Five core problems in the attribution of profits to permanent establishments

The rules regulating the attribution of profit to permanent establishments (PEs) are a fundamental feature of the existing international tax system yet are beset by a multitude of problems. This article identifies five “core” problems with these rules: (1) the absence of a single standard for PE profit attribution; (2) conceptual and practical problems arising in the application of the Authorised OECD Approach; (3) new pressures arising as a result of the changes made to the PE threshold rules by the BEPS Project; (4) the failure to deal with the uncertainties between the transfer pricing rules and the PE attribution rules in the aftermath of BEPS; and (5) a raft of new challenges arising from the work on the digitalization of the economy. To a large degree, these issues are symptomatic of the problems faced by the international tax system as a whole. This article analyses the source, nature and impact of these core problems, before concluding with some brief thoughts on potential solutions.

What are the problems with income allocation rules?

In 2010, the OECD completed its 13-year project to reform the rules governing the attribution of income to permanent establishments (PEs). The final 240-page report comprised four separate papers setting out how the new ‘authorised OECD approach’ (‘AOA’) should work generally, and by reference to certain specific industry sectors. The report also led to a new article and an accompanying commentary in the OECD Model Tax Treaty. 

The intention behind the project was to overhaul the way profits were attributable to PEs and in the process to achieve greater uniformity in the international tax system, thereby reducing the incidence of double taxation. But the work has not delivered the goals it set out to achieve. Five core problems were identified and explored in this research project. 

First, the new approach has not delivered the intended global uniformity of approach. A number of states, including even OECD member countries, have rejected the new approach. For those states adopting the change, the pace of adoption has been glacial. The result is a limited and slow take-up of the new approach, leaving the previous diversity of country approaches not significantly altered and meaning that unresolved differences continue to cause problems in the international tax system. Second, the new ‘AOA’ is in practice difficult to apply: it is highly complex, vague in parts, and over-dependent on assumptions and hypotheses. Contrary to the basic objectives of the new approach, dispute is arguably increased, not contained. Third, certain changes in the BEPS project have had the effect of magnifying the practical impact of the difficulties with the PE attribution rules, primarily by changing the relationship between those attribution rules and the transfer pricing rules.

Fourth, there has been a failure of the repeated attempts (of which there have so far been three) that have been made since the BEPS output in 2015 to resolve the (admittedly complex) task of clarifying the fundamental interaction of the BEPS transfer pricing rules and PE profit attribution rules. The result leaves the taxpayer with little in the way of meaningful guidance in this area. Fifth, there are challenges to the PE attribution rules arising from the ongoing digital debate. Many of the avenues being pursued in the work on digitalised businesses are based on an entirely different conceptual approach to that underlying the existing PE attribution rules.