SPEED READ With the publication in July 2010 of several documents, including a new Article 7 of the OECD MTC and the final Report on Attribution of Profits to Permanent Establishments (PEs), the OECD has completed its review of the attribution of profits to permanent establishments. Under the new ‘authorised OECD approach’ developed by this programme the principles contained in the OECD TP Guidelines, which apply to transactions between separate enterprises, are to be applied by extension to transactions within an enterprise. The new OECD approach has introduced much needed clarity in this area; however, some uncertainties remain.
The taxation of permanent establishments (PE) and, in particular, the attribution of profits to PEs, is an area that has undergone significant changes in recent years as a result of a long running review of the topic by the OECD.
This review concluded in July 2010 with the approval of the 2010 Report on the Attribution of Profits to Permanent Establishments and a new Article 7 of the OECD Model Tax Convention (MTC) and Commentary.
While the review has introduced much needed clarity into the area, some uncertainties still remain. This article provides an overview of the major changes introduced by the OECD and highlights some of the remaining areas of uncertainty.
UK domestic legislation
The UK domestic rules on the taxation of PEs are contained in CTA 2009 s 19-32. Under UK rules, a non-resident company trading in the UK through a PE in the UK is subject to corporation tax on the profits attributable to that UK PE (CTA 2009 s 19).
To determine the amount of profits of a non-UK resident company attributable to a UK PE, the following principles apply:
In addition, no deduction is allowed for payments made to the non-UK resident company in respect of the use of intangible assets held by the company or interest or other financing costs (with the exception of PEs engaged in financial businesses) (CTA 2009 s 31–32).
These rules, with the necessary modifications, also apply to the determination of the chargeable profits of a UK-resident company that are attributable to a PE of the company outside the UK for the purposes of the double tax relief provisions (TIOPA 2010 s 43).
UK domestic rules are modelled on Article 7 of the OECD MTC and its accompanying Commentary, as drafted prior to the July 2010 OECD update. However, the new OECD approach to the attribution of profits to PEs has introduced differences between the UK domestic legislation and the new Article 7.
The new OECD approach
Historically, there was a considerable degree of uncertainty as to how in practice profits should be attributed to PEs. The OECD recognised this and initiated a project to address the issue.
This work has culminated with the release by the OECD of the following documents:
Of the documents listed above, the 2010 Report is the most important, as it sets out in detail the principles that the OECD concluded should be used when attributing profits to PEs together with detailed guidance as to how to apply those principles in practice. The other documents are in some ways changes to the machinery to incorporate the changes in approach set out in the 2010 Report.
Overview of the 2010 Report
The 2010 Report formulates the preferred approach to attributing profits to PEs under Article 7 of the MTC: the use of the ‘separate enterprise’ and arm’s length principles. These principles have to be applied to the interpretation of Article 7 of the MTC. As the Commentary on Article 7 indicates ‘the current version of the Article therefore reflects the approach developed in the Report and must be interpreted in light of the guidance contained in it’ (para 9).
The preferred OECD interpretation of Article 7 is that the principles contained in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘OECD TP Guidelines’), which apply to transactions between separate enterprises, should be applied by extension to transactions within an enterprise.
These ‘transactions’ between the PE and other parts of the enterprise, or ‘internal dealings’, should be recognised for tax purposes, provided certain thresholds are met. This approach is referred to as the ‘authorised OECD approach’ (‘AOA’).
Three key changes to the prior approach resulting from the AOA are as follows:
Some OECD countries were of the view that certain aspects of the AOA were incompatible with the wording of Article 7 of the MTC as then drafted.
One particular concern lay with head office expenses where the wording, argued some countries, required an attribution of expenses rather than a charge calculated using the arm’s-length principle. In order to address these concerns the OECD was forced to issue a new Article 7 (together with associated Commentary) which is clearly compatible with the AOA.
Remaining uncertainties
The 2010 Report has created a situation where UK domestic law is in conflict with the latest OECD position as the domestic legislation does not take these changes into account. For example, notional royalties are specifically prohibited (CTA 2009 s 31).
In our view, it would be helpful if HMRC were to update UK domestic law to bring it into line with the latest OECD position. Such a revision would have the additional benefit of removing a distinction between treaty and non-treaty countries which the existing domestic legislation was originally designed to eliminate.
In this context, it would be helpful in our view if the revised legislation had a specific provision requiring it to be interpreted by reference to the 2010 Report similar to the reference to the OECD TP Guidelines that exists in the UK domestic transfer pricing legislation.
Theoretically, these differences should, from a UK perspective, not matter in practice where the PE is of an entity resident in a country with which the UK has a tax treaty, as we would expect HMRC to apply the AOA to the interpretation of Article 7 under existing treaties, given its involvement in the OECD workings and subscription to the AOA. However, some uncertainty still remains and public confirmation from HMRC on this point would, therefore, be welcomed.
It should be noted that the UK’s existing tax treaties contain wording that in most cases is modelled on the old version of Article 7 of the MTC. Some countries have a static approach to the interpretation of treaties which would not permit the treaty to be interpreted in the light of the guidance in the 2010 Report if the treaty predated the 2010 Report.
In these cases, there is uncertainty and risk of double taxation if HMRC argues for an attribution of profit based on the AOA, whilst another tax authority regards itself bound by the prior interpretation of the MTC. In practice, the risk is likely to be most acute in the areas which have been most impacted by the new approach (ie, head office expenses, interest charges and notional royalties).
Conclusion
The OECD project is to be welcomed as it has introduced further clarity into an area which was previously fraught with difficulty.
Differences between countries as to how to interpret treaties mean that residual uncertainties will remain until the business profits articles of tax treaties globally are revised to incorporate wording based on the new Article 7 – a process that could take some time.
Giles Hillman, an Associate Partner at Deloitte, specialises in providing transfer pricing advice to financial sector clients. His experience includes permanent establishment profit attribution. He participated in the OECD conferences where the discussion drafts on PE profit attribution were discussed. Email: ghillman@deloitte.co.uk; tel: 020 7007 3750.
Elba Virto is a Transfer Pricing Senior Manager at Deloitte. Her transfer pricing experience covers a wide range of industries, including the manufacturing, retailing and financial services sector. She advises on cross-border services, business relocations, intangibles planning and global documentation. Email: evirto@deloitte.co.uk; tel: 020 7007 9010.
