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Transfer Pricing andAttribution of Profits to PEsAntonio Russo, Baker & McKenzie Amsterdam18 June 20151 2015 IBFD

Allocating Taxing Rights over Business ProfitsThe comparison between thetwo Model Conventions isessential insofar a number ofcountries around the World applythe UN Model over the OECDModel.The analysis on profit attributionto PEs requires starting from thedefinition of nexus. The twoModels differ also in relation tothis apsect in addition to the way“measurement and attribution”are addressed.2 2015 IBFD

Some statistics(Daurer, V.; Krever, R.: Choosing between the UN and OECD tax policy model: an African case study, EUI WorkingPaper, RSCAS 2012/60)Construction PE proviso:frequency and time limitationService PE proviso: frequencyand time limitations.3 2015 IBFD

Allocation of Taxing Rights - Art. 7(1) OECD/UN MCsOECD Model Tax Convention on Income and on Capital (2008)UN Model Income Tax ConventionArt. 7BUSINESS PROFITS(1) (S1) [The] profits of an enterprise of a Contracting State shall be taxable only in thatState unless the enterprise carries on business in the other Contracting State through apermanent establishment situated therein.OECD Model Tax Convention on Income and on Capital (2008)Art. 7BUSINESS PROFITS(1) (S2) If the enterprise carries on business as aforesaid, the profits of the enterprisemay be taxed in the other State but only so much of them as is attributable to thatpermanent establishment.Slightly different wording in the 2010 OECD Model Tax Convention onIncome and on Capital, but same meaning.4 2015 IBFD

Allocation of Taxing Rights - Art. 7(1) S2 UN MCUN Model Income Tax ConventionArt. 7BUSINESS PROFITS(1) (S2) If the enterprise carries on business in the other State through a permanentestablishment, the profits of the enterprise may be taxed in the other State but only somuch of them as is attributable to(a)that permanent establishment;(b) sales in that other State of goods or merchandise of the same or similar kindas those sold through that permanent establishment; or(c)5other business activities carried on in that other State of the same or similarkind as those effected through that permanent establishment. 2015 IBFD

Comparison: Article 7(1) S2 of the OECD and UN MCScenario 1Article 7 of the OECDModel Tax ConventionEnterpriseScenario 2Article 7 of the UNModel Tax ConventionEnterpriseState RState SPE6PE 2015 IBFD

OECD APPE Report 2010The APPE Report addresses this complex topic in 4 parts: General PE Financial Institutions Global Trading Insurance CompaniesIt establishes the principles for the application of theAuthorized OECD Approach (AOA), which predicates theapplication of the separate entity theory.By analogy the OECD Guidelines are applied7 2015 IBFD

Single Entity/Relevant Business Activity ApproachState RCompanyLossesSingle entityPEState S8 2015 IBFD

Single Entity/Relevant Business Activity ApproachState R- 50CompanySalesOverall Profit of 50 100PROFITPESalesState S9 2015 IBFD

Functionally Separate Entity ApproachState R- 50CompanySalesOverall Profit of 50 100PROFITPESalesState S10 2015 IBFD

Functionally Separate Entity ApproachState RCompanyLossesPESalesState S11 2015 IBFD

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AOA – 2 step approach 13Determination of the profits attributable to a PE under theAOA requires a 2 step analysis: Step 1 – hypothesise the PE and the remainder of theenterprise as if there were associated enterprises, eachundertaking functions, owning and/or using assets,assuming risks and entering into dealings with each otherand transactions with other related and unrelatedenterprises Step 2 – determine the profits of the hypothesised separateand independent enterprise based upon a comparabilityanalysis 2015 IBFD

What does it imply?In short, the first step of the authorised OECD approach willapply a functional and factual analysis to the PE (based on theguidance in Chapter I and Chapter III of the Guidelines) in orderto:14 Determine the functions of the hypothesised separate andindependent enterprise and the economically relevantcharacteristics (both ―internal and ―external conditions)relating to the performance of those functions (see subsection (i) below) Attribute risks among the different parts of the singleenterprise, based on the identification of significant peoplefunctions relevant to the assumption of risks (see subsection (ii) below) 2015 IBFD

What does it imply? (cont’d)15 Attribute economic ownership of assets among the differentparts of the single enterprise, based on the identification ofthe significant people functions relevant to the attribution ofeconomic ownership of assets (see sub-section (iii) below) Attribute to the PE as appropriate the rights and obligationsarising out of transactions between the enterprise of whichthe PE is a part and separate enterprises (see sub-section(iv) below) Attribute capital based on the assets and risks attributed tothe PE (see sub-section (v) below) Recognise and determine the nature of those dealingsbetween the PE and other parts of the same enterprise thatcan appropriately be recognised, having passed thethreshold test (see sub-section (vi) below) 2015 IBFD

OECD Guidelines applied by analogyComparabilityanalysis is key Identify and test “dealings” Develop the appropriateterm of comparison Identify comparables Traditional Methods andMethods Transactional Profit Methodsapplied in asimilar fashion Other Somekeydifferences16 “Significant People Functions”as yardstickfor attributionSome types of transactions: Transfer of assets Treasury dealings and interestdeductibility Use of IP Services 2015 IBFD

Significant People FunctionsIdentification of the significantpeople functions performed bythe personnel of the PE isimportant as they provide abasis for the attribution of risksand for the economicownership of assetsThe significant peoplefunctions relevant to theassumption of risk and to theeconomic ownership of assetswill vary from business sectorto business sector and fromenterprise to enterprise withina sector17 2015 IBFD

A Case Study18 2015 IBFD

Step 1: Factual and Functional Analysis – Functions (Dealings)Carried Out by the General Enterprise19 2015 IBFD

Allocation of RisksRisksMarket RiskOperational RiskPEXXXXXXXXXInventory RiskXRegulatory riskXXSupply riskXNew product start-uprisk-Product liability andwarranty riskXCredit risk / bad debtriskXXForeign exchange risk20General EnterpriseXX-XXX 2015 IBFD

Step 1: Assets Owned / Used21 2015 IBFD

Step 1: Factual and Functional Analysis – Functions, Assetsand Risks of the PE2 2015 IBFD

Step 2Pricing the identified “dealings” by analogy through theapplication of the OECD Guidelines#%W&*% Y ##?23 2015 IBFD

Current State of Play: Recap Article 7UN MTC“Old” Article 7OECD MTC“New” Article 7OECD MTC24 Profit attributable to PE and same or similargoods or merchandise/business activitiesArt. 7(2) – SE and ALP (restricted Art. 7(3))No AOALimited application of TP principles to certaininternal dealingsProfit attributable to PEArt. 7(2) – SE and ALPLimited application of AOA per 2008Commentary update* (restricted by Art 7(3))Limited application of TP principles tohypothesise separate entity and to recogniseand price certain internal dealingProfit attributable to PEArt. 7(2) – SE and ALPFull application of AOASignificant reliance on TP principles tohypothesize separate entity and to recogniseand price internal dealings 2015 IBFD

Key Take Aways ARTICLE 7: Allocation of taxing rights over business profitsbetween the home and host state, where by the profits attributableto a PE represent: the maximum profits in relation to which the host state may exerttaxing rights under its domestic law the maximum profits in relation to which the home state is requiredto grant DTR Profits attributable to a PE in accordance with Article 7 does notequal taxable income – the actual calculation of taxable income is adomestic law issue Remember to apply at the actual text of the business profits articleof the applicable treaty 25UN Model‘Old’ OECD ModelNew OECD ModelOtherAOA Application of transfer pricingprinciples by analogy – focus ison substance rather than form!(functions,functions,functions ) 2015 IBFD

Thank you!26 2014 IBFD