Allocation of profits to permanent establishments
If a company performs activities in a foreign jurisdiction, a permanent establishment (PE) may arise in that jurisdiction. Subsequently, (taxable) profit must be allocated to the PE. Transfer pricing is a key point when it comes to the allocation of profits to PEs. Moreover, because tax authorities have shown increasing interest in foreign companies performing activities in their jurisdictions, multinational enterprises should manage the existence and the allocation of income to PEs carefully. Throughout the years, the OECD has provided guidance on the attribution of profits to PEs. This section highlights the most important ‘take-aways’ from the OECD publications regarding the allocation of profits to PEs.
A permanent establishment is a fixed place of business through which part or all the business of an enterprise takes place. If decision-making occurs in several countries, there is an increased risk of discussion concerning the allocation of profits to PEs. According to a report on the allocation of profits to PEs by the OECD published in 2010, profits attributable to a PE involve profits which that PE would have derived had it been a separate and independent enterprise. Moreover, such an enterprise must perform the same or similar activities under the same or similar conditions. This method concerns the Authorised OECD Approach (AOA) for the allocation of income to permanent establishments. Through this method, the OECD has established a standard analysis for dealing with the allocation of profits between a head office and a PE.
According to the AOA, the following steps must be taken to correctly allocate profits to a PE
- Step 1
An analysis of functions, assets, risks, and other unique factors attributable to the PE must be conducted. This analysis is significantly driven by where the acting persons are located (the ‘significant people functions’). Subsequently, it must be determined where and under what conditions dealings, i.e. assumed transactions, exist between the head office and the PE.
- Step 2
Where dealings can be recognised, transfer pricing methods as set out in the OECD Transfer Pricing Guidelines must be applied to determine arm’s length transfer prices for the dealings between the head office and the PE.
For this purpose, the AOA regards the headquarters and the PE as if they were separate entities.
Need to allocate profits to a PE
The need to allocate profits originates from the fact that, in case of a PE, both the source country of the PE and the residence country of the headquarters may claim the right to tax profits generated by the PE. This may result in double taxation. Setting clear rules and guidelines on how to allocate profits to a PE represents a critical step towards avoiding double taxation. Multinational enterprises should therefore manage the existence and the allocation of income to a PE carefully.
In the final report containing additional guidance on the allocation of profits to PEs by the OECD published in March 2018, it was made clear that, because a PE is regarded as an independent enterprise, its net profits can be minimal or even zero if they are sufficiently substantiated . Moreover, the report reaffirms that there should be no double taxation when attributing profits to a PE through – for example – the double allocation of functions, assets, or risks.
As previously mentioned, intercompany dealings with a PE should be agreed upon as if the PE were an autonomous and independent business partner. The purpose of transactions between independent enterprises is to earn profits which reflect the activities implemented, the assets involved, and the risks incurred by transaction parties. This fictitious independence must be substantiated thoroughly and reflected correctly in the transfer pricing documentation of the relevant multinational enterprise.
Multinational businesses should be aware that other approaches to PE issues and the allocation of profits are evolving rapidly. Reference should be made to the Multilateral Instrument of the Base Erosion and Profit Shifting project of the OECD and developments regarding digitalisation of the economy and how these factors affect profit shifting. These developments also bring tax-related challenges.
Furthermore, in November 2019, the European Commission published a consultation document addressing the emergence of a new economic nexus. This new nexus is not related to substance, but to users of digital platforms. Moreover, a new profit allocation rule applicable to in-country marketing and distribution activities was introduced in this consultation document. In November 2019, as well, OECD published a discussion paper which referred to a new, similar nexus. These new rules could change the allocation of profits significantly.
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