Introduction

Permanent establishments (PEs) are created as a fiction of tax law (either tax treaty law or domestic law) in order to assign tax jurisdiction over the income derived from operations of a company in a country of which it is not a tax resident.

In calculating the profits of the PE, business expenses are generally deductible under the same rules applicable to domestic companies. This result is generally considered appropriate as a matter of policy, and is also typically required by the non-discrimination clause of tax treaties.

However, special problems are raised by the deductibility of payments to the head office (HO) or other parts of the enterprise, such as payments for certain services, fees, royalties and interest. As opposed to business expenses that are paid to separate entities (for example, providers of raw material or outside lawyers), internal payments are notionally paid from one part of the same legal entity to another. The same problem arises with respect to the transfer of assets, whether tangible goods, financial assets, or other intangibles.

Some of these expenses can be directly attributed to the PE without particular difficulties, such as the purchase of inventory or equipment by the PE, or employee or local management related expenses. Other expenses are not so easy to attribute or allocate, such as expenses incurred by the head office, for example research and development, financing of PE activities, general management overhead, rendering of services such as marketing, or transfer of intangible assets.

This note discusses what amounts should be allowed as deductible expenses in determining the profit of a PE, and the alternatives for doing so.

Treaty and Model Practices

Traditionally, Treaty practice and Model Conventions have denied the possibility to deduct notional payments for internal dealings between a PE and other parts of the enterprise (mainly HO). Internal dealings have not been recognized for tax treaty purposes as regards the determination of the net profits attributable to PE activities.

On the contrary, Tax Treaties normally recognize the possibility to deduct the amount of expenses effectively incurred by the enterprise for the purposes of the permanent establishment, including executive and general administrative expenses, regardless of the State in which the expenses were incurred. State practice allows in that regard the allocation of a proportional part of the general administrative expenses to the PE, and a deduction for this allocated amount.¹

Some Treaties, moreover, clearly specify that amounts paid, otherwise than for actual expenses from the PE to the HO by way of royalties, fees or other similar payments in return for the use of patents or other rights, or by way of commission, for specific services performed or for management are not a deductible expense. Interest payments in the case of a banking enterprise, paid by the PE to the HO in return for money lent to the PE, however, may receive a different treatment and can be considered a deductible expense.

Deductibility of notional payments for internal dealings between a PE and other parts of the enterprise is subject to an important revision, as a result of the Reports on the Attribution of Profits to PE published by the OECD (2006).

The application of the separate and independent fiction to the PE (new article 7.2 of the proposed OECD MC) may lead to a different result, considering the PE as a functional separate and distinct enterprise from the HO for tax purposes. In that scenario, deductible expenses of the PE are not dealt with by article 7 of the Model (Business Profits), but by domestic law, subject to the conditions of the non-discrimination clause of article 24.3 of the Model (paragraph 27). According to such provision expenses are deductible under the same conditions applied to resident companies.

Notional payments to the HO for services, royalties and capital lent should then, under the separate enterprise fiction approach, be deductible from the PE profits. The separate functional enterprise fiction is mandatory for both the residence and the situs State of the PE and, therefore, international double taxation should be avoided. Differing views on the implications or the interpretation of the separate enterprise fiction, especially as regards the method for attributing capital to the PE, may lead to double taxation or double non taxation.

The new OECD approach, however, does not extend the separate enterprise fiction of the PE to the application of articles 10 to 12. Withholding taxes are, therefore, not applicable on notional payments made by the PE to the other parts of the enterprise. States desiring to treat PEs similarly to subsidiary resident enterprises may, nevertheless, consider to implement a withholding tax at source on such notional payments that are recognized for purposes of attributing profits to the PE and guarantee its application in tax treaties through the inclusion of specific safeguarding clauses.

Country Practices

There is a wide range of variation in the specific treatment of internal expenses in domestic legislation of different countries, despite the fact that there is a tendency to accommodate domestic tax law to guiding principles in tax treaty requirements. Moreover, some States have made amendments to domestic tax law so as to reflect the new OECD approach to the PE separate enterprise fiction.

1. Transfer of intellectual property or technology

In the case of the transfer to the PE of intellectual property (IP) and technology developed within the company, there are three general approaches. A few countries do not allow any deduction for payments or notional payments for IP dealings with the PE or internal charges ², especially when the intangible was previously created.

Some countries allow the deduction of royalties charged by the head office (or other parts of the company) at arms length amounts.³ Others allow the sharing of the cost of development of the IP. In the latter case usually the prorated actual cost of research and development is deductible without a mark-up. The prorating is either based on a rate that reflects the proportion of the PE's turnover to the total turnover of the company, the expenses of the PE compared to the total expenses of the company or the fixed assets in the PE compared to the global fixed assets. In countries using the latter approach, notional-royalty payments and fees for technical assistance are generally not deductible.⁴

2. Provision of internal services

There is a wide range of services that may be provided from the HO to the PE, varying from specific services to general management services. Most countries allow as a deductible expense the arm's-length remuneration for services rendered by the HO to the PE. However, in order to accept the deduction of a mark-up, the service must be of the same kind as those provided to third parties in the ordinary course of business of the provider and be actually rendered (i.e. services directly rendered to the PE as opposed to overhead costs related to general management type services) ⁵. The cost of any other services, such as overhead expenses related to general management, administration, training, etc. is usually prorated and the deduction is based only on actual cost. The amount that is prorated between different parts of the company is the total cost of the head office, without taking into account any profit margin (the costs plus the profit margin would equal the arm's-length price of the service).⁶ The proration is usually based on the same type of formula described above in connection with cost-sharing for IP development (i.e. based on share in the total turnover, expenses, or fixed assets) ⁷. In order to avoid an abuse of the deduction, some States limit its amount to a certain percentage of total income attributed to the PE ⁸

3. Transfer of assets

Assets transferred between the head office and the PE are generally regarded as being sold at market value from the HO to the PE, and not being hired or leased.⁹

Therefore, in most countries a notional rent cannot be deducted. ¹⁰. On the contrary, depreciation is allowable based on the value to be attributed to the asset being transferred. In this case, the cost basis of the assets in the hands of the PE is normally stepped up to market value.¹¹

The problem of internal transfer of financial assets mainly arises in relation to international banking. In the banking business it is typical to use branches in other countries instead of subsidiaries due to considerations regarding obligatory capital rules. Therefore transfers of debts often take place between branches in different countries. Most countries take into account such transfers at market value and not the face value of the assets.¹³

4. Capital borrowed from head office

If capital is borrowed by the head office from a third party for the sole purpose of financing a PE, the interest payable is in most countries deductible in determining the profits of the PE.⁹. If such borrowed funds are used partly for purposes of the PE and partly for the head office, generally the interest is broken down between the head office and the PE.¹⁴

Internal funding has normally received a different treatment, preventing the deduction of internal debt payments and receivables from the PE to the HO, with the exception (in some countries) of banks ¹⁵. There is, however, an increasing number of countries that allow some sort of deduction for internal loans to yield a profitable interest¹⁶.

Some countries disallow notional interest payments but allow deduction of interest from loans taken out from third parties if applied to the business of the PE ¹⁷. Some others allow deduction for interest from loans and notional interest on loans from HO. In order to allow such a deduction of notional interest, capital must be attributed to the PE. There is a variation of methods for such a calculation, ranging from the fair decision of the entrepreneur, limited by a capital mirror method ¹⁸, or attributing capital according to the functions performed by the PE. Other countries opt for the application of the same ratio of capital corresponding to the whole enterprise. In other countries the deductibility of the internal interest charge is tied to the maintenance of a normal debt/equity ratio in the PE, which is calculated taking into account the thin capitalization rules. ¹⁹

Fashioning a Solution

As mentioned above, the basic concept behind creating the fiction of PEs was to establish a taxable entity where a non-resident company derives income from a country through economic activities that are substantial within the country but without establishing a separate legal entity for this purpose. Based on a substance-over-form approach, the tax treatment applicable to these fictitious entities should be the same as in the cases where non-residents establish separate legal entities in the form of subsidiaries. If both entities carry out similar economic activities, the choice of legal form should not lead to different tax results. The income of subsidiaries is determined separately based on the subsidiary's revenues and deductible costs and expenses taking into account all incurred items²⁰ - the taxation of PEs should be designed along the same lines.

Therefore, expenses allowed as deductions from the profits of a PE should be those that are actually borne by such a PE (i.e. that are incurred in the interest of the PE and not of another part/parts of the company). This does not mean that the deductible amount should actually be reimbursed by the PE.²¹

The use of intangible property by the PE raises a complex problem. There are two solutions both of which seem to be reasonable: either the deduction of arms length royalty paid to the headquarters may be allowed; or royalty payments may be disallowed and instead the cost of developing such IP may be allowed as deductible expense without allowing for a profit margin. This can be done through the allowance of prorated deductions. Such prorating may be calculated on the basis of the ratio between the overall costs incurred by the PE compared to the total expenses of the company. Alternatively some other more schematic indicator may be used such as the turnover of the PE compared to total turnover of the company or the fixed assets of the PE compared to the total of fixed assets in the whole company.

With respect to the provision of internal services there are two polar solutions. On the one hand, if the company (or certain parts of the company) is engaged in the provision of certain services to third parties and the same service is provided to the PE, the payment for the service should be treated similarly as when it is provided to a third party, i.e. a cost plus profit margin (arms-length price) should be allowed as a deductible expense. This is in line with the principle of treating subsidiaries and PEs similarly. It is, however, far more usual to see services that are provided only for internal purposes for all parts of the company, such as general management or administrative services or training programs.

Transfers of assets should be recognized at market value unless the transfer is temporary. If the transfer of assets is not recognized as a taxable transaction, the assets could be sold from the PE and result in taxable income in the country of the PE while the same income would not necessarily be taxed in the country of the head office (for example if a double taxation treaty exempts PE income from taxation in the country of the head office). The transfers of assets (especially in the case of financial assets of banks) is similar to those that take place between independent entities; therefore there is no reason to give them a special treatment.

Treaties provide rules regarding the deductibility of expenses incurred by PEs. These rules tend to allow the deduction of all expenses related to headquarters including royalties and interest just as in the case of subsidiaries. If domestic rules are different or stricter than the ones in the treaties signed by the country in question, that may lead to additional burden on the tax administration as they would have to apply a different set of rules to PEs depending on the residence of their heaquarters.

In deciding which factor should be used for prorating headquarter expenses, there are two main aspects: applying the factor should lead to a reasonable result and calculating it should not cause an excessive administrative burden. Factors such as the ratio of PE fixed assets to the total of fixed assets may not always be reasonable, however, it is relatively easy to calculate (and to monitor by the tax administration). The ratio of PE turnover to total turnover may also be considered, however here, too, the result may be somewhat far from the economic reality (e.g. if certain portion of the sales revenue due to the activities of the PE is realized in another part of the company). As mentioned above the ratio of the expenses of the PE compared to the total expenses of the company may also be used.

For Further Reference

Aigner, Hans; Züger, Mario. Permanent Establishments in International Tax Law (Linde Verlag, 2003).

Benett, Mary; Russo, Raffaelle. The OECD project on Attribution of Profits to Permanent Establishments: an update. International Transfer Pricing Journal. 5/2007

García Prats, F. A. El establecimiento permanente (Tecnos, 1996).

The Taxation of Permanent Establishments (Irene Burgers et al. eds, International Bureau of Fiscal Documentation, looseleaf 2003).

Vogel, K. on Double Taxation Conventions (article 7).

IBFD. The attribution of profits to permanent establishments: the taxation of intra-company dealings (International Bureau of Fiscal Documentation, 2005).

IFA (Collier, B. General Report) The attribution of profits to permanent establishments. Cahiers de Droit Fiscal International. Vol 91b. (Sdu Fiscale & Financiele Uitgevers, 2006).

OECD. The attribution of profits to permanent establishments (Paris, 1994).

OECD. The attribution of profits to permanent establishments. Parts I-IV (Paris, 2004-2006).