This discussion draft (DD) deals with attribution of profits to a host country resulting from changes to the taxable presence requirement in the definition of a permanent establishment (PE) in BEPS project’s Action 7. Although generally clear and well reasoned, it is of limited usefulness in our view, for two main reasons. These comments explain these shortcomings and suggest how they could be corrected.
First, it applies only to the 2010 version of the OECD model convention, which introduced the ‘authorised OECD approach’ (the AOA) for attribution of profits to a PE. The AOA attempts to extend to PEs as far as possible the independent entity principle as applied to associated enterprises within a multinational enterprise (MNE). A number of OECD countries have not accepted the AOA, and it has also been generally rejected by developing countries. One reason for this is that the independent entity principle is especially inappropriate for a PE, which by definition is part of the same legal entity. Hence, few actual treaties are based on the AOA, and this is also true for most national tax law rules which would apply to entities resident in non-treaty countries. States, especially developing countries (whether or not they decide to join the Inclusive Framework for BEPS), should not be pressurised into adopting the AOA. Instead, the UN Committee of Tax Experts, in liaison with the OECD, should develop its own revisions to the commentary to the UN treaty model consequent on the changes to the PE definition introduced by Action 7. Further work is clearly necessary, by a wider range of countries, and adopting a broader approach, to produce guidance that would be of use to tax payers and tax authorities, especially in the bulk of cases where the AOA is not applicable.
Secondly, the examples provided in the DD adopt a very restricted approach, which assumes that all or most significant people functions take place in the non-resident entity, and hence attribute only limited profits to the PE. They include some illustrations of when aspects of inventory and credit risk management may take place in a PE, but significantly the examples include no discussion of other sales-related functions such as marketing and advertising, which are instead assumed to be controlled by the non-resident entity, with no relevant local input. Similarly, the examples are silent regarding core business functions conducted in host countries that are often found in modern MNE business models. These simple examples may be relevant to relatively small firms based almost entirely in their home countries, which employ a foreign sales agent. But they are entirely unrealistic in relation to most large MNEs and their modern business models, which aim to be both global and local. No MNE can operate effectively by centralising virtually all its significant people functions and all its core business functions at a distance from its customers and suppliers, as is assumed in the examples provided here. Indeed, there are many well known examples of MNEs which employ significant staff in host countries engaged in both customer-facing and many core business functions. The failure of this DD to discuss such situations suggests a lack of consensus on how to deal with them, which may regrettably exacerbate the likelihood of conflicts even between OECD countries.
As the DD is now drafted with its focus on the AOA and its unrealistically simple examples, its effect is to strengthen the BEPS mechanisms used by many MNEs. This contradicts the mandate for the BEPS project, which is to align taxation and value creation.