Implementation of the OECD’s BEPS Actions continued with the signing of the BEPS Multilateral Convention by 68 countries on 7 June 2017, and the publication a couple of weeks later of draft guidance on:
- Attribution of Profits to Permanent Establishments (Action 7)
- Profit Split methods (Action 10).
Multilateral Convention
The Multilateral Convention will modify more than 1,100 existing double tax treaties between the signatory countries. This follows the BEPS Action 15 recommendation for the development of a multilateral instrument to allow countries to swiftly modify their bilateral treaties to implement tax treaty related measures developed as part of the BEPS work. The treaty measures relate to the following BEPS action points:
- Action 2 (Hybrid mismatches)
- Action 6 (Treaty abuse)
- Action 7 (Artificial avoidance of Permanent Establishment (PE) status)
- Action 14 (Improving dispute resolution).
The signatory countries have listed the bilateral treaties they wish to be amended, and have selected the measures to be adopted. For some measures choices are available; for example for Action 6, countries can choose which anti-abuse rule to use: either a principle purpose test or a limitation on benefits article. In general, each amendment only takes effect where there is a ‘match’ in choices, so each treaty will have to be considered individually to determine which amendments/choices are to take effect.
In terms of timing, each treaty state needs to ratify the Convention, and in the case of withholding tax, the changes will not apply until the following 1 January. For the UK, ratification is typically straightforward, and where a treaty is between two such countries, the changes will take effect from 1 January 2018. For other treaties, the changes may not take effect until 1 January 2019 or later.
While some of the BEPS Actions seek to counter complex tax structures, such as Action 2 on hybrid mismatches, Action 7 has the potential for much broader effect. Most international groups benefit from the treaty provisions regarding PEs which allow a company to make sales in another country without having a taxable presence in that other country, so long as their activities in the other country are below a certain threshold. BEPS Action 7 made recommendations to reduce the threshold level in tax treaties in order to prevent the artificial avoidance of PE status.
Attribution of profits to Permanent Establishments
While the development of the new PE thresholds has involved much consultation, the related question of how profits should be allocated to a PE has received less attention during the BEPS process. On 22 June 2017, the OECD published a Public Discussion Draft titled ‘Additional Guidance on Attribution of Profits to Permanent Establishments’. This considers the impact of BEPS on the attribution of profits to PEs under the relevant article in the OECD model tax treaty (Article 7). In summary, the Discussion Draft makes the following points:
- The changes to the PE threshold (eg as implemented through the Multilateral Convention), do not require substantive modifications to the existing rules and guidance on the attribution of profits to PEs.
- The profits to be attributed to a PE are to be determined in accordance with Article 7 of the relevant tax treaty. Article 7 is grounded on the basic principle that the profits attributable to a PE are those that the PE would have derived if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions.
- This principle applies regardless of whether a tax administration adopts the authorised OECD approach (AOA) contained in Article 7 in the 2010 version of the Model Tax Convention (MTC), or any other approach used to attribute profits under a previous version of Article 7 of the MTC.
In determining the profits allocation, a functional analysis should be carried out to determine the attribution of risk assumption and economic ownership of assets to a PE. Guidance produced under BEPS Actions 8-10 (and incorporated into Chapter 1 of the OECD Transfer Pricing Guidelines) clarifies that where the party contractually assuming the risk does not control the risk or does not have the financial capacity to assume the risk, that risk should be allocated to the enterprise exercising control and having the financial capacity to assume the risk. Under the AOA, the notion of ‘significant people functions’ is used for attributing risk assumption and economic ownership of assets to a PE. Broadly, the approaches are consistent in placing emphasis on substance and value creation over contractual form.
From a taxpayer’s perspective, the Discussion Draft provides some reassurance in that no new approach to profit attribution to PEs is proposed, beyond applying existing guidance (in a manner consistent with BEPS). Thus, where the threshold for a PE is reduced as a result of a change to a bilateral tax treaty, in many cases no significant profit (if any) should be attributed to the PE. This assumes existing transfer pricing policies are BEPS compliant and the contractual arrangements reflect the substance of the activities in each country.
In summary, implementation of BEPS Actions limiting treaty benefits (and potentially improving dispute resolution) took a significant step forward last month with the signing of the Multilateral Convention. Draft Guidance published on the Attribution of Profits to PEs provides little further insight for taxpayers, but at least does not substantively modify existing rules and guidance. Group should continue to evaluate and respond to the impact that the BEPS changes will have on their international structures, trading arrangements, and transfer pricing policies and documentation.