Profit Allocation to Permanent Establishments

When expanding abroad, multinationals face a strategic choice: establish a foreign entity, or operate through a Permanent Establishment [“PE”]. If a PE ultimately emerges, knowing how to allocate its profits becomes critical. This is where tax treaties and the Authorized OECD Approach [‘AOA’] take the center stage. Their aim is to prevent artificial profit shifting and to ensure a fair profit distribution among countries, in line with the value created.

What is a PE?

For the purposes of this Article, we’ll refer to the OECD Model Tax Convention [‘MTC’], as this serves as a framework for a vast majority of tax treaties.

Under Article 5(1) of the MTC, a PE means a fixed place of business through which the business of an enterprise is wholly or partly carried on. Common examples include a place of management, branch or office. In addition, Article 5(1) expands the definition to include situations where a person habitually concludes contracts (or plays a decisive role in their conclusion) on behalf of the enterprise, unless the agent’s activities are of mere preparatory or auxiliary nature.

In short, a PE is a business presence in a country that allows that country to tax the enterprise’s profits related to that presence.

We highly recommend reading the following article to gain a deeper understanding of the PE concept:

The Treaty Context: Article 7 of the OECD Model Tax Convention

Under Article 7(1) of the MTC, if an enterprise carries on business in another jurisdiction through a PE, only the profits attributable to that PE may be taxed in the jurisdiction of the PE.

In determination of the profits to be attributed, Article 7(2) of the MTC introduces the ‘distinct and separate enterprise’ fiction: the PE must be treated as though it were an independent entity, performing similar functions, using similar assets, and assuming similar risks under comparable conditions, independent of the remainder of the enterprise. For simplicity purposes, we’ll refer to the ‘head office’ when referring to the remainder of the enterprise.

The hypothesis by which a PE is treated as a functionally separate and independent enterprise is a mere fiction necessary for purposes of determining the business profits of this part of the enterprise under Article 7. The authorized OECD approach should not be viewed as implying that the PE must be treated as a separate enterprise entering into dealings with the rest of the enterprise of which it is a part for purposes of any other provisions of the MTC.”

Accordingly, in determining the profits attributable to a PE, due consideration shall be given to the nature of the activities by both the head office and the PE. This includes the recognition of a notional transaction between the PE and the head office, treating the PE as a distinct and separate enterprise engaged in arm’s length transactions. The attribution of profits then reflects the functions performed, assets used, and risks assumed by the PE, and shall be determined by reference to the internal dealings between the PE and the head office, applying the separate entity approach in a manner consistent with OECD Guidance on Transfer Pricing.

For more on how Tax Treaties work, check out this blog post:

The Authorized OECD Approach and How to Apply it

This is where the AOA comes into play; in its 2010 Report on Attribution of Profits to Permanent Establishments, the OECD introduced a two-step AOA methodology. Its goal? Attribute profits to PEs that reflect economic reality, not just legal arrangements. After all, enterprises (and their PEs) have an incentive to shift costs to high-tax jurisdictions, while shifting profits to low-tax jurisdictions.

“The authorized OECD approach is that the profits to be attributed to a PE are the profits that the PE would have earned at arm‘s length, in particular in its dealings with other parts of the enterprise, 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 permanent establishment and through the other parts of the enterprise. […]

Step 1: functional & factual analysis

We begin by hypothesizing the PE as though it were a standalone enterprise:

1. Identify the so-called Significant People Functions [“SPFs”]: SPFs are the economically significant functions that drive the assumption and management of risks and assets,
2. Attribute risks and assets based on where those SPFs take place, and;
3. Recognize notional intercompany transaction between the PE and the head office (e.g., provision of services).

Step 2: Transfer Pricing application

Once the internal dealings have been accurately described, they must be priced at arm’s length, using Transfer Pricing [“TP”] methods consistent with the OECD TP Guidelines 2022, which involves:

1. Choosing the appropriate TP method;
2. Identifying the tested party (often, the least complex party);
3. Selecting an appropriate Profit Level Indicator [“PLI”], where applicable, and;
4. Conducting a benchmarking analysis, where necessary.

A Case Study: the German Consultancy with a Dutch PE

To make the above tangible we’ll shortly look at a (real life) case: a German head office with a PE in the Netherlands. The PE performs marketing functions in favor of the head office. We consider the AOA:

Step 1: functional & factual analysis

Consider the following summary of functions performed, assets used and risks assumed [“FARs”]:

Based on the functional analysis above, the Dutch PE does not carry out any SPFs. Rather, the Dutch PE qualifies as a routine marketing office. The SPFs are carried out by the German head office. Consequently, the profit attribution to the Dutch PE should be limited to a routine return for its intercompany dealings (i.e., marketing activities in favor of the German head office).

Step 2:  Transfer Pricing application

As outlined above, the Dutch PE undertakes marketing activities in favor of the German head office. Accordingly, the appropriate intercompany transaction to be recognized between the German head office and the Dutch PE is the provision of marketing services. Profit allocation to the Dutch PE must align with the arm’s length principle. This entails:

1. The Dutch PE receiving a reimbursement that reflects the value of any SPFs or intercompany transactions it enters into.
2. Treating transactions between the Dutch PE and the German head office as if they were transactions between independent enterprises.

Next, we’ll have to choose the most appropriate Transfer Pricing method. There are five OECD-recognized TP methods:

1. Comparable Uncontrolled Price (CUP) Method: Compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction.
2. Resale Price Method (RPM): Determines the transfer price by subtracting an appropriate gross margin from the resale price to an independent party.
3. Cost Plus Method: Adds an appropriate markup to the costs incurred by the supplier of goods or services in an intercompany transaction.
4. Transactional Net Margin Method (TNMM): Examines the net profit margin relative to an appropriate base (e.g., costs, sales) that a taxpayer realizes from an intercompany transaction.
5. Profit Split Method: Divides the combined profits from intercompany transactions in a way that reflects the value of each party’s contribution.

These methods help ensure that intercompany transactions are priced fairly and in line with market conditions. We discuss them in further detail in this article:

The TNMM or Transactional Net Margin Method

The TNMM is frequently applied in cases involving the provision of (routine) services, particularly where the service provider (the Dutch PE) does not own valuable intangibles and does not assume significant risks. In this case, the Dutch PE does not own unique intangibles or assume any significant risks. We therefore select the TNMM as the most appropriate TP method for the provision of marketing services by the Dutch PE in favor of the German head office. The TNMM is particularly suitable in such cases, as it allows for the benchmarking of a PLI against comparable independent entities performing similar functions under comparable circumstances. 

The application of the TNMM involves a selection of a tested party, an appropriate PLI and a benchmarking analysis:

• Selection of the tested party:
  the choice of the tested party is based on the functional analysis, with preference given to the entity for which the application of the TP method can be performed with the highest level of reliability. This is typically the least complex party involved in the intercompany transaction.
  • In this case, the Dutch PE, which functions as a marketing office, solely performs routine functions and does not display any other important FARs. Accordingly, the Dutch PE has been selected as the tested party for analyzing the provision of marketing services. 
• Selection of the PLI:
  A PLI measures the relationship the net profit margin relative to an appropriate base (e.g., costs, sales) that a taxpayer realizes from an intercompany transaction. When selecting the PLI, it is important to consider the key value drivers of the business. Given the Dutch PE’s role as a marketing service provider, total costs have been identified as the most appropriate base for the PLI.

Application of the TNMM: applying the TNMM generally involves performing a benchmarking analysis. This is a widely used approach to determine an arm’s length range for intercompany transactions.

Want to Discuss your Specific Case? Book a Slot, it’s on the House!

We’d be happy to help. Feel free to book a meeting with us through the Calendly link below: