This approach may be inconsistent with the principles provided for in Article 7 of a tax treaty. It may also be noted that the House of Lords in the case of Ostime v. Australian Mutual Provident Society had held that world income as a starting point for attribution of income to a PE was inconsistent with the basis of taxation provided for in the tax treaty.
The OECD has developed a working hypothesis as regards the preferred approach for such attribution. It has examined the feasibility of treating a PE as a hypothetical distinct and separate enterprise and has reviewed ways in which transfer pricing principles could be applied by analogy in order to attribute profits to a PE in accordance with the arm's length principle.
The OECD discusses two main approaches to the determination of profits: the "relevant business activity" approach and the preferred approach, the "functionally separate entity" approach. Under the first approach, the profits of an enterprise resulting from a business activity supported by the PE have to be allocated between the residence country and the source country. As a result, the losses of the enterprise as a whole must also be taken into consideration. The second approach does not limit the profit attributed to the PE by reference to the profit of the enterprise as a whole because the PE is deemed to be a "distinct and separate" enterprise. This can lead to a tax burden on a company independent from the fact that the company as a whole had only losses. The OECD proposes to build on the separate enterprise model and proposes an attribution process that applies the arm's length principle.
This preferred approach may result in double taxation, if the assessed profits differ in the country where the PE is situated and the home country. It would be essential to ensure that the total profits (and losses) of the enterprise as a unit are allocated to the PE and to the head office in a way that avoids double taxation. This can be achieved by adopting a "symmetrical approach" (application to both the head office and PE) and by ensuring that the consolidated branch and head office profits do not exceed the total profit.Attributing profits to a PE is one of the most conceptually difficult and practically complex issues in international taxation. The OECD is moving in the right direction, but greater dialogue, including dialogues with business entities and with non-OECD countries will help achieve greater consensus.
The author is a senior tax professional with Ernst & Young