2017 financial services taxation conference · but enter into a huge number of internal...

© Julian Pinson, Jerome Wood and Mary Hu, 2017

Disclaimer: The material and opinions in this paper are those of the authors and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2017 FINANCIAL

SERVICES TAXATION

CONFERENCE

Branch Attribution

Written by:

Julian Pinson

Director

Greenwoods & Herbert

Smith Freehills

Jerome Wood

Tax Manager

Commonwealth Bank of

Australia

Presented by:

Julian Pinson

Director


Smith Freehills

Mary Hu

Associate


Smith Freehills

Jerome Wood

Tax Manager

Commonwealth Bank of

Australia

8-10 February 2017

Palazzo Versace, Gold Coast

Julian Pinson, Jerome Wood and Mary Hu Branch Attribution

© Julian Pinson, Jerome Wood and Mary Hu, 2017 2

CONTENTS

1 Overview ......................................................................................................................................... 4

2 Timeline of key documents/events .............................................................................................. 6

3 Current Australian law and ATO practice .................................................................................... 9

3.1 Law and ATO public rulings ...................................................................................................... 9

3.2 ATO internal derivative guidelines .......................................................................................... 11

4 RBA vs. AOA ................................................................................................................................ 13

4.1 Overview ................................................................................................................................. 13

4.2 What is the RBA? .................................................................................................................... 13

4.3 What is the AOA? ................................................................................................................... 15

4.4 Practical significance of adopting the RBA or AOA ................................................................ 16

5 International comparison ............................................................................................................ 18

6 ATO focus areas in bank PE attribution .................................................................................... 19

7 Current practical issues and risks, including transfer pricing methodologies ..................... 20

7.1 Overview ................................................................................................................................. 20

7.2 Traditional banking activities ................................................................................................... 20

7.2.1 Creation and management of loans with multi-branch involvement ................................ 20

7.2.2 Transfer of existing loans across branches ..................................................................... 22

7.3 Global trading models ............................................................................................................. 23

7.3.1 Allocation of sales income ............................................................................................... 23

7.3.2 Trading – market risk management ................................................................................. 24

7.3.3 Other internal dealings .................................................................................................... 24

7.4 Capital allocation ..................................................................................................................... 25

7.4.1 Australian tax law treatment of capital ............................................................................. 25

7.4.2 AOA for attributing capital ................................................................................................ 26

7.5 Liquidity management ............................................................................................................. 26

7.5.1 Overview .......................................................................................................................... 26

7.5.2 Long term funding costs .................................................................................................. 27



7.5.3 Liquid asset holding requirements ................................................................................... 28

7.6 Inter-branch loans ................................................................................................................... 29

7.7 Insurance in the banking context ............................................................................................ 29

8 Future direction of Australian law and 2013 Board Report ..................................................... 31

8.1 Adopting the AOA ................................................................................................................... 31

8.2 How would the AOA be implemented in Australia? ................................................................ 33

9 Impact of BEPS, MAAL and DPT ................................................................................................ 35

9.1 BEPS ....................................................................................................................................... 35

9.1.1 Overview .......................................................................................................................... 35

9.1.2 Action 7 ............................................................................................................................ 35

9.1.3 Action 2 ............................................................................................................................ 36

9.2 MAAL and proposed DPT ....................................................................................................... 37

9.2.1 MAAL ............................................................................................................................... 37

9.2.2 Proposed DPT ................................................................................................................. 37

10 Conclusion ................................................................................................................................ 38



1 Overview

The attribution of profits to branches or ‘permanent establishments’ (PEs) is exceptionally complex

under Australian law1, although Australia is far from unique in this regard. It involves multiple areas of

‘domestic’ law as well as tax treaties and a massive and forever evolving body of international practice

and guidelines. It is easy to imagine branch attribution as a revenue minister’s least favourite area:

the issues are complex and arcane, but the perceived risks to revenue large.

This historically difficult area is also becoming more complex due to the current ‘base erosion and

profit shifting’ (BEPS) work at the Organisation for Economic Co-operation and Development (OECD)

(such as on branch mismatch structures), and Australia’s own introduction of the new ‘multinational

anti-avoidance rule’ (MAAL) which took in effect in 2016. Some of these changes will affect the

thresholds for PE status, some will affect profit attribution once a PE has been identified, and some

will affect both.

These issues are particularly important in the financial services industry, where branches have been

widely used, particularly by banks.2 By way of example, around 80% of foreign banks operate through

a PE in Australia as opposed to a subsidiary. Bank branches will not only transact with third parties

but enter into a huge number of internal ‘dealings’ with head office and other branches, including

loans, derivatives and foreign exchange transactions.

This paper focusses on PE attribution, from an Australian inbound and outbound perspective, once a

PE has been identified – that is, the paper does not discuss PE status issues. The focus is also on a

number of practical issues currently faced by inbound and outbound banks (although many of the

issues will also be relevant to insurance companies and other financial services entities).

The paper assumes a reasonable degree of knowledge of the current and historic law (and domestic

and international practice) in the area, and the focus is on the practical examples and not on a

theoretical description of how the law is intended to operate. Nevertheless, by way of background we

have included a summarised timeline and description of the key documents/events and a summarised

description of the Australian law relevant to the issues discussed in the paper.3

Australia is at an important juncture in terms of its PE attribution rules: we either continue on with the

current rules, which are piecemeal and frankly a mess, or we adopt the conceptually sounder and

certainly easier to apply (at least for a bank) ‘authorised OECD approach’ (AOA), which is the

emerging international consensus and is already being adopted by many of our major trading partners.

The paper:

1 Unless the context requires otherwise, legislative references in this paper are to provisions of the Income Tax Assessment Act

1936 and the Income Tax Assessment Act 1997, as applicable. 2 A useful summary of the relative advantages for banks of operating through a branch structure as opposed to a subsidiary is

contained in the Australian Financial Markets Association’s 18 December 2012 submission to the Board of Taxation’s Review of

Tax Arrangements Applying to Permanent Establishments Discussion Paper at pp.2-4. 3 For excellent overviews of the current law in this area, we recommend Ian Fullerton’s papers at the 2013 and 2014 Financial

Services Taxation Conferences (The attribution of income, losses and outgoings to foreign permanent establishments of

Australian banks and The attribution of profits to permanent establishments, respectively).



1 describes, in very high-level terms, Australia’s current approach to PE attribution (which is

neither a pure ‘relevant business activity’ (RBA) approach nor a ‘functionally separate entity’

(FSE) approach, but closer to the former than the latter);

2 considers how Australia’s approach compares to the AOA and what other countries are

doing in practice;

3 discusses a number of current practical issues and ATO focus areas in branch attribution,

and how those issues would be dealt with under the AOA; and

4 considers the future of Australian law in this area.

The key potential change to Australian law/practice is obviously the potential adoption of the AOA,

although precisely what this would look like under domestic law and our treaties is unclear. The

consequences of adopting the AOA were addressed by the Board of Taxation (the Board) in its April

2013 Report on its Review of the Tax Arrangements Applying to Permanent Establishments (Board

Report). However, the Board did not explicitly recommend the AOA be adopted, and despite almost

four years having passed, the Government has never responded to the Board Report.

After so many years of inaction, we see merit in the adoption of the AOA for the purposes of our

domestic and treaty PE attribution rules. If the Government cannot get comfortable with any residual

revenue risk in implementing the AOA for all taxpayers, then the AOA should at the very least be

applied to inbound and outbound banks. In practice, the industry already operates on that basis, as

the ATO, Treasury and the Government know. To not formally sanction the AOA for banks achieves

nothing but creates the impression of tax risk and uncertainty, especially for the foreign financial

services entities that the Government repeatedly states that it is trying to attract to Australia in order to

establish Australia as a financial centre.



2 Timeline of key documents/events

As noted above, this paper assumes a reasonable degree of knowledge of the current and historic

Australian law on PE attribution. However, the area is notoriously heavy on domestic and international

laws/guidelines, and it is often unclear what particular version of a document countries have regard to.

Accordingly, we have included a timeline below summarising the key documents/events relevant to

the later sections of this paper (and, in particular, the key differences between some of the

documents). The timeline illustrates:

the increasing acknowledgement from the OECD and tax authorities of the complexity of the

issues, and hence the increasing complexity of the OECD Commentary (Commentary); and

that many of the current ‘practical’ issues discussed in section 7 of this paper have been

around for decades, and it is concerning that the outcomes in an Australian context are still so

uncertain.

Year

Document/Event

1963 Release of Draft OECD Model Double Taxation Convention (OECD Model). Draft Article 7 (Business Profits) states that where an enterprise of a contracting state carries on business in the other contracting state through a PE “… there shall in each Contracting State be attributed to that permanent establishment 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 permanent establishment.”

1977 OECD Model formally introduced along with Commentary. No material changes to Article 7. The Commentary shows the drafters were relaxed about its application. Article 7 was not “strikingly novel or particularly detailed. The question of what criteria should be used in attributing profits to a [PE]… has had to be dealt with in a large number of double taxation conventions and it is fair to say that the solutions adopted have generally conformed to a standard pattern. It is generally recognised that the essential principles on which this standard pattern is based are well founded, and it has been thought sufficient to restate them with some slight amendments… Modern commerce organises itself in an infinite variety of ways, and it would be quite impossible… to specify an exhaustive set of rules for dealing with every kind of problem that may arise. This, however, is a matter of relatively minor importance, if there is agreement on general lines. Special cases may require special consideration, but it should not be difficult to find an appropriate solution if the problem is approached within the framework of satisfactory rules based on agreed principles”.4 This was found to be overly optimistic.

4 1977 OECD Commentary paragraph 2.



The Commentary:

implied that Article 7(2) incorporated a FSE approach (although it did not use that phrase);

stated that the starting point for calculating attributable profits were branch accounts (although these could be adjusted if inaccurate); and

stated that the exceptions to the FSE-type approach were for interest (unless a financial institution), royalties and mark-ups for services.

The Commentary states that if countries did not agree with the FSE approach, then they could agree on more detailed provisions in their treaties. Australia does not do this. Australia made a number of Observations on the Commentary, but no Reservations on the Article. The Observations did not refute the general FSE view in the Commentary.

1984 Max Factor & Co. v. FC of T 15 ATR 231 (Max Factor) The NSW Supreme Court decides, broadly, that dealings between head office and a PE cannot give rise to income/deductions for Australian tax purposes.

1994 Revisions to OECD Commentary, following 1994 OECD PE attribution report. Major revisions to Commentary on Article 7(2). The optimism disappears. The reference to the inability to specify an exhaustive set of rules for dealing with every kind of problem being “a matter of relatively minor importance” is removed and replaced: “…since such problems may result in unrelieved double taxation or non-taxation of certain profits, it is important for tax authorities to agree on mutually consistent methods of dealing with these problems…”.5 The Commentary still generally incorporated a FSE/branch accounts approach, but now specifically provides alternative Article 7(2) language that can be used if countries do not agree with the FSE-type approach. Australia does not do this. The Commentary goes further and states that branch accounts are the starting point including in respect of internal ‘agreements’ between a branch and head office, provided the branch and head office accounts are prepared symmetrically on the basis of such agreements and those agreements reflect the functions performed by the different parts of the enterprise. Considerable attention is given to the transfer of assets, whether or not trading stock, between a branch and head office (or between branches), including loan assets transferred within a bank. The Commentary indicates that the transfers should be capable of being recognised for tax. Specific mention was made regarding the difficulties in attributing capital to bank branches. Australia includes an Observation on the Commentary: “Australia does not recognise intra-entity transfers for tax purposes. Accordingly, Australia does not allow a mark-up for profit on dealings between [PEs] or between a [PE] and its head office”. Australia also includes a number of Reservations on the Article (such as it not covering insurance).

2001 TR 2001/11 – application of the Division 13 PE rules and the business profits articles in Australia’s tax treaties (see section 3 below).

5 1994 OECD Commentary paragraph 2.



2005 TR 2005/11 – branch funding for multinational banks (see section 3 below).

2006 TR 2006/9 – addresses withholding tax on interbranch funding. Whilst the ruling explicitly does not apply to determine attribution of profits, it further acknowledges the use of ‘internal loans’ and also considers the issue of attributing interest expenses to branch operations.

2008 OECD Report on the Attribution of Profits to Permanent Establishments (2008 OECD Report) endorses the FSE as the AOA, but also outlines the RBA approach. Contains specific guidance for banks (Part II), global trading (Part III) and insurance (Part IV).

Major revisions to OECD Commentary:

acknowledge the two different interpretations of Article 7 (RBA and FSE) and the problems this creates;

refers to 2008 OECD Report, including bank-specific sections, and incorporates the conclusions in the 2008 OECD Report but only those that did not conflict with previous versions of the Commentary;

supports a limited FSE approach; and

refers to the 2008 OECD Report discussion on capital allocation and acknowledges different acceptable approaches.

2010 2008 OECD Report re-issued (2010 OECD Report) with amendments to clearly adopt the FSE approach so that the report could be read alongside the new OECD Model Article 7. New OECD Model Article 7 introduced – reflects the FSE as the AOA. Substantial changes to Commentary – specifies that FSE is the AOA. Australia does not make any Observations on the new Commentary. Australia retains its pre-existing Reservations on the Article, although none of these relate to the FSE approach. The Australian single entity Observation made in 1994 was deleted in 2005.

2012 Board October 2012 Discussion Paper on its Review of Tax Arrangements Applying to Permanent Establishments (Board Discussion Paper). Board asked to investigate impacts of Australia adopting AOA.

2013 New domestic transfer pricing rules in Division 815 replace rules in Division 13. OECD BEPS project commences.

2015 Government releases April 2013 Board Report. Multinational anti-avoidance law (MAAL) introduced as part of Part IVA.

2016 Multiple BEPS papers released, including discussion drafts on:

Additional Guidance on the Attribution of Profits to PEs (Action 7) (July 2016)

Branch Mismatch Structures (Action 2) (August 2016)

Exposure Draft diverted profits tax (DPT) legislation released.



3 Current Australian law and ATO practice

3.1 Law and ATO public rulings

As noted above, this paper does not focus in detail on current Australian law and ATO practice.

However, the table below summarises the law applying to inbound and outbound PEs, in particular of

banks, which is relevant to the practical examples in section 7.

Non-resident with Australian PE Resident with overseas PE

All sectors

Domestic rules Broadly, Australia taxes all Australian source income except interest, dividends, fund payments and royalties to which withholding tax applies, subject to any treaty relief.

Other country determines tax base for PE, subject to any treaty relief. Whether or not a treaty applies, Australia relieves double tax by exempting branch income/gains from Australian tax (s.23AH / s.230-30) or by allowing a ‘foreign income tax offset’ (FITO).

Interest expense attributable to the branch would often be incurred in deriving non-assessable non-exempt (NANE) income and hence be non-deductible in Australia. Therefore, broadly, the less capital allocated to a branch the greater the non-deductible interest expense attributed to the branch.

Tax treaties If there is an applicable tax treaty, business profits taxable in Australia capped by Article 7 (i.e. profits attributable to Australian PE).

Australia’s treaties have ‘old’ (pre-2010) version of Article 7, and Australia still formally applies a form of RBA approach (see section 4 below).

Business income/profits taxable in other jurisdiction capped by Article 7. Australia obliged to provide relief from double tax. Branch income/gains often NANE under s.23AH / s.230-30, although may not precisely align with amounts taxed overseas. Otherwise FITO.

Transfer pricing

Amounts attributed to Australian PE in accordance with arm’s length principle under Subdivision 815-C (although Subdivision 815-C can only increase not decrease Australian taxable income). Article 7 of an applicable tax treaty prevails if it would produce a more favourable result for the taxpayer.

Profits attributable to PE guided by arm’s length principle under Subdivision 815-C (although Subdivision 815-C can only increase not decrease Australian taxable income). Income/gains generally treated as NANE under s.23AH / s.230-30.



Administrative approach

TR 2001/11 deals with the operation of Australia’s PE attribution rules under former Division 13 and Australia’s tax treaties for both foreign and Australian PEs. ATO relies on Max Factor to support the view that Australia's then PE attribution rules were based upon allocating a taxpayer's actual income and deductions using an 'arm's length separate enterprise principle' (similar to an RBA approach). (This approach is now built into Subdivision 815-C, pending the Government’s decision on whether to adopt the AOA under Australian law).

Inbound and outbound banks

Administrative approach

TR 2005/11 deals with inbound and outbound inter-branch fund transfers, including inter-branch loans and capital allocations for the purposes of former Division 13 and Australia’s tax treaties. The ATO reiterates the general RBA view, but acknowledges the difficulty/impossibility of tracing to third party income/expenses in the context of banking, and hence accepts the allocation of income and expenses for branches on the basis of the transfers recognised in a bank’s accounts (branch and head office) prepared on an arm’s length separate entity basis (i.e. as a reasonably proxy for allocating actual third party income and expense).

On attribution in relation to inter-branch funds transfers:

“We accept entries in a bank’s books of account that reflect arm’s length interest charges on interbranch funds transfers as a means of determining an allocation or attribution of the bank’s income, expense or profit in accordance with Australia’s PE attribution rules.”6

On attribution of equity capital to a PE of a bank:

“.. the amount of equity attributable to an Australian bank’s foreign branches for Division 820 purposes is the amount actually allocated to them in the bank’s books of account.

Where an amount of equity capital allocated to a foreign branch in the bank’s books of account is adjusted for foreign tax purposes or by the Tax Office for other tax purposes, the adjusted amount should be used in the calculation of the equity capital attributable to the branch for Division 820 purposes.”7

There has never been a ruling covering other intra-entity dealings of banks (such as notional derivatives), although note the guidelines for derivatives discussed in section 3.2 below.

Specific domestic regime

Part IIIB (which is elective) applies for the purposes of determining the taxable income of an Australian branch of a foreign bank, and applies an FSE approach in relation to recognising head office-branch loans and certain derivatives. Interest deductions in relation to loans from head office are capped at LIBOR.

Arm’s length rules in Subdivision 815-B apply to Part IIIB covered arrangements (as opposed to PE rules in Subdivision 815-C).

N/A

6 TR 2005/11 paragraph 9. 7 TR 2005/11 paragraphs 11 and 12.



3.2 ATO internal derivative guidelines

When TR 2005/11 was released, effectively permitting the recognition of inter-branch loans as a

‘proxy’ for allocating third party income and expense, it was widely recognised that exactly the same

practical issues – in particular the inability to trace – arose in relation to internal derivatives. However,

an equivalent tax ruling for internal derivatives has never been issued.

Industry raised this issue periodically, and in its 2013 Report the Board stated that unless the ATO

could provide guidance on internal derivatives the law should be changed.

Ultimately the ATO has produced ‘compliance guidelines’ on internal derivatives (the Guidelines), not

an actual ruling. Despite not yet being available on the ATO website (as at 20 January 20178), various

versions were circulated by the ATO during consultation with the banks, and we understand that the

Guidelines are now considered final for both inbound and outbound banks.

The Guidelines essentially say that, as a matter of compliance, the ATO will accept entries in a bank’s

books of account recording internal derivatives that reflect arm’s length dealings as a means of

determining an allocation or attribution of the bank’s income, expenses or profits in accordance with

Australia’s PE attribution rules. That is, the ATO is essentially saying that, as a matter of compliance,

the TR 2001/11 and TR 2005/11 ‘proxy’ approach can be applied to internal derivatives. There is a

lengthy discussion of the documentary evidence the ATO requires supporting the positions taken by

taxpayers, which the ATO says are in line with the requirements under the transfer pricing rules in

Division 815. Although an actual tax ruling may have been preferable, the Guidelines are certainly

welcome recognition by the ATO of the reasonable approach that the banks had been taking to

internal derivatives for some time.

The Guidelines outline a number of scenarios which are grouped in terms of the ATO’s perception of

level of ‘complexity’, which is said to refer to the level of analysis that the ATO would expect a

taxpayer to have done in order to justify the outcome:

Low complexity: a bank enters into a derivative with a third party (e.g. through a

sales/marketing function) and then moves/transfers the position (i.e. the entire risk

exposure) to another part of the bank through an internal derivative. That is, each internal

derivative is directly related to an actual/specific third party transaction (where that third

party transaction is not a hedging transaction). The internal derivative is a mirror of the

third party derivative other than on price – the pricing of the internal derivative can leave a

margin or spread to appropriately compensate a function (e.g. sales/marketing).

8 The ATO website, as at 20 January 2017, indicates that the Guidelines project is expected to be “completed” on 1 February

2017, presumably meaning that is the scheduled public release date for the Guidelines.



Medium complexity: although there is direct reference to a third party transaction, the

internal derivative does not match the external transaction – e.g. the internal derivative

transfers or hedges only one or more components of the risks associated with the third

party transaction (such as transferring credit risk on a loan asset, but retaining the

FX/interest rate risk). The complexity is said to relate to the ATO’s ability to verify the

pricing and terms of the internal derivatives in this scenario to establish they are arm’s

length. The medium complexity category is also said to include internal derivatives that

involve more than one type of risk, such as interest rate and FX, which would presumably

include an internal cross-currency swap.

High complexity: there are various features that can result in a ‘high complexity’

categorisation, but most fundamentally this category includes internal derivatives that do

not relate directly to any actual external transaction (such as where net exposures are

moved via internal derivatives, or what the ATO refers to as ‘bulk risk transfers’), or

internal derivatives that are not entered into contemporaneously with the actual external

transaction.

The practical issues associated with applying current Australian law to global trading and internal

derivatives are discussed in section 7 below, including the impact of the Guidelines.

It must be emphasised that these are compliance guidelines only – there is no substantive technical

analysis of the low, medium and high complexity examples.

In this regard, the distinction between low, medium and high complexity is not a conceptual or

technical distinction – it is not the same as low, medium and high risk. Assuming a bank’s accounts

are accurate, the basic consequence of low, medium or high complexity classification seems to be

how detailed/robust does the (i) factual and functional analysis and (ii) documentary evidence have to

be for the ATO to accept what is in the accounts. The Guidelines certainly are not prescriptive in this

regard. The implication is that in terms of both steps, there is sufficient OECD PE attribution and

transfer pricing guidance for the banks to know what they should be doing, and they should use their

own commercial judgement as to what is required in their particular circumstances. This is the right

approach – it would have been highly inefficient to require banks to adopt an additional layer of

documentation in order to rely on the Guidelines.



4 RBA vs. AOA

4.1 Overview

In this section we have commented on the basic features of and key differences between the so-

called RBA and AOA approaches to PE attribution. As will be seen, the differences between the

Australian RBA-type approach and the AOA are minor and often only theoretical – in most cases in a

banking context the two approaches should produce the same or at least a very similar result.

4.2 What is the RBA?

The OECD conception of the RBA approach is described in the 2008 OECD Report:

“61. The first broad interpretation, referred to as the “relevant business activity approach”,

defines the “profits of an enterprise” as referring only to the profits of the business activity in

which the PE has some participation (the “relevant business activity”). The term does not

appear in either Article 7 or the Commentary but emerges from country practices on

interpreting what is meant by the phrase “profits of the enterprise” in Article 7(1).

62. Under the “relevant business activity” approach, Article 7(1) imposes a limit on the profits

that could be attributed under Article 7(2) to a PE: the attributed profits could not exceed the

profits that the whole enterprise earns from the relevant business activity. The profits of the

whole enterprise would be those earned from transactions with third parties and those earned

from transactions with associated enterprises, the latter of which would need to be adjusted

under transfer pricing rules if they did not reflect the application of the arm’s length principle.

63. The profits of the enterprise as a whole would be considered as comprising the aggregate

of profit and losses derived from all its business activities. Any limitation on the profits

attributable to a PE under paragraph 1 of Article 7 would be determined relative only to the

profits of the relevant business activity.”

As outlined in the 2008 OECD Report, there is a vast array of different ways that RBA-type

approaches are applied in different countries.

Very broadly, the RBA approach to PE attribution, as incorporated into Australian law and ATO

practice, requires the attribution to a given PE of actual income/expenses derived/incurred by the

entity in its transactions with third parties. Regard can be had to ‘dealings’ between a PE and the rest

of the enterprise (which, being intra-entity have no legal basis/effect) and how those dealings are

accounted for, but only for the purposes of (or as a proxy for) attributing actual third party

income/expenses – the ‘dealings’ in and of themselves have no tax consequences. In contrast, and

as discussed further below, the FSE approach more directly permits recognition of internal dealings

as part of the attribution of profits to a PE.

Australia’s RBA approach is summarised in TR 2005/11:



“Taxation Ruling TR 2001/11 confirms that Australia’s PE attribution rules are based upon

allocating a taxpayer’s actual income and deductions using an ‘arm’s length separate

enterprise principle’. An interbranch payment or charge is not itself recognised as assessable

income or a deductible expense. Rather, actual income and expenses that the entity earns

from or pays to third parties are allocated or attributed between branches. The arm’s length

separate enterprise principle permits intra-entity dealings to be recognised and priced by

analogy to arm’s length separate enterprise transactions, for the purpose of allocating or

attributing the entity’s third party income and expenses.

… we do not accept that Australia’s tax treaties operate on a strict separate entity basis.”9

As noted above, all of Australia’s tax treaties use the ‘old’ (pre-2010) version of Article 7, and

Australia’s domestic PE attribution rules are based on an RBA-style approach – both the old (TR

2001/11 and Division 13) and new (Subdivision 815-C).

In relation to the new rules, this is made explicit in s.815-225(1): “…the arm’s length profits for a PE of

an entity are worked out by allocating the actual expenditure and income of the entity between the PE

and the entity…”.

The arm’s length profits are to be worked out so as best to achieve consistency with:

the 2010 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax

Administrators (2010 OECD TP Guidelines); and

the 2010 OECD Model and Commentary, but only “… to the extent that document

extracts the text of Article 7 and its Commentary as they read before 22 July 2010”10 – i.e.

the 2008 OECD Model and Commentary, which are both included in full in the 2010

materials (for ease of reference given the large number of countries, Australia included,

that would not (at least immediately) be adopting the new 2010 version of Article 7).

Accordingly, the new domestic PE attribution rules continue to apply the RBA approach, overlaying

the most appropriate transfer pricing methods (based on the 2010 OECD TP Guidelines), but only to

the extent that approach is consistent with the basic RBA principle of only attributing actual income

and expenditure of the entity.

Subdivision 815-C recognises elements of the FSE approach, but only to the extent that it is

consistent with the RBA. For instance, Subdivision 815-C recognises the approach of identifying

‘dealings’ between a PE and other parts of an enterprise, but the provisions do not actually deem the

‘dealings’ to produce income or expenses – rather, as under the historic ATO approach, those

dealings are only taken into account in allocating the actual third party income and expenses of the

entity to the PE.

9 TR 2005/11 paragraphs 16 and 17. 10 Section 815-235(2).



4.3 What is the AOA?

The 2010 OECD Report on PEs describes the AOA as follows:

“8. The authorised OECD approach is that the profits to be attributed to a PE are the profits

that the PE would have earned at arm‘s length, in particular in its dealings with other parts of

the enterprise, if it were a separate and independent enterprise engaged in the same or

similar activities under the same or similar conditions, taking into account the functions

performed, assets used and risks assumed by the enterprise through the permanent

establishment and through the other parts of the enterprise. The phrase “profits of an

enterprise” in Article 7(1) should not be interpreted as affecting the determination of the

quantum of the profits that are to be attributed to the PE, other than providing specific

confirmation that “the right to tax does not extend to profits that the enterprise may derive

from that State otherwise than through the permanent establishment” (i.e. there should be no

“force of attraction principle”). Profits may therefore be attributed to a permanent

establishment even though the enterprise as a whole has never made profits. Conversely,

Article 7 may result in no profits being attributed to a permanent establishment even though

the enterprise as a whole has made profits.”

That is, under the FSE approach the PE is treated as having a greater degree of independence from

the rest of the enterprise and intra-entity dealings can be recognised as having tax consequences in

and of themselves – this means that, importantly, Article 7 does not limit the profits that can be

attributed to the PE to that of the whole enterprise. Notional income, gains or losses from internal

dealings are effectively treated as if they were ‘real’ for tax purposes rather than just being taken into

account in attributing amounts from third party transactions to the PE.

The history of the OECD’s adoption of the AOA is set out in the 2010 OECD Report on PEs. A limited

FSE approach was adopted in the 2008 Commentary on old Article 7 and then a more complete FSE

approach adopted in the 2010 OECD Model and Commentary.

Whilst the 2008 Commentary did not go so far as to deem the FSE to be the AOA, it did express a

preference for the FSE by noting at paragraph 11 that the second sentence in the old Article 7(1)

“should not be interpreted in a way that could contradict paragraph 2, e.g. by interpreting it as

restricting the amount of profits that can be attributed to a permanent establishment to the amount of

profits of the enterprise as a whole.” Further, under the 2008 Commentary the recognition of internal

dealings would not extend to internal royalties, interest for non-financial institutions or the provision of

services that are merely part of the general management of a company, for which no mark-ups

(representing a profit paid to another part of the enterprise) could be charged – these should be

allocated on an actual cost basis only. The new Article 7 and the 2010 Commentary do not contain

those restrictions.

The AOA is an FSE approach, but more broadly the AOA can be thought of as currently

encompassing:

the 2010 OECD Model Article 7 and Commentary;

the 2010 OECD Report on PEs; and

the 2010 OECD TP Guidelines.



The AOA is not precisely treating a branch as if it were a separate, independent entity – sometimes it

does not do this – for instance, a branch is regarded as having the same credit rating as the entity of

which it is a part, and nor can the rest of the enterprise guarantee the PE’s creditworthiness.

Broadly, the AOA relevantly involves:

hypothesising, on the basis of a functional analysis, the assets, risks, capital structure

and liabilities that the PE would have if it were an independent enterprise; identifying

intra-entity dealings involving the PE, and applying accepted transfer pricing principles to

determine whether those dealings have been appropriately valued;

in undertaking the functional analysis in the context of financial services, use the “key

entrepreneurial risk-taking functions” (KERT functions) concept as the primary basis of

determining the economic contribution made by the PE, which will typically relate to the

assumption and management of risk; and

have regard to the specialised guidance in Parts II (attribution of profits to PEs of banks),

III (enterprises carrying on global trading of financial instruments) and IV (insurance

companies) of the 2010 OECD Report.

Although there are clearly some differences, it must be said that the guidance in the 2010 OECD

Report regarding how the AOA is to be applied is similar in practice to how the ATO accepts income

and expenses are attributed to a PE – in particular, the initial functional analysis prescribed is similar

to the approach in TR 2001/11 and TR 2005/11.

The obvious difference is the extent to or the purposes for which internal dealings may be recognised.

It is important to emphasise here that the AOA does not just involve having regard to accounting

records and documentation for internal dealings – it still requires a functional and factual analysis of

the branch’s activities. The 2010 OECD Report stated:

“The starting point for the evaluation of a potential ‘dealing’ will normally be the accounting

records and internal documentation of the Permanent Establishment… and ultimately it is the

functional and factual analysis which determines whether the dealing has taken place, not the

accounting records or other documentation provided by the enterprise.”11

There are still a number of uncertainties in relation to how the FSE applies in certain scenarios; for

instance, the 2010 OECD Report allows variability in relation to capital allocation, and is unclear on

debt/equity characterisation and how internal dealings can give rise to FX gains and losses, amongst

other things.

4.4 Practical significance of adopting the RBA or AOA

Clearly there is the theoretical potential for the RBA and AOA to produce different attribution

outcomes and mismatches between countries.

11 2010 OECD Report paragraph 177.



The Board Report includes the most oft-cited example, which is where an entity has an overall loss for

a year from a particular activity, but its overseas PE is profitable (see Example 3 in Appendix C of the

Board Report). In this scenario:

if the profitable PE is in a country that adopts an RBA approach (based on attributing

‘profits’ to the PE), the PE’s net income would effectively be ignored on the basis that

there are no profits of the enterprise to attribute to the PE given it has an overall loss; and

if the head office is in a country that adopts the AOA, the entity would likely be able to

claim its loss in full, but the PE’s profit would not be taxed anywhere (assuming that the

home country has a branch profits exemption).

Although the ATO applies a RBA-style approach to PE attribution, the risks associated with the

limitation on overall profits issue are mitigated by Australia attributing gross income and expenses

(rather than net profit), and the type of limited AOA approach the ATO adopts in TR 2001/11 and TR

2005/11 (i.e. although notional income and expenses are not recognised, they are still taken into

account when allocating actual income and expenses). The ATO certainly thought in TR 2005/11 that

the OECD’s FSE approach would be expected, at least in relation to inter-branch lending, to in

practice produce similar profit attribution outcomes to the ATO’s approach of allocating actual third

party income/expense in TR 2005/11.12

It is also important to remember that even if both countries adopt the RBA or AOA, there will not

necessarily by symmetrical tax outcomes in terms of how each country calculates the income/profits

of the PE. Differences will still arise – e.g. due to variances in depreciation rates, the timing of

recognition of income and restrictions on the deductibility of expenses. This can give rise to not only

timing differences but also permanent differences, particularly where the difference in domestic laws

relates to the types of expenses that are deductible.13

In addition to the potential for the RBA and AOA to produce different attribution outcomes and

mismatches, as a practical matter, the RBA (as conceived by the ATO) is difficult and uncertain in its

application. The AOA, especially for the banks, produces clearer outcomes and is easier to apply.

12 TR 2005/11 paragraph 7. 13 Refer comments in paragraph 32 of the 2010 OECD Commentary on Article 7.



5 International comparison

It can often be misleading to try to summarise whether countries have adopted an FSE or RBA

approach to PE attribution – most countries sit somewhere on the spectrum between the two.

Australia, for instance, has not adopted the AOA, but nonetheless for certain purposes internal

dealings are recognised at least as a matter of administrative practice (for instance, for banks, inter-

branch loans and now derivatives).

Around the world, relatively few treaties currently include the ‘new’ Article 7. Further, through

reservations and positions included in the 2010 OECD Model, a number of countries (OECD and non-

OECD) have expressly stated their intention to not include the new Article 7 in their treaties.14 The

United Nations (UN) has also expressly rejected the inclusion of the new version of the article in the

UN Model (and therefore full implementation of the AOA in the UN Model).

That said, a number of Australia’s significant trading partners do support the new Article 7, including

the US, the UK, various EU member countries, Singapore and Japan. In terms of benchmarking

ourselves against other countries in terms of whether to adopt the AOA, we also need to be clear on

how the AOA would be implemented – for instance, if the Government was considering only

implementing the AOA for banks or the broader financial services sector, then it is generally the case

that our major trading partners in financial services do support the AOA and so any perceived slow

take-up of the AOA around the world should be largely irrelevant to how Australia should proceed.

Although Australia has not formally reserved its position on the new Article 7 (unlike, for instance,

New Zealand), thus far Australia has remained firm in its RBA-type approach, continuing to use the

old Article 7 in its most recently negotiated treaty with Germany (2015).

14 See the Reservations of Chile, Greece, Mexico, New Zealand, Portugal and Turkey in the 2010 Commentary on Article 7 and

the positions of Argentina, Brazil, China, India, Indonesia, Latvia, Malaysia, Romania, Serbia, South Africa, Thailand and Hong

Kong.



6 ATO focus areas in bank PE attribution

By and large, it seems fair to say that bank branch attribution has not been a major focus area of the

ATO in recent years. That said, recent ATO work has included:

issuing the Guidelines on internal derivatives (see section 3.2);

attribution of capital to PEs for the purposes of the thin capitalisation rules (see section

7.4.1);

the tax treatment of inter-branch liquidity-type charges, generally payable by branches to

head office – in particular, in recent years the ATO has conducted significant compliance

activity in relation to liquidity-type charges ‘paid’ by the Australian branches of foreign

banks (as addressed in ATO IDs 2012/90, 2012/91 and 2012/92) (see section 7.5);

compliance activity in relation to the margins applied to inter-branch dealings, especially

derivatives, within both inbound and outbound banks, which partly came out of work the

ATO did in formulating its Guidelines; and

very recently the ATO has expressed concerns with a number of what the ATO regards

as tax arbitrage transactions involving overseas branches of Australian corporate groups

and intra-group transactions, which in BEPS-speak can result in deduction/non-inclusion

outcomes, although these do not appear to relate directly to banks.15

15 For example, Taxpayer Alert TA 2016/7 (Arrangements involving offshore permanent establishments)



7 Current practical issues and risks, including

transfer pricing methodologies

7.1 Overview

In this section, we discuss practical issues in applying the AOA and RBA approaches to profit

attribution to the activities of banks. The activities are primarily drawn from Parts II and III of the

OECD 2010 Report on PEs which cover traditional banking activities and global trading of financial

instruments respectively. In addition to the specific activities related to traditional banking and global

trading, there are activities which are required to be undertaken by financial institutions which are

common to both which we have also covered below e.g. liquidity management and capital allocation.

A common theme in the issues discussed below is that in addition to addressing challenges in

applying the arm’s length principle for internal dealings within an integrated global banking business,

satisfying both the jurisdictions which do adopt the AOA and those that do not is particularly difficult.

In some instances, namely TR 2005/11 and the Guidelines, the ATO has provided administrative

concessions to, in effect, allow banks to apply the separate entity principle. However, for situations

faced by banks outside the facts on which those administrative concessions have been provided,

there may be practical challenges in meeting both the OECD AOA and Australian RBA approaches.

7.2 Traditional banking activities

7.2.1 Creation and management of loans with multi-branch involvement

Part II of the 2010 OECD Report outlines how the AOA applies to a number of factual situations

commonly found in what the OECD refer to as traditional banking activities, being the borrowing and

on-lending of money.

The process for attributing profit to enterprises with PEs undertaking traditional banking activities

follows the prescribed two-step process for all PEs, being:

Step 1: Hypothesise the PE as a separate and independent enterprise; and

Step 2: Determine the profits of the hypothesised separate and independent

enterprise based upon a comparability analysis.



In preparing a functional and factual analysis required under step one, the OECD places particular

importance on determining who undertakes the KERT functions involved in creating and subsequently

managing a loan. The loan is then attributed to the branch which undertakes the KERT functions in

respect of those assets.16 The OECD acknowledges that joint economic ownership may occur if KERT

functions are undertaken in more than one location.17

Under the second step, transfer pricing methodologies are required to be followed to determine the

arm’s length price between the PE and the other parts of the enterprise as if it were a distinct and

separate enterprise.

Comparing firstly step one with the RBA approach, whilst TR 2001/11 deliberately did not address

certain issues associated with banking such as inter-branch fund transfers, the principles for

determining which branch has economic ownership of external loans should follow the methodologies

set out in that ruling.18 Those principles are broadly consistent with step one of the AOA and therefore

the determination of economic ownership of assets, including potential joint ownership, should be no

different.

Whilst both the AOA and RBA approaches acknowledge joint economic ownership, in practice

recognising loans on two balance sheets (and consequently income and expenses in two different

parts of the enterprise) may not be practically easy to apply. Similarly, attributing value to each of the

KERT functions in order to determine the relevant percentages for each booking location can be

subjective as there is not any clear guidance nor may there be comparables easily found that could

be used.

Once economic ownership has been established, analysing dealings with other parts of the same

enterprise as required under Step 2 of the AOA can be challenging. Due to the wide array of business

models employed by global financial institutions undertaking traditional banking activities, the OECD

does not provide a prescriptive methodology for analysing dealings between parts of the same

enterprise. In all fact patterns, there are limited situations where a comparable uncontrolled price

(CUP) would be available to price the internal dealings and therefore other methodologies would need

to be relied upon (e.g. cost-plus).

Further complicating matters, determining the reward of the other parts of the same enterprise may

result in different outcomes under the AOA and FSE.

16 Part II of the 2010 OECD Report paragraph 70. 17 Part II of the 2010 OECD Report paragraph 77. 18 TR 2001/11 paragraph 6 sets out exclusions to that ruling.



For example, the ongoing management and maintenance of a loan or portfolio requires a number of

support functions such as those outlined in the 2010 OECD Report19 e.g. loan administration and

credit exposure monitoring. Some of these activities are likely to be centralised in a global bank. The

provision of these services by the non-booking location may require an allocation of the relevant costs

(rather than an allocation of income) under the principles in TR 2001/1120 however under the AOA a

full transfer pricing analysis may show that a mark-up is required on the inter-branch dealing or an

alternate methodology (e.g. CUP) be used to determine what an arm’s length fee would be for this

service.21 For completeness, we note that this conflict continues to exist post the introduction of

Subdivision 815-C as the discussion in TR 2001/11 is broadly consistent with that in the pre-2010

Article 7 Commentary as it applies to the RBA approach.

7.2.2 Transfer of existing loans across branches

There may be circumstances where the ongoing KERT functions related to an existing loan (e.g. the

decision to retain credit risk) move from one part of an enterprise to another such that it necessitates

a transfer of booking location. This may occur due to either employees of the enterprise themselves

moving locations or employees in another jurisdiction assuming responsibility for the relevant

functions. This may also occur due to a branch being closed down.

Under the AOA, the transfer of an existing financial asset generally represents a deemed disposal

and acquisition at fair value. In some cases, the credit quality of the loan may have deteriorated from

when it was originally funded such that market value of the loan is less than its fair value (being the

amount for which it was funded) and therefore the original booking location should suffer a loss.

Alternatively, the market value of the loan may be greater at the time of transfer than on acquisition

(e.g. as a result of purchasing the loan at a discount) such that the original booking location should

recognise a gain.

Prima facie, under Australia’s RBA approach, there would be no deemed disposal on the transfer of

functions and therefore no taxing event. In many cases, the loan may be immediately or soon

thereafter disposed of by the internal recipient (e.g. the responsibility for managing distressed debt is

assumed by a centralised structuring department which seeks to sell down exposure as soon as

possible) however there may be situations where the exposure continues to stay on foot for a longer

period after the transfer.

19 2010 OECD Report paragraph 7 provides a summary of functions involved in managing an existing financial asset. 20 TR 2001/11 paragraph 5.27 to 5.36. 21 2010 OECD Report paragraph 216 to 220; see also Commentary to Article 7 paragraph 40.



There are similarities between the transfer of loans and the transfer of physical trading stock between

parts of the same organisation as discussed in TR 2001/11.22 In that discussion, the Commissioner

acknowledges that there is an apparent conflict between the Australian law treatment of branches and

a strict application of the arm’s length principle related to the transfer of trading stock between a PE

and head office and the subsequent sale of that trading stock in a different year. However, given how

difficult it would be to trace the specific inputs of a finished product and then allocate the profit at that

particular time, the ATO practice is to accept the position reflected by accounts prepared on a

separate entity basis, on the proviso that they have been properly prepared and the attribution

outcomes are the best estimate of PE profits that can be made in the circumstances.23

Arguably, the conditions for the ATO practice to apply in respect of physical trading stock is present in

the case of financial assets being sold between parts of the same entity and therefore that practice

should apply in that situation.

7.3 Global trading models

7.3.1 Allocation of sales income

In Part III of the 2010 OECD Report, the OECD outlines a range of different operating models

employed by enterprises (primarily financial institutions) undertaking global trading businesses and

discusses both the potential application of the 2010 OECD TP Guidelines and the AOA to those

operating models.

The OECD acknowledges that there is almost a limitless number of different business structures that

may be used to undertake global trading and therefore the report is only able to provide

considerations to be taken into account when setting transfer pricing and profit allocation policies

rather than strict rules. As a result, this can prove difficult for trading organisations, and the tax

administrators in the jurisdictions in which they operate, as each organisation may apply different

transfer pricing methodologies due to their differing business models.

For example, the 2010 OECD Report suggests that sales personnel can be rewarded using different

methodologies depending on the functions performed. Certain sales personnel may merely act as

brokers in respect of standardised products and therefore are likely to be rewarded by a simple fee or

commission such as a number of basis points.24 Other marketers are highly specialised and closely

involved in the deal making process such that they would be expected to be rewarded with a share of

the trading profits and losses. In the middle of these two extremes are sales personnel who do more

than a broking function but are not involved in structuring products and would therefore not be

allocated ongoing market risk management however they may want a share of the day 1 profit.25

22 TR 2001/11 paragraph 5.5 to 5.16. 23 TR 2001/11 paragraph 5.16. 24 Part III of the 2010 OECD Report paragraph 125. 25 Part III of the 2010 OECD Report paragraph 126.



Arguably, all of these methodologies could fit within Australia’s version of the RBA approach albeit

with more difficulty than if the AOA were adopted. Australia separately allocates income and

expenses and therefore each transaction entered into would, in most cases, generate sufficient

income and expenses to be allocated appropriately to sales people to achieve the correct outcome.

7.3.2 Trading – market risk management

In respect of the trading, or market risk management functions, applying the RBA approach can be

tricky in situations where internal derivatives are required. For example, organisations or business

units using an “integrated trading” business structure may have internal derivatives when one trading

location’s market closes to pass the book to another location. Such internal derivatives would typically

be entered into at an arm’s length rate. Unlike the allocation of profit to the sales function as

discussed above, the internal derivative does not directly relate to a single transaction but rather the

current position for the entire book or portfolio.

These internal derivatives may not be directly traceable to an external transaction and therefore may

be considered high complexity transactions under the ATO’s Guidelines as discussed in section 3.2.

In practice, the classification of the transaction as high complexity should not in itself give rise to any

concerns as the internal derivative would be executed at market rates to ensure the book or portfolio

for the branch whose market is closing would not have any mismatches.

7.3.3 Other internal dealings

The OECD notes that credit risk transfers may also occur within global trading enterprises and has

observed that increasingly financial enterprises are not only active in assessing credit risk at the point

of sale but also active in managing credit risk during the lifetime of the financial instrument. The

OECD notes that such a transfer may be recognised provided that the credit department actually

carries out the evaluation, monitoring, and ongoing management of the credit risk.

Similar to the issues faced with internal derivatives as they relate to market risk management, it can

be challenging attempting to apply Australia’s approach to profit attribution to the internal transfer of

credit risk. Where credit risk is bifurcated from the sales and market risk management functions on the

day a customer trade is executed, there should not be any issues in allocating income from that

transaction to the credit risk function, assuming an arm’s length pricing methodology is used.

However, if credit risk was to be transferred during the life of a customer trade which would

necessitate the transferor jurisdiction recognising the disposal of an asset, the same issues would

arise as per the transfer of a loan discussed above.



7.4 Capital allocation

7.4.1 Australian tax law treatment of capital

There are currently differing views in the industry regarding the allocation of equity capital to branches

of outbound banks – specifically, the attribution of Authorised Deposit-taking Institution (ADI) equity

capital and controlled foreign entity equity (CFEE) to an ADI’s PE for the purposes of determining an

ADI’s adjusted average equity capital under the thin capitalisation rules.

By way of a brief background, under the thin capitalisation regime for outbound ADIs, the ADI equity

capital attributable to an entity’s overseas PEs is not included in the average value of its ADI equity

capital for the purposes of measuring whether that amount is less than its minimum capital amount.26

The Explanatory Memorandum to the Act which introduced the thin capitalisation provisions (the EM)

states that (emphasis added):

Equity capital attributable to the banks’ foreign branches will be the amount actually

allocated to them (i.e. the value of capital shown in the banks books of accounts). However,

where such an amount has been adjusted for foreign tax purposes or by the ATO for

other tax purposes, the adjusted amount should be used.27

The first issue is whether the ADI equity capital attributable to a branch for thin capitalisation purposes

can be a notional amount determined by reference to the branch’s operations and assets rather than

the amount recorded in the ADI’s books of account.

The primary argument in support of this view is that both the EM and TR 2005/11 state that an

amount other than the amount in an entity’s books of account can be used for these purposes if the

amount of equity capital allocated to the branch is adjusted for tax purposes of the host jurisdiction or

by the ATO for other tax purposes. In this regard, TR 2005/11 provides an example of where the

capital determined for a foreign branch’s tax calculation in the host country may be the most

appropriate amount to use for thin capitalisation purposes; however, there is no further discussion in

the EM or that ruling on the other Australian tax purposes for which the ATO may adjust the branch’s

capital amount.

26 Section 820-300 of ITAA 1997. 27 Explanatory Memorandum to the New Business Tax System (Thin Capitalisation) Act 2001 (EM) paragraph 5.26.



In addition to technical arguments against the view expressed above, in support of the view that the

amount of ADI equity capital attributable to an ADI’s foreign branch should be the amount recorded in

its books of account, this approach is consistent with the overall intention of the thin capitalisation

regime as it applies to ADIs, that is, to measure the amount of capital used by the entity in its

Australian operations (i.e. not allocated to its foreign operations) against a minimum capital amount

based on assets used in those Australian operations.28 Important to this approach is that the equity

capital of a foreign branch as recorded in the ADI’s accounts is more than just a notional book entry

without consequence - it represents funding that the Australian operations must otherwise raise

through debt issuances (for which interest payments would be deductible) in order to fund its

Australian assets.

The different views on this issue further emphasise the need for a decision to be made on Australia’s

adoption of the AOA, which is discussed below as it applies to capital attribution.

7.4.2 AOA for attributing capital

For the purposes of applying the AOA, the OECD authorises either a capital allocation approach

(which allocates the bank’s actual capital based on financial assets or risks) or a thin capitalisation

approach (which allocates an amount of capital to a branch equal to an amount which a comparable

independent banking enterprise would hold). Given the potential difficulty in applying either of the

authorised OECD approaches for determining the appropriate amount of capital due to the need to

find comparable data, the OECD also states that an alternative safe harbour approach could be used,

being a quasi-thin capitalisation/regulatory minimum capital approach.

The approach already used within Australia, including the existing practice by which capital is

allocated to foreign branches of ADIs, is broadly consistent with the safe harbour methodology

suggested by the OECD. As such, as noted by the ABA submission to the Board’s review into PEs, it

seems possible that Australia’s existing thin capitalisation regime could be retained if Australia were to

adopt the AOA and may be the most practical way of dealing with capital attribution.

7.5 Liquidity management

7.5.1 Overview

In 2012, the Commissioner released three ATO IDs relating to liquidity management costs as they

relate to Australian branches of foreign banks. Before addressing the ATO IDs, we have provided a

summarised background to the potential regulatory requirements which give rise to such costs.

28 EM paragraph 5.2.



The discussion on capital above primarily relates to “free” capital of a bank, however, banks will

typically have total capital requirements which they will likely choose to meet through holding a certain

level of Tier 2 capital which may be deductible. Tier 2 debt will typically be more expensive than short

term debt such as overnight funding or other wholesale debt due to the subordinated nature of such

instruments.

In addition to capital requirements, banks are required to manage their liquidity to ensure that debts

are able to be repaid when they fall due. Basel III introduced two new relevant liquidity ratios: the

liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). Broadly, the LCR requires that

a sufficient amount of high-quality liquid assets (HQLA) (e.g. government bonds) be held by a bank to

cover cash flows required over the 30 day period following the date in which the test is applied. The

NSFR gives rise to a need for banks to borrow at varying maturity dates which gives rise to a mix of

short and long term funding.

For context, we note that ADIs regulated by the Australian Prudential Regulatory Authority’s (APRA)

prudential framework are subject to the LCR under the existing APS 210 ‘Liquidity’ standard. A new

APS 210 which will be effective from 1 January 2018 includes a NSFR requirement.

Liquidity requirements such as those mentioned above can adversely affect bank profits. Investing in

HQLA will result in a lower return on borrowed funds than customer loans and can also result in

losses depending on market conditions and liability profile. Further, longer term borrowings which are

required due to NSFR or similar regulations would typically be more costly than short term loans as

depositors/lenders may require a long term funding premium.

7.5.2 Long term funding costs

In the facts on which ATO ID 2012/90 was provided, a foreign bank applies a ‘charge’ to the

Australian branch for the estimated additional interest cost if assets employed in its Australian branch

operations, that were funded by Australian dollar borrowings by the bank, had instead been funded by

more expensive longer term Australian dollar borrowings of a duration or term equal to the average

duration of the bank’s global borrowings.

It can be inferred from these facts that the foreign bank raises its more expensive long term debt

required for liquidity purposes outside of Australia. Notwithstanding this, the amount of long term debt

raised would take into account the assets of the Australian branch by virtue of the fact that the assets

would be included in the relevant capital and liquidity ratio requirements. That is, in effect, the liquidity

gap in the Australian branch (from borrowing short and lending long) is being offset by more

expensive long term debt raised by the foreign bank’s head office or otherwise outside Australia.

Unfortunately, ATO ID 2012/90 does not explain what the actual arrangements are between the

Australian branch and head office, how they have been documented and how the charge has been

calculated (for instance, whether it can be directly/indirectly traced to actual third party interest costs

of the foreign bank).



The OECD recognises in the 2010 OECD Report that such higher interest deductions should be

appropriately shared between a head office and its PEs and not just deductible in the country in which

the debt was raised.29 Banks may factor the higher interest rates into a blended rate for which funds

are lent to its offshore PEs, however the OECD suggest that an adjustment can be made if such

internal practices of providing blended rates are not used.30

It is not clear from the reasoning in ATO ID 2012/90 whether the latter ‘adjustment’ approach referred

to by the OECD would be accepted by the ATO under Australia’s RBA approach to attributing profits –

it is not clear from the facts in ATO ID 2012/90 whether there is any actual relevant loan to the

Australian branch or some other specific arrangement in respect of which the liquidity-type charge is

being paid. Further, for foreign banks subject to Part IIIB, the additional funding cost would be

restricted from being included in the interest rate on internal loans due to the LIBOR cap. However,

for those banks outside of Part IIIB, including outbound banks, if longer term funding is provided by

the head office to the branch and priced accordingly, the higher interest costs could reasonably be

factored into the interest rates and meet the requirements of TR 2005/11.

Whilst the deductibility of internal charges would be clearer if Australia adopted the AOA, depending

on the facts it may be that the type of internal charge considered in ATO ID 2012/90 represents a

reasonable proxy for actual interest costs incurred by the foreign bank which are properly attributable

to the Australian branch.

7.5.3 Liquid asset holding requirements

ATO ID 2012/91 and 2012/92 relate to the deductibility of interest, net and gross respectively, on

borrowings used to fund general reserve liquid assets.

Whilst the 2010 OECD Report does not explicitly address liquidity charges of the nature in the ATO

IDs, it does recognise that internal funds transfer pricing systems can be used to transfer interest rate

risk and liquidity risk from branches to treasury to facilitate efficient management of risks, provided

such transfers are recognised (i.e. there is a real and identifiable event).31 In this regard, liquidity

charges can be viewed as representing the cost for the head office of managing the liquidity for the

bank and therefore would be accepted as a dealing, and consequently deductible, under an AOA.

The appropriate outcome, consistent with the AOA, is that part of the net cost (which also could be

income depending on the level of return on the liquid assets) related to the funding and holding of

liquid assets should be reasonably allocated to a PE consistent with the facts in ATO ID 2012/91.

Similar to the long term funding costs, the deductibility of the net internal charge would be clearer with

the adoption of the AOA, however, there is a question as to whether a broader application of

Australia’s version of the RBA than that undertaken by the ATO ID could provide the right outcome.

29 Part II of the 2010 OECD Report paragraph 117. 30 Part II of the 2010 OECD Report paragraph 121. 31 Part II of the 2010 OECD Report paragraph 164.



In addition to the arguments suggested above related to the deductibility of interest, there may be

additional arguments that the liquid assets are jointly attributable to the parts of the business for which

they are being held. This may provide a more appropriate outcome as the net position for holding

liquid assets may not always be negative i.e. the return on the liquid assets could be greater than the

cost of funding them.

In this regard, the ATO states in ATO ID 2011/91 that paragraph 4.37 of TR 2001/11 has no

application in respect of the liquid assets as the PE did not “joint[ly] … carry… out a single economic

function” in relation to holding and managing the liquid reserve assets. Arguably, the single economic

function could be read as being broader than simply the holding and managing of the liquid assets

and instead refer to a broader business activity which requires that part of the liquid assets be held.

7.6 Inter-branch loans

Due to the existence of the previously mentioned TR 2005/11, it is widely accepted that as a practical

matter there should not be any material difference between the AOA and the treatment under

Australian law of a bank’s internal loans.

However, as alluded to in the Board Report, if the FSE is formally adopted there would be a policy

question as to whether it would entail levying withholding tax (WHT) on interest ‘paid’ on inter-branch

loans, in which case it would need to be considered whether the lender’s jurisdiction would allow a tax

credit for the amount withheld.32 The same issue currently exists for interest received by a head office

in Australia from an overseas PE on which WHT has been levied in the foreign jurisdiction.

Australia’s FITO regime in Division 770 allows an offset for foreign income tax against Australian tax

payable if it was paid in respect of an amount that is all or part of an amount included in a taxpayer’s

assessable income. Importantly, TR 2005/11 does not deem an amount of interest on an inter-branch

loan to be assessable income - it only states that it can be used as a proxy for allocating or attributing

external income. Therefore, if foreign tax is levied on the actual inter-branch interest, arguably the

amount included in assessable income is a different amount to that on which tax has been withheld

and therefore no FITO would be available.

In addition to the above, there is a question as to how FX gains / losses on internal loans should be

treated which is not currently covered by TR 2005/11. We refer to Tony Frost’s paper ‘Cross-border

dealings within a single entity’33 which examines this issue in more detail.

7.7 Insurance in the banking context

Whilst we have not discussed any practical issues related to branch attribution for insurance

enterprises, it is worth considering whether Australia’s reservation to the Commentary on Article 7

regarding the taxation of insurance has any application to banks.

32 TR 2006/9 outlines the ATO view under the current law. 33 Cross-border dealings within a single entity, Challis Taxation Discussion Group, 5 May 2010.



Division 15 of ITAA 1936 specifically deems insurance premiums received by a non-resident insurer

to be assessable income when:

the insured property is situated in Australia or the insured event can happen only in

Australia; or

the insured person is a resident and an agent, or representative of the insurer in

Australia, was instrumental in inducing the entry of the insured person into the insurance

contract.

An insurance contract for purposes of Division 15 is a contract or guarantee where liability is

undertaken, contingent upon the happening of any specified event, to pay any money or make good

any loss or damage, but does not include a contract of life assurance.

Most banks are active in providing unfunded guarantees or letters of credit (LOC) related to

repayment of outstanding amounts to either customers or to other financial institutions as a means of

sharing risk. Arguably, there is an issue as to whether the fees on the guarantee or LOC could be

considered an insurance premium and therefore captured by Division 15 if either of the tests referred

to above are satisfied.



8 Future direction of Australian law and 2013

Board Report

8.1 Adopting the AOA

Australia did not record any Reservations to the new Article 7(2) or any relevant observations on the

2010 OECD Commentary. This suggests that Australia supported the AOA and that the Australian

representatives were expecting our domestic law would be amended to align with the AOA – in fact it

is well known that Australian representatives were closely involved in developing the AOA.

All of this would seem to justify an expectation back in 2010 that Australia would quickly adopt the

AOA.

In 2011, the Board was asked to examine the advantages and disadvantages of Australia adopting

the AOA, and how it should be implemented if the Government decided to proceed. The Board’s

review was:

“… to have regard to the broad principle that profits attributed to the Australian tax base

should appropriately reflect economic activity in Australia and as far as practicable the

relevant rules should be aligned with and interpreted consistently with international

standards.”34

Although the Board Report was completed in April 2013, it was not released publically until June

2015, at the same time as four other entirely different reports. The Board Report on PEs received no

special attention in the accompanying Media Release.35

The Board did not conclude one way or the other on whether Australia should adopt the AOA –

although, to be fair, they were not squarely asked their opinion on that question. Disappointingly, after

four years the Government has still never responded to the Board Report – simply noting back in

June 2015 that it and the other four reports:

“… are an important input into the tax reform process. They will be carefully considered

alongside the submissions we have received from all parts of the community in response to

Re:Think, the tax discussion paper”.36

There has been nothing further from the Government on whether Australia will adopt the AOA.

Industry submissions, including from AFMA and the ABA, almost unanimously supported the adoption

of the AOA, and noted that in the case of banks in practice the AOA was largely being applied by both

the banks and the ATO already.

34 2012 Board Discussion Paper at paragraph iv. 35 Assistant Treasurer Josh Frydenberg’s 4 June 2015 Media Release “Release of Board of Taxation reports”. 36 Ibid.



The ATO’s submission was confidential and was never released, so we do not know whether the ATO

argued in favour of or against adopting the AOA. However, the Board Report states that the ATO

submitted that the RBA approach had the advantages of attributing actual income and expenditure

and ensuring that income cannot be shifted from one location to another simply to reduce tax.37 The

Board Report stated that:

“… the ATO has submitted that it would introduce significant integrity risk to adopt an

approach which allocated income based on the act of documenting a notional internal dealing

rather than on whether the documented dealing was evidence of actual business operations

of the branch. It submits that any such approach would mean that the tax treatment of

business operations would be based on the choice of whether or not to document an internal

dealing. If internal documentation were assumed to be sufficient ‘evidence’ in itself for the

purposes of attribution of profits, significant revenue would be at risk”.38

That, of course, is not an accurate description of the AOA. The AOA is still based on a functional and

factual analysis, and is not “based on the act of documenting a notional internal dealing”.

The key advantages and disadvantages of adopting the AOA, as perceived by the Board, were

outlined at Observation 4 of the Board Report.

Advantages Disadvantages

Ability for entities (particularly banks) to recognise internal derivatives

Additional compliance costs and uncertainties for entities in the non-financial sector and small and medium enterprises

Assist Australia in the goal of being a financial centre, to the extent our key trading parties are also adopting the AOA

Limited guidance on applying the AOA

The AOA more appropriately reflects the relative contribution of a branch where there is an overall loss

With respect to the perceived compliance-related disadvantages, this would depend on how the AOA

was implemented in Australia – the Board suggested (at Observation 5) that adopting the AOA for

financial institutions only, such as through the extension of Part IIIB to Australian financial institutions

and so as to cover all Division 230 financial arrangements, would remove this disadvantage. That

said, the Board was generally not keen on the idea of adopting the AOA only for the banks.

The big unknown for the Board was the revenue impact of adopting the AOA – particularly in respect

of Australian PEs of foreign entities. It is clear from the Board Report that no modelling had been

done, or even any significant thought given to how it could be modelled.

37 In particular, see paragraphs 3.11 to 3.14. 38 Board Report paragraph 3.13.



The Board was clearly not convinced that there would be no material revenue impact and rejected the

argument that adopting the AOA would merely provide legislative support for the current

administrative practice (that argument always having more strength in relation to banks than general

corporates).

We are not aware of any further work being done on modelling the impact of adopting the AOA in

Australia, which is disappointing given that the Government may be unwilling to push ahead unless

they are relatively comfortable that there would be no material revenue at risk.

At the time when the Board Report was completed, the ATO had only just begun to collect information

about internal dealings from corporate tax returns through the International Dealings Schedule. The

Board stated that this would provide a starting point for estimating the revenue impact of the AOA –

however, again, we are not aware of any further work being done on this.39

Despite not formally recommending the AOA be adopted, the report clearly indicated that the Board

thought that the AOA was a conceptually better approach than the RBA, and that ultimately that

should be the deciding factor. In this regard:

the Board was of the view that “… a decision for Australia to adopt the FSE approach

should not be solely based on the extent of the current take-up of new Article 7 but also

on whether the FSE approach is a conceptually sound approach that would bring benefits

to Australia”40; and

the Board later stated, in a different context, that: “The Board does consider that the FSE

approach is conceptually better equipped to deal with the ways in which risk is allocated

and managed within sophisticated multinational enterprises than more traditional

approaches that start with the profits that the whole enterprise earns from the relevant

business activity and imposes a limit on the profits that can be attributed to the relevant

PE”.41

As noted above, the Board recommended that the ATO should provide guidance on whether, under

current Australian law, bank internal derivatives could be recognised for the purposes of PE

attribution, and that if such guidance could not be provided by the ATO under current law that the law

should be amended to provide the required certainty. Whilst the Guidelines ultimately issued by the

ATO provides a reasonable level of certainty in respect of internal derivatives, formally adopting the

AOA would address other issues identified by the Board and in this paper.

8.2 How would the AOA be implemented in Australia?

The Board canvassed a number of possible ways to adopt the AOA in Australia (Observation 5),

including:

adopting the new (2010) Article 7 on a treaty-by-treaty basis;

39 Board Report paragraph 6.56. 40 Board Report paragraph 4.12. 41 Board Report paragraph 6.38.



adopting the AOA in full in domestic law; and

a more limited option to adopt an FSE/AOA approach in domestic law for financial

institutions only.

A treaty-by-treaty approach would have the advantage of allowing the Government to restrict the AOA

only to jurisdictions that agree to apply the AOA on a reciprocal basis. However, (i) many countries

may not agree to reciprocate, and (ii) this approach would likely take decades to implement and

require resources that, frankly, Treasury currently does not have. Realistically, it seems highly unlikely

that this option would ever be successfully pursued.

The Board seemed reluctant to recommend adopting the AOA in full in domestic law, and also

seemed reluctant to recommend a specific AOA regime for the banks (despite acknowledging at

various points that by and large Part IIIB had worked well).

The Board certainly hedged its bets, but the closest it came to a recommendation was the proposal to

adopt a ‘more limited AOA’ into domestic law whilst negotiating new treaties including the new Article

7:

“The Board considers that if the FSE approach were to be adopted in Australia, an option

which would assist in restricting the diversity of outcomes would be to introduce amendments

to domestic law to reflect the more limited FSE approach as per the guidance contained in the

2008 OECD Commentary on old Article 7, which could be supplemented with bilateral

negotiations with treaty partners to adopt new Article 7”.42

However, that would presumably require later amendments to implement the AOA in full into domestic

law.

Putting to one side precisely how it is done, the authors see merit in adopting the AOA in full, at least

in the finance sector where it is already largely being applied in practice in any case. Given that the

treaty-by-treaty approach does not seem feasible, the best approach would seem to be adopting the

AOA in full into domestic law through Subdivision 815-C, which would be consistent with the approach

already taken to modernising Australia’s transfer pricing rules.

42 Board Report paragraph 5.26.



9 Impact of BEPS, MAAL and DPT

9.1 BEPS

9.1.1 Overview

This paper does not focus on BEPS and PE attribution, given the BEPS-specific sessions at this

conference. Further, generally speaking, the PE work being done as part of BEPS is not overly

focussed on issues in the financial services sector (although the changes that flow out of this work will

inevitably affect the sector).

In terms of the taxation of PEs, the BEPS work affects both (i) the identification of PEs (especially in

terms of arrangements that could be regarded as deliberately avoiding PE status), and (ii) the

attribution of profits to PEs. Various BEPS actions are relevant in relation to PE attribution, including:

Action 2: Neutralise the Effects of Hybrid Mismatch Arrangements

Action 4: Limit Base Erosion via Interest Deductions and Other Financial Payments

Action 6: Prevent Treaty Abuse

Action 7: Prevent the Artificial Avoidance of PE Status

Actions 8 – 10: Assure that Transfer Pricing Outcomes are in Line with Value Creation

9.1.2 Action 7

Action 7 (Prevent the Artificial Avoidance of PE Status) is likely to be particularly relevant for financial

services. Any reduced PE threshold is likely to increase the risk of inadvertently creating a PE. For

instance, the risk of a fixed place of business PE in the context of private banking involving numerous

client visits and the use of local offices.

Action 7 also proposes changes to the test for dependent agent PEs. which is extremely important in

a financial services context – such as for financial advisors/managers, or for dealers/traders which

operate on a global basis through separate subsidiaries which originate trades which are then booked

in a central booking site.

It is worth noting that the 2015 Australia-Germany tax treaty includes new articles implementing

various BEPS Action 7 recommendations (such as short-term PE splitting, commissionaire

arrangements etc.).



As part of Action 7, in July 2016 the OECD released a Discussion Paper entitled Additional Guidance

on the Attribution of Profits to PEs. The aim was to provide additional guidance in relation to PEs that

would arise as a result of the changes to the PE thresholds made as part of Action 7, in particular in

relation to commissionaire and warehousing arrangements. Given its focus on those particular types

of arrangements, the discussion paper does not contain much directly relevant to the issues

discussed in this paper. However, it is worth noting that the analysis in the paper at various points

seems to assume that there would be symmetry in the sense that if the PE recognises a deduction in

relation to an internal dealing then the head office is taxable on that amount in the home jurisdiction.43

Article 7 imposes a cap on the business profits that can be taxed in the jurisdiction in which the PE is

located, and requires that relief against double tax be provided in the home country, but it does not

require that the home country tax any amounts of notional income.

9.1.3 Action 2

The BEPS Action 2 work is also interesting in terms of how it interacts with the OECD’s general work

on PE attribution.

The 2015 OECD final paper on ‘BEPS Action 2: Neutralising the Effects of Hybrid Mismatch

Arrangements’ contained relatively minor comments on how the BEPS hybrid provisions may apply to

branches.

However, this was then followed up in August 2016 with a discussion paper on ‘BEPS Action 2 –

Branch Mismatch Structures’. This discussion paper identifies instances where hybrid mismatches

may arise from both branch third party transactions as well as internal dealings – for instance, an

internal dealing could create a mismatch if one side recognises a deduction but there is no pick-up of

income on the other side. Two points are worth noting in terms of the analysis in the discussion paper:

a basic problem in terms of internal dealings creating mismatches is that there will often

be inconsistent recognition of internal dealings between countries, yet in trying to identify

internal dealings as ‘hybrids’, the paper effectively assumes that the dealings are

recognised on both sides – i.e. that both countries are applying a type of symmetrical

FSE approach although very often that will not be the case; and

the paper seems to effectively recommend that countries introduce a ‘subject to tax’ test

in any exemption that they provide for offshore PEs – that is, to try to limit the number of

situations where a deduction/non-inclusion scenario arises, by only allowing an

exemption when the profits are actually taxed in the other country. Australia removed the

‘subject to tax’ condition in s.23AH in 2004, and to reintroduce such a condition would be

a substantial change in policy.

43 In particular, see page 28 of the discussion paper at paragraph 93.



9.2 MAAL and proposed DPT

Other presentations at this conference are focussed on the MAAL and proposed DPT, and as such

we have only commented briefly on the impact of these regimes. However, obviously the regimes

further complicate the PE landscape in Australia, particularly for inbound multinationals.

9.2.1 MAAL

The MAAL was the centrepiece of the Government’s purported crackdown on multinational tax

avoidance in the 2015-16 Federal Budget, and was regarded as the Australian response to the UK

diverted profits tax. It is now contained in s.177DA (schemes that limit a taxable presence in Australia)

and only applies to foreign multinationals. Broadly, it is directed at schemes involving large foreign

multinationals that supply goods or services to Australia and book the revenue offshore (despite

Australian customers dealing mainly with Australian employees) and have a principal purpose of

avoiding an Australian taxable presence.

If the MAAL applies, the relevant tax benefit identified by the ATO is likely to include the income from

the supply that would have been attributable to an Australian PE of the foreign entity, but with the

difficulty that the delineation of the PE would be a purely hypothetical exercise as it would be different

to the actual factual position.

9.2.2 Proposed DPT

The MAAL was followed by the announcement of a proposed DPT, as the multinational tax avoidance

centrepiece of the 2016-17 Federal Budget. Treasury released Exposure Draft legislation on 29

November 2016, with a very short initial three week consultation period. Unlike the MAAL, the DPT is

not confined to foreign multinationals, but is designed to apply to Australian based multinationals as

well. Very broadly, the DPT would sit within the general anti-avoidance framework and is intended to

target global groups who have ‘diverted’ profits from Australia to offshore associates, using

arrangements that have a ‘principal purpose’ of avoiding Australian income or withholding tax and

reduce the tax paid on profits generated in Australia by more than 20%. Income tax would be payable

on the amount of the ‘diverted profit’ at 40%. It is not entirely clear from the Exposure Draft alone how

the DPT would apply in the context of branches. This has been pointed out to Treasury. Submissions

have also requested clarification that the DPT cannot apply in relation to intra-entity dealings.



10 Conclusion

Many of the issues discussed in this paper are not new – the same issues or variants of them have

been around for years if not decades. Branch attribution is a difficult area and will always be more

complex than the tax treatment of and transfer pricing for separate entities. So we should never

expect a simple set of rules in Australian domestic law and our treaties capable of producing a clear

and unambiguous answer in all possible branch attribution scenarios.

However, we should be able to expect that our law would adopt the best possible conceptual

approach to branch attribution that, to the greatest extent possible, reduces uncertainty, produces

results that are consistent with commercial realities and reduces compliance costs. It is especially

important, for taxpayers, administrators and the Revenue that this be done for the largest taxpayers,

especially the banks. If that requires a separate set of rules for those taxpayers then so be it.

This is not what we have at the moment. The law and binding ATO rulings on branch attribution are a

mess – it is only the fact that the ATO is generally adopting a sensible, pragmatic compliance

approach that allows life to go on. But if Australia is about to add further sets of rules to the branch

attribution pile, especially as part of BEPS, then our rules need a solid base. In our view, the FSE may

be able to provide that base.

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