The publication of the 2010 Report on the Attribution of Profits to Permanent Establishments (the OECD Permanent Establishment Report) was the outcome of a circa 13-year project to reform the rules governing the attribution of income to permanent establishments. BEPS Action 7 provided further guidance on the attribution of profits to permanent establishments in 2018.
The OECD Permanent Establishment Report established the concept of the ‘authorised OECD approach’, or ‘AOA’, which presents the idea of treating a permanent establishment as if it were an independent and functionally separate entity engaged in the same or similar activities under the same or similar conditions. Under the authorised OECD approach, profits are attributable to a permanent establishment based on a comparability analysis, taking into account the functions performed, assets used, and risks assumed by the permanent establishment.
The relevance of permanent establishments and the authorised OECD approach has only increased with technological developments that have made remote work and/or flexible work a reality for many businesses. Allowing employees to work remotely, possibly in a different country from their employer, has become a necessity for many multinational businesses, be it a result of their business’s need or to meet the requests of hired talent.
Permanent establishments have a particular importance in the financial industry. The fundamental principle underlying the attribution of profits to permanent establishments in Part II (banking), Part III (global trading), and Part IV (insurance) of the authorised OECD approach is the concept of the key entrepreneurial risk-taking (KERT) function. Under this concept, financial assets, such as loans or trading assets, are attributed to the permanent establishment where the KERT function is performed. The capital required to fund the assets and profits or losses associated with the assets, taking into account any ‘dealings’ with other parts of the same entity, are attributed to the KERT location on the same basis.
Situations can arise in which KERT functions may have to be split. This is particularly relevant for lending in the banking sector, where there are multi-layered approval processes starting with local relationship managers giving the first approval, followed by sector committees, risk committees up to senior management, and global relationship managers. In such multi-layered scenarios, allocating the KERT functions, or potentially split KERT functions, is a particularly complex task.
In addition, operating models and value chains are changing, with consequences for permanent establishments, as a result of the development and adaptation of technology. As an example, certain insurance policies (especially in the property and casualty sectors) are being underwritten on an automated basis following a decision-making process that is embedded in software. In such a case, where should the KERT function for the underwriting function be attributed? Another example is the use of ‘edge computing’ solutions for digitalised businesses where part of the value creation may be obtained through servers and their proximity to their markets without local human activity.
For questions of profit attribution to permanent establishments, the authorised OECD approach is an important tool for businesses and tax authorities across industries and jurisdictions. Nevertheless, not all countries accept the authorised OECD approach, and questions may remain as to whether it has been incorporated into local law and tax treaties to avoid and mitigate double taxation. Further complexities arise as businesses and the role of permanent establishments have undergone changes over the past few years in a way that could not have been anticipated at the time the OECD’s 2010 Report on the Attribution of Profits to Permanent Establishments was written.
Interview with Manuel de los Santos
In light of recent changes and the ‘new ways of working’ in particular, Manuel de los Santos, the head of the transfer pricing unit at the OECD’s Centre for Tax Policy and Administration, believes that it may be the right time to revisit the topic of permanent establishments from a transfer pricing perspective.
“It’s a fantastic topic that we have kept to the side for a while,” he said in an interview with Deloitte. “We haven’t been discussing it internally, not even with the membership, whether it’s [worthwhile] to rethink the attribution of profit to [a] permanent establishment, as drafted in the 2010 report.
We need to pause and see whether the core OECD instruments are still fit for purpose
“I think the reason was sound because in that period we [were] focusing on fixing one of the issues that we identified in the profit allocation rules through the MLC [the Multilateral Convention to Implement Amount A of Pillar One] and the new taxing right. It felt a bit like Dr. Jekyll and Mr. Hyde – talking about different things under different principles.
“But now that work on pillar one is winding down, we need to probably pause and reflect, and see whether the core OECD instruments [Chapter I of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, or the authorised OECD approach of 2010] are still fit for their purpose; in particular, in the context of all the discussions about global mobility and remote working.”
Deloitte pointed out that even with the OECD Permanent Establishment Report, there is not always global consistency on permanent establishment profit attribution, including among OECD countries. Manuel de los Santos explained the OECD’s approach.
“The consistent application of the international taxing standard is always at the top of our agenda,” he said. “It’s something that we are always monitoring very closely and we acknowledge that, even within the OECD membership, we still have different approaches to attribute profits to a permanent establishment because different versions of the model were incorporated into the applicable tax treaty and that’s putting a lot of tension on the system.
“For those that are less familiar with the OECD, I would explain that we run a survey [with] the membership every two years to determine the programme of work for the next two years. That’s how we are getting the priorities for the membership, in order to see where we can focus, or where we should focus, our resources.
“Again, all that [resource] has been taken [up] during the last few years as a result of the work on the pillars. But I think that now we are coming back to this more conventional OECD way of working and I’m confident that we will get back to discussions again on the AOA, Chapter I, and particularly in the context of global mobility.”
Deloitte asked Manuel de los Santos for his thoughts regarding the interaction of the BEPS transfer pricing rules and permanent establishment profit attribution rules; i.e., the concept of risk control functions under Article 9 of the OECD’s Model Tax Convention on Income and on Capital and the permanent establishment concept of significant people functions/KERT functions.
“When I joined the OECD in 2016, I was actually put to work on the follow-up of Action 7 and the attribution of profit to a permanent establishment,” he said. “They had a small report – 2018 I think it was when it was published. It was a challenging one and it showed that there are divergencies in interpreting the OECD instruments when it comes to the profit allocation under permanent establishments.
“It was a fantastic exercise in terms of mapping out the differences between Chapter I and the 2010 Permanent Establishment Report. And you are correct… when you look at the definition of risk control functions and you compare that to the significant people functions in the AOA, they overlap sometimes, maybe most of the time, but there are situations where they actually do not lead to the same conclusion.
“So, part of the discussion we had back in the day, and that we are going to have in the future, is to ask, while recognising those gaps, do they still make sense from a policy perspective? Because part of the outcome of that discussion was that we recognised that those gaps exist, but they are not so significant that they require a whole revamping of the AOA report. But maybe now with the new reality, where we can see further divergencies, maybe it’s time to actually rethink those situations.
“You can think also of the attribution of capital to permanent establishments, which is a different animal to what is governed under Article 9 [the transfer pricing article of double tax treaties]. Again, I think those are the areas where we need to start taking some time to think about whether the new reality is putting too much pressure on those situations, where in the past we thought that they were not that significant, but they are actually becoming more significant now.”
Finally, Deloitte asked Manuel de los Santos's perspective on whether there will be – and indeed whether there is a need for – further alignment between the OECD Permanent Establishment Report and the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
“We are very much in the hands of the membership and how countries perceive [this] as one of the priorities where they want to focus their resources,” he said. “But I can tell you that if we look outside of the membership, if we look at the business community, even academia, there is a growing interest in going back to discussions that we had in the past in the context of the attribution of profit to [a] permanent establishment, because the perception by them is that those gaps between the allocation of profit to a subsidiary and the allocation of profit to a permanent establishment are becoming more significant than what we thought in the past.”
Reassessment of the attribution of profits to PEs on the horizon
The increasing importance of the attribution of profits to permanent establishments is a result of changes in the organisation of businesses and their employees, and the role of technology in organisations. Businesses and the OECD agree that, in relation to remote working, now is considered to be the right time to revisit the guidance, in light of these changes.
The first article in the series, in which Manuel de los Santos shed light on the upcoming work of the OECD on global mobility and hybrid working models, is available here.
The final article covers the developments in transfer pricing audits and dispute resolution mechanisms, presenting Manuel de los Santos’s thoughts on the subjects.
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