The New OECD “Functionally Separate Entity Approach” and the Impact on Permanent Establishments of Foreign Business in Russia International Tax Forum St. Petersburg Dr. Wolfgang Salzberger September 19 th, 2013

13/06/2016 Fußzeile22 Financial highlights by division 1 Basis points. 2 Including corporate staff. Gases Division (in € million) Change Revenue12,59111, % Operating profit3,4033, % Operating margin27.0%27.5%–50bp 1 Number of employees50,60539, % Engineering Division (in € million) Change Revenue2,5612, % Operating profit % Operating margin12.2%12.0%+20bp 1 Number of employees6,5646, % Other Activities (in € million) Change Revenue % Number of employees 2 4,7965, %

13/06/2016 Fußzeile33 Engineering Division Revenue 2012 by region Africa 4.3% (2011: 6.8%) North America 14.7% (2011: 12.4%) Asia/ Pacific 33.7% (2011: 25.0%) South America 3.6% (2011: 1.5%) Europe 25.3% (2011: 23.7%) Middle East 18.4% (2011: 30.6%)

13/06/2016 Fußzeile413/06/20164 Basics Parts of construction contracts -Construction projects are normally divided into different steps, several steps can be performed within the home country (offshore) and others have to be performed in Russia (onshore): Feasibility studyDelivery of Delivery of Delivery, Delivery equipment,equipment and constructionspare parts, special equipmentassistance with the service, commissioning commissioningother services. E Engineering EP Engineering, Procurement EPS Engineering, Procurement, Supervision EPC Engineering, Procurement, Construction S + S Spareparts, After Sales Service

13/06/2016 Fußzeile5 Basics Contract templates -Contracts for major projects are Turnkey Lumpsum Contracts in principle, contracts on reimbursable basis are the exception  other contract templates  single contract,  consortia  split contracts (e.g. offshore, onshore)  establishment of a Joint Venture

13/06/2016 Fußzeile6 Profit Allocation Head Office – Permanent Establishment (PE) Direct and Indirect Method On the basis of the 2008 OECD Model Tax Convention (MTC) the profit could be determined by -the direct method -the indirect / mixed method (e. g. Art. 7 IV DTA Russia-Germany). According to Art. 7 OECD-MTC 2008, para 51, this method could be used  „… where the affaires of the PE are so closely bound up with those of the head office, that it would be impossible to disentangle them on any strict basis of branch accounts“.  „Where it has been customary in such cases to estimate the arm‘s length profit of a PE by reference to suitable criteria it may well be reasonable that the method should continue to be followed, notwithstanding that the estimate thus made may not achieve as high a degree of accurate measurement of the profit as adequate accounts. Even where such a courses had not been customary it may exceptionally be neccessionary for practical reasons to estimate the arm‘s length profit based on other methods.“

13/06/2016 Fußzeile7 Profit Allocation Head Office – Permanent Establishment Transfer Pricing Methods - Comparable uncontrolled pricing method  resale minus method (e. g. gross margin = (net sales – cost of sales) / sales revenue)  cost plus method  other methods  transactional profit split (e. g. transactional net margin method)  global profit split (comparable profit method, formula apportionment)

13/06/2016 Fußzeile8 Profit Allocation Head Office – Permanent Establishment Transfer Pricing Methods  According to OECD TP Principles 2010, para 2.1, the best method rule is applicable  the standard methods as well as the transactional profit methods are in line with the arm’s length principle  the profit split / formula apportionment should only be used in extraordinary cases (OECD TP Principles 2010, ) -According to the German Ministry of Finance the transactional profit method  is only applicable if the standard methods cannot be used  can only be used for companies with routine functions

13/06/2016 Fußzeile9 Profit Allocation Head Office – Permanent Establishment Cost Plus Method -According to the German Ministry of Finance the Cost Plus Method should have been applied for if  key personnel is not employed on construction site  PE performs solely routine functions  PE does not bear any risks

13/06/2016 Fußzeile10 Profit Allocation Head Office – Permanent Establishment OECD Model Tax Convention 2010 On the basis of the OECD Model Tax Convention 2010, however,  only the direct method should be applicable  there is no need for the indirect method any more (Art. 7 OECD MTC 2010, para 41)  use of the direct method in a two step approach (Art. 7 OECD MTC 2010, para 21 f):

13/06/2016 Fußzeile11 Profit Allocation Head Office – Permanent Establishment Functionally Separate Entity Approach – Step 1 1.Fiction of the PE as a separate, independent enterprise a. identification of the activities performed by the PE b. analysis of the functions performed by the PE, based on the „significant people functions“ c. identification of the assets attributable to the PE d. risk analysis e. deemed equity of the PE

13/06/2016 Fußzeile12 Profit Allocation Head Office - Permanent Establishment Functionally Separate Entity Approach – Step 2 2.Determination of the arm‘s length price for transactions between the Head Office and the PE („Dealings“) a.through the application of the generally accepted transfer pricing methods b. on internal dealings (realization of profit without market transactions) c. in due consideration of functions performed, assets used and risks adopted

13/06/2016 Fußzeile13 Profit Allocation Head Office - Permanent Establishment Challenges (I) -Major challenges for the use of the functionally separate entity approach for construction PE’s  allocation of selected activities to the Head Office and the PE (e. g. procurement)  identification of „Dealings“  allocation of the revenue  function and risk oriented allocation of the warranty  scope shifts  change orders

13/06/2016 Fußzeile14 Profit Allocation Head Office - Permanent Establishment Challenges (II) -Major challenges for the use of the separate entity approach for Construction PE’s  identification and allocation of “significant people functions”  cost plus method as best method?  full costs vs. costs attributable to a PE  budgeted costs vs. actual costs  charges for internal dealings vs. contribution of assets and services  allocation of IP and charging of licence fees

13/06/2016 Fußzeile15 Profit Allocation Head Office - Permanent Establishment Functionally Separate Entity Approach and Transactional Profit Split - According to OECD TP Guidelines 2010, para 2.4, transactional profit methods may sometimes be preferable:  „where each of the parties makes valuable and unique contributions in relation to the controlled transaction …  where the parties engage in highly integrated activities, may make a transactional profit split more appropriate than a one side method.“