph 2 is incomplete. The proposed language reflects some of these principles, but it fails to reflect each of these Final Report principles comprehensively. We therefore recommend that the language of Article 7, paragraph 2 be revised to provide as follows: For the purposes of this Article and Article [23A][23B], the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 are the profits it might be 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 on an arm's length basis with the enterprise of which it is a permanent establishment. The profits attributable in each Contracting State to the permanent establishment shall be determined taking into account the functions performed by the permanent establishment and other parts of the enterprise, and the assets deemed owned and the risks deemed assumed by the permanent establishment and by other parts of the enterprise on the basis of the functions performed. COMMENTS FROM CIOT We are concerned that some of the drafting is very wide and gives a lot of room for subjective interpretation. Examples of this are the reference to profits that a company might be expected to make (paragraph 2) We suggest that this will not lead to clarity or a consistent approach amongst the participating States. [The existing paragraphs 3, 4, 5 and 6 are deleted: 3. In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which 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. 4. Insofar as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph 2 shall preclude that 15

16 Contracting State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles contained in this Article. 5. No profits shall be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods or merchandise for the enterprise. 6. For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year by year unless there is good and sufficient reason to the contrary. 3. Where a) in one Contracting State, the amount of free capital that is used for determining the interest that is deducted in computing the profits that are attributable to a permanent establishment situated in that State of an enterprise of the other Contracting State is determined using a method of attributing capital to the permanent establishment that is provided by the domestic law of the first-mentioned State and both States agree that the application of that method produces an arm s length result in conformity with paragraph 2 in that case; and b) that method is different from the method provided by the domestic law of the other State and used by that State to attribute capital to the permanent establishment and, as a result of this difference, part of the profits of the enterprise are charged to tax in both Contracting States and, in the absence of this paragraph, Article 23 would not apply to eliminate the double taxation of these profits, the other State shall, in determining the profits attributable to the permanent establishment for the purposes of Article 23, use the amount of free capital derived from the application of the capital attribution approach used by the first-mentioned State. For the purposes of this paragraph, free capital means capital that does not give rise to a return in the nature of interest that is deductible in the first-mentioned State. [New.] COMMENTS FROM BIAC The Language of Article 7, Paragraph 3 Recommended Deletion to Reinforce Obligation to Relieve Double Taxation in Context of Different Arm s Length Amounts The proposed language of Article 7, Paragraph 3(b) implicitly suggests that certain limits exist under the Model Treaty on the obligation of the contracting states to relieve double taxation. In particular, the phrase at the end of the indented language in Paragraph 3(b) suggests that under certain circumstances, in the absence of [paragraph 3], Article 23 would not apply to eliminate the double taxation of profits. While not clearly articulated in either the draft language of the treaty or in the draft Commentary, the OECD s working premise seems to be that, absent Article 7, Paragraph 3, if the home country's domestic law or its application of transfer pricing principles leads to an arm's length result, it has no further obligation under the treaty to relieve double taxation even if the host country attributes a different arm's length amount of profits to the permanent establishment. Thus, the Discussion Draft implies the proposition that, consistent with their treaty obligations, the contracting states can attribute different amounts of profit to a permanent establishment, provided each amount can be said to be consistent with the arm's length principle. 16