Transfer Pricing Update: New discussion draft issued by OECD

By Les Secular

The OECD has issued an updated Discussion Draft on “The Interpretation and Application of Article Permanent Establishments (‘PE’) – of the OECD Model Tax Convention”. This latest Draft follows consultations on its previous draft issued in October 2011.

Whether or not a PE exists determines not only whether there is a local taxable presence with all the issues that arise there from but, also, can have transfer pricing implications as there would be transactions with the PE that may now be scrutinized and amended for transfer pricing purposes. As such it is important to understand the OECD whether an enterprise has a PE because of a construction site or installation project, the appropriate period should include the period in which the building or its facilities/installation are being tested. In addition, if on completion the taxpayer remains on site that period can also count. Under the OECD Model Tax Convention, a construction site or installation project is not a PE if it lasts less than 12 months. The inclusion of a testing phase can make certain projects last more than 12 months and give rise to issues of tax presence and attribution of profit under transfer pricing rules. It should also be noted that in some double tax treaties based on the OECD Model, the 12 month period is shortened to only 6 months. Aside from this, the discussion draft also considers the question of recurring periods and exclusivity and gives two examples:

• An enterprise carries on drilling operations in a location where the seasonal conditions prevent operations being carried on for more than 3 months in a year but the operations are expected to last up to 5 years. Although each continuous period is only three months, because of the seasonality, the 12 month time test is satisfied and a PE exists for the whole of the 5 years.
An enterprise undertakes catering activities overseas on a photo shoot that will last 4 months. The parents of an employee of the enterprise have a house in the foreign location and the enterprise hires the house and the employees operate a cafeteria for the technicians and actors. Although the site is only in existence for 4 months the enterprise could be deemed to have a PE in the foreign location as its operations are carried on there for the whole time of the operation of the business. This would not apply, however, where the enterprise carries on catering activities in a number of sites in its home country as then the business would be considered as being only temporarily carried on at the foreign location.


Enterprises should thus keep their overseas construction/installation projects under close scrutiny if they are to ensure that tax and transfer pricing issues do not arise.

Another potential minefield is whether or not an enterprise has a PE through employees overseas being involved in contract negotiation. To date, a PE only exists if the local employee is either involved in concluding contracts or plays a significant part in negotiating important sections of a contract. The new discussion draft indicates that a PE will exist if local employees take an active part in negotiations – i.e. involved in decisions relating to type, quality or quantity of products covered by the contracts – as such activities will usually constitute an essential part of the business operations of the whole enterprise. It is acknowledged, though, that the contracts would have to be of significant value to give rise to major concerns. However, as noted above, the OECD Model Tax Convention only expresses the views of the OECD and are not binding; tax authorities can interpret them in different ways and may take a tougher stance – the reduction of the 12 month construction site to only 6 months is one example of a different interpretation and stance by tax authorities.

It should also be noted that “it is not only local employees that can create a PE for an enterprise, an agent with authority to conclude contracts in the name of an enterprise can also create a PE” unless he is acting in the normal course of his business, for example, a stockbroker. An agent can be held to bind an enterprise even in situations where the contracts are not in the name of the enterprises. In some countries, an enterprise has been held to have a PE in circumstances where a sales contract has been concluded with a third party by an agent who did not formally disclose to the third party that it was acting for the enterprise and the contracts did not disclose the name of the enterprise. Also, an agent could be considered to have authority to bind an enterprise where he solicited and received orders which he then sent directly to a warehouse from which goods are delivered and where the foreign enterprise routinely approves the transactions. In the past, the issues have tended to arise primarily on sales contracts but the Discussion Draft suggests that the position should not just cover the sale of goods but also leasing contracts or contracts for services.

The Discussion Draft also considers the question of working from home i.e. an overseas employee operates from his/her home and there is not a formal office of the enterprise in the foreign jurisdiction. New clauses are proposed for inclusion in the Model Tax Convention whereby the use of the home on a regular or continuous basis for carrying on business activities of the enterprise can create a PE if it is clear that the enterprise has required the employee to use that location. It is suggested that this would arise where the enterprise does not provide an office for the employee but the nature of the employment clearly requires an office. This issue could arise where say an employee is sent overseas and the enterprise initially intended to rent an office for the employee but were convinced by the employee that it was more efficient for him to work from his home. If this clause is accepted into the Model Tax Convention without change, an enterprise may have to establish a set policy for employees working overseas that prevent issues arising.

Although a PE is not a separate legal entity, for transfer pricing purposes it is considered a “stand alone” entity. Consequently, the question of attribution of profit made by the enterprise as a whole to the PE arises and transfer pricing methods are applied.

The above are only some of the examples in which suggested changes in the Discussion Draft can have a wide impact and an Article such as this cannot provide comment on every potential change. However it will highlight the main areas of concern to enterprises carrying on business in overseas jurisdictions. The writer also makes no excuses for harping on about the fact that the existence of a PE can not only give rise to corporate tax issues but also to transfer pricing issues. From personal experience over many years, it has been obvious that if tax authorities can prove the existence of a PE, they look at all other aspects of raising tax and transfer pricing is an area in which they are quickly realizing that there may substantial scope for doing so. Transfer pricing for those who are unaware involves cross border transactions between connected parties be it the provision of goods, services, financing or the use of intangibles such as intellectual property, brand names etc. Connected parties must be capable of demonstrating that all of their transactions are at arm’s length – what an independent third party would have paid or received in similar circumstances – and failure to demonstrate this can lead to tax adjustments and penalties. Although a PE is not a separate legal entity, for transfer pricing purposes it is considered a “stand alone” entity. Consequently, the question of attribution of profit made by the enterprise as a whole to the PE arises and transfer pricing methods are applied as if the PE was a separate third party entity. This then enables the local tax authority to raise tax assessments and consider penalties for failure to notify chargeability and/or failure to file correct tax returns. “In the current economic climate where tax authorities are finding their tax take considerably reduced, they are looking at other ways of raising cash and applying transfer pricing rules to a PE situation and levying penalties is a strong possibility.” Whereas, ultimately, a tax liability on a PE will not impact an enterprise as relief will either be available through double taxation relief or through the mutual agreement procedure within a double tax treaty (via a corresponding deduction) there is no relief for penalties and they remain a cost to the enterprise.

The Discussion Draft is just that, a draft for discussion and comments are invited before 31 January 2013 and examined by the Working Party at their meeting in February 2013. It is important though that enterprises are kept appraised of potential changes and developments and appropriate articles in future editions will provide regular updates.

The OECD regularly publish Discussion Drafts on tax matters, the previous ones being issued last year on specific transfer pricing matters such as “Safe Harbours” and “Special Considerations for Intangibles”, and establish Working Parties for each to consider all of the ramifications. Enterprises carrying on business overseas are advised to ensure they receive regular updates on OECD pronouncements as they often end up being incorporated into legislation in a number of jurisdictions and can have serious impact on the worldwide tax position of enterprises. It must be stated though that the Discussion Drafts also clarify issues and will also provide additional guidance, and possible exemptions from tax, in certain circumstances which can be used by an enterprise in negotiations with overseas tax authorities on PE and transfer pricing issues.

About the Author

Les Secular, Partner, True Partners Consulting

Phone: +44 (0)20 7868 2431



The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.