The OECD Model Treaty, Business Profits and Transfer Pricing

One of the key benefits to international transactions is the ability to utilize a network of inter-related corporate entities to shift profits to lower tax regions.  In tax vernacular, this is  referred to as transfer pricing.  While a complete discussion of this discipline is far beyond the scope of this post, it's important to understand the OECD model treaty grants broad authority to taxing authorities to recast the economic terms of a transaction to better reflect arms-length principles.

The granting of authority starts in paragraph 2 of Section 7:

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.

This section ties directly into Section 9, which is titled "Associated Enterprises," and states the following:

1. Where

a)  an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

b)  the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,

and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

The granting of authority is developed and explained over several sections of the commentary.

1.) The starting place for the analysis is the company's books and records.  Paragraph 12 of the commentary to section 7 states:  In the great majority of cases, trading accounts of the permanent establishment -- which are commonly available if only because a well-run business organisation is normally concerned to know what is the profitability of its various branches -- will be used by the taxation authorities concerned to ascertain the profit properly attributable to that establishment.

2.) However, the taxing authority does not have to take these accounts at face value.  Paragraph 12.1 of the commentary to section 7 states: However, where trading accounts are based on internal agreements that reflect purely artificial arrangements instead of the real economic functions of the different parts of the enterprise, these agreements should simply be ignored and the accounts corrected accordingly.

3.) The related commentaries give the taxing authorities broad authority to re-write internal accounts if they do not reflect economic reality.  Paragraph 2 of the commentary to section nine states: "This paragraph provides that the taxation authorities of a Contracting State may, for the purpose of calculating tax liabilities of associated enterprises, re-write the accounts of the enterprises if, as a result of the special relations between the enterprises, the accounts do not show the true taxable profits arising in that State."

So, the taxing authority will start by looking at the company's records.  If these appear to be fine, then the analysis stops there.  But if there's a problem, they can dig deeper and if warranted completely rewrite the transactions if the original terms to not reflect "economic reality."