Transfer Pricing and

Attribution of Profits to PEs

Antonio Russo, Baker & McKenzie Amsterdam

18 June 2015

1 © 2015 IBFD

Allocating Taxing Rights over Business Profits

The comparison between the

two Model Conventions is

essential insofar a number of

countries around the World apply

the UN Model over the OECD

Model.

The analysis on profit attribution

to PEs requires starting from the

definition of nexus. The two

Models differ also in relation to

this apsect in addition to the way

“measurement and attribution”

are addressed.

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Some statistics (Daurer, V.; Krever, R.: Choosing between the UN and OECD tax policy model: an African case study, EUI Working

Paper, RSCAS 2012/60)

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Construction PE proviso:

frequency and time limitation

Service PE proviso: frequency

and time limitations.

Art. 7

BUSINESS PROFITS

(1) (S1) [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.

UN Model Income Tax Convention

OECD Model Tax Convention on Income and on Capital (2008)

Allocation of Taxing Rights - Art. 7(1) OECD/UN MCs

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Art. 7

BUSINESS PROFITS

(1) (S2) 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.

OECD Model Tax Convention on Income and on Capital (2008)

Slightly different wording in the 2010 OECD Model Tax Convention on

Income and on Capital, but same meaning.

Art. 7

BUSINESS PROFITS

(1) (S2) If the enterprise carries on business in the other State through a permanent

establishment, the profits of the enterprise may be taxed in the other State but only so

much of them as is attributable to

(a) that permanent establishment;

(b) sales in that other State of goods or merchandise of the same or similar kind

as those sold through that permanent establishment; or

(c) other business activities carried on in that other State of the same or similar

kind as those effected through that permanent establishment.

UN Model Income Tax Convention

Allocation of Taxing Rights - Art. 7(1) S2 UN MC

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Enterprise

PE

State R

State S

Article 7 of the UN

Model Tax Convention

Article 7 of the OECD

Model Tax Convention

Enterprise

Scenario 1 Scenario 2

PE

Comparison: Article 7(1) S2 of the OECD and UN MC

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OECD APPE Report 2010

The APPE Report addresses this complex topic in 4 parts:

General PE

Financial Institutions

Global Trading

Insurance Companies

It establishes the principles for the application of the

Authorized OECD Approach (AOA), which predicates the

application of the separate entity theory.

By analogy the OECD Guidelines are applied

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State R

State S

Company

Single entity Losses

PE

Single Entity/Relevant Business Activity Approach

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State R

State S

Company

Sales

PROFIT + 100

Sales

- 50

PE

Overall Profit of 50

Single Entity/Relevant Business Activity Approach

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Functionally Separate Entity Approach

State R

State S

Company

Sales

PROFIT + 100

Sales

- 50

PE

Overall Profit of 50

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State R

State S

Company

Sales PE

Losses

Functionally Separate Entity Approach

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Determination of the profits attributable to a PE under the

AOA requires a 2 step analysis:

• Step 1 – hypothesise the PE and the remainder of the

enterprise as if there were associated enterprises, each

undertaking functions, owning and/or using assets,

assuming risks and entering into dealings with each other

and transactions with other related and unrelated

enterprises

• Step 2 – determine the profits of the hypothesised separate

and independent enterprise based upon a comparability

analysis

AOA – 2 step approach

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What does it imply?

In short, the first step of the authorised OECD approach will

apply a functional and factual analysis to the PE (based on the

guidance in Chapter I and Chapter III of the Guidelines) in order

to:

Determine the functions of the hypothesised separate and

independent enterprise and the economically relevant

characteristics (both ―internal and ―external conditions)

relating to the performance of those functions (see sub-

section (i) below)

Attribute risks among the different parts of the single

enterprise, based on the identification of significant people

functions relevant to the assumption of risks (see sub-

section (ii) below)

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What does it imply? (cont’d)

Attribute economic ownership of assets among the different

parts of the single enterprise, based on the identification of

the significant people functions relevant to the attribution of

economic ownership of assets (see sub-section (iii) below)

Attribute to the PE as appropriate the rights and obligations

arising out of transactions between the enterprise of which

the PE is a part and separate enterprises (see sub-section

(iv) below)

Attribute capital based on the assets and risks attributed to

the PE (see sub-section (v) below)

Recognise and determine the nature of those dealings

between the PE and other parts of the same enterprise that

can appropriately be recognised, having passed the

threshold test (see sub-section (vi) below)

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OECD Guidelines applied by analogy

Comparability

analysis is key

• Identify and test “dealings”

• Develop the appropriate

term of comparison

• Identify comparables

Methods

applied in a

similar fashion

• Traditional Methods and

• Transactional Profit Methods

• Other

Some

key

differences

• “Significant People Functions”as yardstick

for attribution

• Some types of transactions:

• Transfer of assets

• Treasury dealings and interest

deductibility

• Use of IP

• Services

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Significant People Functions

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Identification of the significant

people functions performed by

the personnel of the PE is

important as they provide a

basis for the attribution of risks

and for the economic

ownership of assets

The significant people

functions relevant to the

assumption of risk and to the

economic ownership of assets

will vary from business sector

to business sector and from

enterprise to enterprise within

a sector

A Case Study

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Step 1: Factual and Functional Analysis – Functions (Dealings)

Carried Out by the General Enterprise

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Allocation of Risks

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Risks General Enterprise PE

Market Risk XXXX

Operational Risk XXXXX XX

Inventory Risk X

Regulatory risk XX

Supply risk X

New product start-up

risk

- -

Product liability and

warranty risk

X

Credit risk / bad debt

risk

XX

Foreign exchange risk XXX

Step 1: Assets Owned / Used

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Step 1: Factual and Functional Analysis – Functions, Assets

and Risks of the PE

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2

2

Step 2

Pricing the identified “dealings” by analogy through the

application of the OECD Guidelines

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#%W&*%$Y$##?????

Current State of Play: Recap

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Article 7

UN MTC

“Old” Article 7

OECD MTC

“New” Article 7

OECD MTC

• Profit attributable to PE and same or similar

goods or merchandise/business activities

• Art. 7(2) – SE and ALP (restricted Art. 7(3))

• No AOA

• Limited application of TP principles to certain

internal dealings

• Profit attributable to PE

• Art. 7(2) – SE and ALP

• Limited application of AOA per 2008

Commentary update* (restricted by Art 7(3))

• Limited application of TP principles to

hypothesise separate entity and to recognise

and price certain internal dealing

• Profit attributable to PE

• Art. 7(2) – SE and ALP

• Full application of AOA

• Significant reliance on TP principles to

hypothesize separate entity and to recognise

and price internal dealings

Key Take Aways

ARTICLE 7: Allocation of taxing rights over business profits between the home and host state, where by the profits attributable to a PE represent:

the maximum profits in relation to which the host state may exert taxing rights under its domestic law

the maximum profits in relation to which the home state is required to grant DTR

Profits attributable to a PE in accordance with Article 7 does not equal taxable income – the actual calculation of taxable income is a domestic law issue

Remember to apply at the actual text of the business profits article of the applicable treaty UN Model

‘Old’ OECD Model

New OECD Model

Other

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AOA = Application of transfer pricing principles by analogy – focus is on substance rather than form! (functions,functions,functions…)

Thank you!

26 © 2014 IBFD