Discussion draft under BEPS Action 7, profits attributed to permanent establishments

BEPS Action 7, permanent establishments

The Organisation for Economic Cooperation and Development (OECD) earlier this week released a discussion draft concerning the attribution of profits to permanent establishments under work in relation to Action 7 of the base erosion and profit shifting (BEPS) project.

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Read the discussion draft [PDF 434 KB] concerning work in relation to BEP Action 7, Preventing the artificial avoidance of permanent establishment status

Background

The final report on Action 7 of the BEPS project mandated follow-up work to develop additional guidance on the issue of attribution of profits to permanent establishments (PEs). Although the report concluded that substantive modifications to the existing rules and guidance concerning the attribution of profits to a PE under Article 7 of the Model Treaty Convention (MTC) was not required, the report stated that there was a need for additional guidance as to how the rules of Article 7 would apply to PEs resulting from the changes in the report, as well as on how the results of the work on other parts of the BEPS project concerning transfer pricing (in particular, the work related to intangibles, risk, and capital) would be taken into account.  

Discussion draft

The OECD released a discussion draft setting out this additional guidance on 4 July 2016. The discussion draft first stresses that while the changes made in the final report on BEPS Action 7 modified the threshold for the existence of a deemed PE, the changes did not modify the nature of the deemed PE, and thus how any existing guidance on how to attribute profits to a PE should be applicable to a PE that is deemed to exist as a result of such changes. Nonetheless, the discussion draft states that additional guidance on the attribution of profits to PEs generally is desirable and is necessary to take into account the changes to the transfer pricing guidelines.

The discussion draft identifies two fact patterns that would particularly benefit from additional guidance concerning the attribution of profits to PEs, since these fact patterns would not have constituted PEs prior to the changes under the Action 7 final report:

  • Dependent agent PEs (DAPEs), including those created through commissionnaire and similar arrangements
  • Warehouses as fixed place of business PEs

The discussion draft analyzes each fact pattern by reference to Article 7 of the MTC and the associated Commentary, as well as the 2010 Report on the Attribution of Profit to Permanent Establishments, which endorse the Authorized OECD Approach (AOA), and identifies a number of questions on which comments are specifically sought.  

Examples

The discussion draft illustrates the application of the profit attribution guidance to the two fact patterns using a series of examples. The first four examples illustrate the application of the AOA to a DAPE created through a commissionaire or similar arrangement whereas the fifth one illustrates the application of the AOA to a warehouse as a fixed place of business PE. 

Examples 1 through 4 use variants of a basic fact pattern in which a non-resident enterprise sells to unrelated customers using a sales agent in a particular jurisdiction.  In three of the four examples, the sales agency function is performed by an associated enterprise whereas in one this function is performed by an employee of the non-resident enterprise. It is assumed that the non-resident enterprise has a DAPE in the sales jurisdiction under discussion. In the examples when the sales agency is performed by an associated enterprise, the analysis starts with an evaluation of arm’s length compensation to the associated enterprise under Article 9 (in particular, the guidance under the OECD transfer pricing guidelines). All examples then evaluate the attribution of profit to the DAPE under the AOA. In applying the AOA, the first step is to identify the significant people functions and the locations where those are performed. Given the findings of the first step, the second step then determines appropriate attribution of profit to the DAPE under the AOA.

  • Example 1 illustrates the attribution of profits to the DAPE under the AOA in a situation when an analysis under Article 9 concludes that the contractual allocation of risk between the non-resident enterprise and the associated enterprise sales agent is appropriate and that the associated enterprise earns arm’s length compensation for its sales agency activities. In applying the AOA, it is first determined that the DAPE is not attributed economically significant risks of the non-resident enterprise, assets or capital since it has no significant people functions, when the meaning of “significant people functions” is interpreted to be similar to control over risk functions discussed in Chapter I of the OECD transfer pricing guidelines. Second, it is determined that given that there are no risks or assets attributed to the DAPE, there are no profits attributed to the DAPE.  
  • Example 2 illustrates the impact of a reallocation of risk at arm’s length away from the contractual allocation of risk. The facts of Example 2 are the same as in Example 1 except that the sales agent is now found to control and assume inventory and credit risk—thus, its arm’s length compensation is determined to be greater than in Example 1. However, since the non-resident enterprise, and not the sales agent, legally owns the inventory for which it has laid out funds, the non-resident enterprise gets a funding return for its inventory ownership. In applying the AOA, it is determined that the DAPE performs significant people functions related to inventory and credit to customers resulting in an attribution of risks and associated assets—inventory and receivables—to the DAPE which aligns with the assumption of risk by the sales agent under Article 9. All returns for the assumption of credit and inventory risk and economic ownership of inventory and receivables are already provided to the associated enterprise sales agent under the Article 9 analysis except for the funding return for inventory held by the non-resident enterprise. This funding return is then attributed to the DAPE. 
  • Example 3 illustrates the attribution of profits to the DAPE in a situation when an analysis under Article 9 is not required. The facts are the same as in Example 2, except that the non-resident enterprise sends one of its employees to perform full-time selling activities instead of using the sales agent of Example 2. In applying the AOA, similar to Example 2, the DAPE is attributed inventory and credit risk along with the associated assets—inventory and receivables—and capital to fund these risks. Under the AOA, the DAPE is attributed profits that reflect the assets, risks, and capital attributed to it, as well as the functions it performs. Were the DAPE a separate enterprise, it is determined that it would earn an operating margin similar to a distribution entity. This example gives the DAPE the same return as the combination of the associated enterprise and the DAPE in Example 2.
  • Example 4 illustrates the consequences for the attribution of profits to the DAPE resulting from an attribution of risk under the AOA different from the allocation of risk under Article 9. The facts in this example are the same as in Example 2 except that both the non-resident enterprise and the sales agent perform control functions related to credit risk. As is contractually specified, the non-resident enterprise assumes credit risk. The sales agent does not assume credit risk but gets arm’s length compensation for its control functions. In applying the AOA, it is first determined that both the DAPE and the non-resident enterprise perform significant people functions related to the credit risk. It is assumed that this risk is shared in proportion to the credit management costs of the non-resident enterprise and its DAPE. Profits are then allocated to the non-resident enterprise and the DAPE in this same proportion, leading to profits or losses in the DAPE in excess of the compensation to the associated enterprise sales agent under Article 9.  

The last example in the discussion draft illustrates the application of the AOA to a fixed PE arising from the use of a warehouse solely for the purpose of storage, display or delivery of goods or merchandise belonging to a non-resident enterprise, and not qualifying as preparatory or auxiliary to the overall business activity of the enterprise.  Example 5 includes three scenarios. In Scenario A, warehousing is the core business of the non-resident enterprise. In Scenario B, warehousing is an internal function of the non-resident enterprise’s business. In Scenario C, warehousing is an internal function of the business carried out by an unrelated enterprise. In all scenarios, the significant people functions are assumed to be performed by the head office. The PE of the non-resident enterprise is attributed economic ownership of the warehouse and is remunerated some variant of a routine warehousing profit and a return for ownership of the warehouse.  

The discussion draft also includes a final section noting that coordination of the application of Article 7 and Article 9 may be necessary to avoid instances of double taxation between the DAPE of a non-resident enterprise and an associated dependent agent enterprise, both subject to taxation in the host country. The discussion draft notes that various mechanisms for a coordinated application of those Articles were suggested in the draft, but the draft invites comments on those mechanisms and whether additional mechanisms may be necessary to avoid such double taxation or to alleviate compliance burdens.

Comments on the discussion draft are due by 5 September 2016.

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