Attributing Profits to a Permanent

Establishment

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Abstract

The permanent establishment concept has a history as long as the

history of double taxation conventions. Currently, the international

tax principles for attributing profits to a permanent establishment

are provided in Article 7 of the OECD Model Tax Convention on

Income and on Capital, which forms the basis of the extensive network

of bilateral income tax treaties between OECD Member countries

and between many OECD and non-OECD member countries. There

is considerable variation in the domestic laws of OECD member

countries regarding the taxation of permanent establishments. In

addition, there is no consensus among the OECD Member countries

as to the correct interpretation of Article 7. This lack of common

interpretation and consistent application of Article 7 can lead to

double, or less than single, taxation. This paper begins by explaining

the importance and the need to have clearly defined rules with regard

to the attribution of profits to a permanent establishment. It then

analyzes the Discussion Draft released by the OECD on August 3,

2004, changes made and very specific issues that need to be resolved

in the said draft. It also examines the various issues that may arise

while implementing the said draft from both business and country

perspectives. Finally, the paper goes on to discuss the implications

of the draft on existing rules for profit attribution rules existing in

different countries like the U.S., Canada, Switzerland and India.

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Contents

1 Introduction 5

1.1 A Brief History of the Permanent Establishment Principle . . 51.2 Purpose of profit attribution provisions . . . . . . . . . . . . 61.3 Importance of the New Discussion Draft . . . . . . . . . . . . 7

2 Basic Approach 8

3 First Step: Determining the activities and conditions of the

hypothesized distinct and separate enterprise 10

3.1 Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103.2 Assets used . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103.3 Risks assumed . . . . . . . . . . . . . . . . . . . . . . . . . . . 103.4 Attributing capital to the permanent establishment . . . . . . 113.5 Determining funding costs . . . . . . . . . . . . . . . . . . . . 12

4 Second step: Determining the profits of the hypothesized

distinct and separate enterprise based upon a comparability

analysis 13

4.1 Applying Transfer pricing methods to attribute profits . . . . 134.2 Comparability analysis . . . . . . . . . . . . . . . . . . . . . . 144.3 Capital assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 144.4 Intangible Property . . . . . . . . . . . . . . . . . . . . . . . . 154.5 Treatment of Dependent Agent Permanent Establishments . . 164.6 Key Entrepreneurial Risk-Taking Functions . . . . . . . . . . 174.7 Documentation . . . . . . . . . . . . . . . . . . . . . . . . . . 17

5 Changes made by the revised Draft 17

5.1 Dealings: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175.2 Allocation of Capital . . . . . . . . . . . . . . . . . . . . . . . 185.3 Determining funding costs . . . . . . . . . . . . . . . . . . . . 185.4 Intangible property . . . . . . . . . . . . . . . . . . . . . . . . 185.5 Notional Interest . . . . . . . . . . . . . . . . . . . . . . . . . 195.6 Dependent Agent Permanent establishments . . . . . . . . . . 195.7 Symmetrical Application of the authorized OECD approach . 20

6 Practical implementation issues 20

6.1 Issues for governments . . . . . . . . . . . . . . . . . . . . . . 216.2 Issues for taxpayers . . . . . . . . . . . . . . . . . . . . . . . . 21

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7 Apparent tensions in the Discussion Draft 22

7.1 Documentation . . . . . . . . . . . . . . . . . . . . . . . . . . 227.2 Separate and Distinct Entity Approach . . . . . . . . . . . . . 227.3 Functional analysis in general . . . . . . . . . . . . . . . . . . 237.4 Assets used and conditions of use . . . . . . . . . . . . . . . . 247.5 Capital Allocation . . . . . . . . . . . . . . . . . . . . . . . . 247.6 Application of Guidelines . . . . . . . . . . . . . . . . . . . . . 257.7 Absence of a definition for “profits” . . . . . . . . . . . . . . . 257.8 Dependent Agent Permanent establishment . . . . . . . . . . . 267.9 Deference to Host Country Determinations . . . . . . . . . . . 27

8 Impact of the Draft Convention on the existing practices

relating to the attribution of profits to a Permanent

Establishment 28

8.1 Issues regarding US bilateral treaty provisions . . . . . . . . . 288.2 Impact of the Discussion Draft on Canada . . . . . . . . . . . 298.3 Swiss approach to the allocation of profits to Permanent

Establishments . . . . . . . . . . . . . . . . . . . . . . . . . . 318.4 Taxation of Business Process Outsourcing Units in India . . . 32

9 Conclusion 33

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1 Introduction

1.1 A Brief History of the Permanent Establishment

Principle

An early version of the permanent establishment principle has been tracedto the late 1800s when European nations negotiated bilateral tax treaties togovern the tax treatment of cross-border economic activity1. The modernversion of the rule arose after World War 1 when nations became concernedthat international double taxation was inhibiting international trade andinvestment. After the War, for example, Canadian tax authorities attemptedto tax incoming mail order sales of a U.S. firm despite the fact that this firmonly advertised its goods in Canada2. The Americans maintained that theUnited States should have the exclusive right to tax these earnings, creatingpotential double taxation of the same business activities.

As a result of growing concern, the League of Nations commissioned agroup of tax experts to come up with a mechanism to ensure that doubletaxation would be avoided. The group arrived at a consensus and developedthe permanent establishment concept that became enshrined in a 1927 modeltax convention and later adopted in the 1963 Organisation for Economic Co-operation and Development (OECD) model tax treaty (as well as subsequentrevisions of this model treaty in 1977 and 1992) 3.

The OECD Model Tax Convention on Income and on Capital (hereinafterreferred to as the Model Treaty) provides the basis for most of the existingbilateral income tax treaties, especially those among developed countries.These treaties generally try to prevent double taxation by assigning priorityrights of taxation between the tax authorities of the two countries. Althoughthe treaties generally confer on the country of residence the priority right totax the income of an enterprise, they create a number of exceptions pursuantto which the country of the source of the income has the priority right oftaxation. One of these exceptions is the right of the country in which anenterprise maintains a permanent establishment to tax the business profits

1The requirement for a fixed place of business within source countries is typically tracedback to the tax treaty between Austria-Hungary and Prussia in 1899. See Arvid A. Skaar,Permanent Establishment: Erosion of a Tax Treaty Principle 65-101 (1991).

2See Michael J. Graetz & Michael M. O’Hear, The ”Orginal Intent” of U.S.

International Taxation, 46 Duke Law Journal 1021, 1088 (1997) (arguing the originalintent of U.S. international income tax policy favored source-based taxation).

3Reforming the permanent establishment principle through a quantitative economicpresence test, Arthur J. Cockfield; See also, ”Commentary on Article 7 of the OECD ModelTreaty: Allocation of Profits to a permanent establishment”, in Taxation of Permanentestablishments, IBFD online publication.

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attributable to that permanent establishment.Once a permanent establishment exists, Article 7 of the OECD Model

Treaty and the comparable article in most bilateral tax conventions permitthe taxing authority of the country in which the permanent establishmentis situated to tax the profits attributable to the permanent establishment.The expanded concept of permanent establishment increases the ability oftax authorities to conclude that a non-resident has an actual or deemedpermanent establishment in a jurisdiction and therefore the need for there tobe a uniform set of principles and procedures for determining the portion ofan enterprise’s profits that are attributable to a permanent establishment. Inthe absence of such uniformity, the risk of both taxing authorities imposingtax on the same income is likely to become a barrier or certainly a disincentiveto cross-border operations.

1.2 Purpose of profit attribution provisions

A: Limitation of source-based taxation

The provisions of Article 7 have long been viewed as designed to preventtaxation of the profits of a non-resident enterprise, except to the extent thatthey are attributable to a permanent establishment of the enterprise. TheOECD Commentary on Article 7, endorses:

“the generally accepted principle of double taxation conventions that anenterprise of one state shall not be taxed in the other State unless it carrieson business in that other State through a permanent establishment situatedtherein...the second and more important principle is that, when an enterprisecarries on business through a permanent establishment in another State, thatState may tax the profits of the enterprise but only so much of them as isattributable to the permanent establishment, in other words that the rightto tax dose not extend to profits that the enterprise may derive from thatState otherwise than through the permanent establishment.”4

The limitations provided by Article 7 reflect the view that the hostcountry should be permitted to tax the profits of a non-resident enterpriseonly if it has substantial connection with that country. Even whereit is agreed that an enterprise has a local permanent establishment,the determination, allocation and verification of income and expensesattributable to the permanent establishment often normally are more difficultfor the host country to ascertain than for the residence country.

4OECD Commentary on Article 7, paras 3 and 5. See also 1996 US Model TechnicalExplanation of Article 7, para 1.

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B. Minimization of double or inappropriate taxation

By minimizing the exposure of non-resident enterprises to taxation injurisdictions with which they have limited contact, the provisions of Article7 have helped to avoid overlapping claims of jurisdiction to tax. Globalbusinesses are encountering increased examination activity on permanentestablishment issues in many countries, typically involving the attributionof substantial profits. Their primary concerns regarding the attribution ofprofits to a permanent establishment are that:

• A consistent approach be applied internationally.

• Adequate certainty be provided in advance regarding the interpretationand implementation of the agreed approach.

• Associated compliance burdens not exceed an administrable level.

Each of these goals must be satisfied if the primary purpose of tax treaties- the avoidance of double or inappropriate taxation, is to be achieved.

In recent years, a growing focus on permanent establishment issuesled to the conclusion that the OECD member countries needed to reacha greater consensus on the principles to be applied in attributing profitsto permanent establishments. Accordingly, beginning in 1998, the OECDundertook an effort to reconsider the interpretation of Article 7 with a viewtowards achieving consensus among the member countries on its correctinterpretation.

The Working Party published an initial discussion draft in February 2001that focused both on general issues (Part1) and issues relating to the bankingsector (Part II). This has been followed by drafts relating exclusively tobanking and global dealing issues (Parts III and IV)

In 2 August 2004, the OECD published a revised version of PartI of its “Discussion Draft on the Attribution of Profits to PermanentEstablishments”, The new Discussion Draft revises and updates thedescription of the key building blocks and general principles to revise therules on income attribution applicable under Article 7 of the OECD ModelTax Treaty (the “Model Treaty”).

1.3 Importance of the New Discussion Draft

Revised Part I of the Discussion Draft is an extraordinarily importantdocument. The OECD suggests that the thinking reflected in thisdocument is now sufficiently far advanced that it represents the “authorizedOECD approach” to attributing profits to permanent establishments. The

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implication is that, OECD member country competent authorities will inall likelihood immediately begin to apply the principles contained in theAugust 2, 2004 Discussion Draft in resolving cases involving permanentestablishments. The OECD suggests that any future changes to thisdocument will be only for the purpose of clarification and should not beexpected to change the substance of the tax rules set out in the August 2draft.

The rules of the Discussion Draft apply principally to companies thatoperate in branch form in treaty jurisdictions. However, because thisdocument is issued at a time when tax authority assertions of the existenceof permanent establishments are proliferating in transfer pricing and othertax audits around the globe, the rules for attributing income to permanentestablishments contained in the Discussion Draft may often be relevant tothose operating in subsidiary and partnership form 5.

2 Basic Approach

The starting point of the OECD analysis is that the income of a permanentestablishment should be determined on the basis of an assumption thatthe permanent establishment should be viewed as a “functionally separateentity.” 6.

Under this approach, paragraph 1 of Article 7 is interpreted as notaffecting the determination of the quantum of the profits that are to beattributed to the permanent establishment, other than providing specificconfirmation that, “the right to tax of (the host country) does not extend toprofits that the enterprise may derive from that State otherwise than throughthe permanent establishment. The terms ‘profits of an enterprise’ and ‘onlyso much of them’ in Article 7 are interpreted as referring only to the profits ofthe business activity in which the permanent establishment has participated7.

The treatment of a permanent establishment as a distinct and separate

5Attributing Income to Permanent Establishments, By Joseph Andrus, Adam Katz,Richard Collier, Annie Devoy, and Isabel Verlinden (PricewaterhouseCoopers)

6Under this approach, paragraph 1 of Article 7 is interpreted as not affecting thedetermination of the quantum of the profits that are to be attributed to the PE, otherthan providing specific confirmation that, the right to tax of the host country does notextend to the profits that the enterprise may derive from that state otherwise than throughthe permanent establishment. (See Para 19 of the Discussion Draft)

7Tax Treatment of “Dealings” Between different parts of the same enterprise underArticle 7 of the OECD Model: Almost a century of uncertainty; Raffaele Russo, OfficialJournal of the International Fiscal Association Volume 58 Number 10, October 2004.

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enterprise has both a strong base in historical international practice as well asin a theoretical foundation that will serve well in ensuring that the taxationof permanent establishments comes within the purview of the arm’s lengthstandard8.

Consistent with the basic methodology set out in earlier versions of theDiscussion Draft, income is then attributed to a permanent establishment byapplying the following steps:

1. A detailed functional analysis must be undertaken in order toidentify the location of key entrepreneurial risk-taking functions in thepermanent establishment and its home office9 .

2. Assets and risks of the business are attributed to the permanentestablishment and home office based on the location of the performanceof the key functions as identified in the functional analysis10 . Thepart of the enterprise attributed the asset will also be attributed anyassociated profit.

3. Free capital is allocated to the permanent establishment in proportionto the assets and risks allocated to the permanent establishment.

4. income is allocated to the permanent establishment by applying theOECD Transfer Pricing Guidelines to the notional separate legal entityassuming it has the assets, risks, and capital determined under the firstthree steps and deals with its home office on an arm’s-length basis.

8Letter dated 11th October 2004 from the BIAC (Business and Advisory Committeeto the OECD) on the Discussion Draft to the OECD on the Discussion draft.

9The determination should be on a case by case basis as the key entrepreneurial risk-taking functions and their relative importance will depend on the particular facts andcircumstances.

10The functional analysis will examine all the facts and circumstances to determine theextent to which the assets of the enterprise are used in the functions of the PE and theconditions under which the factors are used, including the factors to be taken into accountto determine which part of the enterprise is regarded as the economic owner of the assets,See Para 58 of the Discussion Draft.

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3 First Step: Determining the activities and

conditions of the hypothesized distinct and

separate enterprise

3.1 Functions

The first step of the authorized OECD approach determines the activitiesand conditions of the hypothesized distinct and separate enterprise. Thefunctional and factual analysis takes account of the functions performedby the personnel of the enterprise as a whole including the permanentestablishment-“people functions” 11 and assesses what significance if anythey have in generating the profits of the business. The functional analysisneeds to be carried out in a thorough and detailed manner in orderto establish the exact nature of the function being performed. This isbecause where the functional analysis has determined that the permanentestablishment has performed key entrepreneurial risk taking functions, thepermanent establishment will be attributed the assets and risks associatedwith those functions. This in turn leads to the attribution to the permanentestablishment of the income and expenses associated with those assets andrisks.

3.2 Assets used

To the extent that assets are used in the functions performed by thepermanent establishment, the use of those assets should be taken intoaccount in attributing profit to the functions performed by the permanentestablishment. Regard has also to be given as to the conditions under whichthe asset is used; the capacity in which the permanent establishment usesthe asset will have an impact on the amount of profits attributed to it.

3.3 Risks assumed

The division of risks and responsibilities within the enterprise will have to be,“deduced from conduct of the parties and the economic principles that governrelationships between independent enterprises” 12. This deduction must be

11People functions can range from the routine to the key entrepreneurial risk takingfunctions of the business. The latter are those which require active decision making withregard to the most important profit generators of the business and so it will be particularlyimportant for these to be identified under the functional analysis.

12Discussion Draft Para 25.

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accompanied by analyzing the internal practices of the enterprise, by makinga comparison with what similar enterprises would do and by examining anyinternal documentation showing how the attribution of risk has been made.

3.4 Attributing capital to the permanent

establishment

Under the authorized OECD approach-

1. The permanent establishment is treated as having an appropriateamount of capital in order to support the functions it performs, theassets it uses and risks it assumes.

2. An arm’s length amount of “free capital”13 is attributed to thepermanent establishment.

The Discussion draft provides several alternative methods for attributing anarm’s length amount of capital to a permanent establishment. It indicatedthat this was done because it was not possible to obtain an internationalconsensus on a single allocation method, which it suggests was due to thefact that “there is no single approach which is capable of dealing withall circumstances” 14 . The Discussion draft accordingly endorses fouralternative approaches, which differ substantially:

• The capital allocation approach, which involves allocating anenterprise’s actual ’free capital’ in accordance with the attribution ofassets owned and risks assumed.

• The economic capital allocation approach, which involves allocatingeconomic capital based on all economic risks.

• The thin capitalization approach, which requires the permanentestablishment to have the same amount of ‘free capital’ as anindependent enterprise would have if it were carrying on the sameor similar activities under the same or similar conditions in the hostcountry.

• The safe harbour approach, a quasi-thin capitalization approach,which requires the permanent establishment to at least have the same

13The term “free capital” is defined as an investment which does not give rise to aninvestment return that is deductible for tax purposes under the rules of the host countryof the PE.

14See Discussion Draft Para 142

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amount of ‘free capital’ required for regulatory purposes as would anindependent enterprise operating in its sector in the host country,potentially combined with a safe harbour.

To the extent that taxpayers are allowed to choose from among the alternativemethods, the resulting flexibility may assist them in applying the authorizedOECD approach. However, it is not entirely clear from the Discussion draftwhether taxpayers are free to make this choice, or whether it is a decision tobe made by each OECD member state.

3.5 Determining funding costs

Once the amount of “free capital” has been determined, the balance ofthe funding requirement is the amount by reference to which the interestdeduction is calculated. There is more than one authorized approach toattributing interest bearing debt and to determining the rate of interest tobe applied to that debt.

• Treasury Dealing: While movement of funds between parts ofthe enterprise do not necessarily give rise to dealings, there arecircumstances under which they could be recognized as internal interestdealings within non financial enterprises, for the purposes of rewardinga treasury function.

• Tracing approach: Under this approach, any internal movement offunds provided to a permanent establishment are traced back to theoriginal provision of funds by third parties.

• Fungibility approach: Where, money borrowed by a permanentestablishment of an enterprise is regarded as contributing to the wholeenterprise’s funding needs, and not particularly to the permanentestablishment’s funding needs. This approach ignores the actualmovement of funds within the enterprise and any payments of inter-branch or head office/branch interest. Each permanent establishmentis allocated a portion of the whole enterprise’s actual interest expensepaid to third parties on some pre-determined basis.

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4 Second step: Determining the profits of

the hypothesized distinct and separate

enterprise based upon a comparability

analysis

The authorized OECD approach is to undertake a comparison of dealingsbetween the permanent establishment and the enterprise of which it is a part,with transactions between independent enterprises. By analogy with theGuidelines15 , comparability in the permanent establishment context meanseither that there are no differences materially affecting the measure used toattribute profit to the permanent establishment, or that reasonably accurateadjustments can be made to eliminate the material effects of such differences.

4.1 Applying Transfer pricing methods to attribute

profits

A permanent establishment differs from a subsidiary and is not legally oreconomically separate from the enterprise. Therefore, dealings between apermanent establishment and the enterprise of which it is a part normallydon’t have legal consequences for the enterprise as a whole implying agreater need for scrutiny16 of dealings between a permanent establishmentand the rest of the enterprise. The starting point for the evaluation of apotential “dealing” will normally be the accounting records of the permanentestablishment showing the purported existence of such a ”dealing”. Underthe authorized OECD approach that “dealing” as documented by theenterprise will be recognized for the purposes of attributing profit, providedit relates to a real and identifiable event17 . A functional analysis should beused to determine whether such an event has occurred and should be takeninto account as an internal dealing of economic significance.

One of the relevant 1995 Guideline principles requires that “dealings”of an enterprise with its permanent establishments are to be respected in

15OECD Transfer Pricing Guidelines for multinational enterprises and taxadministrations, 1995.

16This greater scrutiny means a threshold needs to be passed before a dealing is acceptedas equivalent to a transaction between independent enterprises acting at arm’s length andplacing the onus on the taxpayer to demonstrate that it would be appropriate to recognizethe dealing.

17For example, the physical transfer of stock in trade, the provision of services, use ofan intangible asset, a change in which part of the enterprises using a capital asset, thetransfer of a financial asset, etc

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much the same way as transactions between members of a multinationalgroup, provided that such dealings are not inconsistent with the substance ofthe particular business transactions or activities. The tax authorities must,therefore, refrain from restructuring actual transactions and documenteddealings of the two parties involved.18

A second relevant 1995 Guideline principle is the recognition that transferpricing is not an exact science and that, therefore, as long as transfer pricesare within a range of comparable prices, no adjustment is necessary. Inthis respect, it is very important, that the enterprises are given sufficientflexibility.19

These two important principles protect taxpayers against unwarrantedadjustments of transfer prices by taxing authorities. In competent authoritycases, the burden of proof lies with the country that proposes an adjustment,which is important in the interest of minimizing the likelihood of doubletaxation.

4.2 Comparability analysis

According to the guidelines there are five factors determining comparabilitybetween controlled and uncontrolled transactions; characteristics of propertyor services, functional analysis, contractual terms, economic circumstancesand business strategies.

The comparability analysis might determine that there has been aprovision of goods, services or assets between one part of the enterprise andanother that is comparable to a provision of goods, services or assets etc.between independent enterprises. Accordingly, the part of the enterprisemaking such a “provision” should receive the return, which an independententerprise would have received for making a comparable “provision” in atransaction at arms length. Notwithstanding the fact that the permanentestablishment is not a distinct and separate legal entity from the rest of theenterprise, the same economic goals can nonetheless be replicated as betweena permanent establishment and the rest of the enterprise as a notionalconstruct to assist in the attribution of profits to a permanent establishment.

4.3 Capital assets

Here the first step would be to determine whether the enterprise itself ownsthe assets, leases it or rents it from an independent enterprise. In this

18See Paras 1.36 and 1.37 of the 1995 Guidelines.19See Para 4.17of the 1995 Guidelines.

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respect documentation of the arrangement will be of assistance, however,if the documentation does not reflect the true conduct of the parties, theactual conduct of the permanent establishment and the enterprise will needto be considered in order to establish the true nature of the arrangement.The Functional analysis will determine where the economic ownership of anasset belongs depending upon which part or parts of the enterprise performthe key entrepreneurial risk-taking functions in respect of that asset.

4.4 Intangible Property

The draft begins from the position that existing guidance under Article 5and 7 is minimal and further states that the position reached in the 1994Report is defective in many respects.

According to the Draft, the economic ownership of intangible propertyshould be made on a similar basis as the attribution of assets; that is,on the basis of where the key entrepreneurial risk-taking functions wereperformed. For example, a transfer may be documented as a “rental”, but thepermanent establishment is in fact responsible for its regular maintenance,recruits personnel to conduct unforeseen repairs and further decides whetherto continue use or replace the asset. In the said circumstances economicownership of the asset appears to have been transferred to the permanentestablishment 20.

With respect to internally developed trade intangibles, the revisedDiscussion draft takes the position that the key entrepreneurial risk-taking functions are those functions related to the development of theintangible. Active decision-making and day-to-day management of researchand development programs would, in most instances, be the key factors.

The Discussion draft states: “it is not so much the intention to use theintangible per se that should be a factor in determining economic ownershipof an intangible, but the extent to which the intended user performed thekey entrepreneurial risk taking functions, e.g., by taking (or taking part in)the initial decision to develop the intangible or undertaking the day to daymanagement of the research and development program.”

Under the OECD methodology applicable to permanent establishments,economic risks cannot be separated from functions, so that a permanentestablishment could not become the economic owner of intangibles merelyby virtue of paying the bills for research, unless it also participates in themanagement and performance of the research.

With regard to marketing intangibles the Discussion draft admits that it

20See Para 204 of the Discussion Draft.

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may be more difficult to identify which functions and risks actually relate tothe creation and ongoing maintenance of the global marketing intangibles.However, it states that the same principles should apply to determine the soleor joint ”economic” ownership of marketing intangibles as trade intangibles.

4.5 Treatment of Dependent Agent Permanent

Establishments

According to the Discussion draft in cases where a permanent establishmentarises from the activities of a dependent agent, the host country willhave taxing rights over two different legal entities- the dependent agententerprise (which is a resident of the host country) and the dependent agentpermanent establishment (which is a permanent establishment of a non-resident enterprise)

The host country can only tax the profits of the non-resident enterprisewhere the functions performed in the host country on behalf of the non-resident enterprise meet the permanent establishment threshold as definedunder Article 5. Further, the quantum of that profit is limited to the businessprofits attributable to operations performed through the dependent agentpermanent establishment in the host country.

The same principles that are used for other types of permanentestablishments will be used to attribute profits to the dependent agentpermanent establishment. The dependent agent permanent establishmentwill be attributed the assets and risks of the non-resident enterprise relatingto the functions performed by the dependent agent permanent establishmenton behalf of the non-resident, together with sufficient free capital to supportthose assets and risks. The OECD approach then attributes profits to thedependent agent permanent establishment on the basis of those assets, risksand capital.

The analysis would also focus on the nature of functions carried by thedependent agent on behalf of the non-resident enterprise and in particularwhether it undertakes key entrepreneurial risk-taking functions. Here, ananalysis of the skills and expertise of the employees of the dependent agententerprise is to be considered, in order to determine whether the dependentagent acts on behalf of the non-resident enterprise in performing negotiatingor risk-management functions.

In practice, the dependent agent enterprise may not perform keyentrepreneurial risk taking functions and if it does not then the attribution ofthe assets, risks and profits to the dependent agent permanent establishment,are correspondingly reduced or eliminated.

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The authorized OECD approach recognizes that it is possible inappropriate circumstances to attribute profits in addition to the arm’s lengthreward that has been

4.6 Key Entrepreneurial Risk-Taking Functions

As noted above, the entire scheme for allocating income to permanentestablishments turns on identifying the geographic location of theperformance of key entrepreneurial risk-taking functions.

The Discussion Draft defines key entrepreneurial functions as “thosewhich require active decision making with regard to the most important profitgenerators of the business.” The identification of these factors is a highly fact-specific exercise. The Discussion Draft suggests that key entrepreneurial risk-taking functions will not necessarily be the same in any two analyses, evenfor enterprises in the same industry.

4.7 Documentation

The Discussion Draft suggests that taxpayers should prepare documentationsupporting their application of the Discussion Draft rules in accordance withthe Transfer Pricing Guidelines.

5 Changes made by the revised Draft

5.1 Dealings:

Various commentators found fault with the 2001 Draft for not providing asufficiently clear explanation of the concept of “dealings”21 . In particular,to what extent would the tax authorities be bound by the characterizationof dealings by the taxpayer? The Discussion draft now provides furtherguidance on this issue. It states that, because the dealings between apermanent establishment and the rest of the enterprise normally have nolegal consequences the onus is placed on the taxpayer to demonstrate that itwould be appropriate to recognize the dealings22.

21”Summary of the Proceedings of an invitational seminar on the attribution of profits topermanent establishments.”, B.J. Arnold & M.Darmo, (2001), vol. 49, no.3 Canadian TaxJournal, 525-549 (The OECD uses the term “dealings” as being analogous to the conceptof transactions taking place between separate enterprises: i.e., a dealing is a “transaction”that takes place between the PE and another part of the same legal enterprise.)

22Discussion draft Para 174.

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5.2 Allocation of Capital

The new draft continues to provide that a portion of the enterprise’s capitalmust be attributed to the permanent establishment to support the functionsit performs, the assets it uses and the risks it assumes, but provides additionalguidance on how this is to be done “to ensure that a fair and appropriateamount of profits is allocated to the permanent establishment.” In particular,the new draft significantly modifies and expands the discussion of capitalallocation, rejecting the previous preference for a single method in favorof providing several alternative methods for determining an arm’s lengthamount of capital to be attributed to the permanent establishment23 .

5.3 Determining funding costs

The application of the authorized OECD approach represents a significantdeparture from the existing commentary by authorizing an approach toattributing interest expense based on the recognition of internal interestdealings in non-financial enterprises in appropriate circumstances. Theauthorized OECD approach is able to do this because it is rooted in a detailedfunctional and factual analysis, which attributes functions, assets and risksto the permanent establishment, then attributes a sufficient amount of “freecapital” to support the assets used and the risks assumed.

5.4 Intangible property

The Discussion draft discusses the determination of the “economic owner” ofintangible property, for both internally developed and acquired intangiblesand for trade and marketing intangibles. This is a modification from theoriginal draft which provided that that it might be appropriate to allocateintangible assets between a permanent establishment and the home office byreference to the place where the intangible was used or intended to be used.The ownership and use of trade intangibles are said generally to depend onwhich part of the enterprise undertakes the “active decision-making” relatingto the development or acquisition of the intangible and the “day-to-daymanagement” of the risks associated with its development or use. In thecase of marketing intangibles, the revised draft concludes that it generallyis not possible to identify one part of the enterprise as the owner of the

23OECD Revises Proposed Changes on the attribution of Profits to a PermanentEstablishment, as Examination Activity Increases, Mary C.Bennett and Carol A.Dunahoo, Washington D.C.

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global marketing intangibles, although this may sometimes be possible formarketing intangibles specific to the permanent establishment’s host country.

The shift of the focus from potential use to participation in developmentas the key factor to consider is a welcome development.

5.5 Notional Interest

The existing Commentary to Article 7 does not authorize a deduction inrespect of internal debts and receivables in computing the profits of apermanent establishment generally, except for payments of interest actuallymade for different parts of a financial enterprise. Thus, making a distinctionbetween financial and non-financial enterprises. The 2001 Draft proposedto continue the approach of not recognizing internal “interest” dealings fornon-financial enterprises. The Discussion draft significantly departs fromthis approach by allowing the recognition of internal interest dealings innon-financial enterprises in appropriate circumstances24.

5.6 Dependent Agent Permanent establishments

The 2001 Draft did not address the specific issues that might arise in thecontext of dependent agent permanent establishments. But the Discussiondraft added a separate section examining the special considerationsapplicable to dependent agent permanent establishments. This sectionprovides “specific guidance on the attribution of profits to a dependent agentpermanent establishment that is consistent with the arm’s length principle inaddition to the arm’s length price for services performed by the agent”. Asa result of this approach, a dependent agent permanent establishment canbe allocated income over and above the arm’s length fee already due to thedependent agent permanent establishment .25

In an earlier draft of Part III of the Discussion Draft, relating to globaldealing in financial products, the OECD had suggested that compensation inaddition to the arm’s-length fee to the dependent agent should be attributedto the permanent establishment. This was by far the most intenselydebated point at the recent public consultation in Geneva, Switzerland heldto discuss the OECD income attribution project with affected businesses.Notwithstanding the adverse comments from affected businesses in Geneva,revised Part I clearly takes the position that a dependent agent permanentestablishment can, under appropriate circumstances, be allocated income

24Discussion draft Paras 149 and 167.25Discussion draft Para 267.

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over and above the arm’s-length fee due to the dependent agent that givesrise to the permanent establishment. This income arises when employees ofthe dependent agent perform key entrepreneurial risk-taking functions andtherefore attract to their location assets and risks under the methodologysummarized above. The assets and risks belong to the principal, not theagent, but because the functions giving rise to those assets and risks occurin the agent’s country, they should properly be allocated to the permanentestablishment in that country, not to the home office.

5.7 Symmetrical Application of the authorized OECD

approach

One consequence of the authorized OECD approach is that the “functionallyseparate entity” approach is used irrespective of whether a country is the hostcountry or the home country, or whether it gives relief from double taxationby exemption or credit methods. This common interpretation of Article 7should reduce the incidence of double taxation because of the differencesin the way countries compute the quantum of profit to be attributed to apermanent establishment under the arm’s length principle. The developmentof the authorized OECD approach therefore represents a clear improvementover the existing situation, even if it does not address all issues.

In situations where the host country applied one method of attributingprofits and the home country applied another approach, taxpayers whoprepared symmetrical accounts 26 in the way recommended by thecommentary were, in the past, exposed to the risk of double taxation. Thisproblem has been solved under the authorized OECD approach whereby,taxpayers who apply symmetrical accounts applying the functionallyseparate entity approach should, in principle, be able to satisfy both taxadministrations that an arm’s length amount of profits have been attributedto the permanent establishment.

6 Practical implementation issues

The new approach as provided under the Discussion draft will create a majorchange in the way profits must be attributed to permanent establishments,and relief from double taxation must be provided. To ensure successful

26Symmetrical preparation of accounts means that “the values of transactions or themethods of attributing profits or expenses in the books of the permanent establishmentcorresponded exactly to the values or methods of attribution in the books of the headoffice.

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implementation of the Draft, domestic laws of most OECD countries mustbe amended to conform to the new approach.

There are questions concerning how the residence country can relievedouble taxation based on either the exemption or the credit method (article23 A, or 23B):

1. Whether, the relief must be based on the profits that have effectivelybeen taxed, or on the profits that would result from the application ofthe new approach

2. Whether relief must be based upon the taxable profits calculated underthe rules of the residence country or the source country. Where thebilateral rules are clear in that respect, the question remains as towhether or not a residence country is prepared to accept the allocationmade by the host country or vice versa.

To ensure the consistent and fair application of the authorized OECDapproach to taxpayers, adequate guidance must be provided in advanceregarding the operation of that approach both to governments and totaxpayers.

6.1 Issues for governments

Tax administrations can expect to experience an increased demand forexamination and other resources to administer the complexities of theauthorized OECD approach. Similarly, they should expect an increaseddemand for competent authority resources to address the increased number ofcross-border disputes that will arise upon implementation of that approach.

6.2 Issues for taxpayers

The Discussion draft places increased emphasis on documentation and makesit clear that the onus will be on the taxpayers to provide the requisitedocumentation of the manner in which they attribute profits to theirpermanent establishments. This will require the documentation in manycases of internal dealings for which no documentation is currently maintainedor required, especially in the case where the taxpayer did not intend to createa permanent establishment.

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7 Apparent tensions in the Discussion Draft

7.1 Documentation

One obvious conflict present in the Discussion draft exists between theOECD’s emphasis of the need for taxpayers to document their dealings andthe warning that any such documentation will be relied upon only to a limitedextent.

For instance, the OECD insists on determining the economic ownership,as opposed to simply accepting the legal ownership (in this context,determined by how the ownership of the assets is recorded in the booksof the enterprise) of a capital asset. It is true that an enterprise cannotenter into legally binding agreements with itself, as can be accomplishedbetween related companies. But if a hypothetical separate entity is subjectto tax, then hypothetical agreements giving effect to various intra-companyarrangements that are documented in advance should also be the basis ofevaluation by the tax authorities of the bona fides of such arrangements. TheDiscussion draft presumes that such documentation is inherently suspiciousand will require cautious reassessment by tax administrators to determinewhether it reflects the economic reality. Further, there are situations wheredocumentation is not commonly prepared by taxpayers, yet the preferredOECD approach requires that such documentation be prepared on a going-forward basis.

7.2 Separate and Distinct Entity Approach

The basic premise of the Discussion draft is that the permanent establishmentshould be hypothesized as a separate and distinct entity for the purposesof attributing profits to that permanent establishment. However, someof the OECD positions, as outlined in the Discussion draft, seem to beinconsistent with this general hypothesis. This situation arises in the contextof attributing credit rating to the permanent establishment. The OECDsuggests that in attributing “free capital”to a permanent establishment, thecredit-worthiness of the enterprise as a whole should be attributed to thepermanent establishment. This appears contradictory with hypothesizingthe permanent establishment as a separate and distinct entity. The OECDsuggests that the “factual situation of the enterprise” is such that thesynergies and risks generated by the enterprise, resulting in the credit rating,cannot be assigned to a particular part of the enterprise, as these things are“fungible”27 ; however, this is precisely what the OECD approach requires,

27Discussion Draft Para 93.

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i.e., the execution of a functional and factual analysis to identify whatconsiderations should be associated with a particular part of the enterprise.

7.3 Functional analysis in general

The 2004 Report does not provide adequate guidance regarding the mannerin which activities are to be taken into account in attributing profitsto the permanent establishment. It focuses heavily on where the ‘keyentrepreneurial risk taking functions’ are performed and what their relativeimportance is. It notes, however, that these key functions will vary fromsector to sector and even from enterprise to enterprise and concludes thatthe determination must be made on a case-by case basis because it ‘willdepend on the particular facts and circumstances’

The Draft further requires analysis of all activities performed on behalfof the permanent establishment, and of all activities performed by thepermanent establishment on behalf of other parts of the enterprise. It failsto give practical guidance on how to deal with situations where key functionsthat are closely related are carried out partly within and partly outsidethe host country, or to acknowledge that, where some or all of the relevantactivities occur outside of the host country, the necessary information maynot be readily available 28.

For instance, suppose an enterprise resident in Country A sells itsproducts to customers in Country B through a permanent establishmentlocated in Country B where the enterprise has a dependent agent whoregularly negotiates and concludes contracts on behalf of the enterprise.Suppose further that the result of such sales is that the enterprise holdsreceivables from its customers. In that case, the enterprise would have todetermine where the ‘key entrepreneurial risk taking functions’ are performedthat relate to the holding of those receivables. Should these functions beviewed as attributable to Country B, because that is where the sales areconcluded that give rise to the receivables? Should they be viewed asattributable to Country A, on the grounds that the enterprise’s head officepersonnel there set the criteria for extending credit to customers in CountryB? Should it matter whether the enterprise records bad debts on the booksof its Country A head office or Country B permanent establishment?

The Discussion draft does not provide much in the way of guidance forresolving these very practical issues. This is merely an example of oneof the several situations that may arise while attempting to identify the‘key entrepreneurial risk taking functions’ associated with the activities of

28Supra note 23.

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the permanent establishment. What is clear is that the profit attributionexercise outlined in the Discussion Draft will always be extraordinarily factintensive, that primary weight is placed on the functional analysis, and that,as with all fact-intensive exercises, this process will be one open to substantialdisagreement and dispute.

7.4 Assets used and conditions of use

According to the draft, the economic ownership of an asset ‘belongs with thepart or parts of the enterprise performing in particular the key entrepreneurialrisk taking functions in respect of that asset, and that the actual acquisitionof an asset by one part of the enterprise is not determinative in assigningits economic ownership within the enterprise’29. What is not clear from thislanguage is whether the focus is intended to be on the key entrepreneurialrisk taking functions in respect of the acquisition of the asset or in respectof its use.

Further, the draft provides little practical guidance to the taxpayersor tax authorities on the types of evidence that would be sufficient todemonstrate that assets (including, e.g. financial assets and intangible assets)used by a permanent establishment are properly considered loaned, leasedor licensed to the permanent establishment, rather than owned by it, forpurposes of determining the amount of profits attributable to the permanentestablishment.

7.5 Capital Allocation

To the extent that taxpayers are allowed to choose from among the alternativemethods the differences among the methods of capital allocation and theirnumerous weaknesses are likely to give rise to disputes between taxpayersand authorities and even among authorities. Although the Discussion draftprovides a certain amount of detail and states an intention to ‘set forth a clearprinciple and provide practical guidance on how to apply that principle inpractice’, it does not furnish adequate guidance to ensure clear and consistentapplication 30.

The approach in the discussion draft according to which, the host countrycan choose an allocation of capital, which then has to be accepted by thehome country when providing relief from double taxation is neither supported

29Discussion draft Para 199.30See, The attribution of profits to a permanent establishment: Issues and

recommendations, Mary C. Bennett and Carol A. Dunahoo, Baker & Mckenzie LLP,Washington, INTERTAX Volume 33 Issue 2, Kluwer Law International 2005.

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by the OECD Model Convention nor the Commentary, and is contrary tothe arm’s length principle. It is difficult to conceive that any country wouldbe prepared to accept the proposition that the host country will have theright to determine not only the attribution of capital, but also the place atwhich key entrepreneurial risk-taking functions are located and the mannerin which the assets, risks and functions are to be allocated 31.

7.6 Application of Guidelines

The conceptual link between attribution of profits to a permanentestablishment and the arm’s length principle is apparent; it must beimplemented in practice. The Discussion draft is headed in the properdirection in this regard32.

The Discussion draft calls for the imputation of contractual terms tointernal dealings within the enterprise, by analogy to the contractual termsof comparable transactions between independent enterprises33. This willrequire a series of subjective determinations that will inevitably lead todisagreements at least in some cases. Further, the absence of contracts inthe permanent establishment context, and of documentation especially in thecase of dependent agent permanent establishments, will make the applicationof a proper comparability analysis very difficult.

The Discussion draft contains very little discussion on which transfer-pricing method is to be chosen, besides indicating that the transfer pricingguidelines are to be applied by analogy. A more detailed discussion is requiredin this regard thereby providing guidance to taxpayers on this issue andconfirming an adequate level of agreement on it among tax authorities.

7.7 Absence of a definition for “profits”

The Discussion draft acknowledges that problems may arise where the hostcountry’s domestic rules prescribe one authorized approach for attributingcapital and the domestic rules of the home country prescribe a differentapproach. The OECD suggests that a solution to this problem can be foundin the existing Commentary to Article 23 of the convention, where the homecountry is supposed to compute “profits” as defined by its domestic law.Further, there is no definition of the term ”profits” in article 7, the hostcountry may apply the relevant formulation found in its domestic law. The

31See Letter dated 11th October 2004 from the BIAC (Business and Advisory Committeeto the OECD) on the Discussion Draft to the OECD on the Discussion draft.

32Ibid.33Discussion draft para 179.

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OECD then acknowledges that the amount of profits calculated by the homeand host countries could very well be different, but notes that it thoughtit inappropriate to address this issue, as this would require changes tomember countries’ domestic laws dealing with double taxation. As pointedout by some commentators, the words of Article 7(2) expressly mandatingthat the profits attributable to a permanent establishment should apply ineach contracting state would be virtually meaningless if the home and hostcountries determined the profits of a permanent establishment under theirrespective domestic laws.34

7.8 Dependent Agent Permanent establishment

Revised Part I of the Discussion Draft clearly states intent to apply itsprovisions to dependent agent permanent establishments (i.e., permanentestablishments created when one entity operates in a country on behalf of anonresident legal entity by habitually exercising the authority to contract onbehalf of that entity).

In a global dealing context this analysis would have the effect of assigningto the dependent agent permanent establishment part of the return to thecapital of the enterprise. In the context of a sales agent relationship (orperhaps a commissionaire) functions that could attract income to the hostcountry of the dependent agent permanent establishment might be holdingor managing inventory in that country (causing inventory risk to take itssitus in the permanent establishment), conducting research, or other keyentrepreneurial functions. One very serious potential concern seems tohave been allayed in the Discussion Draft, however. There had been somesuggestion that in certain circumstances under the OECD methodology theselling activities of a sales agent or commissionaire could cause marketingintangibles (and the returns on those intangibles) to be allocated to the hostcountry of a dependent agent permanent establishment. However, paragraph272 of revised Part I of the Discussion Draft contains the following statement:

In particular, it should be noted that the activities of a mere sales agentmay well be unlikely to represent the key entrepreneurial risk-taking functionsleading to the development of a marketing or trade intangible so that thedependent agent permanent establishment would generally not be attributedprofit as the “economic owner” of that intangible.

This statement should limit the ability of tax authorities to assert thatmarketing intangible related returns can be allocated properly to an allegeddependent agent permanent establishment. This, in turn, will significantly

34Supra note 26 at Para. 12.

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reduce the leverage that a taxing authority can potentially create by assertingthe existence of a dependent agent permanent establishment in the contextof a normal transfer pricing audit of a sales agent or commissionaire.

The narrow focus on ‘key entrepreneurial risk taking functions’ ignoresthe value of capital raising and capital and risk management as well asother significant functions typically undertaken in the home office or anothercentralized location of a securities firm and thus results in an overallocationof profits (or loss) to the dependent agent permanent establishment35 . TheDiscussion draft states that it does not intend to expand or otherwise modifythe existing dependent agent permanent establishment definition, but doesmake it clear that a related entity acting as a sales agent in a countrymay give rise to a dependent agent permanent establishment. Under thesecircumstances, the question arises as to whether any income in addition tothe arm’s-length fee to the sales agent for its services, determined undernormal transfer pricing principles, should be allocated to the permanentestablishment so created.

7.9 Deference to Host Country Determinations

While it is clear that free capital must be allocated among branches based ona functional analysis, it has been impossible for the OECD member countriesto finally agree on a single detailed method for making these allocations in abanking context. This has led to the articulation of an interesting canon oftreaty interpretation, which is elaborated in revised Part I.

Essentially the position is that where more than one method of attributingincome and deductions is “approved” or “appropriate” under a treaty, thehost country may apply any of the approved methods. The taxpayer’s homecountry is then obligated to grant relief from double taxation, even thoughits own domestic tax rules are different and acceptable under the treaty.

An unfortunate consequence of this approach is that a global enterprisemay find that it needs to undertake allocation exercises in different ways indifferent countries and its home country may be obliged to provide relief fromdouble taxation for all of them.

What remains somewhat unclear is the extent to which foreign taxcredit limitation and sourcing rules in the home country’s domestic law andpreserved under Article 23 of the Model Treaty, may operate to preventfull double tax relief in situations in which host countries follow differentapproved rules.

35Letter dated 27th April 2005 from the Securities Industry Association to Mr. JeffreyOwens, Director, Centre for Tax Policy and Administration, OECD.

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8 Impact of the Draft Convention on

the existing practices relating to the

attribution of profits to a Permanent

Establishment

8.1 Issues regarding US bilateral treaty provisions

To date, the US has agreed in only two recent treaty agreements - thosewith the UK and Japan - to the application by analogy of transfer pricingprinciples to attribute profits to a permanent establishment36 .

The 24 July 2001 exchange of notes accompanying the treaty with theUK provides in relevant part, in connection with Article 7, that:

‘It is understood that the OECD Transfer Pricing Guidelines will apply,by analogy, for the purposes of determining the profits attributable toa permanent establishment. Accordingly, any of the methods describedtherein-including profits methods-may be used to determine the income of apermanent establishment so long as those methods are applied in accordancewith the Guidelines. In particular, in determining the amount of attributableprofits, the permanent establishment shall be treated as having the sameamount of capital that it would need to support its activities if it were adistinct and separate enterprise engaged in the same or similar activities’.

The notes subsequently exchanged on 6 November 2003 in connectionwith the signature of the US-Japan Treaty state this point somewhatdifferently: ‘It is understood that the principle as set out in paragraph 1of Article 9 of the Convention may apply for the purposes of determining theprofits to be attributed to a permanent establishment. It is understood thatthe provisions of Article 7 of the Convention shall not prevent the ContractingStates from treating the permanent establishment as having the same amountof capital that it would need to support its activities if it were a distinct andseparate enterprise engaged in the same or similar activities.’

There is a substantive difference in these formulations. The UKlanguage is mandatory (’shall’), while the Japanese language appears to bediscretionary (‘may’, ‘shall not prevent’). The Japanese language is puzzling,considering that the 2001 Draft does not characterize the application of theauthorized OECD approach in the treaty as optional. The attribution ofcapital appears to be left to the discretion of the Contracting States, however,

36See, The attribution of profits to a permanent establishment: Issues andrecommendations, Mary C. Bennett and Carol A. Dunahoo, Baker & Mckenzie LLP,Washington, INTERTAX Volume 33 Issue 2, Kluwer Law International 2005.

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it is not clear whether the application of Article 9 (transfer pricing principles)is meant to be at the discretion of the Contracting States, of the taxpayer, orboth. This creates a risk of disputes between the tax authorities, and betweenthe taxpayer and tax authorities, regarding the approach to be followed in aparticular case.

Given the significance of the change and the need to ensure symmetricalapproaches in the residence and source jurisdictions, it is appropriate toamend treaties where application of the authorized OECD approach isdesired. Confirmation of the US Treasury Department of its position inthis regard would provide taxpayers with greater guidance and certainty37.The following implications of applying the authorized OECD approach underUS bilateral treaties should be clarified:38

• Will parallel application of the ‘old’ and ‘new’ profit attributionapproaches create new risks of double taxation for global companies, inaddition to increased administrative burdens for taxpayers that mustapply parallel sets of rules?

• Is this a transitional issue and if so how urgent is its resolution?

Given the present insufficiency of guidance on the application of theauthorized OECD approach, efforts to reach an international consensusthrough the OECD, in consultation with business, should be broadened andredoubled. To minimize confusion during the transition period, adequatetraining should be provided to tax administrators and counsel.

8.2 Impact of the Discussion Draft on Canada

It is not clear whether the Canadian courts have whole-heartedly accepted theseparate entity notion approach of Article 7 that is the authorized OECDapproach. Although some have argued that this concept is alive and wellin Canada39, the publicly stated positions of the Canada Revenue Agency,in particular in denying the deduction of notional expenses, might suggestotherwise. This position is based on the Tax Court of Canada decision inCudd Pressure40.

In Cudd Pressure, the issue was whether a non-resident could deduct anotional rent charge in computing the income attributable to its permanent

37Supra Note 22.38Ibid.39D.A. Ward, “Attribution of Income to Permanent Establishments,” (2000), vol. 48,

no.3 Canadian Tax Journal, 559-576.40Cudd Pressure Control Inc. v. R., 98 DTC 6630 5Fed.CA), 1995 2 CTC 2382 (TCC).

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establishment in Canada. The Tax Court of Canada suggested that theconcept of notional expenses is not recognized in Canada and that theprofits of the permanent establishment should be determined pursuant tothe domestic law. The Court then noted that paragraph 4(b) of the IncomeTax Conventions Interpretation Act was intended to ensure that Canadianpermanent establishments could not deduct amounts that were unavailableto Canadian taxpayers as deductions in calculating their business incomewhen calculating the profits attributable to the permanent establishment41 .

Justice McDonald, dissenting in part, determined that because theCanada- U.S. Treaty allowed for the deduction of notional expenses in thecomputation of profits attributable to a permanent establishment, recourseto domestic principles was not essential, and therefore such notional expensescould be deducted in appropriate cases.

Although the decision of Justice McDonald is seen by many as anauthority supporting the concept of deducting notional expenses on thegrounds that such deductions are supported by the application of the separateentity approach for the purposes of computing profits attributable to apermanent establishment in Canada, the Canada Revenue Agency disagreeswith this proposition. Instead the Canada Revenue Agency supports the taxcourt’s analysis, which relies on the Income Tax Conventions InterpretationAct for the proposition 42that, “where a term is not defined in the treaty,the term has the meaning that it has for the purposes of the Act from timeto time”.

On the basis of the Discussion draft, the working hypothesis will verylikely require changes to the Commentary, and possibly the actual wordingof Article 7, to the effect those notional expenses will expressly be allowed.Although it is expected that Canada will accept the new provisions of Article7 without reservation43, the question as to what changes to Canada’s lawswill be necessary to give effect to these new provisions remain open.

It is not clear whether any Canadian court would allow internationaltreaties to “trump” domestic law in situations involving the computation ofthe profit to be attributed to the permanent establishment. In accordancewith the Tax court of Canada’s interpretation of paragraph 4(b) of the

41The tax treaty under consideration was the Canada-U.S. Reciprocal Tax Convention(1942), the ”Canada-U.S. Treaty.

42See, for example, Income Tax Technical News - No. 18, dated 16 June 2000 (“TechnicalNews No. 18”).

43To date Canada has accepted the provisions of Article 7 without reservation. Inaddition, Canada has not noted any observation with respect to the Commentary toArticle 7. As a result, in accordance with paragraphs 28 to 32 of the introduction to theOECD Model Convention, Canada should be considered as accepting both.

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Income Tax Conventions Interpretation Act in Cudd Pressure, some mightargue that the domestic law can override the separate entity concept ofArticle 7. As a result changes to the Act and/or the Income Tax ConventionsInterpretation Act may be necessary to remove potential conflicts betweenthe changes to Article 7 and the domestic statutory provisions44 .

8.3 Swiss approach to the allocation of profits to

Permanent Establishments

According to Swiss Law, the main methods used for the allocation of profitsto a permanent establishment are the direct and indirect methods:

Under the direct method, the profits which are to be attributed toeach permanent establishment are those which it would have made ifthe permanent establishment had been a separate, unrelated and distinctenterprise engaged in the same or similar activities under the same or similarcircumstances. Income is therefore determined on the basis of separateaccounts pertaining to the permanent establishment. In other words, thepermanent establishment is treated as a separate entity. This method is inconformity with the authorized OECD approach of treating the permanentestablishment as a “functionally separate entity”.

Under the indirect method, the income of the permanent establishmentis calculated as a fraction of the total profits earned by the enterprise. Thepermanent establishments participation in the total capital is quantified byapplying coefficients based on a comparison of assets, turnover, and numberof hours worked or other appropriate factors.

The U.S.- Switzerland tax treaty specifically mentions that the directmethod of allocation must be applied. This is a result of Article III,paragraph 3 which states as follows:

“Where an enterprise of one of the contracting States is engaged intrade or business in the territory of the other contracting State through apermanent establishment situated therein, there shall be attributed to suchpermanent establishment the industrial or commercial profits which it mightbe expected to derive if it were an independent enterprise engaged in thesame or similar activities under the same or similar conditions and dealingat arm’s length with the enterprise of which it is a permanent establishment.”

Pursuant to the introduction of the new Swiss Federal Tax Law in 1995,some commentators argue that the rules for the prohibition of intercantonal

44OECD Revised Discussion Draft on Attribution of Profits to a PE: Commentary andCanadian Implications; Carrie D’Elia and Maria Tatarova, Osler, Hoskin & Harcourt LLP,Canada.

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double taxation, should only be applicable to Swiss residents with enterprises,permanent establishments or real estate situated abroad. Hence, the directmethod of allocation would be applicable to foreign residents with enterprises,permanent establishments or real estate situated in Switzerland45 . Thisinterpretation is questionable and has not been confirmed by the SupremeCourt as yet.

If Switzerland has to conform to the new provisions of the OECD Draft,they have to begin by applying the direct method consistently.

8.4 Taxation of Business Process Outsourcing Units in

India

Although India is not an OECD member country, it is interesting toobserve the growing trends in India with regard to the attribution of profitsto permanent establishments. India has witnessed a steady growth ofoutsourcing of business processes by foreign entities to business processoutsourcing units situated in India. Business process outsourcing in Indiais carried out either by captive service providers such as branches or wholly-owned subsidiaries of the foreign parent or through independent businessprocess outsourcing companies. The tax implications of such foreign entitiesoutsourcing activities have been a matter of debate.

On January 2, 2004, the Central Board of Direct Taxes issued a Circularregarding the taxability of income in the hands of foreign entities outsourcingbusiness processes to Indian entities. The circular differentiated between‘core activities’ and ‘incidental activities’ carried out by the business processoutsourcing unit, in order to evaluate if they constitute a permanentestablishment in India of the foreign entity. This resulted in controversiesbecause of the differentiation between ‘ core activities’ and ‘incidentalactivities’.

On August 9, 2004 the Central Board of Direct Taxes issued a new(draft) circular which deals with taxation of foreign entities outsourcing theiractivities to business process outsourcing units in India. The said circularhas the following implications:

(a) If there is no connection between the foreign entity who is outsourcingcertain services and an Indian business process outsourcing unit to whom ithas been outsourced, the Indian business process outsourcing unit will not bea permanent establishment of the foreign entity. Further, the Indian businessprocess outsourcing unit would be assessed to tax as a separate entity. (b) Ifforeign entities have a business connection/permanent establishment in India

45Ibid.

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by way of a branch, sales office, dependent agent, only so much of the profitsare attributable to the activities carried out in India by such permanentestablishment would be liable to be taxed in India.

The Circular refers to Article 7 of the OECD Treaty and observes thatthe profits attributable to the permanent establishment are those which thepermanent establishment would have made as if it had been dealing withan entirely separate entity, instead of dealing with its head office, underconditions and prices prevailing in the ordinary market, which correspondsto the arm’s length principle. It is evident that the new draft circular issuedby the Central Board of Direct Taxes in India is in line with the hypothesissuggested by the OECD on the attribution of profits to a permanentestablishment.

9 Conclusion

As observed in the OECD’s November 19, 2004 statement, it is clear thatmany issues remain to be resolved. The OECD summarized these issues asfollows:

Timing issues

The timing originally envisaged to finalize Parts I to III was too optimistic

Transition Issues

Questions were asked about the legal status of the current drafts pendingfinalization of the work on changes to the OECD model. On the practicalside the Report developed an approach for determining which part(s) of anenterprise owns intangibles developed by the enterprise, which raises issueson how to deal with an intangible developed in the past.

Outstanding issues needing clarification

Clarification was sought on the meaning and role of the key entrepreneurialrisk taking functions in the OECD approach. Another key issue was the scopefor double taxation that may arise from the Report’s conclusion that therewas more than one valid approach for attributing capital to a permanentestablishment. Clarification was sought on how the Report’s proposedsolution to this problem- the symmetrical application of the approvedapproaches-would work in practice.

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The Discussion draft suggests that, once finalized, its conclusions will be‘implemented’ through amendments to the Commentary on Article 7, andsupplemented with ‘further practical guidance’ in the OECD Transfer pricingguidelines.

However, from the discussion above, we may conclude that additionalsteps are required before the discussion draft can truly be viewed as havingreached the stage of providing a legal and administrable framework for theattribution of profits to a permanent establishment.

There is a concern on the part of the business community that merefinalization of the discussion draft will cause some countries to believe thatthere are now well-developed rules for attributing profits to permanentestablishments, which will likely lead to more ready assertions of permanentestablishment status. In reality, the discussion draft falls short of creatinga zone of certainty about the ultimate result. Several further stepswill be required to approach that goal, including amendment of theArticle 7 Commentary and refinement of the transfer pricing guidelines tobetter illustrate how they should be applied by analogy to the permanentestablishment situation. Further, the final report should provide that theOECD views the new approach as a significant change and recommendsthat member countries implement the new approach with the same typesof transitional measures that would accompany a change in law 46.

The OECD should produce practical examples to ensure that the new,somewhat theoretical, approaches of the Discussion draft will work asexpected in practice. The questions of whether tax authorities and taxpayerswill be able to reach common conclusions on typical cases concerning the “keyentrepreneurial risk taking function”, or in the allocation of assets, risks andcapital in specific situations has to be tested against realistic examples beforethe new approach is formally approved by the OECD for implementation inthe Convention, commentary or in the Guidelines.

The overall assessment by the business community of the workability ofthe new approach in the Discussion draft, will depend upon the acceptanceby the OECD that profit attribution to a permanent establishment is not anexact science. From that perspective, it is important that it is crucial thattax examiners understood that business decisions of an enterprise must berespected, and that all results within a reasonable arm’s length range shouldbe acceptable. Under these circumstances, the multiple approaches underthe Discussion draft can be quite useful, but only if both the home and hostcountries are prepared to respect the commercial practices of the enterprisesas to structuring and pricing of their dealings.

46Supra note 35

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The new Approach should only become effective after its adoption by alarge majority of member countries. They should also be given a sufficientperiod to allow for the adjustment of their national tax systems and for theimplementation of the newly created rules both by the enterprises and thetax authorities. Without a thorough discussion of the necessary adjustmentsrequired under domestic law and the change of many domestic regimes, it canbe anticipated that the new rules will not be applied consistently in practice,with the result that the new approach will lead to general confusion andadditional cases of double taxation 47.

It is anticipated that the proposed review of the Model convention toidentify changes to Article 7 arising from the Discussion draft could takeeighteen months to two years. Given the uncertainties relating to theimplementation and impact of changes to the OECD’s preferred approach(which are bound to exist until some time after changes are made to theCommentary and Model Convention), the international community couldface years of uncertainty in terms of identifying the parameters for attributingprofits to a permanent establishment.

47Letter dated 11th October 2004 from the BIAC (Business and Advisory Committeeto the OECD) on the Discussion Draft to the OECD on the Discussion draft.

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