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commentary to be used in the negotiation of future treaties and of amendments to existing treaties. Thus, the OECD Committee on Fiscal Affairs recently released as a discussion draft what it called the second part of the implementation package — a new version of article 7 and related commentary changes. The committee will be receiving comments on this discussion draft until December 31, 2008, and it is expected that the new article and the commentary changes will be included in the next update to the OECD model tax convention, which is tentatively scheduled for 2010. 56 Considering that this article is focused on case law on the attribution of profits to agency PEs, and the decisions were held before the release of the discussion draft of the new version of article 7 and related commentary changes, all comments made refer to the current wording of the OECD model convention and the ‘‘Report on the Attribution of Profits to Permanent Establishments.’’ One first important issue that arises is what weight should be given to this report in applying tax treaties currently in force. The specialized doctrine has already discussed at length the legal status of the commentary to the OECD model convention, and it can be said that there is no generally accepted view on this controversial issue. 57 If the legal status of the commentary is unclear and subject to a variety of different interpretations, more obscure is the role of a report that was, at the time the decisions being analyzed were held, not implemented yet. The OECD recognizes in paragraph 7 of the revised commentary on article 7 that there are differences between some of the conclusions of the report and the interpretation of article 7 previously given in the commentary in a way that the report should only provide guidelines for the application of the arm’s-length principle incorporated in the article to the extent that it does not conflict with the commentary. In case of conflict between the two, the commentary should always prevail over the report. 58 This is not mere academic debate; rather, it is a very important issue in practice as the conclusions of the report lead to major consequences on the attribution of profits to PEs in general and particularly to agency PEs. The Indian Income Tax Appellate Tribunal had to 56 See id. 57 See, e.g., Vogel, supra note 3, at 43; David A. Ward, ‘‘The Role of the Commentaries on the OECD Model in the Tax Treaty Interpretation Process,’’ Bulletin — Tax Treaty Monitor (Mar. 2006), p. 98; and John F. Avery Jones, ‘‘The Effect of Changes in the OECD Commentaries After a Treaty Is Concluded,’’ Bulletin — Tax Treaty Monitor (Mar. 2002), pp. 102-109. 58 Mary Bennett and Raffaele Russo, ‘‘OECD Project on Attribution of Profits to Permanent Establishments: An Update,’’ Int’l Transfer Pricing J. (Sept./Oct. 2007), p. 283. SPECIAL REPORTS face this dilemma in the SET Satellite case; the taxpayer referred to the report as ‘‘what the law should be and not what the law is.’’ 59 To address the different interpretations, I will first present a summary of the authorized OECD approach to attribute profits to PEs in general, followed by an analysis of its specific features regarding agency PEs, and finally the particularities of the single taxpayer approach. C. The Authorized OECD Approach Between the two main interpretations of the provisions of article 7 of the OECD model convention regarding the attribution of profits to PEs, the OECD opted for the functionally separate entity approach, rather than the relevant business activity approach. Now one can see that the reason why the first is also called the authorized OECD approach is because it provides for the OECD preferred interpretation of article 7. 60 The authorized OECD approach provides that the profits to be attributed to a PE must be the profits that it ‘‘would have earned at arm’s length if it were a legally distinct and separate enterprise performing the same or similar functions under the same or similar conditions.’’ 61 Conversely, the functionally separate entity approach does not limit the profits of the PE by reference to the profits of the enterprise as a whole. As a consequence, it is perfectly possible under this approach to attribute profits to a PE even if the enterprise, considered as whole, incurs a loss. The OECD report reaffirms the primacy of the arm’s-length principle in attributing profits to PEs by determining the adoption of the functionally separate entity approach. As shown below, the application of this approach requires a stretch: The PE is supposed to be treated as a functionally separate entity of its head office, though it is part of the same enterprise. Once the PE cannot enter into actual transactions with other parts of the enterprise of which it is part, it is necessary to provide for the recognition of the dealings between the PE and its head office, which goes against the axiom that an enterprise cannot make a profit from dealing with itself. 1. The Authorized OECD Approach to PEs The application of the functionally separate entity approach under the report requires a two-step analysis: • the functional and factual analysis; and • the comparability analysis. 59 Indian Income Tax Appellate Tribunal, Apr. 20, 2007, decision 535/Mum/04 and 205/Mum/04. 60 Para. 78 of the ‘‘Report on the Attribution of Profits to Permanent Establishments,’’ Part I (General Considerations), (2006). 61 Id. at para. 10. TAX NOTES INTERNATIONAL FEBRUARY 2, 2009 • 431 (C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
SPECIAL REPORTS In essence, the first step involves the application, by analogy, of the principles described in the 1995 OECD transfer pricing guidelines to identify the economically significant activities and responsibilities undertaken by the PE, while the second step is the comparability analysis and the application of the transfer pricing methods to determine an arm’s-length profit of the PE. The two-step analysis is summarized as follows in the OECD ‘‘Report on the Attribution of Profits to Permanent Establishments’’: Step One A functional and factual analysis, leading to: • The attribution to the PE as appropriate of the rights and obligations arising out of transactions between the enterprise of which the PE is a part and separate enterprises; • The identification of significant people functions relevant to the attribution of economic ownership of assets, and the attribution of economic ownership of assets to the PE; • The identification of significant people functions relevant to the assumption of risks, and the attribution of risks to the PE; • The identification of other functions of the PE; • The recognition and determination of the nature of those dealings between the PE and other parts of the same enterprise that can appropriately be recognised, having passed the threshold test; and • The attribution of capital based on the assets and risks attributed to the PE. Step Two The pricing on an arm’s length basis of recognised dealings through: • The determination of comparability between the dealings and uncontrolled transactions, established by applying the Guidelines’ comparability factors directly (characteristics of property or services, economic circumstances and business strategies) or by analogy (functional analysis, contractual terms) in light of the particular factual circumstances of the PE; and • Applying by analogy one of the Guidelines’ traditional transaction methods or, where such methods cannot be applied reliably, one of the transactional profit methods to arrive at an arm’s length compensation for the dealings between the PE and the rest of the enterprise, taking into account the functions performed by and the assets and risks attributed to the PE. The functional and factual analysis described in step one of the report resembles the analysis provided in the 1995 OECD transfer pricing guidelines. The difficulty in replicating the principles developed in the guidelines in a PE setting is that, differently from what happens when applying article 9 to associated enterprises dealings, a PE is not legally a separate enterprise but is part of the same enterprise of its head office. The solution found by the OECD Committee on Fiscal Affairs to cope with this difficulty was to look at the functions of the people working for the enterprise to attribute the assets, risks, capital, rights, and obligations belonging to the PE. 62 As a result, under the authorized OECD approach, economic ownership of assets should be attributed to the PE in accordance with the significant people functions as well as the risks related to the functions performed by people in that PE. Also, the authorized OECD approach establishes mechanisms to attribute capital to the PE in line with the assets and risks attributed to it and criteria for the recognition and determination of the dealings between the PE and its general enterprise. The second step involves the determination of remuneration of any dealings between the hypothesized enterprises on the basis of the functions performed, assets used, and risks assumed, as provided for in the 1995 OECD transfer pricing guidelines. 63 2. The Authorized OECD Approach to Agency PEs Regarding the attribution of profits to agency PEs, the OECD believes that the same principles adopted for other types of PEs should apply. As a matter of consistency, the OECD believes there is no reason to apply a different mechanism of profits attribution when it comes to agency PEs. Consequently, profits should be attributed to the agency PE on the basis of the assets and risks of the nonresident enterprise relating to the functions performed by the former on behalf of the latter. The authorized OECD approach leads to the treatment of the dependent agent and the agency PE as two different taxable entities. As pointed out by Hans Pijl, the authorized OECD approach takes the functions performed in the host state as the starting point for the attribution of profits. Moreover, under the notion that assets and risks follow functions, the functional and factual analysis will determine the assets and risks that must be attributed to the 62 Id. at para. 18. 63 Id. at para. 13. 432 • 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.
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