Transfer Pricing Times: Volume X, Issue 7
One of the most vexing issues in transfer pricing is the treatment of so-called Permanent Establishments (“PE”). A PE can generally be defined as a business, or even just a person, located in a “host country” and acting on behalf of an enterprise located in a different country (i.e., the “home country”). The tax risk is that the host country tax authorities could attribute taxable profits to the PE that exceed those commensurate with its actual activities. Conversely, the home country could deny any deductions resulting from a generous attribution of profits to the PE (particularly if it does not agree that a PE exists). Consequently, there is a real risk of double taxation, a risk that could be mitigated by establishing a supportable and documented transfer pricing policy for the PE.
Regulatory guidance with respect to attributing profits to PEs can be found in Article 7 of the Organization for Economic Cooperation and Development (“OECD”) Model Tax Convention (“MTC”). Article 5 of the MTC provides a definition of what constitutes a PE. Though specific definitions of a PE can vary among countries, it is usually characterized by a fixed place of business (e.g., a place of management, a branch, office, factory, etc.) 1 in the host country. Some countries apply a six-month time requirement for a PE to be deemed to exist, but this is not a firm rule. The important consideration in determining whether a PE exists is to determine whether the operation, activity, or person has the ability to enter into contracts which are binding on the home-country enterprise.
A particularly slippery slope in this regard is the Dependent Agent PE (“DAPE”) concept, which could be a single person able to conclude contracts binding an enterprise, and who “habitually” exercises that authority. (This is in contrast to an independent agent, who may occasionally conclude contracts on behalf of an enterprise but does so for other enterprises as well, and is therefore not a PE.) It is important to note that a DAPE need not be an employee of the home enterprise.
Through the MTC, the OECD has adopted the “functionally separate entity” approach for analyzing transfer pricing policies as applied to PEs. Under this approach, even though a PE is not a separate legal enterprise, profit should be attributed to it as if it were and dealing with the home enterprise on an arm’s length basis. This is known as the authorized OECD approach, or “AOA”. Note that under the AOA, profits can be attributed to a PE even though the enterprise as a whole loses money, as long as the PE profits are an arm’s length amount based on its activities. Furthermore, such a profit allocation does not need to be actually implemented, but is rather a fiction by which taxable profits are calculated for the PE. (The fictional nature of this exercise, along with differing country approaches regarding its implementation, could contribute to difficulty in defending offsetting deductions in the home country.)
Application of the AOA resembles a typical transfer pricing study of a related party (i.e., subsidiary). The functional analysis takes on even more importance, with a focus on Significant People Functions (“SPFs”), as the extent of SPFs resident in the PE determines the share of profits that should be attributed to it, particularly when it comes to functions related to the assumption and /or management of various business risks. The AOA also attributes to the PE economic ownership of assets for which significant functions relevant to that ownership are performed by people in the PE.
Many of the same concepts apply to a financial services enterprise, with the SPF terminology replaced by Key Entrepreneurial Risk-Taking Functions (“KERTs”). This is in recognition of the close link between risk and assets in this industry. For example, assets (or capital) must almost always be attributed to the entity (or PE) that manages the associated risks. If a portfolio of derivatives is managed by a PE, then that PE must be viewed, for tax purposes, as owning the capital supporting the associated risks. This is true even in situations where a PE assumes risks which were originally situated in another part of the enterprise. Outside of financial services, however, risks may be less intimately linked with assets, so that there may be less overlap between SPFs relevant to the assumption of risks and those relevant to the economic ownership of the assets. For example, one entity can own plant and equipment, while another entity actually manages credit, inventory, and other risk arising from business operations.
The unique and central role of capital in the financial services industry can lead to complications in applying the AOA. Given that capital must follow risks, the tax fiction of the AOA is amplified by the need to theorize the amount as well as the type of capital owned by a PE performing risk-taking functions. Determination of an arm’s length level of capital consistent with the KERTs performed by the PE is challenging since the PE is not a separate enterprise and therefore does not have its own capital. The level of capital consistent with the PE’s functions can also depend on regulatory requirements, in both the home and host country, on which there is little agreement at this point. However, we can agree that along with the functions performed, attributed capital will have a substantial impact on profitability.
The type of capital attributed to a financial services PE also matters. In particular, the assumed mix of “free” and interest-earning capital will impact profitability. Free capital includes equity and retained earnings, items which do not give rise to interest deductions when attributed to a PE, whereas interest-bearing capital consists primarily of safe debt instruments. Capital standards, such as those promulgated under the Basel III accord, make a distinction between the amounts of free and non-free capital to be held in support of specific risk activities. However, these standards are not uniformly applied, and significant country-to-country differences exist. Consequently, the “right” amount of free capital attributable to a PE will seldom be known with complete certainty, and even minor variations can have a substantial impact on taxable profitability (e.g., more free capital relative to debt means higher profits).
As mentioned earlier, the risk of double taxation when it comes to PEs, real or deemed, is substantial. Not all countries agree on the OECD approach, or even on the definition of a PE. 2 Countries such as the US, UK, and Netherlands generally follow the AOA, while others (e.g., Argentina, Brazil, Hong Kong) do not. Yet others, such as Germany, Australia, and Korea, have domestic regulations that are partially consistent with the AOA, but still unique to the local country. Consequently, the challenge to taxpayers is how to best manage this diverse landscape when looking at their global operations. Multinationals should recognize that no one approach will meet the requirements of every country in which they operate. However, applying an internal consistent policy can be an effective defense, even in countries that disagree with the profits attributed to local PEs on a stand-alone basis (exceptions may have to be made in certain cases). In any case, as with every other area of transfer pricing, the general policy when it comes to attributing profit to PEs, and determining exceptions to that policy, should be carefully documented in order to maximize the chances of a successful defense.
Changes in Transfer Pricing on the Horizon for France
On June 6, 2013, the French General Inspectorate of Finance (“IFG”) published a draft report on its website, titled The Mission for International Comparisons for the Fight against Tax Evasion Using Intragroup Economic and Financial Transfers, highlighting its proposals for strengthening existing transfer pricing rules in France. This initiative is aimed at combating tax avoidance by multinational enterprises (“MNEs”) and includes implementation of additional penalties for foreign MNEs that fail to comply with its documentation requirements. 3 Key revisions proposed by this draft include:
- Reaffirming the Arm’s Length Principle in French Law – Although the arm’s length principle is used in practice in France, it was not yet written into French Law. The proposal seeks to better reflect the scope of the arm’s length principle within French Law, in line with the OECD Guidelines.
- Reversal of Burden of Proof – Taxpayers in certain high risk situations (e.g., corporate reorganization, preferential tax treatment, negative net margin, etc.) will be required to provide the tax administration with more information than is currently required.
- Broadening of Penalties – Taxpayers may be subject to a penalty, even if no adjustment is found to be necessary, for the lack of appropriate documentation.
- Increased Access to Taxpayer’s Cost Accounting Records – A company’s tax accounting records provide information crucial to understanding the scope of transactions and comparisons between entities, as well as the calculation of margins. By opening this access, the French tax authorities would receive a level of information and understanding on par with the best practices implemented by its foreign partners (e.g., US, UK, Canada, and Germany).
While all of these changes are geared toward bringing the taxing authorities and the taxpayer on more even ground, the key proposal focuses around the requirement to produce transfer pricing documentation. Under this proposal MNEs operating in France are subject to transfer pricing penalties regardless of whether or not an adjustment to the intercompany pricing is deemed appropriate. Thus, as French taxpayers may face stricter transfer pricing laws in the future as a result of this proposal, it becomes even more pertinent for companies to prepare and maintain their transfer pricing documentation.1 A branch can be a PE, but the latter’s definition includes other types of operations and activities.2 Many countries, particularly in the developing world, subscribe instead to the UN Model Tax Treaty, which rejects the AOA.
3 Currently, this publication is available solely in French through the French Finance Ministry website: http://www.economie.gouv.fr/files/2013-note-IGF-evasion-fiscale.pdf.