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Date:28^th July 2010	Compiled by: M Sathya Kumar
Attributing profits to permanent establishments The existing Article 7 of the OECD Model Tax Convention provides that the profits attributable to a PE may be taxed in the source country. Taxation these days has become an innovative and creative sphere intertwining within itself study of various other disciplines. In this context, the pronouncements of the Organisation for Economic Co-operation and Development (OECD) on the international taxation side merits consideration, especially in areas of cross-border trade and commerce. In May, the OECD Committee on Fiscal Affairs released the draft contents of the 2010 update to the OECD Model Tax Convention. The same is likely to be approved formally by the Council shortly. The 2010 update would include the changes that were previously released for comments. Amongst others, the significant update which merits consideration is the manner of attribution of profits to a permanent establishment (PE) of an enterprise. The existing Article 7 of the OECD Model Tax Convention provides that the profits attributable to a PE may be taxed in the source country; and specifically Para 2 of the said Article lays down the manner of computing the profit attributable to such PE, which it might be expected to make, if it were a separate and distinct enterprise. Further, Para 3 of Article 7 provides certain expenses which are to be allowed as deductions while computing the profit attributable to a PE. Removing ambiguities The proposed draft has attempted to remove certain ambiguities which arise on a simple reading of the existing provisions of Article 7. The most noteworthy departure from the existing model, inasmuch as it is now suggested that computation of profits attributable to a PE after taking into account functions performed, assets used and risk assumed by an enterprise through its PE. Further, the proposed update provides that the country of residence while levying tax on the entire profit, that is, including profit attributable to a PE in the source country and then to the extent necessary, elimination of double taxation by making a proper adjustments. Further, in a situation where the taxpayer has determined the profits attributable to the permanent establishment in a like manner in each contracting state and both the states agree that the taxpayer has done so in accordance to the Article, no adjustments should be made to the profits in order to reach a different result. Where the taxpayer has not determined the profits attributable to the permanent establishment in conformity with the said Article, each state is entitled to make adjustments so as to be in conformity with Article 7 prescribing inter alia the rules of attribution, in fact the other state to make appropriate reciprocal adjustments to ensure that there is no double taxation. Thus, the other state is committed to making such a corresponding adjustment only if it considers that the initial adjustment is justified both in principle and as regards the amount. Here, it is important to bear in mind that an accounting school of thought does exist to the effect that nobody can make profits or losses out of transactions with oneself, and intra-organisation transactions can indeed be viewed as transactions with oneself because a PE is per se a part of the enterprise itself. Thus, the proposed Article seeks to imbibe the principle, as all it seeks to do is allocation of overall profits to various tax jurisdictions in such a manner that sum of PE profits in all jurisdictions is equal to the overall profits of the enterprise where the business activity involves more than one tax jurisdiction. Even with respect to the transactions covered by the fiction of Article 7, which are only intra- organisation or intra associated enterprises transactions, the issue that arises is to what degree this fictional independence can be stretched out. Here, it is requisite that the intra-organisation transactions should be valued at the prevailing market price in ideal conditions, while it is also a recognised accounting approach that the fiction of hypothetical independence merely permits taking into consideration, the intra-organisation transactions, at the normal transaction value, which otherwise would be impermissible. One other significant aspect under consideration in this regard in the update of 2010 would be to look out for the changes in relation to deductibility of certain expenditure when computing the income of the enterprise in either contracting state. The conditions for the deductibility of expenses are a matter to be determined by domestic law, subject to the other provisions of the convention, as applicable. Any variations between the domestic laws of the two states concerning matters such as depreciation rates, the timing of the recognition of income and restrictions on the deductibility of certain expenses will normally result in a different amount of taxable income in each state even though, for the purposes of the Convention, the amount of profits attributable to the PE will have been computed on the basis of method under Article 7. Also, to the extent that the difference results from domestic law variations concerning the nature and methodology of computation of expenditure that are deductible, as opposed to timing differences in the recognition of these expenses, the difference will be permanent. Article by Aseem Chawla and Surabhi Singhi
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