3.3.3.3 Art. 7 OECD MTC: Business profits

Art. 7 OECD MTC focuses on the allocation of the taxing right on business profits. The starting point is that profits may be taxed in the state where they originate economically.1 The main rule of art. 7 is that the business profits of a resident of a state may not be taxed in the source state unless the business activities are conducted through a permanent establishment.2 In the case of a permanent establishment, the state of the permanent establishment has the rights to tax the profits attributable to the permanent establishment. The state of residence may still tax the entity for worldwide profits under art. 7, par. 1, OECD MTC, but must provide for the avoidance of double taxation.3

Problems may arise with respect to the application of art. 7 OECD MTC if one state allocates a different amount of profits to the permanent establishment than another state. This is the case, for instance, with differences in timing and other differences in profit computation.4Additionally, since the provision does not include a subject-to-tax requirement, depending on national legislation, situations of double non-taxation may arise. This is the case if the taxing right is attributed to a Contracting State, while this state does not exercise such power.5

Whether there is a permanent establishment must be tested on the basis of art. 5 OECD MTC.6 This premise is based on the idea that an entity only participates sufficiently in the economic life of the other state to grant it taxing rights when there is a permanent establishment in that other state.7 The permanent establishment concept has no force of attraction. Profits that have not been realized by a permanent establishment should not be attributed to it.8

The second paragraph of art. 7 OECD MTC provides a general rule for attributing income to a permanent establishment. In the 2010 update of the OECD MTC, the OECD definitively opted for the separate entity method.9 The permanent establishment is seen as an independent enterprise, a functionally separate entity.10 Transactions between a permanent establishment and the head office should therefore be conducted at arm's length prices, via the Authorized OECD Approach.11 In this context, the functions performed, assets used and risks incurred must be considered.12 For example, the permanent establishment should take into account profits in respect of an internal transaction, irrespective of whether the head office has sold the products to third parties, thereby realizing the profit. The approach underlines the separate entity approach underlying the provision. After all, the permanent establishment must be treated as a separate entity for the purposes of profit determination. In this context, any activities of group entities are in principle not relevant,13 unless the activities affect the conclusion as to whether or not there is a permanent establishment.

The third paragraph of art. 7 OECD MTC provides for the avoidance of double taxation in the allocation of the permanent establishment profits. If a state adjusts the profit attributable to a permanent establishment, the other state must make a corresponding adjustment to the profit to prevent double taxation.14 In the event of a difference of interpretation with regard to the application of the second paragraph, the third paragraph provides a mechanism for preventing the double taxation.15 Such a difference may, for instance, relate to the allocation of interest charges, since the OECD prescribes different approaches for this.16 Application of the same substantive standards to two or more national tax authorities does not guarantee uniform outcomes.17 If states do not agree on the adjustment of the profit, a MAP can be initiated.18

The final paragraph of art. 7 OECD MTC stipulates that more specific provisions take precedence over the generic provision on business profits as contained in the article.19

All in all, art. 7 OECD MTC aims to provide for the avoidance of double taxation by dividing the taxing rights between the state of residence and the state of source. Since no subject-to-tax requirement is included in the provision, situations of double non-taxation may arise. Furthermore, problems may arise with respect to the application of art. 7 OECD MTC if one state allocates a different amount of profits to the permanent establishment than the other state. Proper application of the second paragraph – and, if necessary, the third paragraph as well – should rule out double taxation. Hence, the provision seems to be in line with the objective of the OECD MTC to avoid double taxation. At the same time, an adequate allocation of the profits to the head office and the permanent establishment should not provide any opportunities for tax avoidance. Also in this respect the provision seems to be in line with the OECD MTC.

There is criticism in the literature with respect to the method of allocating profits between the head office and the permanent establishment. By applying the arm’s length method, an attempt is made to achieve a situation similar to the one that would exist between third parties. The question is whether this is possible. It is argued that the normative base of art. 7 OECD MTC is flawed. The arm’s length principle is not suitable to allocate profits to permanent establishments of highly integrated enterprises. A multinational enterprise and its permanent establishments together form a unitary business with a common profit-motive.20 Additionally, if taxpayers are free to interpret the profit allocation method, this may facilitate tax avoidance.21