The OECD issued a discussion draft on 4 July 2016 on how the attribution of profits to permanent establishments (PEs) under Article 7 of the Model Tax Convention (MTC) should take account of the changes in the final BEPS reports to both the PE definition and the Transfer Pricing Guidelines. The discussion draft is focused on two areas: a) dependent agent PEs (DAPEs); and b) warehouses as fixed place of business PEs. It takes the form of four examples relating to DAPEs and one example relating to warehouses. Each example is followed by specific questions to commentators. The discussion draft also discusses the coordination of Articles 7 and 9 of the MTC. Interested parties are invited to send their comments by 5 September 2016, and the OECD intends to hold a public consultation in Paris on 11-12 October 2016.
The discussion draft clearly states that the examples should not be used beyond the purpose of seeking comments on the draft. The analysis should not be interpreted as providing guidance either on the transfer pricing outcome or until the guidance on the attribution of profit to PEs is finalised.
The DAPE examples are based on a company, Prima, which manufactures consumer products in Country A for sale in Country B. In examples 1 and 2, the products are sold by Sellco, a group company resident in Country B. The analysis considers both transfer pricing between Prima and Sellco under Article 9 and attribution of profits to the DAPE of Prima under Article 7.
Examples 3 and 4 consider the position where an employee of Prima is sent to another country to carry out sales on a full-time basis. Article 9 is not applicable, but Article 7 remains relevant.
In example 1, Sellco only carries out sales agent activities, there are no significant people functions (SPFs) performed by Sellco relevant to the attribution of Prima’s assets and risks to its DAPE. Article 9 provides Sellco with a sales commission, with the residual profit applicable to Prima. The Article 7 analysis concludes that no additional remuneration is due under Article 7.
The clarification in example 1 that many DAPEs will not give rise to additional tax is welcome, but uncertainty will remain over local filing requirements in these cases.
In example 2 Sellco carries out SPF activities in respect of Prima business. In particular, Sellco manages inventory risk albeit that Prima owns the inventory throughout. Article 9 provides Sellco with a higher reward for the additional activities and management of risks, but provides a funding return for ownership of inventory to Prima. The Article 7 analysis determines that as Sellco is managing the risks of inventory, the funding return is applicable to the DAPE of Prima.
In example 3 the products are sold by a Prima employee based in Country B, so Article 9 is not relevant.
Example 3 is similar to example 2, the employee controls the credit and inventory risks; the SPF performed by the employee attributable to the DAPE result in profits attributable to the DAPE above the salary paid to the employee.
In example 4 both Sellco and Prima’s head office have a role in controlling credit risk. Sellco’s reward includes an incentive element under which it shares in the upside and downside from credit risk, while the risk return to Prima and the bad debt losses themselves are split between Prima’s head office and DAPE.
Examples 2 and 4 raise the issue of the financial capacity of the agent to bear losses and comments are specifically requested on this point.
Example 5 considers three scenarios: in the first, the warehouse is a profit centre and receives income from third parties. In the second, it is a cost centre with its own employees, while in the third it is operated by a third party. In each scenario, the head office provides know-how and advice while the PE functions in the first and second scenarios are routine. The profits attributed to the PE in each case are commensurate with economic ownership of the warehouse and, for the first two scenarios, with its routine functions.
At the same time as the above discussion draft, the OECD released another discussion draft on revised guidance on profit splits. An article on this will feature in next week’s Tax Matters Digest.
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