Policy Proposals Business Law
Comments on the Public Discussion Draft on BEPS Action 7
Additional Guidance on the Attribution of Profits to Permanent Establishments
Tax Treaties, Transfer Pricing and Financial Transactions Division
Centre for Tax Policy and Administration
Organisation for Economic Co-operation and Development
1. General Comments
In response to the recommendations of the BEPS final report, Article 5 of the OECD Model Tax Convention will be revised to expand the scope of agent permanent establishments (PEs) and determine on a case by case basis whether an entity's activities are of a preparatory or auxiliary character. However, the report did not address the issue of the attribution of profits to newly recognized PEs. In this sense, we welcome the Public Discussion Draft on Additional Guidance on the Attribution of Profits to Permanent Establishments, which is based on the Authorised OECD Approach (AOA).
Under the AOA provided for in Article 7 of the OECD Model Tax Convention, profits attributable to a PE are defined as profits earned by the PE if it were a separate and independent enterprise and calculated based on the concept of the transfer pricing taxation. However, the AOA is a relatively new concept and not adopted by all jurisdictions. While OECD member countries are expected to introduce the AOA, non-OECD countries are unlikely to do the same, which has created a concern over the continuation of income calculation approaches that are not consistent with the AOA (e.g., taxation based on deemed profit rates and worldwide taxation).
Under these circumstances, the expansion of the scope of PEs will inevitably result in an increased double taxation. With the scope of PEs to be broadened as a result of the BEPS Project, it would be necessary for the purpose of striking a balance to build an appropriate consensus on the calculation of profits attributable to a PE. We agree with the direction of the Draft's discussions as they suggest that an appropriate application of the AOA will in most cases result in zero or insignificant profits attributable to a PE. Going forward, it is critical to further refine the Guidance and ensure that rules on the scope of PE and profit attribution are interpreted and implemented in a consistent manner across OECD members and non-members.
If the multilateral instrument, which will be open for signature by the end of this year, is used to modify a bilateral tax treaty, such modification must be accompanied by the adoption of this AOA-based Guidance. We consider that it is unreasonable and unacceptable to make a modification to Article 5 only, prior to the adoption of this Guidance.
The Public Discussion Draft provides examples of both dependent agent PEs and warehouse PEs. All of them include specific numerical values, helping taxpayers and tax authorities share a better understanding of them. However, the Draft has also raised some questions, in relation to which we would like to make comments in the section below.
2. Comments on Specific Issues
(1) Dependent Agent Permanent Establishments
In its section providing for dependent agent permanent establishments (DAPEs), the Draft presents Examples 1, 2, and 4, in which Prima, a consumer product manufacturer in Country A, engaged Sellco, Prima's associated enterprise in Country B, to perform selling activities in Country B for Prima, and the activities performed by Sellco for Prima give rise to a PE of Prima in Country B. In these examples, a transfer pricing analysis is performed first under Article 9 of the OECD Model Tax Convention to allocate profits of Prima and Sellco, and then an AOA analysis is carried out under Article 7 to calculate profits attributable to Prima's head office and the PE. We consider that the order of the analysis, that is, beginning with the analysis under Article 9, is easy to understand and reasonable.
In order that there be certain profits attributable to the PE, there needs to be significant people functions performed by Sellco on behalf of Prima. In Example 1, on the grounds that Prima assumes inventory and credit risks and Sellco does not perform significant people functions, it is concluded that no profits are attributable to the PE. On the other hand, in the case of Example 2, Sellco assumes inventory and credit risks and Sellco performs significant people functions, but no profits are attributable to the PE until a funding return in relation to inventory is recognized. In Example 4, while Sellco assumes inventory risks, functions related to credit management are performed jointly by Prima and Sellco, and there is a significant amount of profits attributable to the PE. Three questions arise in relation to this.
The first question is about the significance of assigning a PE status when no profits are attributable. In Example 1, while it is a convincing argument that the amount of profits attributable to the PE should be zero, it would be a waste of effort for both taxpayers and tax authorities if an enterprise needs to compute profits and file income tax returns despite not being required to pay corporate income taxes. In addition, once a PE status is assigned, it may create, depending on the jurisdiction, certain adverse effects, including the imposition of individual income tax. We thus believe that assigning a PE status is inappropriate in and of itself in such a case.
The second question is concerning the concept of Example 2. The OECD's 2010 Report on the Attribution of Profits to Permanent Establishments, which is frequently referred to in this Public Discussion Draft, suggests that in a case where a dependent agent (Sellco) performs significant people functions on behalf of a non-resident enterprise (Prima), a certain amount of profits should be attributed to the PE (para. 234), explicitly denying the "single taxpayer approach," which contends that a payment of an arm's length reward to a dependent agent enterprise fully extinguishes the profits attributable to the dependent agent PE (para. 235-239). However, in Example 2, while Sellco is assumed to be performing significant people function, the amount of profits attributable to the PE before recognizing a funding return is determined to be zero. Moreover, it seems that loss may be attributed to the PE depending on the amount of interest costs.
In addition, in Note 10, this Public Discussion Draft says, "When the analysis under Article 9 has already been performed to allocate risk to Sellco, the analysis under Article 7 will not attribute the risk to the DAPE." This apparently suggests the adoption of the "single taxpayer approach." Although we are comfortable with the concept of the "single taxpayer approach," it would be helpful for us if the OECD clarifies its stance on this matter. Any guidance on the method of calculating funding returns would also be helpful. Anyway, it is again pointless to assign PE status in a case where profit attributed to the PE is extremely insignificant.
The third question is about the relationship between Examples 2 and 4. While Sellco bears overall credit risk in Example 2, it performs credit management functions jointly with Prima in Example 4. According to our understanding, this suggests the fact that in Example 4, Sellco performs less functions compared to Example 2, but the amount of profits attributed to the PE in Example 4 is larger than that in Example 2. Although we are not sure that it is correct to assume that, under the AOA, the amount of profits attributable to the PE will increase in accordance with the extent to which Sellco performs significant people function on behalf of Prima, the result of Examples 2 and 4 is not consistent with the assumption, which is a little bit confusing.
The Public Discussion Draft explains that the risk allocation approach differs between Articles 9 and 7 of the Convention (para. 80). In addition, the 2010 Report on the Attribution of Profits to Permanent Establishments also describes that the AOA is not designed to achieve the equality of outcome between a PE and a subsidiary in terms of profits (para. 55). Even if certain differences are unavoidable, a clear explanation will be necessary about the significant difference in outcome between Examples 2 and 4. From our standpoint that the analysis under Article 9 should be respected, it seems to be a double count by the host country in which Sellco is situated (service and incentive fees received by Sellco under Article 9 of the Convention/Prima's profits attributed to the PE under Article 7 of the Convention). We consider that further review would be necessary during the finalization phase of the Guidance.
We withhold judgment on the appropriateness of the result of Example 3. Although the facts of Example 3 are the same as those in Example 2 except that the person who bears inventory and credit risk is Employee instead of Sellco, profit attributed to the PE in each example differs. We have general concern that a source country could casually assign PE status to activities performed by company employees and unfairly argue that more profits should be attributed to the PE.
(2) Warehouse PE
The warehouse PE section in the Public Discussion Draft discusses Scenarios A, B, and C, in which a warehouse PE status in Country W is assigned to WRU, a company resident in Country A. In Scenario A, WRU provides warehousing services to third party customers. In Scenario B, WRU is engaged in the sale of products and runs the warehouse through its own employees. In Scenario C, WRU is engaged in the sale of products and the warehousing function is performed by a separate enterprise. In all scenarios, the amount of profits attributable to the PE is observed to be very small, but certain points need to be clarified.
In Scenario A, the PE needs to compensate WRU's head office for the granting of rights to the intangibles and the provision of advice regarding the inventory usage and replenishment. In this regard, it would be helpful if some information on the compensation computation approach would be given.
In Scenarios B and C, it is explained that the attribution of profits to PEs can be "streamlined" by attributing to the PE profits commensurate with investment in that asset (para. 97 and 101). However, we have found vagueness in the meaning of the wording "streamlined" and therefore recommend that the profits attributable to the PE be explained in the same way as Scenario A, i.e., by using the income statement. We consider that no profits including the investment return on the assets should be attributed to the PE at least in the Scenario C, since WRU has no employees at the PE and uses the PE only to store its inventory in the scenario.
It should be noted that, similarly to an agent PE, it will be of little practical benefit to assign a PE status to a warehouse to which no profits are attributable. In such a case, the assignment of a PE status should be refrained from.
Subcommittee on Taxation