Managingpermanentestablishmentrisk

The transfer pricing challenge of the future—Managing permanent establishment riskTransfer pricing

perspectives

Re:solutions

moving towards certainty

The transfer pricing challenge of the future—

Managing permanent establishment riskBy Jorgen Juul Andersen (PwC US)In trying to predict the future, it is tempting to look to the past for direction. But what

happens when tried and true models and assumptions from the past change so dramatically

that they make it impossible to envision what the future will hold? What if all of this happens

in the current environment, where the global business community is changing rapidly all

while the world endures a major financial crisis?This is the scenario for stakeholders who are tasked with managing permanent

establishment (PE) risk following the recent release of new guidelines from the Organisation

for Economic Co-operation and Development (OECD) for allocating profit to a OECD released its first discussion draft on allocation of profit to a PE in early 2001.

The original release was followed by numerous additional reports and revised versions,

which, taken together, reflect the OECD’s thought process for developing technical guidance

regarding profit allocation for PEs. The length and depth of the process also indicate the

complexity of an issue that is not subject to any type of ‘quick fix’.Two documents relevant to this discussion were released in 2008. The first document is the

final report on allocation of profit to a permanent establishment. The second is a discussion

draft of a revised Article 7 and commentary which, if adopted in final form, would fully

implement the changes outlined in the definition of a PE is defined by Article 5 in the Model Tax Treaty. The amended

commentary to Article 7 does not intend to change the definition, but the release

of the OECD documents will likely increase the focus on PEs for years to come.A defined PE is associated with a fixed place of business. For example, is a business

address available or does the local representatives work from home? Do they have

business cards indicating conclusion of sale? Are their activities of a preparatory or

auxiliary character?The traditional allocation of profit to a PE was based upon an ‘all or nothing’ approach:

either there was a taxable presence and therefore an allocation should be made, or the

activities did not meet the threshold for a PE and no allocation was made. The allocation

was made arbitrarily based upon revenue or new commentary language in Article 7, changes the approach to allocate profit

Transfer pricing perspectives58

to a PE by assessing the value chain between the head office and the potential PE in

its entirety. As a result of this change, the process for determining a profit allocation

has become much more complex, but likely also more accurate. Article 7 reengineers

transfer pricing methodology as the tool to identify and qualify the value of the activities

undertaken throughout the value chain between the head office and the potential PE and the

performance of the proper allocation of profit. This new process may appear to work well in

theory, but the reality, it is often much more difficult to describe, especially when it comes to

allocation for a tax directors, this represents a tremendous challenge. Despite the limited number of

examples from case law, some cases in India (Rolls Royce, Morgan Stanley), Italy (Phillip

Morris) and France (Zimmer) offer some guidance. The cases are very different in content

and nature, but the common denominator was that the PE challenge came as a surprise,

that is that documentation to sustain the tax position had to be produced subsequently

which always creates a procedural risk to the tax sly, tax directors may have relied on the PE analysis. When a PE did not exist or the

activities were deemed to be of a preparatory and auxiliary character, there was no need to

start a process of allocating profit.

The Article 7 approach, as reflected in the new commentary and the profit attribution report,

looks specifically at the head office and the PE it allocates assets based on where within that

single entity functions are performed, and it allocates risks based on the allocation of assets.

It then proceeds to allocate income between the home office and the PE based on transfer

pricing principles, treating the PE as a notional separate the new approach differs from traditional TP approachAs stated earlier, the new approach focuses on the value chain between the head-office

and the traditional transfer pricing approach is based upon an analysis of the factual and

functional arrangement. In addition, the contractual relationship is evaluated to determine

the risk and assets deployed. Hence, in ordinary transactions between affiliates, it is

possible to segregate functions, risks and ownership to assets by virtue of the contractual

relationship. This is the approach deployed by tax authorities and professionals when

performing a functional and risk arrangement between a PE and its head office is referred to as a :solutions – moving towards certaintyPricewaterhouseCoopers59

The first step is to identify whether a dealing could existFor multinational companies (MNCs) working cross-border without established legal entities

in host countries, the question of whether an arrangement may constitute a dealing can

appear. Typical examples are cross-border projects, where people from the head office are

on the ground for a longer period of time, or are making decisions that significantly influence

the outcome to the project; or if the head office engages in extended maintenance or

warranty provisions; or all of the progressive companies are introducing virtual management models, where the

skill sets and competencies of management rather than the geographic location of a

manufacturing site or head office determine how the business is operated. For example,

although a company’s sales directors are located in US, thought they have responsibility

for the sales in Asia. The UK production manager may have a global responsibility, but the

head office might be in New York. Management meetings are conducted through virtual

technologies (instant messaging, video conferencing, etc.), and may even be conducted

from a private residence in order to lower office costs. These types of examples will create

a significant challenge, both in identifying whether a dealing is actually taking place between

the head office and a potential PE and in allocating the appropriate conducting the analysis within this type of model, an organisation’s HR department

is often a good place to start, since they know where staff is located and usually have

determined that they are in compliance with local tax and social laws. Identifying insurance

policies taken out on people and projects is another helpful should be borne in mind that the accounting records typically will not reflect the

transactions corresponding to a dealing until it has actually been identified and

treated er pricing perspectives60

The second step is to identify what is happeningUnder the new process outlined in the commentary on Chapter 7, tax directors should

keep in mind that they are properly the only people in the organisation who can speak with

authority about PE and PE-related issues. Hence, the tax director needs to have a more

sophisticated grasp of the investigation in order to better understand which part of the

value chain is undertaken and by whom. The traditional function and risk analysis must be

conducted with a dealing is found to exist, the allocation of profit is based on a division of function risks

and assets between the head office and the PE. But unlike the traditional functional analysis,

risk and function cannot be separated by a legal agreement. The analysis further divides

assets and liabilities between the head office and the PE using the capital employed for the

underlying directors will need to build a more intelligent reporting structure to accurately

demonstrate whether or not a dealing exists. As always, the devil is in the details. The

reporting structure should resemble that of a function and risk analysis, where the

tax director seeks to obtain information from both the host and home country of the

arrangement in question.

A dealing should be documented similarly to a legal arrangement (i.e. establish the terms

and conditions) although, by nature it can not be legally binding on the parties.

The documented dealing should also ease the audit order to complete the analysis, an allocation of capital (PE equity) is made to assert the

independence of the PE.

Re:solutions – moving towards certaintyPricewaterhouseCoopers61

The third step is the valuation process for establishing an accurate transfer priceSome may ask, isn’t a PE always considered a service provider? As such, it would be

appropriate to use the cost plus approach, which would render the economic result

insignificant. Why undertake the entire administrative burden of full implementation of the

guidance for allocating profit to a PE?Simply because cost plus may be the right approach. But it will have to be justified based on

the actual factual and functional analysis — any TP method must represent a viable l care should be observed with respect to the handling of significant people functions.

Where undertaken in the PE context, capital follows risk, which follows assets, which follow

functions. Hence the execution of significant people functions in the host country may lead

to the application of profit split as a more reasonable method for allocation of as in an ordinary transfer pricing study, the price setting will depend on the qualification

of the transaction in conjunction with the functional risk analysis and should ultimately be

supported by relevant benchmark a PE is found to exist as part of the exercise, a compliance burden is automatically created

and the filing of separate tax returns in the host country may be fourth step is documentation

The allocation of profit to a PE will also be subject to the documentation requirements in

Chapter 5 of the OECD guidelines on transfer pricing documentation by the time profit from dealings is determined, taxpayers need to a make reasonable effort

to ascertain whether their approach to determining that profit is in accordance with the arm’s

length er pricing perspectives62

The OECD report highlights elements that can establish the existence of a PE’s dealings:•