Global Tax Alert | 8 November 2017
OECD holds second public consultation on attribution of profits to PEs and profit splits
On 6-7 November 2017, the Organisation for Economic Co-operation and Development (OECD) held a public consultation with respect to the discussion drafts on Additional Guidance on Profit Attribution to Permanent Establishments (the PE Discussion Draft) and on Revised Guidance on Profit Splits (the PSM Discussion Draft) that were released earlier this year.1 The consultation was an opportunity for stakeholders to engage directly with the OECD Secretariat and the country delegates who are responsible for the OECD’s transfer pricing work. The OECD Working Party will discuss the comments and next steps at its next meeting in November 2017.
On 5 October 2015, the OECD released final reports on all 15 focus areas in its Action Plan on Base Erosion and Profit Shifting (BEPS). Among the final reports were the final report on Action 7: Preventing the Artificial Avoidance of Permanent Establishment Status (the Action 7 Report)2 and the final report on Actions 8-10: Aligning Transfer Pricing Outcomes with Value Creation (the Actions 8-10 Report).3 Following these reports, the OECD on 4 July 2016 issued the discussion drafts on profit attribution to permanent establishments and on profit splits. Following a public consultation process, updated discussion drafts were issued on 22 June 2017.
The PE Discussion Draft provided additional guidance on the attribution of profits to permanent establishments (PEs) following the recommendations in Action 7, including the new definition of dependent agent PE and the anti-fragmentation rule. The PSM Discussion Draft dealt with the clarification and strengthening of the guidance on the transactional profit split method (PSM) and sets out the text of the proposed revised guidance on the application of this method. The proposed guidance did not represent a consensus view of the OECD’s Committee on Fiscal Affairs nor of the Inclusive Framework on BEPS.
Both discussion drafts included an invitation to interested parties to send their comments. In total, the OECD received over 730 pages of comments on the two discussion drafts. The public consultation on 6-7 November was a dialogue among stakeholders, country tax officials, and the OECD Secretariat on key issues and concerns addressed in those comments. The consultation was hosted by OECD Working Party No. 6, which is responsible for the OECD’s work on transfer pricing matters. The first day of the public consultations covered the additional guidance on application of profit splits; the second day covered the proposed revisions to the guidance on profit attribution to PEs.
Revised profit split guidance
The first day of the public consultation on profit splits began with an opening statement by Franz Tomasek, co-chair of Working Party No. 6. Tomasek emphasized that there is no intention to extend or narrow the scope of the application of transactional profit splits. The selection of a transfer pricing method always aims at finding the most appropriate method for a particular case.
The Business International Advisory Committee (BIAC), representing international business, started off by referencing the significant changes in international tax policy in the past year, including BEPS-related and BEPS-inspired measures at the European Union level, the introduction of the Multilateral Instrument,4 proposed changes in the value added tax legislation and digitalization and the digital economy. They stated that changes are not happening overnight, and are creating significant uncertainty for international business. BIAC commented that the PSM Discussion Draft is directionally sensible, but that they see opportunities for improvement by providing additional, numerical and realistic, examples, and stressed that any changes to be applied should take into consideration the practical implications.
The guidance on splitting of anticipated versus actual profits was considered confusing. The guidance on unique and valuable contributions could be further clarified, while the examples suggested a lower threshold for the application of a profit split. In practice, BIAC observed that tax authorities argue the application of profit splits, in particular in cases with high profits, but not necessarily symmetrically when losses would occur. They also mentioned that sharing and jointly controlling economically significant risks should not automatically lead to the sharing of profits. They also wanted to see more guidance on valuation, on the application of profit splits to ongoing transactions and on application of a residual profit split in relation to the remuneration of routine functions.
The BEPS monitoring group, as a representative of civil society, called for the systemization of the PSM. They are of the view that one-sided transfer pricing methods are not able to deal with synergies and don’t sufficiently capture residual profits. They believe the profit split method could provide a basis for a pragmatic solution. To achieve that, the profit split method should be based on more standard techniques, based solely on objective factors (e.g., personnel, assets, etc.) to apportion profits. This approach would ignore internal group-controlled arrangements. They are of the view that this would also dispense with the need for subjective value judgments, greatly reducing the potential for conflict and uncertainty.
The discussions looked at:
- Selection of the transactional PSM as the most appropriate method, focusing on the three indicators mentioned in the discussion draft: unique and valuable contributions, highly integrated operations and the shared assumption of economically significant risks or the separate assumption of closely related economically significant risks. Several country delegates emphasized that the mere existence of one or more of the indicators not necessarily should lead to the conclusion that a profit split should be applied.
- One of the country delegates observed that many business commentators seemed to imply that a transfer pricing method like a profit split can only be used if it is used frequently by independent parties. He strongly expressed that that is not the OECD’s view.
- An important part of the discussion on risks as an indicator dealt with the question how to remunerate a party that is contributing to the control over risk, while not being allocated that risk, as included in par. 1.105 of the Transfer Pricing Guidelines. Business commentators stressed that there should be a clear distinction between joint assumption of risks and the situation of par. 1.105 where one party is assuming and controlling the risk and another party is contributing to the control over the risk. Specifically the question whether a party contributing to the control could be compensated in the form of a profit split was discussed although the outcome was not conclusive.
- Many business commentators indicated there should be a distinction between the shared assumption of risks and the separate assumption of related risks. In their view, the latter situation should not lead to a profit split.
- Business requested more guidance on profit splits of anticipated profits and actual profits, including on the interaction with shared assumption of risks.
- Business requested further elaboration on the examples included in the discussion draft and to add examples with a fact pattern leading to the conclusion that profit split is not the most appropriate method.
- Business requested guidance on how to split profits including what split factors to use.
Invited by the co-chair, BIAC provided closing comments. While acknowledging that the guidance contains useful elements, the BIAC representative (he) mentioned the focus of the consultation had been on areas for improvement. The guidance in BIAC’s view supports the general belief that profit splits should only be applied in relatively rare and exceptional circumstances. Furthermore, he expressed that the discussion draft should be improved by providing more clarity on the definitions, e.g., what constitutes a unique and valuable contribution, and by maintaining and proving consistency with other instruments included in the Transfer Pricing Guidelines. Finally, he reiterated the importance of examples, including examples on situations that should not lead to the application of a profit split, and situations in which losses are being split.
Additional PE guidance
The consultation on the Additional Permanent Establishment Guidance began with opening remarks from Hans van Egdom, Co-Chair of Working Party No. 6. Egdom mentioned the key issues to be discussed: (i) the order of application of Article 7 and Article 9 of the OECD Model Tax Convention (MTC); (ii) the consistency between Article 7 and Article 9 of the OECD MTC with regard to the allocation of risk and (iii) approaches to coordinate the application of Article 7 and Article 9 including mechanisms to reduce the additional compliance burden for businesses.
The four examples included in the revised PE Discussion Draft were discussed in detail during the consultation. Three out of the four examples deal with Dependent Agent PEs (DAPEs), whereof two examples discuss DAPEs triggered by sales activities of a related entity and one example discusses a DAPE triggered by procurement activities of a related entity. The fourth example deals with profit attribution to a fixed place of business PE in a case where the PE is triggered by the anti-fragmentation rule in Article 5(4) of the OECD MTC.
The following issues were discussed intensively during the consultation:
- In which order should Article 9 and Article 7 of the OECD MTC be applied when attributing profits to a DAPE, and does the order of application impact the resulting amount of profits to be attributed to the DAPE? The vast majority of commentators expressed the view that the application of Article 9 should logically precede the application of Article 7, i.e., in a first step the intercompany transaction between the nonresident entity and the intermediary/agent entity should be appropriately delineated and priced at arm’s length, followed by an attribution of profits of the nonresident enterprise to its DAPE (if any profit is attributable).
- Are there any differences between the concepts of “risk control functions” (used to allocate risk to a related entity in the BEPS Actions 8-10 Report) versus the concept of “significant people functions” (used to allocate risk to a DAPE in the OECD Authorized OECD Approach Report)? While commentators agreed that the wording used in the definition of the two concepts differs to some extent, thus potentially allowing for different interpretations or conclusions on the allocation of risk, a number of speakers claimed that the two concepts should actually be aligned. Furthermore, some commentators stated that it is hard to find any real-life examples of activities that give rise to an allocation of risk under one concept, but not under the other concept.
- What is the (notional) dealing between the head-office of the nonresident enterprise and the DAPE? The revised discussion draft suggests that a DAPE per se has to be hypothesized as a buy-sell entity. Hence, in the sales example, this means that the DAPE is deemed to purchase goods from the head office and to sell those goods to third party customers. A number of commentators raised concerns that this characterization may not be appropriate in each and every case. Commentators stated that the revised discussion draft is lacking a proper functional and factual analysis to support a conclusion on the characterization of the DAPE and the delineation of the dealing between the head office and the DAPE.
- What measures can be taken to reduce or mitigate the additional compliance burden for taxpayers and tax administrations that come along with the envisaged increase of the number of PEs? Commentators agreed that administrative simplicity in handling additional DAPEs triggered by the lower PE threshold in BEPS Action 7 is very important, in particular where there is little or no profit attributable to the DAPE. One potential option – as was suggested in EY’s written comments – could be to allow the resident entity to elect in its tax return that the activities of the entity have created a DAPE of a nonresident entity, but that no profit is attributable to the DAPE. Such election could overrule the obligation of the nonresident entity to file a tax return in the source country.
The Co-Chair invited BIAC to provide closing comments. These comments included:
- The OECD is encouraged to supplement the examples included in the discussion draft with more details on the actual facts and circumstances underlying the examples, and to perform a proper functional and factual analysis supporting the characterization of the DAPE and the delineation of the dealing between head office and DAPE.
- There seems to be broad consensus that the Article 9 analysis should precede the Article 7 analysis. Accordingly, a firm statement in that direction would improve the clarity of the OECD guidance.
- There should also be more guidance in the discussion draft whether and/or to what extent the two concepts of “risk control functions” (under Article 9) and “significant people functions” (under Article 7) are aligned.
- More guidance is requested on approaches to increase administrative simplicity, in particular in cases where there is no or very little profit attributable to a DAPE.
The OECD Working Party will discuss the comments at its next meeting to follow immediately after the November public consultation. For now it is unclear whether new discussion drafts will be released.
The changes in the threshold for PEs included in the October 2015 BEPS reports, in combination with the proposed changes on attribution of profits to PEs, and the proposed changes on profit splits may have significant impact on global businesses. Global businesses should evaluate the implications of the proposed additional guidance and also monitor the follow-up work by the OECD.
1. See EY Global Tax Alert, OECD releases revised discussion drafts on profits splits and attribution of profits to permanent establishments, dated 26 June 2017.
2. See EY Global Tax Alert, OECD releases final report on preventing the artificial avoidance of permanent establishment status under Action 7, dated 19 October 2015.
3. EY issued multiple alerts on the various topics covered in the Actions 8-10 report. See EY Global Tax Alert, OECD releases final transfer pricing guidance on risk and recognition under Actions 8–10, dated 13 October 2015, on the topics that are most relevant for the business consultation.
4. See EY Global Tax Alert, 68 jurisdictions sign the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS, dated 7 June 2017.
For additional information with respect to this Alert, please contact the following:
Ernst & Young Belastingadviseurs LLP, Transfer Pricing, Rotterdam
- Ronald van den Brekel
Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft, Transfer Pricing, Cologne
- Thomas Ebertz
Ernst & Young LLP, Global Tax Desk Network, BEPS Desk, New York
- Jose A. (Jano) Bustos
- David Corredor-Velásquez
EYG no. 06340-171Gbl