tax notes international - Tuck School of Business - Dartmouth College

SPECIAL REPORTS
reports were of the same view is that there is little or
no guidance from the tax authorities on the issue of
attribution of profits to PEs. Moreover, most jurisdictions
have little, if any, case law on this issue. 7
The existence of different interpretations on the
scope of article 7 is therefore against the purpose of a
tax convention for the avoidance of double taxation,
giving rise to harmful consequences on the exchange of
goods and services between states. The lack of consistency
in applying a treaty provision is a major contradiction
to the purpose of that treaty in providing a harmonized
sharing of taxing rights between the
contracting states. 8
In this context, this article discusses the application
of the provisions of article 7 of the OECD model convention
regarding the situation when an agency PE is
found to exist, especially in the case when a subsidiary
constitutes an agency PE of its foreign parent company.
In other words, it is intended to analyze through
the existing case law the main features of this particular
type of PE.
Furthermore, the different approaches to attribute
profits to agency PEs will be addressed, namely the
functionally separate entity approach, also known as
the authorized OECD approach or dual taxpayer approach;
and the single taxpayer approach, also referred
to as the zero-sum approach. It is intended to provide
an answer to the question of whether there may be a
profit attributable to an agency PE in excess of the
arm’s-length remuneration paid to the dependent agent.
Phrased differently, the issue at stake is whether it is
possible to attribute a separate profit to an agency PE
once the agent had an arm’s-length reward for the service
provided for the nonresident enterprise. This is a
very controversial issue, as there is much disagreement
in the international tax community with the OECD
preferred approach.
It is a very sensitive issue in practice as it directly
affects the supply chain management of multinational
enterprises, when the characterization of an agency PE
may have a significant impact on the overall costs. 9
Through their supply chain management, multinational
enterprises will often seek to structure their activities in
a foreign country in a manner that either avoids the
7
Philip Baker and Richard S. Collier, General Report, ‘‘The
Attribution of Profits to Permanent Establishments,’’ Cahiers de
Droit Fiscal International, Vol. 91b, Subject II (Amersfoort: Sdu
Fiscale & Financiële Uitgevers, 2006), pp. 34-35.
8
In some situations, the existence of different interpretations
may derive from the domestic legislation of a particular state,
giving rise to the issue of treaty override.
9
Hans Pijl, ‘‘The Zero-Sum Game, the Emperor’s Beard and
the Authorized OECD Approach,’’ Eur. Tax’n (Jan. 2006), pp.
29-35.
characterization of an agency PE 10 or provides for the
most advantageous allocation of functions, assets, and
risks. Generally, multinational enterprises will seek to
allocate functions, assets, and risks in a low-tax jurisdiction
to achieve a lower worldwide effective tax rate.
In this context, the lack of clear guidance on the appropriate
atribution of profits to agency PEs is a significant
obstacle to the structuring of an optimal supply
chain from a multinational enterprise’s perspective.
Indeed, it is widely recognized that in the field of
taxation the lack of certainty is harmful to both taxpayers
and states as it may hinder cross-border trade. 11
The importance of this subject can also be deduced
from the decision of the International Fiscal Association
to dedicate a plenary session to the attribution of
profits to PEs at its 60th Congress. Among the issues
discussed in the plenary session was the attribution of
profits to agency PEs when there is a supplementary
profit attributable to such PE in addition to the arm’slength
reward paid to the agent. The lack of consensus
among the panel members indicates the extent of the
controversy on this issue.
Therefore, it is hoped that the analysis of the relevant
case law, especially Morgan Stanley and SET Satellite,
and the opinions of prominent tax scholars might
point towards a predominant direction on the interpretation
of the issue at stake that could avoid the uncertainty
on the tax consequences of setting up a business
involving an agency PE.
II. The Agency PE
The main rule of article 7 of the OECD model tax
convention basically states that the profits of an enterprise
must only be taxed in its state of residence (home
state) unless the enterprise carries on business in the
other contracting state through a PE situated therein
(host state). In this latter case, the profits of the enterprise
may be taxed in the other state, but only so much
of them as are attributable to that PE.
It derives from the wording of the provisions of article
7 that the existence of a PE is the decisive factor
for the allocation of taxing rights regarding the business
profits of an enterprise. As stated by Brian J. Arnold,
the PE requirement ‘‘is a minimum threshold
10
Avoiding the characterization of a PE is not only a matter
of achieving a lower worldwide effective tax rate, but also avoiding
a high burden of compliance costs.
11
As early as 1776, Adam Smith outlined certainty as one of
the four principles of an ideal tax system, along with equity, convenience,
and economy. Adam Smith, An Inquiry Into the Nature
and Causes of the Wealth of Nations (London: Methuen and Co.,
Ltd., ed. Edwin Cannan, 1904), available at http://
www.econlib.org/library/Smith/smWN21.html.
422 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL
(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.