Tax officials preview coming OECD guidance on profit splits, attribution of profits to PEs

by Julie Martin

Tax officials provided an update of international tax and transfer pricing guidance currently being developed at the OECD, including work on profit splits and on attribution of profits to permanent establishments (PEs), at Washington DC conference sponsored by the OECD, USCIB, and BIAC held June 6–7.

Andrew Hickman, who heads the transfer pricing unit at the OECD Centre for Tax Policy and Administration, noted that OECD Council on May 23 formally approved the OECD/G20 base erosion profit shifting (BEPS) plan amendments, making the BEPS transfer pricing work under actions 8—10 and 13 applicable in countries that explicitly adopt the transfer pricing guidelines into their domestic law.

The OECD intends to publish a revised version of the transfer pricing guidelines later this year, Hickman said. Before that, though, the chapters must be updated to conform to the BEPS changes, particularly the new analytical framework in Chapter I on delineating transactions and allocating risk, Hickman said. The transfer pricing guidelines were last published in 2010.

Hickman said the OECD is about to complete work modifying Chapter IX of the guidelines on business restructurings to conform to the Chapter I framework and will soon release draft changes. The OECD is not open to any discussions about the concepts in the draft; it will just seek feedback on whether the conforming changes create any problems, he said.

Guidance being developed on cost contribution arrangements (CCAs) will also conform to the new Chapter I framework, Hickman said. The OECD will be very specific about the valuation of contributions and the kinds of participants to a CCA arrangement that are acceptable, he said. Participants need to control the risks that are subject to the CCA, he said.

“There isn’t a free lunch here – you can’t put something into a cost contribution arrangement at under value and move it somewhere else to a party that has no real interest in that arrangement,” he said.

Attribution of profits to PEs

Draft guidance on the attribution of profits to PEs and on profit splits should be released in time to provide tax specialists with some good beach reading, Hickman quipped.

Much of the guidance on the attribution of profits to PEs will focus on the interaction between Article 7 of the OECD model tax convention, which deals with attribution of profits to PEs, and Article 9, which deals with associated enterprises. The guidance will particularly focus on dependent agent PEs, Hickman said.

Hickman said that the BEPS transfer pricing work in actions 8—10, including the work on risk allocation, may change the amount of profit allocated between a nonresident enterprise and a dependent agent enterprise.

For dependent agent PEs, where the dependent agent enterprise is an associated enterprise, the risk framework under Article 9 may allocate risk to the dependent agent enterprise, and therefore the resulting profits would no longer be profits of the nonresident which would then be attributed to the dependent agent PE, he noted.

Hickman said the guidance will clarify that there are instances where there can be additional profit in a dependent agent PE even when Article 9 is applied properly to determine the profit to the dependent agent.

For example, under a transfer pricing analysis, the functions performed by a dependent agent enterprise may not lead to the assumption of risk by the dependent agent enterprise, such as when the nonresident contractually assumes risk and exercises control.  At the same time, under Article 7, the significant people functions can mean that the risk is shared, so the dependent agent PE may have additional profit over the arm’s length return to the dependent agent enterprise, he said.

Hickman also noted that any return to capital to fund an asset under Article 9 may be attributed to the dependent agent permanent establishment if the asset is economically attributed to the dependent agent permanent establishment under Article 7.

“Article 9 ain’t Article 7, and the two should not collapse on itself as a matter of policy or appropriate application of the current articles,” said Mike McDonald, US Treasury financial economist and chair of Working Party No. 6 of the OECD’s Committee on Fiscal Affairs, responsible for the work.

McDonald said the guidance “takes on the notion of the analysis under Article 9 and getting that right, and then the notion of ‘what are the incremental profits over and above the Article 9 profits that are attributable to a dependent agent PE.'” He said that, in his view, it is most effective to complete the Article 9 analysis before turning to Article 7.

 Profit Splits, hard-to-value intangibles

During a separate panel, Hickman said that draft guidance being developed by the OECD on profit splits will describe the transfer pricing method in the context of a value chain to show why profit splits may be the correct method and also to give some assistance in determining how to split profits.

Brian Jenn, an attorney advisor with the US Treasury, said the US approves of the direction the OECD work is headed. Jenn said some had worried that profit splits would be considered the default most appropriate method for any relatively integrated multinational business. Instead, the guidance is going more in the direction of providing greater clarity by delineating circumstances in which a profit split is the appropriate method, he said.

Jenn said that even if the BEPS plan did not call for guidance on profit splits, the OECD would have needed to revisit the guidance anyway to account for the Chapter I revisions. The determination of whether a profit split is best method involves the question of who controls the risk and has financial capacity to bear the risk, he said.

Hickman said work will distinguish two types of profit splits: one which splits actual profits and the other which sets prices based on a split of anticipated profits.

In a split of actual profits, multiple parties split profits on the basis of contributions and all share the risk of unanticipated profits or losses, he said. “This is something particular you would need to establish in your functional analysis to determine the appropriateness of any profit split of actual profits,” he said.

A price-setting profit split of projected profits, on the other hand, does not involve sharing of risk but more typically involves a situation where there are contributions that are difficult to benchmark, Hickman said.

The method could be used, for example, if parties wish to share rights in an intangible, but do not know what the intangible is worth. The parties first figure the expected profits from the activity using the intangible, so profits are combined. Then, a discounted cash flow valuation of future projected earnings is conducted and routine contributions are eliminated to determine the value of the intangible. That value is used to set the price for the transaction, he said.

In a price-setting profit split, the party that licensed the intangible has no further interest in the business so all risks are borne by the other party, he noted.

Hickman added that the guidance will also specify that the profit splitting factors must be measured in a reliable and verifiable manner. He said that countries are concerned about profit splits based on less concrete analysis.

The OECD is also working on more guidance on hard-to-value intangibles, Hickman said. The guidance will not make any changes to the existing guidance; its purpose is to assist tax administrations with the rules that are already set.. He said the guidance will provide examples of how tax administrations should apply the provisions.

Interest deductions

Achim Pross, OECD Head of International Cooperation and Tax Administration, said the OECD will issue a consultation document later this year on interest deductibility related to banking and insurance. Pross said the OECD has not yet decided whether there should be particular rules for these industries.

“[F]or the regulated side of the banking [sector], there is probably, on the whole, not that much risk that it would require an OECD [agreed-to] rule,” Pross said. He said there already is a lot of regulation of capital requirements, though hybrid debt can create some issues.

Pross said interest income from a banking operation inside a group can have an impact on the fixed ratio. If the fixed ratio rules are modified to carve out such banks from a group, the issue then arises about how to deal with the group ratio rule, Pross said. Also, while a carve out may be easy for bank in an industrial group, it may be more difficult if the multinational is a financial intuition, he said.

Jason Yen, an attorney advisor at US Department of the Treasury, said that the US does not believe there should be specific, targeted, interest dedcutibility rules for banks.

Pross also said he expects that draft guidance will be released this July providing more detail on the group ratio rule for the BEPS interest deductions limits, with final guidance released by December. Pross said that there will be no changes to the group ratio rules, just more detail, such as an explanation of how the group ratio is affected when there are losses in a group.

Model treaty commentary on PEs

Jacques Sasseville of the OECD’s tax treaty unit said that work is also underway drafting commentary to Article 5 of the OECD model tax treaty on PEs.

The commentary must be updated to integrate changes proposed in a 2012 discussion draft on Article 5 with the significant changes made to the PE threshold in BEPS action 7, Sasseville said. The work on the 2012 draft was put on hold when the BEPS work commenced, he said.

The resulting new Article 5 and its commentary will be included in the next update of the OECD model, currently scheduled for 2017, Sasseville said.

Sasseville said that there will not be an opportunity for public comment on the integrated commentary.

“We are not going to change or expand on the commentary that we just adopted after a long process of consultations [though] we may need to fix a few things to make the integration possible,” Sasseville said.

He said that among the more important topics in the 2012 draft to be incorporated into the commentary are the meaning of “at the disposal of,” home offices as PEs, how to address a main contractor that subcontracts all aspects of a contract, the time requirement for the existence of a permanent establishment, and the meaning of “to conclude contracts in the name of the enterprise.”

Quyen Huynh, an associate international tax counsel at the US Treasury, explained that the PE changes that resulted from BEPS action 7 should be applied prospectively only. Because the BEPS changes were so significant some of the 2012 draft commentary provisions will have relevance only for preexisting treaties, she said. An example, she said, is paragraph 75 of the 2012 discussion draft, regarding the preparatory or auxiliary issue, which clearly conflicts with the OECD report under action 7.

Multilateral instrument

Huynh also said that the US is participating in the development of the multilateral instrument to implement BEPS. When it is complete, the US will assess whether it will sign on to all or part of the agreement. The outcome of the work on profit attribution will play a role in the US decision, Huynh said. She noted that the PE standards developed in the OECD BEPS plan are not minimum standards, and also said the US is interested in the provisions on mandatory binding arbitration.

During a separate panel, Henry Louie, US Deputy to the International Tax Counsel, said that in analyzing whether to sign on to the multilateral instrument, US officials are analyzing the US’s current level of exposure to BEPS issues on account of US bilateral tax treaties.

For example, the US is examining whether it has consistently adopted rules preventing treaty shopping and “rules that would prevent our own residents from hiding behind a structure in the other country to avoid our own residence tax,” he said.

Louie said that if the degree of US exposure to BEPS issues is not uniform, the question then arises as to whether the multilateral instrument will allow counties the flexibility to update some treaties but not others.

Another question is the degree to which the US agrees with substance of the recommendations, Louie said. He noted that the 2016 US Model Income Tax Convention, issued in February, differs from the BEPS recommendations in some areas. The technical matter of using a multilateral instrument to amend many bilateral treaties must also be assessed, he said.

Finally, Louie said, the US will need to assess whether signing the multilateral instrument will allow treaty partners to address their concerns, but not the US’s concerns, causing a reduction in US bargaining power.

Mike Williams, Director, Business and International Tax, at the UK’s HM Treasury and chair of the ad hoc group of counties working on the multilateral instrument, said work on the multilateral instrument will not change any underlying rules, except in the case mandatory binding arbitration, where substantive rules will be drafted.

Numerous complex issues must be address to allow the integration of the instrument’s provisions into exiting tax treaties, such as how to handle situations where countries have already gone beyond BEPS minimum standards in their tax treaties, Williams said.

Jesse Eggert, an OECD senior advisor on the BEPS project, said the work on mandatory binding arbitration will go beyond what is provided in the OECD model provisions. Default rules will be added to cover situations where countries have agreed to adopt mandatory binding arbitration but have not yet entered into a bilateral agreement specifying the details of such a rule by the time a case enters arbitration.

Eggert added that the work on the multilateral instrument will not likely be released in draft form before it is finalized because it is the product of negotiation among countries.

Eggert said that the correct balance must be struck in the instrument. If it is too inflexible, countries may not be willing to sign it; if it has too much flexibility, the instrument will turn into a series of bilateral negotiations. He said it seems possible to allow countries flexibility to apply or not apply the multilateral instrument based on the type provision.

He also said it is still unclear at this point whether the multilateral instrument will permit countries to opt out of minimum standards, though he said that in his view, this would be inappropriate.