Profit allocation between head offices and branches: what is the methodology used by financial institutions?

In the recent years, many banking and insurance groups have opted to operate in different jurisdictions by using branches as opposed to a set up using subsidiaries. This development of the number of branches trigger questions from Tax Authorities around the world, in particular on the allocation of profits between the Head Office (HO) and its branches.

As a major financial center, Luxembourg is also exposed to this issue. Currently, The Tax and Transfer pricing (TP) rules applicable in Luxembourg do not explicitly cover the allocation of profits between the HO and its branches. In the absence of explicit references in the current TP legislation, the OECD guidelines are often used as a guidance to determine the profits to be allocated to its branches.

The OECD framework

The Authorized OECD Approach (AOA) was introduced in the 2008 OECD Report on the Attribution of Profits to Permanent Establishments to address the limitations of the older static approach to allocate profits to permanent establishments (PEs). The static approach, which had been used before the AOA introduction, often failed to reflect the true economic activities and risks of PEs, leading to inaccurate profit allocations. The 2008 AOA introduced a more dynamic framework, requiring a functional and factual analysis to treat the PE as a separate entity for tax purposes. In 2010, the OECD formalized the AOA into a two-step process: first, performing a functional analysis to identify Key Entrepreneurial Risk-Taking (KERT) functions, and second, applying the arm’s length principle to allocate profits. In 2017, the OECD further refined the AOA through its commentary, incorporating lessons from the Base Erosion and Profit Shifting (BEPS) project. This update emphasized the need for precise delineation of transactions between the HO and PE, introduced new guidance on capital allocation, and aimed to address tax avoidance concerns. The AOA’s development reflects the OECD's efforts to modernize tax principles in line with the complexities of global business operations.

General Description of the Luxembourg Legal Framework for Profit Allocation to PE

Although a PE does not have any legal personality different than its HO, HO and its PE constitute two separate entities from a tax perspective.

If we take the example of a Luxembourg HO having different PEs established in the European Union (EU), the profit of the combined legal entity will have to be broken down between Luxembourg and the respective countries. As the Luxembourg TP rules and regulations do not explicitly cover the case of a profit allocation between the HO and its PEs, reference should be made to the relevant tax treaty entered into between Luxembourg and the relevant host country.

Luxembourg’s tax treaties follow the OECD Model Tax Convention and include provisions for profit allocation under Article 7. This article aims to prevent double taxation and ensure that profits are fairly attributed to the jurisdiction where the business activities occur.

The AOA dynamic approach is used in most of Luxembourg's double tax treaties with OECD and EU countries, such as France, Germany, Belgium, and the Netherlands (following the OECD 2010 version of Article 7).

However, Luxembourg still applies a static approach in tax treaties with some countries that were signed before the 2008 introduction of the AOA, where older, formula-based methods are used (for example, Brazil, India, and certain non-OECD countries). These static methods typically allocate profits, without a detailed analysis of the PE’s actual activities or risks.

General Description of the Profit Allocation Process under the AOA

Typically, in accordance with AOA the profit allocation process consists of the following steps:

Functional Analysis

This step involves identifying the key functions performed, assets used, and risks assumed by the PE, with a focus on the significant people functions (SPFs). For financial institutions, the KERT functions are typically associated with managing financial assets, making decisions on lending and investing, and managing risks such as credit and market risks.

Allocation of Assets and Risks

In the banking industry, the allocation of assets under the AOA relies heavily on identifying key functions related to the creation of assets and the management of risks.

A) Creation of Assets

The creation of financial assets in a banking context generally refers to activities such as loan origination, investment, and deposit-taking. The key functions involved in the creation of these assets often include:

The loan origination: Where the PE is responsible for evaluating creditworthiness, approving loans, and setting the terms and conditions of lending, the asset should be attributed to the PE.

The investment decisions: When the PE makes decisions regarding the acquisition or disposal of a loan or other financial assets, financial assets should be attributed to the PE.

B) Management of Risks

In the banking industry, risks such as credit risk, market risk, and operational risk need to be managed effectively to ensure the stability of the institution. These risk management activities are tied to the capital that is allocated to the PE. Some key functions related to risk management include:

The credit risk management: If a PE is responsible for monitoring and mitigating the credit risk of loans or investments it has originated, then this risk is attributed to the PE.

The market risk management: PEs involved in managing assets may handle market risks associated with fluctuations in asset prices. If the PE is actively involved in managing these market risks, the assets are attributed to the PE, and sufficient capital must be allocated to mitigate potential losses.

Quantification of Risks

For the quantification of risks, the Basel framework is commonly applied to banks to measure credit, market, and operational risks. The internal models of the bank, such as Value at Risk (VaR) models, are also commonly used when approved by regulatory authorities. These models provide a precise measurement of risk compared to standardized approaches, as they account for correlations between different risk categories.

Allocation of Free Capital

The allocation of capital is crucial for ensuring that a PE has sufficient resources to cover the risks it assumes. Below are the most common methods of capital allocation for banks:

Capital Allocation Approach: This method allocates capital based on the proportion of the Risk-Weighted Assets (RWA) attributed to the PE. It directly ties the allocation of capital to the PE's risk profile, following the same principles that are used for the overall bank under the Basel framework.

Economic Capital Approach: This approach allocates capital based on the economic risks the PE is exposed to, rather than simply on regulatory minimums or external comparables.

Thin Capitalization Approach: The thin capitalization approach compares the capital allocated to the PE with that of similar independent enterprises.

Quasi-Thin Capitalization Approach: This method involves allocating capital to a PE based on minimum regulatory capital requirements.

Allocation of Debt financing

The allocation of debt is also a key consideration, with three main methods used:

Fungibility Approach: This method assumes that debt is not specifically tied to any single entity or branch and is allocated to the PE proportionally based on the share of total assets or the RWA attributed to the PE.

Tracing Approach: Under the tracing approach, specific debt liabilities are traced directly to the assets or transactions that they finance.

Dealing Approach: In this approach, the allocation of debt is based on the terms of internal dealings between the PE and the HO, treating the internal transactions as if they were third-party transactions.

Pricing of the Dealing

The transfer pricing of intra-group transactions between the HO and the PE must follow the arm’s length principle. This ensures that the PE is properly compensated for any functions performed or services provided to other parts of the enterprise. The appropriate transfer pricing method depends on the specific circumstances of the transaction and the functions performed by the PE.

Points of attention

When considering profit allocation between the HO and a PE in Luxembourg from tax and TP perspective, several critical aspects must be addressed:

The influence on Corporate Income Tax (CIT) in Luxembourg: Proper allocation of profits directly affects the CIT base in Luxembourg. Incorrect allocation of profits, particularly underestimating the contribution of the foreign PE, can result in overestimation of CIT, increasing the tax burden on the entity in Luxembourg. Ensuring profits are allocated accurately is essential to avoid misallocation and excessive taxation. Proper TP documentation should be prepared to avoid potential double taxation.

The influence on Net Wealth Tax (NWT): The allocation methodology should not only address the allocation of profit between a HO and its PEs, but also address the allocation of assets, which ultimately would impact the NWT base of the Luxembourg HO.

The influence on Exit Taxation: Reallocation of assets between jurisdictions should be performed on a fair value basis and, consequently, could potentially create situations of exit taxation. When assets are moved out of Luxembourg, any unrealized capital gains on those assets may be taxed, as Luxembourg loses the right to tax future gains. Proper analysis should be performed upfront to avoid unexpected tax liabilities.

The tax Balance Sheet and Equity Requirements: The tax balance sheet must accurately reflect asset and debt values for both CIT and NWT purposes. Equity levels of the PEs of banks should align with regulatory requirements, such as Basel rules for financial institutions. While regulatory equity requirements set a minimum, the equity attributed for tax purposes can be higher but should not fall below regulatory standards. This ensures that equity and debt ratios comply with both tax and regulatory obligations.

Conclusion

The profit allocation between a HO and its PEs is a complex process and a major source of tax controversy around the globe. Due to the development of the number of PEs in the financial sector, Luxembourg is exposed to this change, which creates a challenge for the taxpayers and the Luxembourg Tax Authorities. As in many instances, the fact of having a robust TP documentation is recommended for the financial institutions as a preventive measure to avoid potential controversy.