Tax Treaties, Transfer Pricing and Financial Transactions Division
Centre for Tax Policy and Administration
Organisation for Economic Co-operation and Development

Keidanren is grateful for the opportunity to provide comments regarding the Public Discussion Draft on BEPS Action 7 Additional Guidance on Attribution of Profits to Permanent Establishments. In the near future, the broader definition of permanent establishment ("PE") recommended in the 2015 Final Report on Action 7 will be effectively incorporated into bilateral tax treaties through a multilateral instrument and other means. The situation urgently calls for the development of guidance on PE profit attribution that is acceptable to taxpayers and tax administrations alike.

This Public Discussion Draft contains multiple points that we consider beneficial. A particularly important one is paragraph 12, which states that any approach to the application of Articles 7 (business profits) and 9 (associated enterprises) of the OECD Model Tax Convention "must ensure that there is no double taxation in the source country." Similarly convincing is paragraph 19, which reads: "When the accurate delineation of the transaction . . . indicates that the intermediary is assuming the risks of the transactions of the non-resident enterprise, the profits attributable to the PE could be minimal or even zero." Likewise, we welcome the administrative approaches to enhance simplification in paragraphs 20 and 21 that are newly presented taking into account countries not adopting the authorized OECD approach ("AOA").

On the other hand, when it comes to guidance for applying these high-level concepts to individual specific cases, there is still much room for clarification and enhancement. Deeper consideration should be given to the relationship between Articles 7 and 9 of the Model Tax Convention so as to prevent taxpayers from being exposed to the risk of double taxation and to limit any increase in their compliance burden. Equally essential is to particularize the administrative approaches to enhance simplification.

Whereas this Public Discussion Draft pertains to the attribution of profits to a PE, further guidance should be provided in the future to elaborate on whether certain activities fall within the definition of PE to begin with, including the demarcation between activities deemed preparatory or auxiliary and those not deemed so.

1. Relationship between Articles 7 and 9 of the Model Tax Convention

Similar to the July 2016 public discussion draft, this Public Discussion Draft devotes many pages to examples in which a non-resident enterprise is deemed to have a PE in the source country due to the activities there of the intermediary that is an associated enterprise. In those cases, the conventional double-taxpayer approach is applied to the relationship between the profits of the intermediary and those of the non-resident enterprise's PE, as seen in paragraph 19 that reads: "The host country's taxing rights are not necessarily exhausted by ensuring an arm's length compensation to the intermediary." The rationale given in paragraph 17 is that significant people functions for the attribution of risk under Article 7 are not interchangeable with risk control functions under Article 9.

This rationale does not seem reasonable from our perspective of advocating the single-taxpayer approach, a position that regards a PE determination as unnecessary in the first place provided that the intermediary's profits are properly calculated pursuant to transfer pricing rules. What should be noted here is that, according to the AOA under Article 7, the profits attributable to a PE are those that the PE would have derived if it were a separate and independent enterprise, and such profits are calculated pursuant to the concepts of transfer pricing. Since it is incomprehensible and confusing to apply a concept deviating from Article 9 only to the attribution of risk, we request that conceptual consistency be established between Articles 7 and 9.

Thereafter, if the double-taxpayer approach is still to be enforced, detailed guidance should be provided concerning the difference in the positions of Articles 7 and 9 with regard to risk, including in what situations a difference materializes.

As to the order in which Articles 7 and 9 are applied, this Public Discussion Draft mentions many jurisdictions first applying Article 9 but appears to ultimately accept either order, in paragraph 12. However, if a non-resident enterprise has in the source country an intermediary that is an associated enterprise, it is only logical to undertake an Article 9 analysis first. We recommend that the final version of this guidance explicitly state that Article 9 should be applied first.

2. Administrative Approaches to Enhance Simplification

This Public Discussion Draft introduces administratively convenient procedures as ways of recognizing the existence of a PE and collecting the appropriate amount of tax resulting from the activity of the intermediary. While we as taxpayers welcome this direction, those procedures entail the following issues:

The first is the necessity of more detailed guidance. As paragraph 21 rightly points out, in the event that a non-resident enterprise is determined to have a PE, the potential burden on that enterprise of having to comply with host country tax and reporting obligations cannot be dismissed as inconsequential (precisely speaking, the potential burden is significantly heavy rather than "inconsequential"). In light of that possibility, administratively convenient procedures should not be limited to simply collecting from the intermediary the tax including the amount that would be levied on a PE if it were determined to exist. Rather, such procedures should include even admitting that no PE requiring a determination exists to begin with; otherwise, the effect will be insufficient. Serious consideration should therefore be given to the aforementioned approach that regards a PE determination and its profit calculation as unnecessary provided that transfer pricing rules are properly enforced. If this proves difficult to be agreed upon, consideration should then be given to the adoption of an approach that regards a PE determination and its profit calculation as unnecessary in cases where its profits (or revenue) are evidently not expected to exceed a fixed amount.

The second issue is the thorough enforcement of the AOA. In the event that, after taking all the above into consideration, a PE is still determined to exist, we assume that the appropriate amount of tax resulting from the activity of the intermediary will be collected pursuant to the administratively convenient procedures presented. To render this practicable, these procedures must be particularized, including what the "appropriate amount of tax" signifies. Relying solely on the insufficient explanations given in this Public Discussion Draft may invite arbitrary interpretations by the source country's tax administration, resulting in double taxation. The final version of this guidance should explicitly require that profits attributable to PEs be calculated in accordance with the AOA only, without considering such factors as deemed profit margins and worldwide taxation. It should also include provisions that preclude tax administrations from readily conducting audits and reassessments to increase profits attributable to PEs.

It is unclear whether, under administratively convenient procedures, a foreign tax credit is available to a non-resident enterprise with regard to the amount that is corresponding to the tax attributable to the PE and is paid by the intermediary. Presumably, this matter cannot be determined by the tax administration of the source country alone, making it necessary to seek the view of the tax administration in the country of residence. We expect this matter to be clarified in a manner that ensures the elimination of double taxation.

The third issue is the strengthening of enforceability. As regards the significance of these procedures, this Public Discussion Draft merely states in paragraph 21 that countries are not prevented from continuing or adopting those administratively convenient procedures. This statement is unhelpful from the perspective of eliminating double taxation and alleviating the compliance burden. The final version of this guidance should recommend more clearly that these procedures be adopted, thereby urging countries participating in the Inclusive Framework to take concerted action. At a minimum, each country should be required to disclose whether it adopts these procedures in order to ensure predictability for taxpayers.

3. Examples

In this Public Discussion Draft, the examples illustrating calculations of profits attributable to PEs are explained in text only, unlike the July 2016 public discussion draft which also presents numbers and computations. Numerical explanations may take on a life of their own at times, but figuring out the conclusion from conceptual explanations alone is quite difficult. Accordingly, it is preferable for explanations presenting numbers and computations to be reintroduced. If this is not possible, at a minimum, several additional examples should be provided to illustrate more complex cases, separating the functions and risks of an intermediary from those of the PE.

The key to calculating profits attributable to a PE is to clearly recognize internal transactions between the non-resident enterprise's head office and the PE, along with external transactions attributable to the PE. From that standpoint, we find it useful that Examples 1 to 4 individually offer analysis, but would like to provide some comments.

Example 1

While we understand that this example is premised on the existence of the PE, the structure of the example appears unconvincing in that revenue from external sales is attributed to TradeCo's PE, which recognizes the cost of goods sold through internal transactions with the head office. Further, we suspect that if one performs calculations as specified in this Public Discussion Draft, the profits attributable to the PE might turn out to be zero or negative.

In addition, when calculating "the amount that TradeCo would have received if it had sold the goods to an unrelated party performing the same or similar activities under the same or similar conditions that SellCo performs on behalf of TradeCo in Country S," necessary data is likely to be difficult to obtain, whether internally or externally. Another issue of note is the possibility that tax administrations might arbitrarily select comparables.

In respect to "other expenses, wherever incurred, for the purposes of the PE" that are deducted in the process of calculating the profits attributable to the PE, treating these as the shared expenses of the head office and the PE seems also feasible because they are direct and indirect expenses to generate the PE's revenue. We expect guidance on the specifics and calculation methods of these expenses to be enhanced.

Examples 2 and 3

Overall, these examples have similar issues to Example 1. In either example, additional explanation would be helpful that sheds light on the reason why the PE is determined to exist in the first place.

Example 4

In this example, while the business activities at the warehouse and those at the office are viewed as part of a cohesive business operation, two PEs are determined to exist, with the result that profits attributable to the warehouse PE and the office PE are calculated separately. As this conclusion may add to the complexity of the tasks of filing tax returns and coping with audits, we request consideration be given to a simpler method that enables profit calculations as a single PE. Additionally, unlike the previous three examples that all mention an administratively convenient procedure, no such reference is seen in Example 4. Unless there is a compelling reason not to do so, an administratively convenient procedure should be included in Example 4 as well. We also expect another example to be given to clarify whether the conclusion differs if the warehouse operated by an associated enterprise is staffed by the employees of the same.

In this example, the business activities at the warehouse and those at the office have a commonality in the sense that these two divide roles to sell OnlineCo's products in Country S. However, there also are cases in which no commonality exists: for instance, the warehouse is tasked with delivering a product while the office is responsible for gathering information on another business. Care needs to be taken to prevent such cases from being subjected to the anti-fragmentation rule.

Sincerely,

Subcommittee on Taxation
KEIDANREN