Business income and
associated enterprise
Prashant Khatore
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Agenda
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Introduction
Article 7
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OECD Model and Commentary
UN Model
2010 OECD Commentary Update
Article 9
Introduction
Residence State
Source State
Enterprise
Business
activity
Art. 7(1): Source state
may only tax profits
attributable to PE
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Art. 5: Definition
of Permanent
Establishment
Art. 7: Income
Attributable
to PE
Introduction
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Why is profit allocation to a PE
important?
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Business profits is the most important
category of income for international (and
domestic) tax purposes
It determines the extent of Source
State’s taxing rights by reference to:
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Nature of income
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Quantity of income
It determines amount/limit of Double
Taxation relief in Residence State
Structure of Art. 7 OECD MC
1.
2.
3.
4.
5.
6.
7.
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Main rule + Exception
Arm’s length Principle
Allocation of Expenses
Indirect Method (Fractional Apportionment)
Special Rule for Purchasing Offices
Continuity and consistency in Profit Attribution
Relationship with other Distributive Rules
Art. 7(1) – Main Rule/Exception
“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.”
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Enterprise of a Contracting State:
Art. 3.1.d
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Permanent Establishment:
Art. 5
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Attributable:
Art. 7(2)–(3) and (4)
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Art. 7(2) OECD MC – Arm’s length principle
Subject to the provisions of para. 3, where an enterprise of a CS carries on
business in another CS through a PE situated therein, there shall in each CS be
attributed to that PE the profits 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 PE.
Two main interpretation:
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Relevant Business Activity Approach
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Functionally Separate Entity Approach (preferred one)
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Application of Art. 7(2)
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Relevant Business Activity Approach
(“only so much of them”)
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Only profits of the business activity in which the PE has some
participation
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Loss in a transaction for the enterprise as whole can result in loss for
PE
Application of Art. 7(2)
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Functionally Separate Entity Approach
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Application of Arm’s length principle, so also taxation of notional
profits possible
Preferred Approach by the OECD (see 2004 Discussion Draft)
“Only so much of them” is just rejection of “force of attraction”
Force of Attraction Principle – OECD vs UN
Residence State
Enterprise
Source State
Business
income
PE
Business income from a source
not effectively connected to PE
Attribution to PE?
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OECD MC rejects force of attraction
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UN MC contains limited force of attraction (Art. 7.1)
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“Sales in that other State of goods or merchandise of the same or similar kind as
those sold through that PE” or
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“Other business activities carried on in that other State of the same or similar kind
as those effected through that PE”
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OECD MC Art. 7(2) – Example
State A
Co. A
(Manufactures Bikes)
State B
Transfer the bikes
PE of Co.
A
Sales
to Customers
in Country B
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OECD MC Art. 7(2) – Example
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Cost of the bikes:
50
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FMV at time of transfer to State B:
75
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Sales price to customers:
110
In some states:
► State A levies tax upon transfer to
PE on 25 (75–50)
► State B levies tax upon sale to
customer on 35 (110–75) and
State A taxes also 35 (110–75)
but gives relief on 35 (exemption
or credit)
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State A levies tax on 25
State B levies tax on 35
In other states:
► State A does not levy tax upon
transfer to PE
► State B levies tax upon sale to
customer on 35 (110–75) and State A
also levies tax at that time but on 60
(110–50) but gives relief on 35
OECD MC Art. 7(2) – Commentary
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Trading accounts of the PE are the starting point for profit allocation.
If:
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they reflect real economic functions
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They are in accordance with the arm’s length principle
“These trading accounts could be accepted by tax authorities” (para. 12.1)
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PE State may tax notional profits when an asset leaves the State,
because concept of realization depends on domestic law. Residence
State must seek a bilateral solution on a case by case basis
(para.15).
The arm’s length principle is subject to the provisions contained in
para. 3 of Art. 7, in particular as regards interest, royalties, etc. (para.
12.2)
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Art. 7(3) OECD MC – Expenses
“In determining the profits of a PE, there shall be allowed as
deductions expenses which are incurred for the purposes of
the PE, including executive and general administrative
expenses so incurred, whether in the State in which the PE
is situated or elsewhere”
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Art. 7(3) OECD MC – Expenses
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The OECD Commentary contains several ‘exceptions’ to
the arm’s length principle (though it says there is no
difference of principle between para. 2 and 3 of Art. 7):
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Temporary transfer of assets
Intangibles
Services
Transfer of funds
Good management
Art. 7(3) OECD MC – Internal Dealings
Objects of transactions
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Assets
Intangibles
Services
Funds
Management
Question
For each type of internal
transaction, what can be
deducted from the income
attributable to the PE?
► Nothing
► Costs
► Costs + profit
Note: Deduction is not subject to actual charge to PE
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Art. 7(3) UN Model – Expenses
“… However, no such deduction shall be allowed in respect of amounts,
if any, paid (otherwise than towards reimbursement of actual expenses)
by the PE to the HO of the enterprise or any of its other offices, by way of
royalties, fees and other similar payments in return for the use of patents
or other rights, or by way of commission, for specific services performed
or for management, or, except in the case of a banking enterprise, by
way of interest on moneys lent to the PE. Likewise no account shall be
taken, in the determination of the profits of a PE, for amounts charged …
by the PE to the HO …”
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Indirect Method – Art. 7(4)
“Insofar as it has been customary in a Contracting State to determine the
profits to be attributed to a PE on the basis of an apportionment of the
total profits of the enterprise to its various parts, nothing in [Art. 7(2)] shall
preclude that State from determining the profits to be taxed by such an
apportionment as may be customary; the method of apportionment shall,
however, be such that the result shall be in accordance with the
principles contained in this Article”.
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Allowed as an exception and on condition that:
► method must be customary in the state concerned
► result in accordance with the principles of Article 7
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Purchasing Offices – Art. 7(5)
“No profits shall be attributable to a PE by reason of the
mere purchase by that PE of goods or merchandise for the
enterprise.”
Follow up to Art. 5(4)(d): “the maintenance of
a fixed place of business solely for the
purpose of purchasing goods …” does not
constitute a PE
Note that the UN Model leaves the question
open to negotiations between States
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Continuity and Consistency – Art. 7(6)
“For the purposes of the preceding paragraphs, the profits to
be attributed to the PE shall be determined by the same
method year by year unless there is good and sufficient
reason to the contrary”
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2010 OECD Commentary
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Article 7 replaced by new article in 2010 update
Essence of commentary same as that contained 2008 update; but
changes to reflect 2010 changed article
Two step approach to attribute profit
1.
2.
Use functional and factual analysis to hypothesize the PE as a distinct
and separate enterprise
Application of the arm’s length principle to the hypothetical enterprise in
accordance with the 1995 Guidelines (by analogy)
First step is the most problematic
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Clause on Purchase Office attribution exemption and rule of
consistency deleted in 2010 update
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Article 9 (associated enterprises)
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Primarily deals with transactions between related parties
Relationship defined to cover participation in capital
control & management
Transactions to be at arm’s length
Provision of correlative relief – relationship with MAP
article
Absence of correlative relief in some tax treaties
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Q&A
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Thank you.
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