BEPS Guidance on Permanent Establishments and Transfer Pricing: Breaking Down the Walls

Tax Management

Transfer Pricing Report™

Reproduced with permission from Tax Management Transfer Pricing Report, Vol. 23 No. 25, 4/24/2015. Copyright 姝 2015 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

BEPS Guidance on Permanent Establishments and Transfer Pricing: Breaking Down the Walls The authors argue that the BEPS discussion drafts on permanent establishments and on transfer pricing are in conflict: that each attempts to tax the same income, but attributes that income to different related parties. The authors also consider how China would apply new PE rules and how China’s notion of ‘‘market premium’’ fits into the new conceptions of income. A digital economy case study is used to illustrate these matters.

BY DAVID CHAMBERLAIN KPMG CHINA

AND

CONRAD TURLEY,

I. Introduction ultinational companies are in the midst of the most tumultuous period ever seen in developing rules for international taxation. While efforts have been made in the past to prevent double taxation of the same income, never before have the nations of the world joined together so forcefully in a collective effort to ensure that corporations pay their ‘‘fair share’’ of taxes—that is, to ensure that all corporate income is subject to ‘‘single taxation.’’ Equally importantly, the effort seeks to ensure that income is earned in the proper place, as summed up in the Group of 20 countries’ unanimous statement from their October 2013 meeting in St. Petersburg: ‘‘Profits should be taxed where eco-

M

David Chamberlain is a director, and Conrad Turley is a senior tax manager, with KPMG China’s Beijing office.

nomic activities deriving the profits are performed and where value is created.’’1 A major impetus for this effort was the popular perception that corporate taxpayers were not behaving in accordance with a broad notion of ‘‘tax morality.’’

Headlines like the New York Times’ ‘‘How Apple Sidesteps Billions in Taxes’’2 and the U.K. Daily Mail’s ‘‘Starbucks Doesn’t Pay a Bean in UK Tax’’3 offer a flavor of the debate.

A. The BEPS Project The OECD gave a name to the corporate tax avoidance behavior that the nations would join together to 1 The Group of 20 countries’ finance ministers made a similar statement in Moscow after endorsing the Organization for Economic Cooperation and Development’s Action Plan on Base Erosion and Profit Shifting. See 22 Transfer Pricing Report 368, 7/25/13.

2 Available at http://www.nytimes.com/2012/04/29/business/ apples-tax-strategy-aims-at-low-tax-states-andnations.html?_r=0 (4/29/12).

3 Available at http://www.dailymail.co.uk/news/article2218192/Starbucks-tax-Coffee-chain-shortchanges-Britishtaxypayers-paying-just-8-6m-past-14-years.html (10/15/13).

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2 curtail: base erosion and profit shifting (BEPS). The name was coined in the OECD’s initial study of BEPS phenomena in early 2013, and the organization’s initial report was prepared in time to be presented to the G-20 at its February 2013 meeting in Moscow.4 The report was soon followed by the Action Plan on Base Erosion and Profit Shifting in July 2013.5 The BEPS action plan represents an ambitious project to combat all international tax strategies—including transfer pricing strategies—that help companies avoid taxation of income or unjustifiably shift income into low-tax environments.

The BEPS plan comprises 15 action items that address specific areas of international tax law. The goal is to produce consensus documents outlining the efforts countries would subsequently seek to take with respect to each action. An extremely aggressive timeline was set: roughly half the actions were scheduled to be completed by September 2014, most of the remaining actions by September 2015, and the whole project is to be concluded in December 2015. So far, all of the deadlines have been met. Seven consensus documents were released in September 2014.6 The OECD has pushed ahead with the remaining actions, issuing a number of discussion drafts for public comment in advance of final documents in September and December 2015.

This article considers two controversial discussion drafts that have come out of the BEPS process: s ‘‘BEPS Action 7: Preventing the Artificial Avoidance of PE Status,’’ released Oct. 31, 2014;7 and s ‘‘BEPS Actions 8, 9 and 10: Discussion Draft on Revisions to Chapter I of the Transfer Pricing Guidelines (including Risk, Recharacterisation, and Special Measures),’’ released Dec. 19, 2014.8 The authors will consider the potential impact of these drafts using a case study on a digital economy business set forth further below. For convenience, the case study will refer to a parent company based in the residence country and its subsidiary based in the source country.

The authors assert that these two drafts are in conflict. That is, the income that would be attributed to the parent company under the expanded definition of agent PEs in the October 2014 draft on PEs is the same income that would be attributed to the subsidiary by virtue of the expanded range of risks allocated to it under the December 2014 draft on risk. While both drafts strive to resolve the same central problem, the combined, simultaneous effect of these two drafts might lead to vastly increased complexity for businesses in practice. Consequently, it might be best to consider, while the BEPS process of developing the new rules is still underway, whether the reach of the proposed new agent PE rules might be limited, in light of the extent to which the proposed new transfer pricing approach is designed to resolve some of the central issues. Limiting the new agent PE rules in this way would not under4 The report, ‘‘Addressing Base Erosion and Profit Shifting,’’ and a subsequent declaration by the OECD are available at 22 Transfer Pricing Report 174, 6/13/13.

5 Available at 22 Transfer Pricing Report 379, 7/25/13.

6 See the story, which contains links to the documents representing work on those items, at 23 Transfer Pricing Report 643, 9/18/14.

7 Available at 23 Transfer Pricing Report 918, 11/13/14.

8 Available at 23 Transfer Pricing Report 1170, 1/8/15.

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mine the ability of states to tax the value created within their jurisdictions, as the new transfer pricing rules would provide for this, but rather would contribute to the administrative workability, and thus to the successful roll out and implementation, of these important BEPS reforms.

B. Motivations Behind the Discussion Drafts Various observers on the general thrust of the BEPS work have remarked that a new ‘‘single firm’’ paradigm to the treatment of multinational enterprises runs through the proposals in relation to a number of the BEPS actions, including those on PE and transfer pricing.9 This constitutes a sea change to the global consensus approach, which might be said to date to the amendments made to the League of Nations draft convention in 1933. Those amendments firmly established that, for a range of international tax purposes, the separate legal entities that constitute a multinational enterprise would be fully respected as contracting with each other as independent entities to the extent that the terms of their transactions and interactions could be shown to adhere to the arm’s-length principle.

The sole reference in OECD BEPS documents to the single-firm concept is in the Sept. 16, 2014, report on the digital economy: With the advent of the development in information and communication technology (ICT), reductions in many currency and custom barriers, and the move to digital products and a service based economy, these barriers to integration broke down and MNE [multinational enterprise] groups began to operate much more as single global firms. Corporate legal structures and individual legal entities became less important and MNE groups moved closer to the economist’s conception of a single firm operating in a co-ordinated fashion to maximise opportunities in a global economy. Attention should therefore be devoted to the implications of this increased integration in MNEs and evaluate the need for greater reliance on value chain analyses and profit split methods.

[Emphasis added.]10 While none of the other drafts described in this article explicitly pursues this line of thinking or uses the phrase ‘‘single firm,’’ it is the authors’ opinion that the discussion drafts reflect the influence of the single-firm outlook to a far greater extent than preexisting international tax standards.

All through the radical changes that the world has seen in the last 80 years—the spread of the onset of the Third Industrial Revolution and the digital age, the integration of formerly autarkic communist states into the global economic system and the remarkable rise of the multinational entity as one of the key drivers of the world’s economic development—adherence to the separate legal entity principle has been retained.

9 See remarks of PricewaterhouseCoopers LLP’s David Ernick, a former U.S. Treasury official, quoted by Kevin A. Bell and Dolores W. Gregory in ‘‘BEPS Shifts from Talk to Action in 2015, Dominating Tax Planning, Government Legislation, and OECD’s Calendar,’’ 23 Transfer Pricing Report 1183, 1/22/15.

10 The report is available at 23 Transfer Pricing Report S-28, 9/18/14.

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3 However, a number of countries that consider that their markets and their productive resources have been particularly crucial to the commercial success of multinational enterprises have been voicing criticism of both: s the organizational and tax structuring approaches of these companies, which they perceive to diminish the tax revenue collected by their jurisdictions, and s the existing international tax rules that permit this.

To the extent multinational companies at the center of their complaints have their headquarters and the tax residence of their parent companies outside the countries making these criticisms, and their subordinate operations through subsidiaries or other presence in these countries, the countries making these complaints may be termed ‘‘source countries.’’

In particular, source countries raised the objection that multinational companies were using the particular respect accorded by international tax rules to the separate-entity status of subsidiaries in source countries to unfairly limit the amount of the companies’ global profits that were subject to local tax, thereby undervaluing the contribution of the local market.

Corporate tax planning strategies operated both at the level of the parent and the subsidiary. The local subsidiary could undertake great efforts in developing customer relationships and building a vibrant local market, but ownership of the resulting marketing intangibles was assigned to the parent company instead of the subsidiary due to the latter’s limited risk profile. The parent company was able to ‘‘mine’’ the local market and, in the view of the source country, shift tremendous market-related profits away from the local subsidiary, eroding the source country’s tax base.

Such arrangements could be in place from day one or could be used to transform existing arrangements, as with restructurings that stripped the risk from a local subsidiary by, for example, converting a full-fledged distributor into a commissionaire or marketing service provider or sales support company. Source countries faulted the transfer pricing rules—specifically, the rules’ respect for a separate legal entity’s power to contract on terms of its choosing with related parties, including the contractual allocation of risk—for abetting such arrangements.

Meanwhile, the parent company was not subject to local tax either because it could, in the view of the source country, artificially avoid PE status by taking advantage of the treaty PE concept. This could be a function of using fairly obvious deficiencies in the PE concept, such as the exclusion of commissionaires in civil law jurisdictions from being treated as dependent agent PEs, or through limiting the activity of local subsidiaries to sales support, which would see the latter build the market but avoid assuming the authority to create binding contracts with customers in a way that would trigger agent PE. In this regard, the respect for the subsidiary’s separate legal status, and non-attribution of the operations of the subsidiary to the parent company, might be viewed as overly limiting of the source country’s taxing rights in relation to the parent.

The problems were considered particularly acute for new business models associated with the digital economy (detailed further below), which allowed multinational companies to realize unprecedented value from the local market—that is, from the user base for a global company’s products and services—while at the TAX MANAGEMENT TRANSFER PRICING REPORT

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same time limiting the company’s footprint in the local country.

The Dec. 19 draft on risk and the Oct. 31 draft on PE, both guided by new approaches that have greater regard for local source country activities as part of a larger multinational construct, set out to address these perceived imbalances. However, while the risk draft fixes its sights on the local subsidiary, emphasizing the importance of the functions housed in it to value creation within the multinational group, the PE draft casts the local subsidiary’s separate legal personality aside, and identifies taxable PEs of the overseas parent wherever it carries on activities (through subsidiaries or otherwise) that build the customer relationships from which market value derives.

In this way, while the risk draft pierces the ’’wall’’ of the local subsidiary, the PE draft bulldozes it. The authors argue in this paper that the simultaneous piercing and bulldozing of the wall leads to an unholy mess and make proposals to limit the scope of application of the new PE rules.

The authors flesh out these arguments in the context of practicing in China. The Chinese tax authorities, while they do not frame their methods and approach in terms of risk identification along the lines of the risk draft, are in the global vanguard of assertive transfer pricing with their tenacious pursuit of local marketing intangibles and their pioneering of the concept of location-specific advantages, including ‘‘market premium,’’ which arguably leads in a similar direction as the risk draft. In the PE space, repeated indications from the tax authorities are that PE scrutiny is set to step up. Set against this backdrop, the introduction of the BEPS transfer pricing and PE proposals to China would be dynamite to the walls of Chinese subsidiary operations. This article explores the potential China implications of the proposed new approaches and recommends adjustments to the current proposals.

II. Digital Economy Business Model A. Digital Economy Context A major motivator of the BEPS project was the tax challenges of the digital economy. Key features of the digital economy, distinguishing it from the traditional economy, were seen as putting great pressure on existing international tax norms. The original 2013 OECD BEPS report noted, ‘‘It is possible to be heavily involved in the economic life of another country . . . without having a taxable presence there or in another country . . . questions are being raised on whether the current rules are fit for purpose.’’ Moreover, major multinationals that were players in the digital economy were seen as some of the most aggressive pursuers of BEPS strategies.

Digital economy issues were seen as so central to the BEPS project that they were the subject of Action 1, which had some of the earliest deadlines. The final consensus document was one of the set of deliverables issued in September 2014.11 The digital economy report made no firm recommendations of its own, but promised to play a role in all other action items, concluding that because the digital economy is ‘‘increasingly becoming the economy itself, 11

See note 10, above.

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4 it would be difficult, if not impossible, to ring-fence the digital economy from the rest of the economy for tax purposes.’’

The challenges presented by the digital economy to traditional international tax principles and mechanisms are multiple and while they do affect all industries, they are most clearly brought out in relation to so-called pure play digital economy businesses, as outlined below.

At the level of basic electronic commerce, companies are able to interface with consumers in another market to carry out activities including marketing, order placing, payment processing and delivery (in particular for digital products) without the need for a physical presence in the country of sale (that is, a traditional commercial intermediary such as a foreign branch or local agent), which could give rise to a PE. To the extent that local physical activity is needed (for example, customer relationship building, logistics for delivery of physical goods or after-sales service), this could be fragmented into separate local service subsidiaries or into branch presences that fall under the preparatory and auxiliary thresholds. The PE challenge was accompanied by income characterization challenges (the distinction becoming blurred as to whether a given supply involved the provision of goods, or a supply of services, a license for royalties or a leasing) and by tax administration challenges wrought by the loss of transaction intermediaries and physical controls on cross-border commerce flows.

The rapid development, from the mid-2000s onwards, of what the OECD has termed ‘‘multi-sided business models’’ has added to these difficulties. Online payment services, app stores, online search engine advertising, cloud computing and participative networked platforms—which leverage shared and user-created content, harness the positive externalities of network effects and are characterized by massive data collection and analytics—are argued to give rise to novel difficulties in determining how and where value is created.

These issues sit alongside the PE, income characterization and tax administration challenges outlined above.

It has been argued, for example in the French government’s Collin & Colin report,12 that the generation of content by users on social networking or file sharing platforms, or users’ passive or participative provision of data on their consumption habits, or even their contributions to the existence of network effects by their mere use of a platform can be considered sources of value creation for tax purposes. This is on the basis that Internet user data is a key driver of value creation (for example, for product customization, purchase recommendations and price discrimination).

Consequently, it has been argued that where a social networking platform, for example, receives its income from the sale of collected user data to third parties or from the grant of access to vendors to sell to the user base, the jurisdiction of the users should be in a position to assert taxing nexus. It was argued that this would limit profits transferred to pay for intangibles overseas, depending on number of users and intensity of data collection. However, such an approach creates conundrums. For example, which is more relevant to allocat12 See Rick Mitchell, ‘‘French Report Urges OECD, G-20 Action to Boost Taxation of Global Internet Giants,’’ 21 Transfer Pricing Report 971, 2/7/13.

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ing profits—the location of the users or of the parties to whom data or access is to be sold?

The recognition of these factors into a new ‘‘significant digital presence’’ tax nexus concept, drawing away from the traditional physical presence PE concept, was even raised in the digital economy report. Designed to apply to wholly digital ‘‘fully dematerialized digital activities,’’ this would look at the concentration of contracts with users in a given jurisdiction, level of engagement with users and consumption of the enterprise’s product or service in that market, as well as a variant based on the degree of monitoring of users in a country with a view to collecting information. The threshold could be supplemented by further tests of depth of customer relationship, such as availability to the customer of banking facilities and supply from his own country, as well as an interface in his own language.

However, these radical proposals do not appear to have much traction. The OECD has emphasized in particular the continuing relevance of the principle of neutrality under the 1998 ‘‘Ottawa Taxation Framework’’13 and the inappropriateness of a different PE threshold for the digital economy as against traditional commercial models. Both the digital economy report and the subsequent focus of the BEPS work show a preference for adapting traditional tools to deal with non-tax outcomes, and both the PE and transfer pricing drafts continue to require physical presence for allocation of income.

B. Digital Economy Case Study Alongside the risk draft, the BEPS transfer pricing working group released a discussion draft addressing the profit split method.14 Unlike the risk draft, the draft on profit splits did not propose specific language to be incorporated in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Rather, the draft posited eight specific scenarios where some form of profit split method might be the most appropriate method for setting or testing transfer prices and asked for comments from interested parties addressing how they would handle each scenario.

Scenario 2 of the profit split draft presents a common fact pattern for a multinational with a ‘‘multisided and integrated digital economy business model.’’ While the principles of the PE draft and risk draft could be applied to fact patterns outside the digital economy as well, Scenario 2 will be used for discussion purposes in this article. The profit split draft presents Scenario 2 as follows (the original paragraph numbering is retained):

Scenario 2 14. The RCo Group provides a number of internet services (for example search engines, email services, advertising, etc.) to customers worldwide. On one side of the business model, advertising services provided through an online platform are charged to cli13 The framework is described in the Sept. 16, 2014, digital economy report (see note 10, above) as well as the March 24, 2015, OECD discussion draft (available at 23 Transfer Pricing Report 21, 5/1/14).

14 ‘‘BEPS Action 10: Discussion Draft on the Use of Profit Splits in the Context of Global Value Chains,’’ available at 23 Transfer Pricing Report 1170, 1/8/15.

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5 ents for a fee that is generally based on the number of users who click on each advertisement. On the other side, online services are offered free of charge to users, whose use of the services provides the RCo Group with a substantial amount of data, including location-based data, data based on online behaviour, and data based on users’ personal information. Over the course of years of data collection, refinement, processing, and analysis, the RCo Group has developed a sophisticated technology that enables it to offer to its clients the ability to target specific advertisements to certain users. The more extensive the online services, and the greater the extent of the associated data, the more valuable and attractive the other side of the business model becomes for clients wishing to advertise.

15. The technology used in providing the internet advertising services, along with the various algorithms used to collect and process data in order to target potential customers, were originally developed and funded by Company R, the parent company of the RCo Group.

16. For larger markets and in order to deal with key clients for advertising services, the group has established a number of local subsidiaries. These local subsidiaries perform two functions: they promote the use of online services provided free of charge to users, translate them into the local language, tailor them to the local market and culture, ensure that the services provided respect local regulatory requirements, and provide technical consulting to users. In addition, they generate demand for and adapt advertising services. In doing so, they also regularly interact with staff members in Company R in charge of developing the technology and make suggestions, notably on the algorithms and technologies used and their adaptation to local market features, and on new features that would be attractive to users in their market.

Building on this example, further posit that RCo Group is highly profitable. One can assume that the technology and algorithms, which are understood to have been originally developed by the parent company, represent valuable intangible property. However, when the parent sells the online services cross-border, it must be conceded that the user base and location-specific data relating to each country where the group operates also are very valuable. Moreover, assume that RCo Group’s profitability in each of its major markets is due in part to its being able to achieve first-mover advantage.

III. Agent PE Approach A. Existing PE Regime—In General The PE concept is governed by Article 5 of both the OECD and United Nations model tax conventions. Put briefly, the existing PE concept uses the rule that if a nonresident taxpayer has a fixed place of business,15 carries on construction work that last more than a fixed time,16 or has a dependent agent with the power to ha-

bitually enter into contracts in the name of the taxpayer,17 then there will be a PE in the source state. The profits of that PE can be taxed in the state of source.

However, Article 5.4. of the OECD Model Tax Treaty excludes the right of the source country to tax business profits that can be attributed to auxiliary and preparatory activities—some of which are covered under specific exclusions—even if these activities are carried out through a fixed place or through a dependent agent.

PE may be viewed as a threshold permitting and enforcing source taxation but it also is a limit in favor of residence state taxation, which permits some potentially value creating activity in the source state to go untaxed. The manner in which the PE concept has been constructed reflects the competing goals of facilitating cross-border trade and investment by reducing administrative burdens on the one hand, and preventing tax avoidance on the other. Ultimately, considerations of workable and efficient administration have led the PE concept to be wedded to a concept of control of geographic space, and have led to a focus on the contribution of assets and activities in a given controlled geographic space to income generation.

Given that the PE concept is being drawn in different directions, it is perhaps not surprising that its operation fails to entirely fulfill the objective, set for PE by some, that a source state should be able to tax ‘‘substantial participation’’ by foreign enterprises in the source state’s economic life.

B. Existing PE Regime—Agent PEs Under existing PE rules, the parent company will have an agent PE in the source country if an agent, other than an independent agent, acts ‘‘on behalf of [the parent] and has and habitually exercises . . . an authority to conclude contracts in the name of the [parent].’’

Thus, even if the parent company has no physical presence in the source country, it can be found to have a PE if it acts through an ‘‘agent’’ there. Since an ‘‘independent’’ agent does not create a PE, it is nearly always a finding that a local subsidiary acts as an agent for the parent that gives rise to a PE. That is, even though the subsidiary is a fully taxable local entity, the parent can become taxable as well if the subsidiary undertakes prohibited acts.

The OECD Committee on Fiscal Affairs has said that ‘‘the rationale behind the agency provisions is to prevent foreign enterprises from escaping source taxation by operating through agents rather than directly through a fixed place of business.’’18 That such a requirement arises is a function of the respect shown for the separate legal entities that constitute a multinational. This respect necessarily means that the assets and operations of a multinational, housed within a local subsidiary, cannot be considered at the disposal of the overseas parent entity or other group sales companies, and so agent PE is a stopgap.

Such respectful treatment of separate legal entities was not inevitable, and at the time of the 1933 League of Nations draft convention updates, which contributed to the global consensus on respecting all multinational 17

OECD model, Article 5.5.

OECD Committee on Fiscal Affairs, ‘‘Issues Arising under Article 5 (Permanent Establishment) of the Model Tax Convention,’’ issued Nov. 7, 2002.

18

15 16

OECD Model Tax Convention, Article 5.1.

OECD Model Treaty, Article 5.3.

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6 companies as separate legal entities, France, Germany and Italy had all treated subsidiaries of foreign enterprises as PEs of those foreign enterprises under their domestic law, and had sought to preserve this treatment in their double tax agreements (DTAs).19 The global consensus fastened to the separate entity approach, supported strongly at the time in particular by the work of the renowned U.S. economist Mitchell Carroll;20 and the OECD, as inheritor and guardian of the common international tax rules, has adhered to it strongly to the present day.

Respect for the separate legal entity concept necessarily affected the form of the dependent agent PE concept in Article 5.4, as a legal form approach to associated enterprises made it natural to conclude that agency also was being used in a strict legal sense, requiring a legal authority to bind the foreign enterprise to be habitually exercised by the local associate for a PE to exist.

Subsequent updates to the OECD Model Tax Treaty Commentary provided for a broader understanding of when an authority to bind was exercised: in 1994, it was provided that the contract would not need to be in the name of the parent, so long as it was legally binding on it; and in 2003 it was clarified that an agent PE still might exist, even where the contracts were executed by the parent, where the subsidiary was authorized to negotiate all elements and details of a contract in a manner that is binding on the parent. Nonetheless, the OECD agent PE approach always has applied, and continues to reach for, a concept of agent conduct equivalent to signing contracts, rather than developing a concept that focuses on a foreign enterprise having a substantial activity in market jurisdiction via the business activities of a local person—whether designated as agent or otherwise—as being sufficient for source country taxation.

Countries have differed in the manner in which they have adopted the particulars of the agent PE approach.

For example: s Japan and India frequently have included the acceptance of orders in their DTA dependent agent provisions, as a basis for PE, going beyond the OECD focus on the authority to conclude contracts. s Countries differ in terms of whether they view ‘‘authority to bind’’ as having been awarded to the local person (1) when grant of discounts by the subsidiary within a range have been pre-approved by the parent, (2) when standard contracts are signed by the subsidiary or (3) when old contracts are renewed by the subsidiary. s Countries also differ on whether they consider the negotiation of draft contracts, which are not binding on the parent or are subject to genuine subsequent approval, as being sufficient to be consider that ‘‘authority to bind’’ has been granted; s Countries further differ on the level of consideration needed for approval—it can be required that a knowledgeable person at the foreign multinational individually considers each negotiation result for approval, 19 John F. Avery Jones et al., ‘‘The Origins of Concepts and Expressions used in the OECD Model and their adoption by states,’’ Bulletin for International Taxation, 2006.

20 Carroll, ‘‘Taxation of Foreign and National Enterprises: Methods of Allocating Income,’’ League of Nations, Geneva, 1933, Vol. IV.

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while more or less automatic mass approval of agentnegotiated contracts, even on pre-set terms, might give rise to PE. s Many countries also adopted the slightly different UN approach, under which dependent agent PE extends beyond contract signing to include the habitual maintenance of a stock of goods from which deliveries on behalf of foreign enterprise are regularly made.21 Nonetheless, in almost all cases countries have sought to justify their PE taxation in terms of a local person creating binding relations between the foreign multinational entity and the local customer, with a local subsidiary to be subject to agent PE assessment under exactly the same criteria as any other local person. The OECD bolstered the emphasis on this approach with the 2003 Model Tax Treaty Commentary updates, providing that ‘‘the control which a parent company exercises over its subsidiary in its capacity as a shareholder is not relevant in a consideration of the dependence . . . of the subsidiary in its capacity as an agent for the parent.’’

Only in exceptional anti-abuse cases, such as specific cases recorded in Spain and in Italy,22 have tax authorities been noted to have cast aside the focus on the role of the local subsidiary in creating the binding relations between the foreign seller and the local customer.

Rather, by ‘‘breaking down the walls’’ of the local subsidiary, they have treated the physical and human resources of the local subsidiary as those of the foreign parent. However, it is precisely this breaking down of walls that the new proposed BEPS agent PE concepts now propose.

C. Why Are New Agency Concepts Needed?

The existing agent PE concept’s requirement for a local subsidiary to exercise an authority (albeit implied) to bind (albeit without a need for contract signing) a foreign enterprise in contract with customers, together with the opportunities for fragmentation by means of geographic dispersal of activities and segmentation of activities into separate corporate vehicles, have been argued to provide the basis for significant tax planning.

A multinational could have a substantial economic presence in a country without incurring commensurate tax liabilities, such as with sales support subsidiaries that deal with customers but leave contract signing to the overseas parent. Given appropriate protocols (for example referral of all orders and contracts to the overseas entity for approval, approval of any terms or prices deviating from pre-approved range), these companies, in many countries, would not be viewed as effectively concluding contracts on behalf of the parent.

Quirks in the operation of civil law agency concepts also allowed, particularly in some European Union jurisdictions, for leveraging the fact that so-called commissionaires, which do not contract in the name of a 21 International Fiscal Association, ‘‘Cross-border outsourcing—issues, strategies and solutions,’’ Cahiers de droit fiscal, 2014.

22 For example, see cases in Spain involving Roche (rec.

1626/2008) and Dell (HR-2011-02245-A), and the Italian case involving Philipp Morris (2002). Also see A.M. Jimenez, ‘‘Preventing the Artificial Avoidance of PE Status,’’ Papers on Selected Topics in Protecting the Tax Base of Developing Countries, UN, September 2014, available at http://www.un.org/esa/ ffd/wp-content/uploads/2014/09/ 20140923_Paper_PE_Status.pdf.

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7 foreign principal, cannot bind the latter. Consequently, local subsidiaries could sell for the account of the foreign parent, while not legally binding them, and so avoid PE. Some of the proposed new agent PE concepts consequently break down the walls of the local subsidiary and effectively attribute certain actions of the staff of the local subsidiary to the parent. With the voiding of the separate legal entity status of the subsidiary necessarily goes the voiding of the legal agent concept at the heart of the agent PE. In light of some of the newly proposed approaches, ‘‘agent PE’’ is possibly no longer a valid description.

D. Proposed Revisions to Agent PE Rules The BEPS plan’s observations on Action 7,23 designed to prevent the artificial avoidance of PE status, set relatively modest goals: The definition of permanent establishment (PE) must be updated to prevent abuses. In many countries, the interpretation of the treaty rules on agency-PE allows contracts for the sale of goods belonging to a foreign enterprise to be negotiated and concluded in a country by the sales force of a local subsidiary of that foreign enterprise without the profits from these sales being taxable to the same extent as they would be if the sales were made by a distributor. In many cases, this has led enterprises to replace arrangements under which the local subsidiary traditionally acted as a distributor by ‘‘commissionaire arrangements’’ with a resulting shift of profits out of the country where the sales take place without a substantive change in the functions performed in that country.

However, the proposals made in the PE draft24 potentially go much further than this, taking the agent PE concept as a concept of agent conduct equivalent to signing contracts, and supplanting it with a concept that focuses on a foreign party having a substantial activity in a market jurisdiction via a local person.

Two core changes are proposed to be made to the agent PE concept: (1) the nature of the activities that give rise to agent PE, which will be changed from the existing standard; and (2) the legal and economic consequences of those activities for the nonresident, required for an agent PE to exist.

Two options have been put forward regarding each of those changes, and the four proposals are the possible combinations of these.

Regarding the ‘‘nature of activities,’’ two options are being considered. Each would replace the activities, focused on by the existing agent PE threshold (that is, ‘‘concludes contracts’’), with a new activities descrip23

See note 7, above.

The authors do not consider here the other PE changes proposed in the PE draft, such as the anti-fragmentation rules and the limitation of access to the preparatory and auxiliary exclusions. Those rules may increase the circumstances in which PEs are identified on the basis of activities currently falling under the PE threshold. However, it is primarily with the BEPS agent PE proposals that the overlap with the BEPS transfer pricing proposals, the focus of this article, arise, and so discussion is limited to agent PE. 24

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tion providing that the person in the market jurisdiction: (a) engages with specific persons in a way that results in the conclusion of contracts, or (b) concludes contracts or negotiates the material elements of contracts.

Regarding (2), the legal and economic consequences for the nonresident, two options are being considered.

Each would replace the existing requirement that the local person, acting on behalf of the foreign enterprise, is acting ‘‘in the name of’’ the enterprise, with a new conception of the consequences for nonresident: (a) that the activities of the person in the market jurisdiction—however dealt with at (1) above—result in contracts for the supply of goods owned by the foreign enterprise or for the provision of services by the foreign enterprise; (b) that the activities of the person in the market jurisdiction—however dealt with at (1) above—result in contracts that, by virtue of the legal relationship between the local person and the foreign enterprise, are on the account of and risk of the enterprise.

The proposed new rules potentially capture a much wider range of arrangements meeting the test for an agent PE. Alternative (1)(b) has been argued to simply formalize in the OECD Model Tax Treaty the looser concept of agent PE that already has been developed in the Commentary over the years. However, concerns remain that the negotiated terms focused on might stretch further than final material terms to also cover any negotiation of material terms—for example, preliminary or interim discussions. The business community, in its submissions to the OECD, has sought clarity of the expression ‘‘material terms,’’ asking the OECD to specify that those are limited core matters needed for a binding legal commitment (that is, goods description, quantity and price), that simply attending negotiations or forwarding conditions to a principal are excluded and that active involvement in negotiations is needed.

Concerns have been expressed in particular that if option (1)(a) were adopted, and not narrowed from its current form, then ‘‘engagement’’ with customers through any marketing or customer relationship management activity conducted by the local subsidiary—to say nothing of contract negotiation—might result in a PE. Contributors to the OECD’s consultation on the PE draft queried whether the mere existence of a relationship between the local subsidiary and the end customer could result in PE if customer relationship is a key component of contractual negotiation. Others noted that after-sales service might be regarded as resulting in repeat business, and under the proposed PE wording therefore might be considered to ‘‘result in’’ contracts.

Going further, some said a local market Internet service provider (ISP) company, through hosting a foreign enterprise’s website, might be considered to have ‘‘engaged’’ with the local market users of that website in a way that resulted in contracts. With a rule as broad as this, there would not be any ‘‘tweak’’ that existing arrangements designed to avoid PE could employ in order to continue to avoid PE tax. This is particularly true of local market sales support companies or offices that promote products and deal with customers to tee up contracts for an overseas company.

In light of this, it would seem that, if option (1)(a) were adopted, the only way to potentially avoid PE staBNA TAX

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8 tus would be to convert the arrangement to a buy-sell model. However, structuring this as a tax-efficient limited-risk arrangement also might raise issues given that the PE draft’s proposed changes to the legal and economic consequences for the nonresident affect cases where the parent company and the source country customer have an indirect relationship.

In particular, option (2)(b), by focusing on contracts being ‘‘on the account and risk’’ of the foreign enterprise, could affect limited-risk arrangements such that a foreign company selling into a market via a limitedrisk distributor and retaining some of the risks associated with the goods sold might be viewed as having a PE. When coupled with the option (1)(a) focus on ‘‘engagement’’ that results in the conclusion of contracts, this would go far in the direction of overturning the OECD Model Tax Treaty and Commentary’s traditional respect for separate legal entities and its acknowledgement that a separate legal entity can act as an independent service provider while contractually limiting the risk it assumes.

E. Applying PE Draft to Digital Economy Case Study The PE draft, by taking the agent PE concept as a concept of agent conduct that is equivalent to signing contracts, and supplanting it with a concept that focuses on a foreign party having a substantial activity in a market jurisdiction via a local person, potentially brings the digital economy scenario outlined above within the scope of the new PE rules.

The description of the subsidiary’s role in marketing the parent’s online and advertising services in the scenario is somewhat thin, specifically providing: ‘‘The local subsidiaries promote the use of online services provided free of charge to users . . . and provide technical consulting to users. In addition, they generate demand for and adapt advertising services.’’ These activities would seem to fall well below the PE threshold under the current OECD Model Tax Treaty as the subsidiary likely does not ‘‘conclude contracts’’ that are binding on the parent. On the other hand, these marketing and promotion activities might well be significant enough to the widespread adoption of the services in the source country that they would be regarded as ‘‘engaging with specific persons in a way that results in the conclusion of contracts,’’ consequently giving rise to an agent PE under the new rules. The new agent PE concept does not demand that the local subsidiary effectively bind the overseas entity in contractual relationships with customers (or that it is implicitly authorized to do so).

Rather, it treats the staff of the local subsidiary as effectively working for the parent to the extent that their activity contributes (in a manner as yet unspecified) to the creation of customer contracts, so demolishing the wall separating the subsidiary from the parent.

Furthermore, some commenters would take the position that, even if the parent company’s staff dealt with the customers and vendors remotely, the local market ISP company hosting the overseas enterprise’s website might be considered to have ‘‘engaged’’ with the local market users of that website in a way that resulted in contracts, creating an agent PE. Consequently, in many situations a business operating in the manner described might find itself, under at least some of the PE proposals, in a position where would be impossible to struc4-24-15

ture business arrangements to avoid tax without seriously compromising its commercial operations.

Accordingly, the new PE concepts go a long way toward recognizing and resolving source countries’ concerns that their markets and productive resources have been extremely important to multinationals’ commercial success but have not been adequately rewarded.

This is particularly true for companies like the one in the scenario described in this article, which have business models associated with the digital economy— something that allowed multinationals to realize unprecedented value from the wide Internet user base in the local market.

Once the parent company is found to have an agent PE, it is necessary to attribute profit to that PE for tax purposes. It is here that the agent PE rules intersect with the new transfer pricing rules. The rules for attributing profit to PEs are discussed further below.

IV. China’s Approach to Agent PEs The new BEPS PE proposals come at a highly crucial juncture for China, when a shift in Chinese PE enforcement policy is highly anticipated. Repeated statements by senior Chinese tax officials on their intent to enforce PE more vigorously have followed rigorous enforcement of service PEs against secondment arrangements since 2009. The State Administration of Taxation’s Circular 103 (2009) prompted heightened enforcement by local tax authorities, deeming staff seconded by foreign companies to their China subsidiaries to continue to act for their foreign parents in rendering services to local subsidiaries. Detailed clarifications on the circumstances in which a service PE would be deemed to arise in the case of secondments were subsequently set out in Announcement 19 (2013).25 However, to date, enforcement of the fixed place PE and agent PE concepts has not been considered overly assertive. A factor in this regard has been the manner in which representative offices (ROs) have been taxed.

While ROs do not constitute separate legal entities under Chinese law, as a registered presence they have in fact been taxed as entities, with the tax authorities generally not granting protections that otherwise would apply under PE clauses in DTAs. To date, the tax authorities generally have appeared satisfied with collecting the tax revenue that arises from taxing ROs on a deemed margin cost plus basis, and generally have not inquired further with a view to establishing a basis for deeming agent PEs and taxing further income.

What is more, the Chinese tax authorities generally have maintained respect for the separate legal personality of associated companies in China, usually incorporated as a wholly foreign-owned enterprise (WFOE).

The authorities are not known to have sought to horizontally aggregate the activities of ROs and local subsidiaries, nor have there been reported cases of the Chinese tax authorities looking through a subsidiary to regard its human and material resources to be for the use and direction of the parent. While PE risk regularly is highlighted as a key issue by China tax advisers, this principally relates to secondments given the authorities’ historic focus on this area. Structures and protocols directed at avoiding triggering agent PEs through the ac25

See

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9 tivities of sales support WFOEs have not, to date, been targeted.

In recent times, given the Chinese tax authorities’ use of assertive transfer pricing concepts such as local marketing intangibles and market premium, it has been assumed that they would use transfer pricing tools rather than expanded PE concepts to enforce source taxing rights and simply would accept the revenue brought in from deemed margin taxation of ROs without pushing out the agent PE concept. It also was understood that no significant resources were committed to tracking frequent business travelers to China for the purposes of asserting agent PE. The impact in China of any changes to the agent PE concept in consequence of the BEPS work would need to be judged against the country’s existing tax rules and guidance. China’s very broad (and vague) domestic tax rules on ‘‘establishment or place of business’’ conceivably can be interpreted to accommodate a wide variety of PE concepts, but China’s extensive DTA network, with 105 agreements, means that the DTA threshold for PE, which in China treaties can follow either the OECD or UN model, will nearly always be relevant. The application of the DTA PE concept then needs to take into account the existing SAT guidance on applying PE in SAT Circular 75 (2010).26 Circular 75, while it borrows from the OECD Model Tax Treaty Commentary, does so selectively. Similar to the OECD Commentary, Circular 75 clarifies that ‘‘conclude’’ does not only mean signing a contract itself, but also includes the participation of the Chinese agent in negotiation of the contract terms on behalf of the foreign enterprise. Circular 75 further clarifies that the determination of whether an agent ‘‘exercises an authority’’ will follow a substance-over-form approach, looking at whether the negotiations, in which the agent participates, have as their subject matter the contract details that ultimately become binding on the foreign enterprise.

As notable as what is included into Circular 75 from the OECD Model Tax Treaty Commentary are the elements omitted. The OECD Commentary offers up the example of a person who is ‘‘authorized to negotiate all elements and details of a contract’’ as an agent PE. By excluding this, China allows for the possibility that even partial negotiation suffices. The OECD Commentary observes that the ‘‘mere fact’’ of negotiation participation is not sufficient for PE to be asserted, an observation omitted by Circular 75.

Tax observers in China have noted that the broad and vague language of Circular 75 has the potential to facilitate efforts of local tax authorities to put at least some of the new BEPS PE concepts into effect, even before DTAs are updated to reflect final BEPS guidance.

Given the statements of support for the BEPS project by top Chinese leadership, including by President Xi Jinping at the G-20 Leaders Summit in November 2014, it appears that SAT officials are fully intent on incorporating the BEPS deliverables into Chinese law, but updating the extensive Chinese DTA network, in the absence of a successful conclusion of the multilateral instrument initiative, could take many years.

To avoid claims of an agent PE under current rules, WFOE and RO personnel typically follow a series of approval protocols to document that their authority for 26

See note 25, above.

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contract conclusion was constrained (for example, that the authority to accept orders and contracts is solely in the hands of the foreign vendor) and that their discretion for negotiation of contract terms was limited to that pre-approved by the foreign vendor (with divergence from the ‘‘discretion range’’ requiring further approvals from overseas).

To the extent that local sales support WFOEs and ROs are used and sales are contracted for from outside China, such arrangements could come under particular pressure, as under the new agent PE concepts marketing, promotion, preliminary negotiation, customer relationship management all may be considered to give rise to PE as the WFOEs and ROs would ‘‘engage with specific persons in a way that results in the conclusion of contracts.’’ Furthermore, limited-risk distributors in China also might be at risk of China PE depending on whether the local engagement by the distributor was considered to give rise to contracts for ‘‘the account of and risk of’’ the foreign enterprise.

With a nod to the digital economy scenario outlined above, it might be noted that the draft new Tax Administration and Collection Law will include provisions for reporting on e-commerce businesses. Online trading platform operators will need to provide the tax authorities with registration information of e-commerce traders operating on their platforms and the tax authorities will be entitled to audit the trading status and payment history in relation to the traders on the platform. As platforms such as TMall and JD.com account for the bulk of Chinese online sales, and given the manner in which online shopping has rapidly come to dominate Chinese retail, this reported information will be key to the authorities asserting PE claims against foreign electronic retailers selling into China and the proposed new PE rules would give the Chinese tax authorities the technical basis to enforce the tax.

V. Transfer Pricing Approach A. BEPS and Transfer Pricing The BEPS plan includes three items—Actions 8, 9 and 10—intended to ensure that ‘‘transfer pricing outcomes are in line with value creation.’’ A key goal of Action 8, on intangibles, is ‘‘ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation.’’ Similarly, key goals of Action 9, on risks and capital, are ‘‘to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks’’ and to ‘‘require alignment of returns with value creation.’’ Thus, in keeping with the spirit of the BEPS project’s mandate, a major part of the OECD’s efforts in the transfer pricing arena involve trying to define what constitutes ‘‘value creation.’’ As will be shown, the discussion drafts seem to assume that value is created only through the active performance of functions.

Ultimately, neither intangibles nor risks can be fully addressed in isolation: intangibles are created as a result of taking on development risk. Accordingly, although the deliverable for Action 8 was ‘‘completed’’ by the September 2014 deadlines, many of the most important paragraphs—that is, those addressing intangibles BNA TAX

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10 creation and ownership, and allocation of intangiblesrelated profits—were left in draft mode.27 The OECD’s work on transfer pricing aspects of intangibles actually predates the BEPS process by a number of years. In 2010, the OECD announced it would begin a project on the transfer pricing aspects of intangibles with a primary goal of updating Chapter 6 of the OECD Guidelines. A scoping paper was published on the OECD website for public comment. At the business consultation held in November 2011, representatives of the business community suggested the OECD release interim drafts of its work as it progresses for further detailed public comment. Drafts were released in June 2012 and July 2013.28 When the BEPS plan was introduced, the intangibles project was subsumed within Action 8.

Subsequent work on all three substantive transfer pricing actions will effectively be consolidated.29 Action 9, on risk, and Action 10, on high-risk transactions, officially were merged soon after the action plan was launched. The risk draft30 was issued under the auspices of all three Actions (8, 9 and 10). Discussion drafts on cost contribution arrangements and hard-to-value intangibles that are slated for release in early 2015 also relate to all three actions. The same is true for the final output to be issued in September 2015, which presumably will comprise a complete update of all relevant chapters of the OECD guidelines.

The draft portions of the September 2014 guidance on intangibles and the provisions of the risk draft are correlated. The September 2014 intangibles draft instructed transfer pricing analysts to inquire which of the related parties’ functions are the ‘‘more important’’ ones in order to determine where intangible-related returns should flow.31 The risk draft confirms that these are the functions related to the management and control of risk. The intangibles guidance posited that the party that merely bears funding risk should earn a ‘‘risk-adjusted rate of anticipated return on its funding.’’32 The risk draft calls into question whether any risk at all could be attributed to the funding party. The intangibles draft warned that intercompany contracts form only the ‘‘starting point’’ for a transfer pricing analysis involving intangibles.33 The risk draft at paragraph 3 repeats the warning with respect to risk analysis, but gives very little room for contract interpretation to produce a different result than functional analysis alone would.

B. Historic Transfer Pricing Paradigm The changes to transfer pricing analysis being brought about by the BEPS project are potentially radi27 See ‘‘Guidance on Transfer Pricing Aspects of Intangibles,’’ available at 23 Transfer Pricing Report S-185, 9/18/14.

28 The 2012 draft is available at 21 Transfer Pricing Report 262, 7/12/12; the July 2013 draft is available at 22 Transfer Pricing Report 441, 8/8/13.

29 In addition to the substantive transfer pricing actions, the BEPS plan includes Action 13 on transfer pricing documentation requirements, including the so-called country-by-country report. See the latest draft on documentation and country-bycountry reporting at 23 Transfer Pricing Report S-232, 9/18/14.

30 See note 8, above.

31 See draft, note 27, above, para. 6.56.

32 September 2014 intangibles draft, note 27, above, para.

6.61.

33 See draft, note 27, above, para. 6.35.

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cal. To understand how radical these changes are, it is necessary to reflect on the historic paradigm that transfer pricing analysts have come to rely upon over the past 20 years.

Whether a particular affiliate undertakes functions and uses tangible assets is largely dictated by business needs and is not subject to artificial planning or manipulation. The overall level of risk that a multinational’s business faces also is a business matter; however, tax planners historically believed that the allocation of that risk between associated enterprises could be set through intercompany contracts. For example, the parent company could indemnify the subsidiary against losses.

As for ownership of intangible property—often a multinational’s major driver of profit—this historically has depended on which affiliate bears the costs and risks of development. The bearing of development cost, and of intangible-related risks, largely could be set by contract. Moreover, in order to assume development costs and risks by contract, tax planners generally took the view that the associated enterprise would not necessarily have substantive business operations of its own or undertake significant functions. All that was needed was sufficient capital to bear the costs of the risks assumed, including potential future costs such as product liability or intellectual property litigation.

In traditional transfer pricing planning, the subsidiary operating in the source country might be ‘‘stripped’’ of risk and given a guaranteed return—that is, a return that is low but stable, often the result under the transactional net margin method (TNMM). This could be accomplished by paying a subsidiary performing R&D a service fee equal to all of its costs plus a guaranteed markup. Similarly, transfer pricing policies could be put in place that ensure a distribution subsidiary bears minimal risk and receives a return on sales that is guaranteed to fall within a specified range. While the extent of functions performed by the distribution subsidiary might influence the level of the guaranteed return, the specific nature of the functions would not affect whether the distribution subsidiary would share with the parent any of the multinational’s residual profits or losses under a profit split approach.34 While this type of transfer pricing planning ‘‘stripped’’ risk, it did not necessarily imply erosion of the tax base. Historic transfer pricing planning offered an economic bargain for source countries. If the local subsidiary performed only routine functions and did not bear significant risk or own intangible assets, the subsidiary would be guaranteed a low but stable return. On the other hand, if the local subsidiary bore risks and perhaps owned some intangibles, then its return would be potentially higher but would fluctuate—earning a profit in some years, but losses in others. Accordingly, the arrangement arguably was fair to the source country: it received a guaranteed stream of tax revenue from a low-risk entity rather than having to depend on uncer34 ‘‘Residual profits or losses’’ refer to profits or losses remaining after both the parent and the subsidiary have been compensated with TNMM-based returns for their routine functions. These generally are considered to be profits or losses related to ownership of intangibles and taking of extraordinary risks, including development risks.

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11 tain tax revenue from a risk-bearing one. This is what the risk draft refers to as the ‘‘risk-return trade-off.’’35

C. ‘Accurate Delineation of the Transaction’ The goals of the risk draft seem modest: The allocation of risk should be analysed as part of the first aspect of a comparability analysis which is to identify the commercial or financial relations between the associated enterprises in order that the controlled transaction is accurately delineated. A written contract may set out the allocation of risk. . . .

It must be considered in each case whether an allocation of risk contained in written contracts is consistent with the factual substance of the transaction as reflected in the conduct of the parties. Where differences exist between contractual terms related to risk and the conduct of the parties, the parties’ conduct in the context of the consistent contractual terms should generally be taken as the best evidence concerning the actual allocation of risk.36 The writers of the risk draft have emphasized their view that, where it is necessary to set aside the terms of the contract, the exercise is not about ‘‘recharacterizing’’ the transaction but rather about ‘‘accurately delineating’’ it.37 However, whether this is considered a recharacterization of the transaction or an accurate delineation of the transaction, disregarding the parties’ contractual risk allocation and substituting a different allocation of risk can have a dramatic effect on selecting the most appropriate transfer pricing method and on the appropriate profits to be recognized by each party.

One should not underestimate the ease with which the risk draft allows setting aside contractual risk allocations. It is not merely a matter of confirming that the parties have complied with the terms of the contract.

This already is required by the guidelines in their current form, which provide that it is ‘‘important to examine whether the conduct of the parties conforms to the terms of the contract or whether the parties’ conduct indicates that the contractual terms have not been followed or are a sham.’’38 The risk draft goes much further, giving little or no respect to the historical method of allocating risk to one contracting party by means of giving the other a guaranteed return. Paragraph 60 of the risk draft makes this fact crystal clear: ‘‘The parties’ assumption of risk does not in itself determine that they should be allocated the risk for transfer pricing purposes.’’

The risk draft would allocate risks in rigorous conformity with functions related to the control and management of risks. It is true that paragraph 38 of the risk draft preserves key language already found in paragraph 1.49 of the current guidelines: ‘‘In arm’s length transactions it generally makes sense for the parties to 35 This concept is discussed on pages 14 and 15 of the risk draft (see note 8, above), where specific comments on the issue are solicited.

36 Risk draft (note 8, above), para. 43.

37 See the interview with Andrew Hickman, head of the OECD transfer pricing unit, and Marlies de Ruiter, head of the organization’s division on tax treaties, transfer pricing and financial transactions, at 23 Transfer Pricing Report 1219, 1/22/15.

38 OECD guidelines, para. 1.53.

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be allocated a greater share of those risks over which they have relatively more control’’ (emphasis added).

Paragraph 9.20 of the current guidelines further tempers this language by stating that examining the party having relatively more control over risk is a ‘‘relevant’’ but not ‘‘determinative’’ factor in determining the allocation of risk between the parties. However, the risk draft adds half a dozen examples that lead one to conclude that this observation has been transformed from a general guideline to an invariable rule.

Paragraph 1.49 of the OECD guidelines (preserved in paragraph 38 of the risk draft) already gave an example where ‘‘Company A’’ would be ‘‘unlikely’’ to take on substantial inventory risk while ‘‘Company B’’ controls the level of production. The risk draft then adds the following examples: s paragraph 57, described below; s paragraph 59, which concerns a distributor that ‘‘shares in product risk management’’ (and presumably deserves a return related to intangible development) because it played a role in determining what products would be produced by predicting trends in the market; s paragraph 60, which concerns a distributor that is improperly allocated product recall risk (as well as a higher return) because it is the manufacturer that is responsible for ‘‘supplier audit programmes, extensive testing protocols, mandatory training, and a culture of improvement’’; s paragraph 61, which would not allow an allocation of risk to a related insurance provider that does not have the capacity to ‘‘assess, underwrite and manage’’ the risk; s paragraph 62, which concerns a supplier that controls the products, volumes and promotional campaigns of a related-party distributor and therefore should bear product obsolescence risk; and s paragraph 63, which concerns a company that owns specialist equipment but does not control its utilization and therefore, the draft states, should earn only a financing return.

The most telling example is found in paragraph 57 of the risk draft. It concerns a manufacturer that is paid a guaranteed markup on actual costs by another group company. Assume for the purposes of this discussion that the other company is the ultimate parent of the group. This type of arrangement, which effectively insulates the manufacturing subsidiary from all risk, is quite common in traditional transfer pricing planning. Commonly, the goal of such planning is not to erode the tax base of the source country. By contrast, the goal often is to ensure that the source country receives a guaranteed stream of tax revenue that is commensurate with the functions undertaken and assets used within the country. This type of arrangement allows the multinational to efficiently and effectively manage its global transfer pricing compliance risk. The alternative of setting transfer prices for raw materials supplied to the manufacturer and prices for finished products purchased from the manufacturer on a transactional basis likely would lead to widely fluctuating profits for the manufacturer, be much more difficult to manage and greatly increase the risk of controversy on audit.

Paragraph 57 launches a headfirst attack on this conventional planning technique. It opens with this observation: The performance of risk management may have an important effect on determining arm’s length pricing BNA TAX

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12 between associated enterprises, and it should not be concluded that the pricing arrangements adopted in the contractual arrangements (see Section D.2.2) determine the respective contributions to risk management.

Paragraph 57 continues by discounting the notion that the manufacturing subsidiary is protected from the risk of raw material price fluctuations by virtue of its cost-plus remuneration. The ‘‘key point,’’ it says, ‘‘is whether there exists an operational or financial risk associated with raw material price fluctuation and if so how that risk is managed in the business.’’ If this risk is in fact managed by the parent company, then the parties’ purported risk allocation, and consequently the pricing policy, may be respected. If, however, the manufacturing subsidiary manages the risk, then the risk allocation, and consequently the pricing policy, is suspect. Then again, tracking paragraph 57 to its final sentences, the view is that even if the parent company manages the raw material price risk, the transfer pricing policy nonetheless is suspect if the manufacturing subsidiary manages any of the risks associated with production utilization, sophistication of manufacturing, quality control, flexibility to switch production or any other unspecified factors.

The long list of potential risks in paragraph 57 is completely consistent with the risk draft’s definition of risk, which rightly is very broad: There are many definitions of risk, but in a transfer pricing context it is appropriate to consider risk as the effect of uncertainty on the objectives of the business. In all of a company’s operations, every step taken to exploit opportunities, every time a company spends money or generates income, uncertainty exists, and risk is assumed.39 The risk draft then gives helpful guidance on several wide-ranging categories of risk: strategic or marketplace risk, infrastructure or operational risk, financial risks, transactional risks and hazard risk.40 Truth be told, it is the broad definition of risk that ultimately gives rise to so much uncertainty when the principles of the risk draft are applied. If risks are considered at such a level of granularity, then the likelihood that both parties to any intercompany transaction will be involved in managing and controlling specific risks is great.

D. Profit Split Solution Under the risk draft, to a large extent, risk follows function. However, it is not all functions that are relevant to the allocation of risk. Paragraph 55 of the risk draft lays out two essential elements of risk management: the decision to take on or decline a risk-bearing opportunity and the decision of whether and how to respond to the risks associated with the opportunity. According to paragraph 55, a third element of risk management is performing active measures to mitigate risks or otherwise affect risk outcomes. Unlike the first two elements, paragraph 55 would allow risk mitigation functions to be outsourced, provided the outsourcing party assesses, monitors and directs the outsourced measures.

It is hard to escape the implication that the risk draft’s approach will lead to selection of a profit split method as the most appropriate method in a great number of cases. This is in sharp contrast to traditional transfer pricing planning where the cost plus method or TNMM generally is adopted. This conclusion derives from the combination of the fact that, under the risk draft, so many types of risk are considered relevant to proper transfer pricing and that the typical multinational manages risks through the joint efforts of all parties. The risk draft highlights the latter consideration: In a group situation, risk management may be carried out at several levels, and not solely by the legal entity that incurs risk through its operations. The board and executive committees may set the level of risk the company is prepared to accept in order to achieve commercial objectives, and to establish the control framework for managing and reporting risk in its operations. Line management in business segments, operational entities, and functional departments may identify and assess risk against the commercial opportunities, and put in place appropriate controls and processes to address risk and influence the risk outcomes arising from day-to-day operations. The opportunities pursued by operational entities require the ongoing management of the risk that the resources allocated to the opportunity will deliver the anticipated return. These functions all contribute to risk management.41 In some cases, the risk management activities of one of the related parties may be so much less important than those of the other party that the cost plus method or TNMM still can be applied. Multinational enterprises may choose to reward the party performing less important risk management functions with a premium return in order to keep the transfer pricing policy simple, administrable and easy to defend. However, this approach essentially is a shortcut. Although the assumption of risk generally leads to an increase in the expected return, the actual return realized may be greater or less depending on the degree to which the risks materialize.42 The draft on the profit split method suggests a hybrid method that is based on TNMM but uses a profit split approach to ‘‘flex’’ the results so as to reflect the outcome of risk-taking.43 While this hybrid method is an interesting idea, implementing it would seem to pose just as much difficulty as a full-fledged profit split—and defending it, in the absence of an advance pricing agreement, likely would be nearly as contentious.

While a function-based profit split will be appropriate in many cases, a more draconian result may be imposed in some cases considered abusive. The article so far has considered a case where transactions are between the ultimate parent company and a sourcecountry subsidiary. When the ultimate parent has interposed a low-function ‘‘cash box’’ entity that is based in a tax haven, the risk draft and the draft portions of the intangibles draft give consideration to how the cash box should be rewarded for undertaking a funding obligation without performing any risk management functions at all. The intangibles draft proposed that the cash box entity receive a ‘‘risk-adjusted rate of anticipated 41

39

Risk draft (see note 8, above), para. 41.

40 Risk draft, para. 42.

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Risk draft (see note 8, above), para. 56.

Risk draft, para. 22.

43 Profit split draft (see note 14, above), para. 32.

42

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13 return on its funding, but no more.’’44 This left open the question of how high the ‘‘risk-adjusted rate’’ might be; after all, venture capital funding of highly uncertain ventures can receive risk-adjusted returns that are very high indeed—a rate approaching 30 percent would not be uncommon.45 The risk draft effectively answers this question: If the cash box company performs no risk management functions, it would be allocated no risks at all—so, presumably, it would be entitled to only a riskfree rate of return.

To reiterate, the approach of the risk draft marks a significant change from previous interpretations of the arm’s-length principle. Allocation of risk by contract is severely limited. Instead, risk is conceived to follow function. If contractual risk is assigned to the associated enterprise that is able to make the decision to incur the risk and to manage the risk, then the contract will be respected. However, if contractual risk—and associated premium returns (or, potentially, losses)—is separated from function, the contract will be reinterpreted to fully align risk with function.

E. Applying Risk Draft Principles to Digital Economy Case Study Next, consider how the digital economy case study might be treated under the risk draft. Recall that the local subsidiary performs three groups of functions:46 s user-related functions including promotion of the free online services, local country translation and regulatory services, and technical consulting for users; s advertiser-related functions such as generating demand for advertising and adapting the advertiser services; and s group-related functions, involving interaction with parent company developers by making suggestions with regard to algorithms and technology as well as new features that would be attractive to users in its market.

Historically, the multinational likely would treat the local subsidiary as a low-risk service provider to which it would pay a cost-plus fee that guarantees the subsidiary’s profitability. A variety of comparables might be used to benchmark specific functions. To promote the online service to users and advertisers, comparable marketing or promotion service providers might be used. For translation activities, it might be possible to find comparable translation service providers (or it may be necessary to rely on a more general set of low-value service providers). For tailoring the services to local market and culture, marketing or public relations consulting companies might be appropriate comparables.

For regulatory compliance, law or accounting firms perform similar functions (although again a more general set of low-value service providers might be more read44

See intangibles draft (note 27, above), para. 6.61.

See Patrick Breslin, ‘‘An Early-Stage Investor Analogy: How Related-Party Transfers of Intangibles Contribute to Base Erosion and Profit Shifting,’’ 22 Transfer Pricing Report 699, 9/19/13, at 702. Note that this is the return earned by the passive investors in a venture capital fund; the returns earned by an active, general partner are much higher (by virtue of ‘‘carried interest’’ and management fees).

46 The profit split draft (note 14, above), by contrast, classified these functions into only two groups: user-facing and advertiser-facing functions. The group-related functions were seen as subsidiary to the other two functions.

45

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ily available). For providing technical consulting to users, there are numerous public companies providing information technology consulting and support functions.

Finally, for interactions with the parent on algorithms, technology and features, again, there are numerous information technology consultants or software development service providers. Some of the comparables may command a low margin (such as translation or regulatory compliance service providers), while others may command higher margins (such as technology consultants). Admittedly, the available comparables may not be a perfect match for the local subsidiary’s relevant functions, but it has been an accepted part of transfer pricing analysis to find comparables that are ‘‘good enough’’ for benchmarking purposes.

Under the risk draft, some functions still can be considered routine and benchmarked under a cost plus method or TNMM: Some controlled and uncontrolled parties and transactions are likely to present a common set of risks.

For example, distributors may present a fairly homogeneous set of risks such that the functions of the controlled distributor can reliably be benchmarked by reference to profit margins of uncontrolled distributors. However, such an assumption needs to be tested in the functional analysis by establishing how the functions of the controlled party contribute to risk management, the impact of the risks, and whether those functions, and other functions, differ to the functions of uncontrolled parties.47 The question of whether a function can be benchmarked by routine comparables or needs to be handled differently (for example, by a profit split method) then turns on whether its functions involve managing the core risks facing the multinational. So, for example, the translation services performed by the local subsidiary in the case study presumably could be compensated under a simple cost plus method. The risks presented by an inadequate translation would seem to be minimal. Regulatory compliance services, on the other hand, may well go to the multinational’s core risks: failure to comply with the source country’s privacy laws, for example, could lead to major legal troubles and might force the group to discontinue providing services in the source country entirely. If the parent company lacks the competency to assess, monitor and direct the subsidiary’s regulatory compliance efforts, then a simple cost plus might not be accepted by local tax authorities.

As for promotion and marketing activities (to both users and advertisers), it may be instructive to compare the analysis of distribution activities in the current guidelines with the new paradigm. Paragraph 1.47 of the current OECD guidelines reads: [W]hen a distributor takes on responsibility for marketing and advertising by risking its own resources in these activities, its expected return from the activity would usually be commensurately higher and the conditions of the transaction would be different from when the distributor acts merely as an agent, being reimbursed for its costs and receiving the income appropriate to that activity.

Thus, under the current guidelines, a great deal turns on whether the distributor ‘‘risk[s] its own resources’’ 47

Risk draft (note 8, above), para. 76.

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14 or is ‘‘reimbursed for its costs.’’ Under the risk draft, it is not possible to rely on the fact that the contract limits the distributor’s risk by reimbursing its costs; instead one must specifically consider how the distributor manages the risks associated with its marketing and promotion activities. Marketing and promotion clearly are core to the multinational’s success or failure in the source country. If the distributor (or, in this case, marketing service provider) undertakes a more extensive set of marketing and promotion functions than the comparable companies and possesses special knowledge of local market conditions over which the parent company cannot or does not exert significant control, then relying on routine benchmarks alone is not sufficient to properly compensate it.

Finally, consider the subsidiary’s ‘‘product development’’ activities, which consist of making suggestions on algorithms, technologies and features that would be attractive to users in the market. It may seem farfetched to reach the conclusion that the subsidiary should share in the profits or losses related to product intangibles. After all, the case study reveals that the parent company was the original developer—risking its own funds—of the ‘‘sophisticated technology’’ that is able to target advertisements to some users. Meanwhile, the subsidiary’s role is limited to providing ‘‘suggestions.’’ However, the risk draft offers a specific example that calls into question any conclusion that the parent company alone is entitled to profits related to product intangibles: The functional analysis should carefully consider how risks are managed before concluding, for example, that only the product developer manages product risk. It may be the case that a distributor has played a significant role in determining the nature and specifications of products likely to meet its predictions of trends in its market, and therefore shares in the product risk management.48 If the suggestions for tailoring the online services to the local market that are made by the subsidiary in the case study presented in this article are particularly significant to the services’ success in the source country, then the risk draft would seem to require that the subsidiary share in the reward.

Perhaps, this example is not as far-fetched as it initially seems. There is no clear-cut distinction between product intangibles and marketing intangibles, nor between the profits attributable to each. If the subsidiary’s contributions to the group lead to great success in the local market, then it may not be unreasonable to ascribe marketing intangibles to it. Taking that step is not too far from France’s suggestion to take into account the size of local user base and quantity of user data in determining whether a PE exists. Nor is it too far from Chinese notions of ‘‘market premium,’’ as discussed below. The value of the marketing intangibles thus is equated with the value of the market itself.

introduced guidance on the issue for the application of what is known as the authorized OECD approach (AOA). As illustrated, the BEPS project seeks to align transfer pricing results with ‘‘value creation’’ and to reduce the dependence on contractual allocations of risk, capital and intangible ownership. Similarly, a key purpose of the AOA is to provide guidance on how to apply the arm’s-length principle in an environment where there are no legal contracts.

Between the late 1990s and 2008, the OECD undertook an extensive project on attributing profits to PEs, which culminated in the publication in 2008 of a report entitled ‘‘Attribution of Profits to Permanent Establishments.’’49 The project sought to develop the ideal approach to PE profits working from first principles. The project was not constrained by the original intent of the drafters of Article 7 of the OECD Model Tax Treaty and its predecessors, nor by the historical practice and interpretation of Article 7 by the various countries using tax treaties based on the OECD model, nor even by the particular wording of Article 7 at that time.

The 2008 PE report definitively embraced the arm’slength principle as the guide for attributing profits to PEs. The report introduced the AOA as a comprehensive method for hypothesizing the PE as a separate entity from headquarters. Although the AOA was considered consistent with the existing model treaty, the OECD decided to introduce a substantially revised version of Article 7 with the release of the new OECD Model Tax Treaty in 2010 in order to more fully and unambiguously implement the AOA. The OECD also issued a 2010 revision of the PE profits report to serve as a reference in applying the new Article 7.50 As discussed in the final part of this article, it is worth noting that the AOA has not been adopted by all countries.

To students of transfer pricing between associated enterprises, the AOA sounds familiar: The authorised 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 . . . 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.51 Thus, the allocation of profits between the PE and the headquarters depends on functions, assets and risks. What differentiates this functional analysis from the traditional functional analysis in the associated enterprise context is that intercompany contracts cannot be consulted to determine how risks or intangible assets are allocated.

Central to applying the AOA is the concept of ‘‘significant people functions’’—sometimes also referred to as ‘‘key entrepreneurial risk-taking’’ (KERT) functions.52 The AOA gives primacy to functions, which pre-

VI. PE Profits and the AOA A. Overview of the AOA Now, at last, comes the question of how profits should be attributed to a PE. Some years ago, the OECD 48

Risk draft, para. 59.

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49 Available at http://www.oecd.org/tax/transfer-pricing/ 41031455.pdf.

50 Available at www.oecd.org/tax/transfer-pricing/ 45689524.pdf.

51 2010 PE profits report, para. 8.

52 In early discussion drafts, the PE profits report used the ‘‘KERT’’ terminology throughout. In the final version, the KERT terminology is reserved for the financial and insurance

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15 sumably are easy to identify with either the PE or the headquarters. Risks and assets then are assigned to the PE by reference to the significant people functions: s Risks attributed to the PE are those ‘‘for which the significant functions relevant to the assumption and/or management . . . are performed by people in the PE.’’53 s ‘‘Economic ownership’’ of assets is assigned to the PE of those assets ‘‘for which the significant functions relevant to the economic ownership of assets are performed by people in the PE.’’54 The pivotal question then is: What functions are ‘‘significant’’? It is important to note that the PE should expect to earn income relating to all functions performed, even those that are not ‘‘significant.’’55 Significance is relevant only to the issue of risks and assets (including intangible assets) assigned to the PE, which are quite relevant to expected rates of return, need for notional royalties and service fees and other issues.

With respect to risk, the significant people functions are those that relate to ‘‘active decision-making’’ about whether to incur the risk and how to manage it.56 Accordingly, activities of management personnel related to setting and overseeing compliance with quality control standards would be significant. Decision making about whether and how to insure equipment and other property used by the PE also would be relevant. In addition, the PE normally should be considered to assume the risks related to the actions of its employees, such as risks related to the negligence of employees.57 There are many similarities between the AOA and the approach of the risk draft and the draft portions of the September 2014 intangibles draft. The concept of ‘‘significant people functions’’ is similar to the notions of risk management functions in the risk draft and of ‘‘more important’’ functions in the intangibles draft.

The fact that the risk draft and the intangibles draft both claim that contractual terms are the ‘‘starting point’’ for transfer pricing analysis suggests that the OECD does not intend for the AOA to apply to associated enterprises the same way it applies to PEs. However, it is difficult to see how the proposed approach differs from the AOA with respect to risk allocation; that is, it is hard to see how the existence of a contract could lead to a different result than otherwise would be obtained based on an analysis of functions alone.

B. Divergence from the AOA The AOA brings a parity of treatment regardless of whether a multinational operates in a country through a subsidiary or through a PE. Insofar the arm’s-length standard has long been recognized as the fairest and most appropriate way to divide income between jurisdictions, acceptance of the AOA therefore is the most appropriate policy choice for countries worldwide. Unfortunately, not all countries in the world have adopted the AOA. sectors due to the close relationship between risks and financial assets. That is, outside the financial and insurance sectors, there may be different significant people functions for risks than for assets. See 2010 PE profits report, para. 16.

53 2010 PE profits report, para. 15.

54 2010 PE profits report, para. 15.

55 2010 PE profits report, para. 17.

56 2010 PE profits report, para. 22.

57 2010 PE profits report, para. 68.

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In fact, when the UN Model Tax Treaty was updated in 2011, the drafters chose not to follow the OECD Model Tax Treaty in its explicit adoption of the AOA. Instead, the UN model continued to use the language for attributing profits to a PE that was used in Article 7 of both model treaties before. This language, to be brutally honest, is schizophrenic. With one hand, the UN treaty provides that the PE should be attributed ‘‘the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.’’58 This clearly is a statement of the arm’s-length standard and fully consistent with the AOA. However, with the other hand, the UN treaty limits deductions that the PE can take,59 even where they would be necessary to achieve an arm’slength result.

Moreover, the UN treaty explicitly sanctions the ‘‘apportionment of the total profits of the enterprise to its various parts’’ (a non-arm’s length approach), provided only that such an approach ‘‘has been customary’’ in the source country.60 Because China customarily has used a ‘‘deemed profit’’ method to attribute profit to a PE, Chinese treaties replace the reference to apportionment of profits with a reference to ‘‘deemed profit.’’61 The Chinese deemed approach is outlined in Circular Guoshuifa [2010] No. 19 (Circular 19).62 Circular 19 provides for margins ranging from 15 percent to 50 percent of sales over a range of different service types.

These margins clearly significantly exceed those that normally would be expected through applying an arm’s-length approach based on comparable companies’ margins.

C. Treatment of Agent PEs Under the AOA It is relatively straightforward to apply the AOA in the case of an ordinary PE. In the case of an agent PE, some modification is needed.63 An ordinary PE comes about when the activities of the parent company’s own employees exceed a certain threshold. The AOA is applied by hypothesizing a separate entity (the PE) that undertakes functions through the parent company’s employees. Generally, all of the activities of the parent company employees in the source country are relevant to the inquiry.

An agent PE, on the other hand, comes about when activities of the subsidiary’s employees advance the interests of the headquarters in specified ways. Therefore, it is necessary to hypothesize an entity (the agent PE) that is separate from both the parent and the subsidiary and undertakes functions on behalf of the parent company through the employees of the subsidiary. However, the activities of the subsidiary’s employees already have been compensated as a result of the subsidiary’s earning an arm’s-length profit of its own. The agent PE is attributed the share of the parent compa58

UN Model Tax Treaty, Article 7(2).

UN Model Tax Treaty, Article 7(3).

60 UN Model Tax Treaty, Article 7(4).

61 See for example, Article 7(4) of the U.S.-China Double Tax Convention.

62 Available at 19 Transfer Pricing Report 196, 6/17/10.

63 Attributing profit to an agent PE is discussed in para. 47 and paras. 227-245 of the 2010 PE profits report (note 50, above).

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16 ny’s income (as opposed to the subsidiary’s income) that is derived from the agency activities of the subsidiary’s employees. Insofar as all of the functions being undertaken in the host country already have been compensated at the subsidiary level, the 2010 PE profits report concluded that the profits attributable to the agent PE generally relate only to the risks and assets of the parent company that are attributed to the agent PE.64 The 2010 PE profits report uses a simple example to illustrate the point that the agent PE’s profits relate solely to risks and assets.65 In this example, the subsidiary operates under a ‘‘typical sales agency agreement’’ and never takes title to the goods to be sold. Although the subsidiary warehouses a stock of goods, these goods belong to the parent company; therefore, under transfer pricing principles as historically applied (that is, prior to the risk draft), the associated inventory risk is borne by the parent company. The PE profits report concludes that ‘‘[a]n arm’s length agency fee’’ paid by parent to the subsidiary ‘‘would not therefore include an element to reward the assumption of these risks.’’66 Assuming the subsidiary’s activities give rise to an agent PE for the parent, the question is then whether any of the reward for assumption of inventory risk should be attributed to the agent PE.67 In the PE profits report, the answer turns on whether the significant people functions related to the assumption and subsequent management of the inventory risk are undertaken by the parent outside of the source country or are undertaken by the subsidiary on behalf of the parent.68 If the risks are undertaken by the subsidiary, then the agent PE’s profit would be calculated by, first, determining what profits the subsidiary would have earned if it had borne the inventory risks (that is, if it were a fullfledged distributor that owned the inventory) and, second, deducting the profits the subsidiary did in fact earn as a sales agent.69 In this way, the portion of the total profit attributable to the risks and assets of the agent PE is isolated from the portion attributable to the subsidiary’s functions.

As noted, in crafting this example, the PE profits report assumes that the historic transfer pricing paradigm applies. That is, because the parent company is the contractual and legal owner of the inventory, inventory risks will be assigned to the parent company even if the subsidiary undertakes key risk management functions.

Under the risk draft, this contractual allocation of risks no longer will be respected; the subsidiary will be deemed to bear the inventory risks and therefore will earn the profit attributable to inventory ownership. As a result, there will be no profit left to attribute to the agent PE.

D. Applying the AOA to Digital Economy Case Study The facts of the digital economy case study presented earlier are more complex than the simple inventory-based example from the PE profits report be64

See 2010 PE profits report (note 50, above), paras. 47 and

232.

65

See the report at paras. 241-244.

2010 PE profits report, para. 241.

67 2010 PE profits report (note 50, above), para. 242.

68 Id. 69 2010 PE profits report, para. 234.

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cause economic ownership of market and product intangibles is implicated. Compare the view of the PE profits report: [I]t should be noted that the activities of a mere sales agent may well be unlikely to represent the significant people functions leading to the development of a marketing or trade intangible so that the dependent agent PE would generally not be attributed profit as the ‘economic owner’ of that intangible.70 The promotion and marketing activities of the subsidiary in the case study presented above that potentially give rise to an agent PE under the PE draft are the same activities that would lead to the subsidiary’s earning a greater share of intangible-related profit under the risk draft. Although the precise wording regarding the attribution of risks based on management and control functions of the subsidiary are not identical between the risk draft and the AOA, there is little if any difference in the resulting risk allocation. Intangible assets would follow from the marketing and development risks that give rise to them, and profits would follow from risks and intangibles.

In short, the AOA would attribute the same amount of income to the agent PE created by the subsidiary’s activities as the risk draft would demand the subsidiary itself earn. More specifically, the amount of income on which the parent would be taxable in the source country would be zero because the income attributable to the PE would be wholly offset by the income earned by the subsidiary. Assuming the new concepts introduced by the risk draft are put into practice and that the source country follows the AOA, the only effect of the PE draft is to impose additional registration and reporting requirements on the parent company. Nothing ultimately is accomplished by expanding the agent PE rules.

VII. Chinese Market Premium Before addressing the resolution of the conflict between the PE draft and the risk draft, it is important to consider how the new conceptions of ‘‘source country’’ income reflected in the drafts measure up against Chinese rules and practice. China has promoted the concept of income related to so-called location-specific advantages (LSAs) for some time, as reflected in its chapter to the UN’s Practical Manual on Transfer Pricing for Developing Countries.71 China’s efforts in this regard were rewarded with the OECD’s addition of a section titled ‘‘Location savings and other local market features’’ to the OECD guidelines.72 The type of LSA that 70

2010 PE profits report, para. 233.

Available at http://www.un.org/esa/ffd/documents/ UN_Manual_TransferPricing.pdf. Also see 21 Transfer Pricing Report 683, 11/15/12 and D. Chamberlain, ‘‘APAs in China: The End of Cheap, the Growth of Affluence,’’ 22 Transfer Pricing Report 344, 7/11/13.

72 The BEPS intangibles draft (note 27, above) took the form of an update to the OECD guidelines that finalized some language and, as noted above, left other language in draft form. The section on ‘‘Location savings and other market features’’ is part of the finalized language and now comprises paras. 1.80-1.92 of the OECD guidelines.

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17 is relevant to this discussion is called ‘‘market premium’’ by the Chinese.73 To quote the OECD guidelines’ discussion of market premium: [T]he comparability and functional analysis conducted in connection with a particular matter may suggest that the relevant characteristics of the geographic market in which products are manufactured or sold, the purchasing power and product preferences of households in that market, whether the market is expanding or contracting, the degree of competition in the market and other similar factors affect prices and margins that can be realised in the market.74 To date, the Chinese primarily have focused on one aspect of market-based LSAs: the premium price that Chinese consumers are willing to pay for luxury goods, as reflected in the following observation in the UN Manual: ‘‘Chinese consumers’ general preference for foreign brands and imported products—this general preference, as opposed to loyalty to a specific brand, creates opportunities for multinationals to charge higher prices and earn additional profits on automotive products sold in China.’’75 Indeed, specific products from famous brands like Prada and Burberry command prices in China that are more than double the prices in Europe or America.

That said, the focus on luxury goods easily can be expanded to other market-based LSAs. For example, the value of the marketplace created by Chinese Internet users, who are the most active online shoppers in the world, is clearly an ‘‘advantage’’ that the Chinese tax authorities would want to capture. China can be expected to be strongly supportive of the new transfer pricing concepts in the risk draft. Whether the risk draft goes far enough to satisfy China’s notion of the share of LSA profit that should accrue to it (or any other source country) remains to be seen. To the extent the Chinese subsidiary is considered to have developed marketing intangibles, capturing the value of the market itself may not be a far stretch.

VIII. Resolving the Conflict This article has shown that, where a multinational operates in a particular source country through a subsidiary, the agent PE provisions of the PE draft and the risk allocation provisions of the risk draft have overlapping results. That is, the income that would be attributed to the parent company under the expanded definition of agent PEs in the PE draft is the same income that would be attributed to the subsidiary by virtue of the expanded range of risks allocated to it under the risk draft. The authors strongly suggest that the OECD reconsider the two drafts and not finalize them both in their current form, but rather—if it is intent to make a 73 China’s chapter of the UN manual (note 71, above), para.

10.3.3.3.

74 OECD guidelines, para. 1.85.

75 China’s chapter of the UN manual (note 71, above), para.

10.3.3.6.

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change—choose one or the other as the preferred approach.

As for applying transfer pricing principles, there has been a serious risk of divergence among the countries of the world in their approaches. Indeed, China’s reliance on market premium theories demonstrates that this divergence already has begun. As a result, it may well be the case that a change to the OECD guidelines more or less consistent with the risk draft is all but inevitable.

With this in mind, the risk draft would seem to be the preferred approach for dealing with the profit allocation issue. Thus, the agent PE provisions of the PE draft should not be implemented—at least not with respect to the activities of a source country subsidiary. Multinational companies should be able to achieve certainty and finality by setting up a subsidiary and ensuring that it earns an arm’s-length return, and should not need to worry about being found to have a PE in the same country.

To simultaneously allow the expanded agent PE concept to situations produces either: s a ‘‘hollow’’ PE with no attributed taxable profit but with administrative and compliance costs for the taxpayer and tax authorities, as well as increased valueadded tax and individual income tax risks for the foreign enterprises; or s excessive taxation due to the application of AOAdivergent profit based attribution methods or deemed profits methods by the source jurisdiction.

Indeed, the PE draft took comfort in the assumption that the AOA would result in appropriate profits being attributed to newly minted PEs.1 The fact that many countries, including China, do not follow the AOA means expansion of PE scope should not be taken lightly.

One cannot thoroughly explore the topic of implementing robust and effective BEPS solutions without considering Action 14, aimed to make dispute resolution mechanisms more effective.77 All aspects of the BEPS project would benefit greatly from increased access to mutual agreement procedure tools, including the urgently needed device of mandatory arbitration.

The authors urge China specifically to overcome its reservations about mandatory arbitration and allow multinationals to enjoy real assurance that they will not suffer from double taxation. This assurance is necessary not just for foreign multinationals making inbound investment, but also for the increasingly numerous and important Chinese multinationals with outbound ambitions. In addition to boosting MAP resources, the nations of the world would be well served to improve and expand their advance pricing agreement programs. If the risk draft approaches are put into place, transfer pricing policies will become more complex than ever before, including much greater use of profit split methods; APAs will be crucial to achieving the fairest and most efficient results for all parties—taxpayers and tax authorities alike.

1

PE draft, para. 45.

See the OECD’s Dec. 18, 2914, draft on that item, available at 23 Transfer Pricing Report 1170, 1/8/15.

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