Transfer pricing with respect to permanent establishments deserves separate attention. Whereas the OECD guidelines are primarily aimed at transactions between legal entities, the allocation of profits to permanent establishments requires a different approach. Here it is not so much about transactions between related entities, but about the allocation of profits to a permanent establishment which is part of a legal entity that carries out its activities in more than one country. It is desirable that both countries allocate profits equally to the permanent establishment. Obviously, this will not always be easy. Because what profit should be attributed to the activities of the permanent establishment?
The Authorised OECD Approach
The allocation of profits to the permanent establishment as described in the ‘Report on the Attribution of Profits to Permanent Establishments’ (PE Report) follows the so-called ‘Authorised OECD Approach’ (AOA). This approach aims to align the allocation of profits to a permanent establishment as closely as possible with the arm’s-length principle as prescribed for a related legal entity (Article 9 OECD Model Convention and OECD Guidelines). In principle, it should not make any difference to a company’s taxable profits whether its activities in a particular country are carried out through a legal entity or a permanent establishment.
This approach means that, more than before, the so-called ‘functionally separate entity approach’ is explicitly chosen: each part of the company must be approached as a separate entity and must be rewarded in the same way as an unrelated entity would have been rewarded under similar circumstances. One of the consequences of the chosen approach is that in the case of a loss-making company, the permanent establishment will not automatically show a loss as well. The profit (or loss) of the permanent establishment depends on its own operation and, in principle, not on the operation of the company as a whole.
Since, in the case of permanent establishments, there is no contractual relationship with the main house, which is always the starting point when analysing transfer prices for legal entities, reality has to be interpreted, as it were, on the basis of economic principles. It is not possible to refer to existing contracts for the analysis, because they are missing. A fictitious entity, as it were, must be created for the calculation of taxable profit, which involves fictitious internal transactions, also referred to as ‘dealings’ in this context.
To get to an arm’s-length profit allocation, the OECD has opted for a two-step approach. In the first step, assets, liabilities and risks are allocated on the basis of the functional analysis. Next, an analysis is made of which notional intra-company transactions (‘dealings’) can be designated between the head office and the permanent establishment.
In the second step, the profit of the permanent establishment is determined on the basis of the analysis in the first step and the application of the arm’s-length principle. The dealings identified in the first step must be assigned an appropriate transfer price in the second step.
In the functional analysis, the assets and related risks should be attributed to the permanent establishment on the basis of the so-called ‘significant people functions’. These are the functions of the people who carry out the activities relating to the assumption and management of the relevant risks. The place where these people carry out their activities is decisive for the attribution of the assets and risks. This is about the people who have a decisive role in the day-to-day running of the business, and less about the people who remotely determine the strategic policy of the business as a whole. The activities of people are thus decisive. For practical reasons, the OECD has chosen to allocate tangible fixed assets on the basis of the ‘place of use’ criterion.
The allocation of assets is followed by the allocation of equity and debt. The PE Report describes various methods for allocating capital, in which the capital structure of the company as a whole (desired approach: ‘capital allocation approach’) or the capital structure of comparable companies (desired approach: ‘thin capital allocation approach’) is decisive.
The financing of the undertaking as a whole or the way in which similar undertakings are financed is the guiding principle for the allocation of assets. The total value of the assets, taking into account the risks attached to those assets, plays an important role. The greater the proportion of the value and risks of the undertaking as a whole represented by the assets and risks of the permanent establishment, the greater the proportion of the equity of the undertaking as a whole that should be attributed to the permanent establishment. The starting point of the allocation of the liability side of the balance sheet is the equity. The amount of loan capital is determined by arithmetic calculation after the value of the assets and the equity for the permanent establishment have been determined. If the value of the assets is 100 and, based on the relative values of the assets and risks, 25 equity is allocated to the permanent establishment, the loan capital of the permanent establishment will be 75.
As a final step of the exercise in the first step, it is assessed whether and which dealings between main house and permanent establishment should be considered. These dealings have consequences for the allocation of profits to the permanent establishment. Again, contractual reality does not exist and, unlike between related parties, an analysis of economic reality must be used to interpret which dealings play a role in the allocation of profits to the permanent establishment. In view of this economic interpretation, it is important that the company properly documents such transactions. As much as possible, the company will follow the existing documentation, but sometimes the company will not be able to avoid recording more than is necessary for its normal operations in order to substantiate the existence (or non-existence) of dealings. After all, he must be able to properly substantiate his allocation of profits to the permanent establishment to the tax authorities.
In step 2, the transfer price of the dealings is determined, based on a comparability analysis as described in the OECD guidelines. This should lead to an arm’s-length reward for the permanent establishment. Read more about the comparability analysis here.
Setting your transfer prices for your PEs differs from setting the transfer price between related entities. Be aware of this and make sure you use the right steps to do so!