Permanent Establishment Allocations: Conceptual Overview

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2 Permanent Establishment Allocations: Conceptual Overview Article 5 of the OECD Model Tax Convention ( MTC ) Article 7 of the OECD MTC Article 9 of the OECD MTC OECD 2010 Report on the attribution of profits (2010 Report) OECD BEPS Action 7: 2015 Final Report OECD BEPS Public Discussion Draft: 4 July 5 September 2016

3 Article 5 of the OECD Model Tax Convention Creation of a Permanent Establishment ( PE ) in a Contracting State Main use is to determine the right of a Contracting State to tax the profits of an enterprise of the other Contracting State. Used to determine whether a Contracting State participates in the economy of the other Contracting State

4 Article 5 of the OECD Model Tax Convention Definition of PE found in Section 1(1) of the Income Tax Act No. 58 of 1962 Art 5(1) of the OECD MTC: through which business of an enterprise is wholly or partly carried on Should have a productive character and take part in the economy of the other country Art 5 does not itself allocate taxing rights, provides guidelines when PE is created in source country

5 Article 5 of the OECD Model Tax Convention Create PE through application of Art 5

6 Article 7 of the OECD Model Tax Convention Art 7(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 carried 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. Only profits attributable to the PE may be taxed No force of attraction rule Force of attraction income such as other business profits, dividends, interest and royalties arising from sources in their territory was fully taxable by them if the beneficiary has a PE therein even though such income was clearly not attributable to that PE (Commentary par 12 on Art 7(1))

7 Article 7 of the OECD Model Tax Convention Art 7(2) Attribution of profits treated as if separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the function performed, assets used and risks assumed by the enterprise through the PE and through the other part of the enterprise. Domestic law Head office and PE is seen as same legal entity Art 7(2) Need to hypothesize that PE is a separate/independent enterprise from Head Office. Once PE is seen as a complete separate enterprise Arm s length principle is applied

8 Article 9 of the OECD Model Tax Convention Art 9 - Arm s length principle: Related parties must deal/transact with each other as if they were independent, third parties OECD Transfer Pricing Guidelines: where conditions are made or imposed between the two enterprise in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly Domestic legislation Section 31 and Practice Note 7

9 Article 9 of the OECD Model Tax Convention

10 Overview of the 2010 OECD Report Authorised OECD approach ( AOA ) Profits to be attributed to a PE are the profits that the PE would have earned at arm s length, in particular in its dealing 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 PE and through the other parts of the enterprise PE should be treated as separate/independent enterprise performing own functions, assuming own functions, assuming its own risks and owning/using assets on its own

11 Overview of the 2010 OECD Report AOA applies the ALP of Art 9 Interpretation of Art 7(2) under the AOA requires two-step analysis: Step 1: Functional and factual analysis performed according to the OECD Transfer Pricing Guidelines Step 2: Determine the remuneration by applying by analogy Art. 9 (transfer pricing tools) Allows the calculation of the profits (losses) of the PE from all its activities: transactions with unrelated/related enterprises and other parts of the enterprise

12 Overview of the 2010 OECD Report Two step analysis Step 1: Fiction of separate entity Hypothesize the PE and the remainder of the enterprise as if they were associated enterprises performing its own functions assuming risks owning assets with own rights and obligations with own capital requirements entering into dealings with each other This is a mere fiction necessary for purposes of determining the business profits of the enterprise. Fiction does not lead to a requalification of income. Objective: Setting up a balance sheet and a profit and loss account for the PE

13 Overview of the 2010 OECD Report Two step analysis Step 2: Determining profits Transfer Pricing Guidelines apply TP methods to attribute profits Determine the arm s length remuneration of dealings consider dealings between head office and PE Choose most appropriate method to the circumstances

14 Step one: Fiction of Separate Entity Functional Analysis OECD Theory The functional analysis determines which of the identified activities and responsibilities of the enterprise are associated with the PE and to what extent. in what capacity functions are performed (i.e. a service performed for another part of the enterprise or as a function of the PE on its own). Basis: Activities performed at the fixed place of business Benchmark: Significant People Functions in many cases Active Decision Making

15 Step one: Fiction of Separate Entity Functional Analysis Objectives Costs follow functions costs in connection with the functions can be allocated to the PE if the significant people functions are performed by personnel of the PE Liabilities in connection with the costs should be shown on the PE s balance sheet

16 Step one: Fiction of separate entity Attribution of risks OECD Theory Attribute to the PE the risks based on the significant functions/active decision making in connection with the assumption and/or management of risks. Examples Inventory Risk: Decision re. inventory level Credit Risk: Decision re. creditworthiness of business partner Benchmark: Risk allocation in agreements between independent parties

17 Step one: Fiction of separate entity Attribution of risks Objectives Costs follow risks costs in connection with the risk (damages due to realisation of risk, insurances) can be allocated to the PE if the risk has to be allocated to the PE Liabilities or Provisions in connection with the costs should be shown on the PE s balance sheet Capital follows risks The attribution of risks also impacts the capital

18 Step one: Fiction of separate entity Rights and obligations Objectives Income and costs follow rights and obligations. Related receivables and liabilities have to been shown on the PE s balance sheet:

19 Step one: Fiction of separate entity Attribution of free capital OECD Theory Overview approaches: Capital Allocation Approach Thin Capitalization Approach Safe Harbor Approach (not an authorized OECD approach) Other Methods (especially for the insurance sector)

20 Overview of the 2010 OECD Report Attribution of free capital OECD Theory Capital Allocation Approach Allocation of enterprise s actual free capital on the basis of the proportion of assets and risks attributed to the PE by the functional analysis. Example: If PE has 10% of the enterprise s assets and / or risks it will have attributed to it 10% of the enterprise s free capital. Limitations in the following cases: PE conducts a different type of business PE operates in different market conditions from the enterprise as a whole Thinly capitalised enterprises War chests of the HQ does not have to be allocated Economic Capital Allocation (suggested in a banking context): Economic instead of regulatory capital as basis for allocation Basis for capital calculation is risk measuring Problem: Sophisticated risk measurement systems necessary

21 Overview of the 2010 OECD Report Attribution of free capital OECD Theory Thin Capitalization Approach Comparison on debt to equity ratios of tested party and independent companies carrying on the same/similar activities under the same/similar conditions in the host country of the PE without reference to the total capital of the enterprise as a whole Problem: Wide range of ratios Limitations: The aggregate amount of free capital it attributes to individual PEs may be greater than the amount of free capital in the enterprise as a whole.

22 Overview of the 2010 OECD Report Attribution of free capital OECD Theory Three approaches for attributing the external interest expense of the enterprise to its PE: Recognition of a treasury dealing: If it is possible to identify one part of the enterprise as undertaking in substance the significant people functions in connection with the cash or financial assets in order to be treated as the owner this part is entitled to an arm s length return from the cash under an internal treasury dealing. Tracing approach: Any internal movements of funds provided to a PE are traced back to the original provision of funds by third parties. The interest rate on the funds provided to the PE are determined to be the same as the actual rate incurred by the enterprise to the third party provider of funds. Fungibility approach: Money borrowed by a PE of an enterprise is regarded as contributing to the whole enterprise s funding needs, and not simply to that particular PE s funding needs. Each PE is allocated a portion of the whole enterprise s actual interest expense paid to third parties on some pre-determined basis.

23 Overview of the 2010 OECD Report Attribution of free capital Objectives Source of funds less free capital less provisions equals interest bearing capital. Free capital and interest bearing capital complete the PE s balance sheet:

24 Step 2: Attribution of Profit to a PE Application of Transfer Pricing Methods Apply the Traditional Transaction Methods Comparable Uncontrolled Price Method Resale Minus Method Cost Plus Method or the Transactional Profit Methods Profit Split Transactional Net Margin Method

25 OECD BEPS ACTION 7: 2015 FINAL REPORT Prevent artificial avoidance of PE status How? Avoid PE status through specific activity exemptions Fragmenting a cohesive operating business Ensure preparatory or auxiliary nature Splitting up of contracts

26 OECD BEPS ACTION 7: 2015 FINAL REPORT Amendments in MTC and Commentary Article 5(5): Where a person is acting in a Contracting State on behalf of an enterprise and in doing so, habitually concludes contracts, or habitually plays the principle role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are: In the name of the enterprise, or For the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or For the provisions of services by that enterprise That enterprise shall be deemed to have a PE in that State in respect of any activities which that person undertakes for the enterprise

27 OECD BEPS ACTION 7: 2015 FINAL REPORT Amendments in MTC and Commentary Article 5(6)(a): Paragraph 5 shall not apply if independent agent. Where, however a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, it will not be an independent agent. Article 5(6)(b): Meaning of closely related to an enterprise One has control of the other or both are under the control of the same persons or enterprises. One possesses directly or indirectly more than 50% of the beneficial interest in the other / aggregate vote and value in the company s shares or of the beneficial equity interest in the company.

28 OECD BEPS ACTION 7: 2015 FINAL REPORT Amendments in MTC and Commentary Article 5(4): Preparatory and Auxiliary Subparagraphs (a) to (d) remain the same Subparagraph (e) and (f) strike out of a preparatory or auxiliary character: Includes a catch all for activities listed in (a) to (f): provided that such activity or, in the case of subparagraph f), the overall activity of the fixed place of business, is of a preparatory or auxiliary character.

29 OECD BEPS ACTION 7: 2015 FINAL REPORT Amendments in MTC and Commentary Article 5(4)(f) - New Anti-fragmentation rule: 4.1 Paragraph 4 shall not apply to a fixed place of business that is used or maintained by an enterprise if the same enterprise or a closely related enterprise carries on business activities at the same place or at another place in the same Contracting State and a) that place or other place constitutes a PE for the enterprise or the closely related enterprise under the provisions of the Article, or b) The overall activity resulting from the combination of the activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprise at the two places, is not of a preparatory or auxiliary character Provided that the business activities carries on by the two enterprise at the same place, or by the same enterprise or closely related enterprise at the two places, constitutes complementary functions that are part of a cohesive business operation.

30 OECD BEPS ACTION 7: 2015 FINAL REPORT Amendments in MTC and Commentary Paragraph 30.2 of the Commentary explains the purpose of the new paragraph 4.1 under Article 5 Prevent an enterprise or group of closely related enterprises from fragmenting a cohesive business operation into several small operations in order to argue that each is merely engaged in a preparatory or auxiliary activity.

31 OECD BEPS ACTION 7: 2015 FINAL REPORT Amendments in MTC and Commentary Splitting- up of contracts lead to abuse under Article 5(3) The Principle Purpose Test ( PPT ) will be added to the OECD MTC under BEPS Action 6.

32 OECD BEPS ACTION 7: 2015 FINAL REPORT Amendments in MTC and Commentary Paragraph 18.1 of Commentary suggest following change to a DTA: For the purpose of determining whether the twelve month period referred to in paragraph 3 has been exceeded, a) Where an enterprise of a Contracting State carries on activities in the other Contracting State at a place that constitutes a building site or construction or installation project and these activities are carried on during periods of time that do not last more than twelve months, and b) Connected activities are carried on at the same building site or construction or installation project during different periods of time, each exceeding 30 days, by one or more enterprises closely related to the first-mentioned enterprise, These different periods of time shall be added to the period of time during which the first-mentioned enterprise has carried on activities at that building site or construction or installation project.

33 OECD BEPS ACTION 7: PUBLIC DISCUSSION DRAFT Additional guidance on Attribution of profits Specifically covers examples relating to Dependent agent PE s and PE s arising under Article 5(1) to which the exemptions in Article 5(4) do not apply (e.g. warehouses as fixed place of business PE). Aims at providing more guidance on the analysis under Art 7 and Art 9 in cases where a PE arises from the activities of a dependent agent, and the host country will have taxing rights over two different legal entities the dependent agent enterprise (which may be a resident of the host country) and the dependent agent PE (which is a PE of a non-resident enterprise). Article 7 applies to dependent agent PE and Article 9 to the transactions between associated enterprise. In calculating the profits attributable to the dependent agent PE it would be necessary to deduct an arm s length reward to the dependent agent enterprise for the services it provides to the non-resident enterprise. Comments on this discussion draft submitted on 5 September 2016

34 Roxanna Nyiri, Head: Transfer Pricing BDO Tax Services