1. 2007 OFII Tax ConferenceAventura, FL 1 Permanent Establishments: New Developments Impacting Inbound Companies Joseph Andrus PricewaterhouseCoopers April 26, 2007 Rafic Barrage Mayer, Brown, Rowe & Maw LLP DRAFT 4/18/07

2. 2007 OFII Tax ConferenceAventura, FL 2 Overview Recent OECD developments: –Public Discussion Draft: The Tax Treatment of Services – Proposed Commentary Changes (December 8, 2006); –Revised Public Discussion Draft: Revised Changes to the Commentary on Paragraph 2 of Article 15 (March 12), regarding the taxation of income from employment; –Final Report on the Attribution of Profits to Permanent Establishments, Parts I (General Considerations), II (Banks), and III (Global Trading) (December 2006);

3. 2007 OFII Tax ConferenceAventura, FL 3 Overview Recent OECD Developments (continued): –Revised Commentary on Article 7 of the OECD Model Tax Convention (April 10, 2007); –Business Restructurings project; –Tax intermediaries project; and –Report on Improving the Resolution of Tax Treaty Disputes (February 2007) and new binding arbitration provisions in U.S. income tax treaties: Availability of binding arbitration procedures in determining the existence of a PE and, if so, the amount of profits attributable thereto.

4. 2007 OFII Tax ConferenceAventura, FL 4 Tax Treatment of Services

5. 2007 OFII Tax ConferenceAventura, FL 5 Background – Current PE Definition Article 5(1) generally defines a PE as “a fixed place of business through which the business of an enterprise is wholly or partly carried on.” –Generally requires at a minimum that “a certain amount of space [be] at [the] disposal” of an enterprise of the other Contracting State and that such place is “not of a purely temporary nature” (i.e., that the place of business has “a certain degree of permanency”). Commentary to Article 5, at ¶¶ 4 and 6. Article 5(2) lists as examples of a PE a branch, an office, a factory, etc. Article 5(3) provides that a building site or construction or installation project constitutes a PE if it lasts more than 12 months (i.e., despite Article 5(1) and (2)).

6. 2007 OFII Tax ConferenceAventura, FL 6 Background – Current PE definition Article 5(4) lists various activities that do not constitute a PE even if carried on through a fixed place of business (e.g., the maintenance of a fixed place of business solely for the purpose of carrying on any activity “of a preparatory or auxiliary character”). Article 5(5) provides that a dependent agent may give rise to a deemed PE for its principal. Article 5(6) provides that activities carried on through an independent agent does not constitute a PE provided that the agent is acting in the ordinary course of its business.

7. 2007 OFII Tax ConferenceAventura, FL 7 UN Model Treaty Definition of PE Article 5(3)(b) of the United Nations Model Double Taxation Convention between Developed and Developing Countries (2001) provides that the term PE includes: –“The furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continue (for the same or a connected project) within a Contracting State for a period or periods aggregating more than six months within any twelve-month period.” Stated rationale of services PE provision in UN Model Treaty: –“It is believed that management and consultancy services should be covered because the provision of such services in developing countries by corporations of industrialized countries often involves very large sums of money.” Commentary to Article 5, at ¶ 9.

8. 2007 OFII Tax ConferenceAventura, FL 8 December 2005 OECD Report December 2005 OECD final report, “Are the Current Treaty Rules for Taxing Business Profits Appropriate for E- Commerce?”: –Proposed to modify Article 5 to include a physical presence test similar to that found in Article 5(3)(b) of the UN Model Treaty. See ¶ 234. –Stated rationale for the proposal: The PE rules “were created with a view towards manufacturing and sales”; the provision of services, like manufacturing and sales activities, involves “significant income- producing functions... in the host jurisdiction that justifies a change to allow the country to tax that income”: “Many service providers are entirely mobile. Lawyers and accountants can meet with clients, do research, consult with colleagues, and draft memos and opinion letters without leaving their hotel room or in a coffee shop. All they need is a laptop and a telephone. Engineers and computer programmers seem to be similarly mobile.” See ¶ 241.

9. 2007 OFII Tax ConferenceAventura, FL 9 Proposed Commentary Changes Published on December 8, 2006, by a Working Group of Working Party No. 1 on Tax Conventions and Relations Questions. Intended to reflect the views of certain States that profits from the performance of services should, under certain circumstances, be taxable in the source state even if not attributable to a PE.

10. 2007 OFII Tax ConferenceAventura, FL 10 Proposed Commentary Changes The views of these States are reflected in proposed changes to the Commentary under Article 5, which sets forth an alternative provision that these States could use to tax income from the performance of services. The proposed changes have already been the subject of much criticism. Many existing treaties between developed and developing countries contain a services PE provision.

11. 2007 OFII Tax ConferenceAventura, FL 11 Proposed Commentary Changes In proposing the changes to the Commentary, it was agreed that the following principles should apply: –A State should not have source state taxation rights on income derived from the provision of services performed by a nonresident outside that State; –Only the profits from services, and not the gross payments for these services, should be subject to tax; –Source state taxation should be allowed only if there is a minimum level of presence in a State (i.e., not when the services are provided during a very short period of time).

12. 2007 OFII Tax ConferenceAventura, FL 12 Proposed Commentary Changes Language of the proposed provision: –Notwithstanding the provisions of [Article 5(1), (2) and (3)], where an enterprise of a Contracting State performs services in the other Contract State: a)through an individual who is present in that other State during a period or periods exceeding in the aggregate 183 days in any twelve month period and more than 50 percent of the gross revenues attributable to active business activities of the enterprise during this period or periods are derived from the services performed in that other State through that individual; or

13. 2007 OFII Tax ConferenceAventura, FL 13 Proposed Commentary Changes b)during a period or periods exceeding in the aggregate 183 days in any twelve month period, and these services are performed for the same project or for connected projects through one or more individuals who are performing such services in that other State or are present in that other State for the purpose of performing such services, the activities carried on in that other State in performing these services shall be deemed to be carried on through a [PE] that the enterprise has in that other State, unless these services are limited to those mentioned in [Article 5(4)] which, if performed through a fixed place of business, would not make this fixed place of business a [PE] under the provisions of that paragraph. ¶ 42.23 (emphasis added).

14. 2007 OFII Tax ConferenceAventura, FL 14 Proposed Commentary Changes The provision deems a PE where one would not otherwise exist under Article 5(1) or (2), such as “where a consultant who provides services over a long period in a country but at different locations that do not meet the conditions of [Article 5(1)] to constitute one or more [PEs].” ¶ 42.25.

15. 2007 OFII Tax ConferenceAventura, FL 15 Proposed Commentary Changes Also may apply where the application of Article 5(3) would not result in a PE: –A large construction enterprise carries on a construction project, or connected projects, in different parts of a country. The individual sites where a single project is carried on do not last sufficiently long for each of them to constitute a PE. However, a PE will be deemed to exist under the proposed provision if the requirements of paragraph (b) are met. ¶¶ 42.27-42.28. States may provide that Article 5(3) prevails over the proposed provision.

16. 2007 OFII Tax ConferenceAventura, FL 16 Proposed Commentary Changes The discussion draft importantly notes that the proposed provision applies only to services performed by an enterprise, and not to services provided to the enterprise: –“[I]f the employees of a separate enterprise (e.g., an enterprise providing outsourced services) provide services to third parties pursuant to a contract that the enterprise has concluded with another enterprise, the services performed through these employees are not performed by the latter enterprise even if they may provide an economic benefit to the business of that other enterprise.” ¶ 42.30. –“Services might be provided by an individual to his employer without that employer performing any services (e.g., an employee who provides manufacturing services to an enterprise that sells manufactured goods).” ¶ 42.30.

17. 2007 OFII Tax ConferenceAventura, FL 17 Proposed Commentary Changes Meaning of “for the same project or for connected project”: –An enterprise may have two different projects to provide services for a single customer (e.g., to provide tax advice and to provide training in an area unrelated to tax advice). While these may be related to a single project of the customer, the services should not be considered to be performed “for the same project.” ¶ 42.39. –“Connected projects” is intended to cover projects that involve the provision of services “of the same or of a similar nature and within the framework of contracts concluded with the same enterprise or associated enterprises.” ¶ 42.40. This appears to be a very subjective standard that will be difficult to administer. The Working Group has invited comments on meaning of “connected projects.”

18. 2007 OFII Tax ConferenceAventura, FL 18 Example Involving India-U.S. Treaty Ruling of the Indian Authority for Advance Rulings in Morgan Stanley (A.A.R. No. 661 (Feb. 13, 2006)): –Held that MSUS had a PE in India as a result of sending some of its employees to India for stewardship activities related to Morgan Stanley’s Indian subsidiary (MSAS) or “on deputation” to MSAS. MSAS performed business process outsourcing (BPO) functions for Morgan Stanley. MSUS planned to send its employees to India “to ensure that [Morgan Stanley’s] high standards of quality are met.” –MSUS argued that it did not have a PE in India because the stewardship activities carried on by its employees in India were not for the benefit of MSAS; rather, they were for the benefit of MSUS. Therefore, the services were not performed “for a related enterprise” within the meaning of Article 5(2)(l). Article 5(2)(l) imposes no minimum time requirement for a services PE resulting from services performed for a related enterprise.

19. 2007 OFII Tax ConferenceAventura, FL 19 Example Involving India-U.S. Treaty Although the AAR rejected MSUS’s argument, it held that, because MSAS was remunerated an arm’s length fee for its services, no additional profits should be attributed to MSAS’s PE in India. The Indian tax authorities have appealed the AAR’s ruling.

20. 2007 OFII Tax ConferenceAventura, FL 20 Revised Article 15(2) Discussion Draft Article 15(1): Source state taxation in respect of salaries, wages, and other similar remuneration derived by a resident of a Contracting State in respect of an employment. Article 15(2): Notwithstanding Article 15(1), exclusive resident state taxation applies in respect of an employment exercised in the source state if: –The recipient is present in the source state for a period or periods not exceeding in the aggregate 183 days in any twelve month period; –The remuneration is paid by, or on behalf of, an employer who is not a resident of the source state; and –The remuneration is not borne by a PE which the employer has in the source state.

21. 2007 OFII Tax ConferenceAventura, FL 21 Revised Article 15(2) Discussion Draft Relationship to services PE proposed Commentary changes: –If the mere provision of services may give rise to a PE, then it may not be possible for the Article 15(2) exception to apply, because the employee’s remuneration must not be “borne by” a PE of the employer in the source state.

22. 2007 OFII Tax ConferenceAventura, FL 22 Example A large part of the activities of a MNE are structured along function lines. KCo and LCo are both part of the MNE. KCo performs human resources functions for the MNE’s group of companies. The services performed by KCo are charged out to the other companies on the basis of the number of employees of each company. X, a resident of State K, is hired by KCo as a senior manager in charge of supervising human resources functions within the MNE. X spends 3 months in State L to deal with human resources issues at LCo. Article 15(2) exception may apply because the work performed by X is an integral part of the business of KCo. However, if the relevant treaty contained a services PE provision, Article 15(2) may not apply (e.g., if employees of KCo are in State L for a sufficiently long period of time during the year to constitute a services PE of KCo).

23. 2007 OFII Tax ConferenceAventura, FL 23 Attribution of Profits to a PE

24. 2007 OFII Tax ConferenceAventura, FL 24 Attribution of Profits to PEs Final OECD Report on the Attribution of Profits to PEs Proposed New Commentary on Article 7 Anticipated Future Developments Potential US Application of OECD Principles

25. 2007 OFII Tax ConferenceAventura, FL 25 Historical Overview of OECD Income Attribution Project Project began in earnest nearly eight years ago Objective was to develop a single set of principles to govern PE income attribution issues under Article 7 of the OECD Model Treaty Not confined to interpretation of existing treaty language Focus primarily, but not exclusively, on banks and other financial institutions Several iterations of the Report published over the years, numerous comments and public consultations Final Report issued December 2006 (Parts I, II and III) First draft of implementing Model Treaty Commentary published April 10, 2007 Final Report Part IV on Insurance yet to come

26. 2007 OFII Tax ConferenceAventura, FL 26 Noteworthy Elements of Final OECD Report Definitive adoption of hypothetical separate entity approach to income attribution Assets and risks follow “significant people functions” Final report (Part I) replaces the KERT concept with significant people functions to reflect difference between treatment of tangible assets and treatment of intangible assets and risks Tangible assets allocated to place they are located Intangible assets and risks allocated on the basis of where people functions related to creation and management of asset are performed Once assets and risks are allocated, transfer pricing guidelines apply to allocate income

27. 2007 OFII Tax ConferenceAventura, FL 27 Noteworthy Elements of Final OECD Report Reiterates that Report is not intended to modify the Article 5 permanent establishment definition Discussion on “symmetry” is eliminated from Part I -- but note the inclusion of the symmetry principle in Draft Commentary Preserves application of the attribution rules to dependent agent permanent establishments – a very controversial point among non-financial services companies Addresses contractual risk transfers and guarantees –No separation of risk and function in a PE context –No guarantee charge between home office and PE

28. 2007 OFII Tax ConferenceAventura, FL 28 Implementation of OECD Report Through Revised Article 7 Commentary Draft for comment published April 10, 2007 Intention is to reflect in Model Treaty Commentary those elements of the Report that do not contradict the existing Model Treaty language The Revised Commentary provides an indication of which provisions of the Report OECD tax administrators believe can be implemented without the negotiation of new treaties It is anticipated that later in 2007, a second set of implementation materials will be issued, modifying the Model Treaty language itself to accommodate the Report and adding to the Commentary

29. 2007 OFII Tax ConferenceAventura, FL 29 Draft Commentary Highlights Revives the symmetry rule – at least for bank free capital attribution purposes Does not clarify fairly confusing language in the existing commentary regarding the allocation of home office expenses – the interaction of paragraph 2 and paragraph 3 of the treaty remains something of a mystery Treats intangible development costs and intangible ownership as items belonging to the enterprise as a whole rather than to the location where key development and management functions take place. This may allow governments to assert that dependent agent PEs should be accorded IP related income.

30. 2007 OFII Tax ConferenceAventura, FL 30 US Implementation Issues Very little evidence that the US has sought to supplement transfer pricing audit enforcement with dependent agent permanent establishment claims Recent treaties contain technical explanation language moving in the direction of the OECD analysis of bank interest deductions and away from exclusive reliance on Treas. Reg. §1.882-5 IRS now in the process of reissuing proposed transfer pricing rules relating to global dealing in financial instruments – presumably along OECD lines IRS indicated that it would issue transfer pricing rules on financial guarantees in connection with the global dealing regulations

31. 2007 OFII Tax ConferenceAventura, FL 31 Business Restructurings

32. 2007 OFII Tax ConferenceAventura, FL 32 Business Restructurings OECD Project on Business Restructurings Other Related Developments

33. 2007 OFII Tax ConferenceAventura, FL 33 Historical Background of OECD Business Restructurings Project Project commenced one year ago with public roundtable discussion Project focuses broadly on tax issues arising in connection with creation of principal company structures by a going business –Issues with PE definition –Transfer pricing issues – risk stripping –Issues surrounding transfers of business opportunity and / or goodwill Project reflects clear government unease with common business structuring and transfer pricing strategies Business advisory group consulted from time to time Sets of specific questions have been issued to the business advisory group for comment Discussion draft of findings expected in 2008

34. 2007 OFII Tax ConferenceAventura, FL 34 Current Issues Open for Discussion Indemnification / payment upon conversion – transfer of intangibles or “loss of profit potential” Determination of arm’s length remuneration of a stripped entity and its principal How to account for group synergies Whether the arm’s length principle applies differently to an arrangement between associated enterprises depending upon whether or not it replaces an existing arrangement, and if so how Must a business restructuring have economic substance at a group level, or at an individual affiliate level, or both

35. 2007 OFII Tax ConferenceAventura, FL 35 Current Issues Open for Discussion (cont.) When can a foreign enterprise be found to have a permanent establishment following a business restructuring Should further guidance be developed to complement the section on Dependent Agent PEs in Part I of the Report on Attribution of Profits to PEs If so, what direction should additional guidance take Can tax savings ever constitute a basis for a claim that a business restructuring has economic substance How should location savings be allocated among members of the group Can a roundtrip intangible transfer ever be respected as having economic substance

36. 2007 OFII Tax ConferenceAventura, FL 36 Other Developments Draft German law on transfers of goodwill Forthcoming Canadian transfer pricing memorandum EU Joint Transfer Pricing Forum