The OECD has further developed the concept of taxation of permanent
establishments of international businesses. Will Germany follow?
Fiscal interests between different countries often collide when it comes to international business. In order to allow global dealings to expand, many countries have concluded bilateral treaties to prevent double taxation: while one treaty country reduces or waives its right of taxation, the other is awarded the right to tax certain income that derives from its territory.
If business abroad is not carried out by a separate legal entity, in many cases the connecting factor for business income taxation abroad is the existence of a so-called ‘permanent establishment’ (PE). Taxpayers that engage in international business then have to face the challenge of identifying their tax obligations and the income attributed to each engagement abroad.
As business continues to become more international and complex, the taxation of PEs is an area of increasing scrutiny. First, there has been a trend recently of lowering the requirements of what qualifies as a PE – and this appears to be accelerating. Second, even up until today, the methodology used when attributing profits to a PE has varied considerably between countries: resulting in either double taxation or (rarely) non-taxation of business profits.
The OECD is the leading forum to develop common positions on cross-border tax policy and administration issues in order to improve certainty for taxpayers and tax authorities.
The OECD offers a model tax treaty and a commentary on the interpretation of its articles; both of which have been subject to constant changes. Many tax treaties are based on the OECD document and often adopt its wording.
The methods for attributing profits among legally separated but associated enterprises are stipulated in Article 9 of the OECD Model Tax Convention, while the methods for attributing profits between a head office and PE that are legally parts of one entity, are governed by Article 7.
The efforts of the OECD to establish a consensus interpretation of its Article 7 have been remarkable and prolonged.
The working hypothesis to view a permanent establishment as a distinct and separate enterprise – the ‘authorised OECD approach’ (AOA) – was first published in August 2004, and the final word on the issue – the Report on the Attribution of Profits to Permanent Establishments – was released in July 2008.
The conclusions of the 2008 report were eventually transferred into updated versions of the model convention (and its commentary) in two tranches. First, the commentary of Article 7 was updated (to the extent that the results of the report did not contradict the article) in 2008. Then in 2010 a new version of Article 7 (and another new commentary) was published.
Finally, in order to harmonise the new Article 7 and the 2008 Report, a final update of the report was also published in 2010.
Accordingly, the OECD Council recommends that member states follow the guidance of the 2008 report for treaties that contain a pre-2010 version of Article 7; future treaties that will contain the new version of Article 7 should be understood alongside the 2010 Report.
Changes to profit attribution
The basic principle of the new Article 7 is to treat a permanent establishment as a separate, hypothetical enterprise. A two step analysis needs to be conducted to attribute profits to a PE.
First, a (partly fictional) analysis should be performed: identifying the function of the PE; attributing risks, assets, and free capital to it; and recognising the ‘dealings’ between it and the head office.
Second, the remuneration between the hypothesised enterprises is determined by analogously applying the transfer pricing tools (including OECD guidelines) of Article 9.
In practice, one of the major changes is that the indirect profit allocation method (based on the now abandoned ‘relevant business activity approach’) is no longer applied. As a consequence we may see a taxable profit attributed to a PE, even though the legal entity (head office and PE) in total is showing a loss.
Furthermore, both the calculation and documentation of a PE’s taxable income will be much more burdensome for the taxpayer.
In this context another hurdle for tax practitioners will be the allocation of jointly used assets (i.e. by the head office and the PE) as well as fictitious ‘dealings’ between the head office and PE, such as treasury dealings that are legally non-existent but feigned for tax purposes.
It seems obvious that the AOA will also affect domestic law in many ways, and therefore significant changes may be expected.
Germany’s PE progress
Since Germany claims authorship of the PE concept developed back in the 19th century – at that time to attribute domestic profits for local trade tax purposes – any major change has resulted and results in heated discussions: German tax law follows principles rather than case law, and most tax experts do so as well.
Germany’s double taxation treaties (DTTs) generally follow the OECD Model Tax Convention, and the OECD commentary is referred to for interpretation. While there is no specific German law dealing with the cross-border attribution of profits and losses between a head office and PE, the German Federal Ministry of Finance has published a circular on PEs which includes the issue of profit allocation and is applicable for DTT and non-DTT cases.
This has been amended several times since it was first implemented in 1999, to try to keep up with the ongoing changes of interpretation in the OECD and the German national jurisdiction – at least where convenient. But despite extensive explanatory notes from the German Federal Ministry of Finance, many practical problems remain unsolved.
The PE circular explicitly refers to the OECD commentary regarding the ‘dealing at arm’s length’ principle of Article 7 of the pre-2010 OECD Model Tax Convention. This is consistent with the German perspective that profits shall preferably be allocated by applying a direct method – i.e. on the basis of separate PE accounting, according to German standards.
In particular cases where the PE and head office undertake similar functions, such a direct method may not be applicable. In this case, profits shall be allocated using an “appropriate” key (an indirect method) based upon turnover, labour or material costs.
In practice we often find a mixture of both methods is applied: a PE profit will be calculated by adding direct costs and a percentage of overhead costs.
After quite a recent change in Section 4 Paragraph 1 of the German Income Tax Act, the transfer of assets from an enterprise to its PE (unless within the EU) will trigger exit tax (taxation of the built-in gain) if Germany’s right of taxation was excluded or limited.
While the German Federal Ministry of Finance regards this change of wording purely as a clarification of a principle that has always been in existence, there are intense discussions between tax experts on this interpretation.
Summarising the current situation in Germany, one might say that profit allocation follows the general idea of the separate entity approach, but with substantial limitations.
The authorised OECD approach
Compared to the current German approach, the concept of dealings which include a mark-up on such intracompany ‘transactions’ has to be seen as a dramatic change. These dealings are inconsistent with the general principle that German tax law is based on civil law and may therefore be questioned, or cause friction regarding several aspects.
The question of whether changes to the OECD commentary need to be considered when interpreting articles of double taxation treaties that were enacted prior to the amendments will likely trigger further heated discussions – although it is commonly understood that changes to an article of the OECD Model Tax Convention will only become relevant in cases where treaties are amended or new treaties are brought in.
However, according to our information, Germany is willing to adopt the new version of Article 7 of the OECD Model Tax Convention and will implement the AOA either with new treaties or revisions of existing treaties.
Introducing the authorised OECD approach for German tax purposes would require an amendment of Section 4 Paragraph 1 of the German Income Tax Act and the Ministry of Finance’s PE circular. As a consequence there might be different regimes applicable for profit allocation, depending on the status of the relevant treaty. The transition period between AOA and pre-AOA cases will obviously create further friction.
At least in Germany, it seems inevitable to have to deal with the AOA subject, although the expected simplification for PE profit allocation still seems to be far away.
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