Summary OECD report of June 22, 2010 on the Attribution of Profits to Permanent Establishments.(“OECD Report”). I. General Introduction. The OECD Report provides guidance on the principles for the attribution of business profits to a permanent establishment(“PE”) , as meant by Article 7 of the OECD Model Tax Convention on Income and Capital.(“MTC”). The Report underlines the similarity between the principles prevailing with regard to transactions between associated enterprises, as developed under Article 9 of the MTC. The Report officially establishes the choice for the separate entity approach, i.e. the PE is treated as a functionally separate and independent entity for purposes of determining its business profits. The Report contains four (4) sections. Section 1 sets out general principles for attributing profits to PEs. Section 2 describes the application of the general principles to enterprices carrying on a banking business. Section 3 covers the global trading aspects . Section 4 relates to the insurance business. The Report follows a two-tier approach in considering the arm’s length principle in the Head office-Branch relationship, called the “Authorized OECD Approach” (“AOA”) . The AOA approach is introduced by the OECD to align the rules for business profits under tax treaties with those of the arms length principle of Art. 9 of the OECD and the OECD Transfer Pricing Guidelines. Under the AOA the profit allocation to a PE is based on the following principles: 1) the PE is a separate enterprise engaged in the same or similar activities; and 2) the PE is independent from the rest of the enterprise of which it is a part and any other legal person, which means that its profits must be determined by means of the arm’s length principle. Under the AOA approach, the profit allocation between the PE and the head office will be calculated in two steps. Under the first step a functional and factual analysis must be executed in which the significant people functions of the PE must be determined, i.e. the functions which the employees of the PE actually carry out compared to the rest of the enterprise and the related responsibilities. Based on this analysis, the assets needed to perform those activities and the related risks must be attributed to the PE. In that connection the free capital to be allocated to the PE must be determined too. Under the second step, the dealings between the PE and its head office must be determined as well as the arm’s length transfer prices for those relationships This calculation will be carried on by reference to the functions performed, assets used and risks assumed by the hypothesized head office and PE enterprises. II. Significant People Functions Under the first step of the AOA, the Significant People Functions (“SPF”) must be determined. The AOA attributes to the PE those risks for which the significant functions relevant to the assumption and/or management of risks are performed by people in the PE and also attributes to the PE the economic ownership of assets for which the significant functions are performed by people of the PE. Depending on the functions performed by the PE the risk could, inter alia, be of a financial and/or operational character.. Examples could be direct business risk, inventory risk, credit risk, currency risk, interest rate risk, market risk, product liability, warranty risks, regulatory risk etc. In line with paragraph 1.52 of the OECD Transfer Pricing Guidelines the division of risks and responsibilities within the enterprise must be deduced from the conduct between the head office and the PE and the economic principles that generally govern relationships between independent enterprises. Relevant factors are the internal practices of the enterprise, such as compensation arrangements and documentation on the allocation of risks between the head office and the PE. III. Allocation of capital to the PE Under the first step of the AOA and the the functional and factual analysis a contribution of “free capital”, i.e. funding of the PE that does not give rise to a tax deductible item in the nature of interest, must be determined. Several methods have been outlined in the Report regarding the proper allocation of free capital to the PE. In the same perspective different methods are available to allocate arm’s length interest and other funding expenses to the PE. The OECD report first mentions the” capital allocation method” under which capital is allocated on the basis of the proportion of assets and risks attributed to the PE by the functional analysis. The application of this method my be problematic if the activities of the PE differ substantial from those of the head office, when the market conditions in the PE country are very different or when the enterprise is thinly capitalized.. For that reason a second method, called the “thin capitalization method” is mentioned, under which a PE should have the same amount of free capital as an independent enterprise carrying on similar activities under similar conditions. With respect to funding expenses a distinction is made between a tracing method and the fungibility method. Under a pure tracing method all internal movements of funds provided to a PE are traced back to the original provision of funds by third parties. Under a pure fungibility approach, money borrowed by a PE of an enterprise is presumed to contribute to the whole enterprise‘s funding needs. A portion of the whole enterprise‘s actual interest expense paid to third parties on some predetermined basis is allocated to each PE. IV. Determination of the profits of a PE As second step, the profits of the PE must be determined by means of accepted transfer pricing methods mentioned in the OECD TransferPpricing Guidelines, such as the Comparable Uncontrolled Price Method and the Resale Minus method. In line with the OECD Guidelines a comparable price or profit must be determined by means of the following factors: characteristics of property or services, functional analysis, contractual terms, economic circumstances, and business strategies. V. Implementation. The contents of the Report have been implemented by a number of jurisdictions, amongst others the Netherlands. Further a new text of and commentary to Article 7 of the MTC has been introduced to coordinate different wordings. A progressing discussion is taking place regarding the application of the new wording to existing tax treaties., so-called static versus dynamic or ambulatory interpretation. A a matter of fact the majority of OECD member countries and also a couple of nonmember countries follows the principles as set out in the Report.