OECD discussion draft on new article 7 (business profits) of the OECD Model Tax Convention.

AuthorMuller, Johann
PositionOrganisation for Economic Co-operation and Development

January 15, 2009

On January 15, 2009, Tax Executives Institute submitted the following comments to the Organisation for Economic Co-operation and Development in respect of a discussion draft on a new Article 7 (Business Profits) of the OECD Model Tax Convention. TEI's comments were prepared under the aegis of its European Direct Tax Committee whose chair is Johann Muller of AP Moeller-Maersk. In addition to Mr. Muller, substantial contributors to the development of TEI's comments were members of the TEI European Chapter's Permanent Establishment group, including Anna Theeuwes of Shell International Production and Development BV, Peter H. Taylor of DuPont du Nemours International, and Alexander Kolbl of General Dynamics Corporation. Also contributing were Alain Berlier of Givaudan Flavors Corporation and John L. Tarkanyi of Johnson Controls, Inc.

On July 7, 2008, the Committee on Fiscal Affairs (CFA) of the Organisation for Economic Co-operation and Development (OECD) released a consultation document setting forth a draft of a revised Article 7 and commentary on the OECD's Model Tax Convention. The draft Article and commentary are the second part of the CFA's implementation of the conclusions of Parts I, II, and III of the Report on the Attribution of Profits to Permanent Establishments. (1) On behalf of Tax Executives Institute, I am pleased to respond to the OECD's request for comments. While TEI commends the OECD for updating Article 7 and the commentary, we are concerned that the proposed revisions will increase uncertainty for taxpayers and taxing authorities thereby increasing the number of disputes between taxpayers and taxing authorities and between the taxing authorities themselves.

TEI Background

Tax Executives Institute was founded in 1944 to serve the professional needs of business tax professionals. Today, the organization has 54 chapters in Europe, North America, and Asia. As the preeminent international association of business tax professionals, TEI has a significant interest in promoting tax policy, as well as in the fair and efficient administration of the tax laws, at all levels of government. Our 7,000 members represent 3,200 of the largest companies in the United States, Canada, Europe, and Asia.

Executive Summary

TEI commends the OECD for updating Article 7 and its commentary. TEI supports the OECD's efforts to ensure uniformity in the methods for attributing profits among associated enterprises governed by Article 9 and the methods for attributing profits between a Head Office and a Permanent Establishment (PE) governed by Article 7.

TEI also supports the implementation of practical profit attribution methods and ensuring that tax administrators' approaches are consistent with the concepts in the authorised OECD approach. A threshold question is how to ensure that the underlying dealings between a PE and the Head Office (and the rest of the enterprise as well) are valid and properly documented. Once documented, the profits can be properly allocated. TEI does not, however, support imposing more stringent profit allocation methods or documentation requirements on dealings between a PE and Head Office under Article 7 than apply to transactions among associated enterprises under Article 9. Hence, TEI urges the OECD to provide additional guidance on acceptable documentation of underlying dealings in order to discourage Member States from imposing more stringent profit allocation methods, documentation, or other requirements for PEs.

In addition, because of the legal and tax uncertainties associated with the inadvertent creation of PEs, most companies will either purposefully establish an entity to conduct business within a particular jurisdiction or minimize their activities to ensure that a PE is not created. Despite taxpayers' best efforts to comply with myriad jurisdictional rules to which they are subject, the business activities in a particular jurisdiction may exceed the de minimis thresholds for permitted preparatory or auxiliary activities and a PE may be inadvertently created. Where that occurs, taxpayers likely may not have available the documentation and records to support a proper attribution of profits. As a result, TEI urges the OECD to consider providing guidance on the conditions that would afford taxpayers a grace period to satisfy documentation requirements.

Next, despite the assurances in the proposed commentary that relief should be afforded where two states attempt to tax the same profits, the lack of a direct mechanism requiring full relief from double taxation ensures (1) a greater risk of double taxation and (2) divergent treatment of group companies and PEs. As a result, we urge the OECD to consider adopting a measure similar to Article 9(2) directly in Article 7.

Finally, notwithstanding the legal fiction that a PE is a separate and independent enterprise, a notional charge is not equivalent to a cash payment. Hence, TEI urges the OECD to eliminate proposed paragraph 26 from the commentary.

TEI also offers specific comments to clarify the effective date of the application of the proposed commentary, the allocation of asset costs, the treatment of Dependent Agent PEs, and the treatment of employee costs under Article 15.

Background on Article 7 Revisions

Proposed Article 7(1) of the OECD Model Tax Convention on Income and Capital provides that the profits of an enterprise of a Contracting State (i.e., the residence state) shall be taxable only in that State unless the enterprise carries on business in another Contracting State (i.e., the source state) through a PE. If the enterprise carries on business through a PE in the source state, the profits attributable to the PE may be taxed by that State.

Under proposed Article 7(2), the profits attributable to the PE are the profits the PE might be expected to make, in particular in dealings with other parts of the enterprise, as if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used, and risks assumed by the enterprise through the PE and through other parts of the enterprise.

Paragraph 2.3 of the discussion draft notes that the principles underlying Article 7, especially paragraph 2, have a long history in the Model Tax Convention. Even though the longstanding separate entity and arm's-length principles are embedded in the article, the practices of the OECD and non-OECD countries in respect of the attribution of profits and the interpretations of Article 7 vary considerably. To minimize uncertainty for taxpayers and increase consistency of interpretation among tax administrations, the OECD released a series of discussion drafts on the Attribution of Profits to Permanent Establishments. In 2008, the OECD released its Final Report on the Attribution of Profits to Permanent Establishments (3) and concluded that a new version of Article 7 should be included in the Model Tax Convention to fully incorporate the principles in the report.

TEI commends the OECD's efforts to update Article 7 of the Model Treaty and the related commentary. References to the OECD's 1995 Transfer Pricing guidelines throughout the revised article's commentary underscore the OECD's commitment to the principled and uniform treatment of associated enterprises (i.e., subsidiaries) under Article 9 and Permanent Establishments (PEs) under Article 7. In addition, efforts to close the gap between the theoretical concepts in the commentary and the effective application of the rules by OECD and non-OECD countries are welcome. Finally, the new article and commentary firmly reject the "force of attraction" rule applied by some countries for determining the profits of a PE. By rejecting that rule, the number of instances of double...

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