The OECD Model Treaty; Business Profits

For the last few weeks, I've been talking about the OECD Model Treaty and how it deals with permanent establishments (see here, here, here, here, here and here) .  Today, we'll explain why all of this talk has been so important, as we'll discuss the idea of business profits, and how the treaty deals with them.  The following italicized paragraphs are from section 7 of the OECD Treaty dealing with business profits:

1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment.

2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment 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.

3. In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.

There is hardly anything in the above statements that is controversial.  It simply states that if a business has a permanent establishment within a jurisdiction, that jurisdiction can levy taxes on the PE to the extent of the profits which are attributable to that country.  In addition, the PE may deduct the expenses that the PE incurs to promote their business.

The opening commentary to this section makes three interesting and oft-debated points.

1.) By expressly stating the PE rule, the treaty is creating a situation that will lead to increased evasion.  For example, a company will deliberately attribute income to a PE established in a low tax country, precisely for the reason that the country has a low tax rate.  For example, Apple is doing this very thing in its tax strategy.

2.) While this is true, the above system's primary benefit -- namely, ease of administration -- outweighs that burden.  Put another way, "Much more importance is attached to the desirability of interfering as little as possible with existing business organization and of refraining from inflicting demands for information on foreign enterprises which are unnecessarily onerous." (from the OECD Model Treaty Commentaries)

3.) This does not mean that fiscal authorities shouldn't be looking for tax evasion; it does mean there should be a balance between investigation and vigilance on one side and a pro-business attitude on the other.

I'll be looking in more detail and the business profit rules in the following posts.