The New OECD Approach on Profit Allocation: A Step Forward Towards Neutral Treatment of Permanent Establishments and Subsidiaries

Abstract

One of the vexing questions in tax law is whether or not the legal form should make a difference in taxing companies. This question arises amongst others when companies do business outside their country of residence.
Companies may set up a subsidiary. The subsidiary, being a separate legal person, will in most countries be taxed as a resident company in the state of incorporation and/or in the state in which it has its effective management. It will be taxed as if it acts on an arm's length basis with the parent company and other associated companies. In case the taxpayer performs its foreign activities without setting up a subsidiary the income derived from these foreign activities may also be taxed in the country where the activity is performed. Most countries tax non-residents on income derived from sources in their country including income derived from permanent establishments situated in that country. These countries generally use the concept of permanent establishment both in their domestic law and in tax treaties. A permanent establishment generally is defined as a fixed place of business through which the business of an enterprise is wholly or partly carried on. PE-profits are determined on the basis of the separate enterprise theory for allocating profits to permanent establishments: the PE-state taxes the profits which the permanent establishment 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. Important exception is the United States. In its tax treaties the United States uses the PE-concept. However, in its domestic law the United States uses the fixed place of business concept in combination with the "income effectively connected with a trade of business" rule.