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Page 1 Business income and associated enterprise Prashant Khatore.

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1 Page 1 Business income and associated enterprise Prashant Khatore

2 Page 2 Agenda ► Introduction ► Article 7 ► OECD Model and Commentary ► UN Model ► 2010 OECD Commentary Update ► Article 9

3 Page 3 Art. 7: Income Attributable to PE Art. 5: Definition of Permanent Establishment Introduction Enterprise Residence StateSource State Art. 7(1): Source state may only tax profits attributable to PE Business activity

4 Page 4 Introduction ► Why is profit allocation to a PE important? ► Business profits is the most important category of income for international (and domestic) tax purposes ► It determines the extent of Source State’s taxing rights by reference to: ► Nature of income ► Quantity of income ► It determines amount/limit of Double Taxation relief in Residence State

5 Page 5 Structure of Art. 7 OECD MC 1. Main rule + Exception 2. Arm’s length Principle 3. Allocation of Expenses 4. Indirect Method (Fractional Apportionment) 5. Special Rule for Purchasing Offices 6. Continuity and consistency in Profit Attribution 7. Relationship with other Distributive Rules

6 Page 6 Art. 7(1) – Main Rule/Exception “The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.” ► Enterprise of a Contracting State: Art. 3.1.d ► Permanent Establishment: Art. 5 ► Attributable:Art. 7(2)–(3) and (4)

7 Page 7 Art. 7(2) OECD MC – Arm’s length principle Subject to the provisions of para. 3, where an enterprise of a CS carries on business in another CS through a PE situated therein, there shall in each CS be attributed to that PE the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a PE. Two main interpretation: ► Relevant Business Activity Approach ► Functionally Separate Entity Approach (preferred one)

8 Page 8 Application of Art. 7(2) ► Relevant Business Activity Approach (“only so much of them”) ► Only profits of the business activity in which the PE has some participation ► Loss in a transaction for the enterprise as whole can result in loss for PE

9 Page 9 Application of Art. 7(2) ► Functionally Separate Entity Approach ► Application of Arm’s length principle, so also taxation of notional profits possible ► Preferred Approach by the OECD (see 2004 Discussion Draft) ► “Only so much of them” is just rejection of “force of attraction”

10 Page 10 Force of Attraction Principle – OECD vs UN ► OECD MC rejects force of attraction ► UN MC contains limited force of attraction (Art. 7.1) ► “Sales in that other State of goods or merchandise of the same or similar kind as those sold through that PE” or ► “Other business activities carried on in that other State of the same or similar kind as those effected through that PE” Business income from a source not effectively connected to PE Attribution to PE? Enterprise Residence StateSource State PE Business income

11 Page 11 OECD MC Art. 7(2) – Example Co. A (Manufactures Bikes) Sales to Customers in Country B State AState B PE of Co. A Transfer the bikes

12 Page 12 OECD MC Art. 7(2) – Example ► Cost of the bikes:50 ► FMV at time of transfer to State B:75 ► Sales price to customers:110 State A levies tax on 25 State B levies tax on 35 In some states: ► State A levies tax upon transfer to PE on 25 (75–50) ► State B levies tax upon sale to customer on 35 (110–75) and State A taxes also 35 (110–75) but gives relief on 35 (exemption or credit) In other states: ► State A does not levy tax upon transfer to PE ► State B levies tax upon sale to customer on 35 (110–75) and State A also levies tax at that time but on 60 (110–50) but gives relief on 35

13 Page 13 OECD MC Art. 7(2) – Commentary ► Trading accounts of the PE are the starting point for profit allocation. If: ► they reflect real economic functions ► They are in accordance with the arm’s length principle “These trading accounts could be accepted by tax authorities” (para. 12.1) ► PE State may tax notional profits when an asset leaves the State, because concept of realization depends on domestic law. Residence State must seek a bilateral solution on a case by case basis (para.15). ► The arm’s length principle is subject to the provisions contained in para. 3 of Art. 7, in particular as regards interest, royalties, etc. (para. 12.2)

14 Page 14 Art. 7(3) OECD MC – Expenses “In determining the profits of a PE, there shall be allowed as deductions expenses which are incurred for the purposes of the PE, including executive and general administrative expenses so incurred, whether in the State in which the PE is situated or elsewhere”

15 Page 15 Art. 7(3) OECD MC – Expenses ► The OECD Commentary contains several ‘exceptions’ to the arm’s length principle (though it says there is no difference of principle between para. 2 and 3 of Art. 7): ► Temporary transfer of assets ► Intangibles ► Services ► Transfer of funds ► Good management

16 Page 16 Art. 7(3) OECD MC – Internal Dealings Question For each type of internal transaction, what can be deducted from the income attributable to the PE? ► Nothing ► Costs ► Costs + profit Note: Deduction is not subject to actual charge to PE Objects of transactions ► Assets ► Intangibles ► Services ► Funds ► Management

17 Page 17 Art. 7(3) UN Model – Expenses “… However, no such deduction shall be allowed in respect of amounts, if any, paid (otherwise than towards reimbursement of actual expenses) by the PE to the HO of the enterprise or any of its other offices, by way of royalties, fees and other similar payments in return for the use of patents or other rights, or by way of commission, for specific services performed or for management, or, except in the case of a banking enterprise, by way of interest on moneys lent to the PE. Likewise no account shall be taken, in the determination of the profits of a PE, for amounts charged … by the PE to the HO …”

18 Page 18 Indirect Method – Art. 7(4) “Insofar as it has been customary in a Contracting State to determine the profits to be attributed to a PE on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in [Art. 7(2)] shall preclude that State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment shall, however, be such that the result shall be in accordance with the principles contained in this Article”. ► Allowed as an exception and on condition that: ► method must be customary in the state concerned ► result in accordance with the principles of Article 7

19 Page 19 Purchasing Offices – Art. 7(5) “No profits shall be attributable to a PE by reason of the mere purchase by that PE of goods or merchandise for the enterprise.” Follow up to Art. 5(4)(d): “the maintenance of a fixed place of business solely for the purpose of purchasing goods …” does not constitute a PE Note that the UN Model leaves the question open to negotiations between States

20 Page 20 Continuity and Consistency – Art. 7(6) “For the purposes of the preceding paragraphs, the profits to be attributed to the PE shall be determined by the same method year by year unless there is good and sufficient reason to the contrary”

21 Page 21 2010 OECD Commentary ► Article 7 replaced by new article in 2010 update ► Essence of commentary same as that contained 2008 update; but changes to reflect 2010 changed article ► Two step approach to attribute profit 1. Use functional and factual analysis to hypothesize the PE as a distinct and separate enterprise 2. Application of the arm’s length principle to the hypothetical enterprise in accordance with the 1995 Guidelines (by analogy) First step is the most problematic ► Clause on Purchase Office attribution exemption and rule of consistency deleted in 2010 update

22 Page 22 Article 9 (associated enterprises) ► Primarily deals with transactions between related parties ► Relationship defined to cover participation in capital control & management ► Transactions to be at arm’s length ► Provision of correlative relief – relationship with MAP article ► Absence of correlative relief in some tax treaties

23 Page 23 Q&A

24 Page 24 Thank you.

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