23 novembre 2020
Attributing “free” capital to PEs: International Accounting Rules as An Alternative to the Authorized OECD Approach (AOA)
Il punto di Gaspar Lopes Dias* e Marcel Roche**
*Associate |Baker & McKenzie; Research Fellow | Working Party on Tax & Legal Matters
** Associate | Crowe Horwath; Research Fellow | Working Party on Tax & Legal Matters
The modifications to the concept of permanent establishment (“PE”) in the 2017 version of the OECD Model (2017 OMTC), which are implemented through Multilateral Instrument (“MLI”), address certain perceived flaws of the concept. Yet, numerous academics and practitioners pose that the real problem with the taxation of business profits is the lack of consensus on the attribution of profits to PEs. The authors acknowledge that this issue is active in many fronts. However, we will address the problem by particularly focusing on the issue of the absence of agreement at the OECD on a single approach to attribute “free” capital to PEs. We will advance that doing so is urgent, and that developing uniform branch accounting rules might provide an alternative solution.
A PE is a connecting factor, for taxation purpose, to a source country based on the existence of a fixed place of business (i.e., fixed place of business PE) or, conversely, of a person that conducts business on behalf of the non-resident entity (i.e., dependent agent PE or DAPE). Although this general definition has been widely accepted in Article 5 of the tax treaty network, it recently has been subject to specific changes based on the OECD’s base erosion and profit shifting (“BEPS”) project. The 2017 OMTC modified paragraphs 4, 5 and 6 of Article 5, reinforcing the definition of preparatory and auxiliary activities and expanding the rules for determining the dependency of the agent on the enterprise in order to prevent the artificial avoidance of PE status.
In connection to the above, Article 7 of the 2017 OMTC establishes that 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 PE situated therein. According to this rule, the residence state has exclusive rights to tax, unless a PE is present in the source state. In this sense, the source state may tax the profits of the enterprise, but only so much of them as are attributable to the PE. Thus, the question here is how to attribute those profits to the PE. Article 7(2) of the 2017 OMTC demands more independence from the non-resident enterprise in comparison to its pre-2010 version in attributing profits to PEs. This provision establishes the AOA, which requires a two-step analysis for profit attribution to PEs. The first step consists in a functional and factual evaluation to hypothesise the PE as a functionally separate enterprise from the head office. The second step determines the remuneration of any dealings between the hypothesised PE and the head office by applying transfer pricing rules by analogy with reference to the functions, the assets, and the risks hypothesised for each.
This functional and factual analysis will attribute “free” capital (i.e. funding that does not give rise to a tax-deductible return in the nature of interest) to the PE for tax purposes, so to allow an arm’s length attribution of profits to the PE. The starting point for the attribution of capital is that under the arm’s length principle a PE should have sufficient capital to support the functions it undertakes, the assets it economically owns and the risks it assumes. In the financial sector regulations stipulate minimum levels of regulatory capital to provide a cushion in the event that some of the risks inherent in the business crystallise into financial loss. Capital provides a similar cushion against crystallisation of risk in non-financial sectors. According to the Report on the Attribution of Profits to PEs of 2010, a balance sheet is, then, drawn for the liability side, not based on significant people functions but rather ‘automatically’ with “free” and “interest-bearing” capital supporting the PE’s functions, assets and risks. Thereafter, only identifiable dealings are recognised between the home office and the PE, and priced at arm’s length, applying transfer pricing by analogy.
However, the problem is that the OECD has recognised that member countries’ have reached a consensus on the principle that a PE should have sufficient “free” capital to support the functions, assets and risks it assumes, but it has not been possible to develop a single internationally accepted approach for attributing the necessary “free” capital under the AOA. The OECD has hoped that in drawing the balance sheet of the PE, the home office country would follow the ‘capital structure’ of the PE drawn in the host country. However, this has hardly been the case because it is nearly impossible for home office countries and host countries to arrive at the same PE profits as they are determined based on domestic tax rules. Moreover, if the credit system is used under Article 23 of a relevant tax treaty, then it will likely result in unrelieved double taxation.
Based on the problems above, an alternative is that the OECD could rather develop international accounting rules for profits instead of applying the AOA. There are several benefits to this alternative. Firstly, this option would not require changing the tax treaty network, which ultimately is a major undertaking in the decentralised structure of international taxation. Secondly, it would not imply merely remunerating functions based on market average mark-ups. Only banks’ PEs must have interest deductions recognised, as otherwise it is not possible to compute their profits. Lastly, the problem would not be that of an accepted approach, but rather of harmonising accounting between the home office and the PE. Conclusively, developing international accounting rules for attributing ‘free’ capital to PEs could become an alternative to the AOA as the home office and the PE would be encouraged to prepare such documentation given it may reduce substantially the potential for controversies derived from their dealings.
