Double taxation treaties generally stipulate that an enterprise's profits attributable to a foreign permanent establishment may only be taxed in the state in which the permanent establishment is situated. How the profit attributable to the permanent establishment should be determined is the focus of a long-standing discussion not yet resolved to this day. The Organisation for Economic Co-operation and Development (OECD) aims to bring clarity to this issue with its "Authorised OECD Approach," known as the AOA, which was transposed into national law in Germany by the Act Implementing the Mutual Assistance Directive and Amending Tax Regulations (Amtshilferichtlinien-Umsetzungsgesetz) effective 1 January 2013.
The following simplified examples illustrate how applying the AOA can affect the attribution of profits to a permanent establishment according to German law.
- The domestic permanent establishment of a head office resident abroad develops new products for the head office. Previously, when calculating the profits of the domestic permanent establishment, the expenses actually incurred as a result of these development activities were attributable to the permanent establishment. Under the AOA, a service relationship as between unrelated third parties is hypothesized between the head office and the permanent establishment and, accordingly, arm's length conditions are applied. The permanent establishment thus does not conduct the development activities merely in return for reimbursement of the expenses incurred due to the activities. Instead, a compensation payment must be calculated in line with the arm's length principle.
- A domestic head office acquires licenses for controlling software. This software is used in both the head office and in the permanent establishment abroad, which in turn performs controlling services for another subsidiary resident abroad. To date, the license fees were required to be divided between the head office and the permanent establishment in accordance with their use of the software. Since the AOA requires the fiction of a service relationship, an arm's length compensation payment must be calculated equal to that which the permanent establishment would pay an unrelated third party for the license. At the same time, arm's length compensation must be attributed to the permanent establishment for the services it performs for the subsidiary.
The taxable profit of the head office and the permanent establishment changes as a rule when the AOA is applied. By extension, this impacts the enterprise's tax rate. In certain cases, the hypothesized service relationship between the head office and the permanent establishment can even result in the assumption of fictitious profits attributable to the permanent establishment if the services provided by the permanent establishment do not affect the enterprise's external profits. Its tax liability would rise as a result.
Ebner Stolz has launched a survey in cooperation with a number of other members of the international consulting network Nexia to determine the extent to which the AOA has already been implemented in other countries. The results have been summarized in a report which provides an initial picture of the effects of the AOA on the attribution of profits to permanent establishments in these countries and indicates whether classification conflicts can be expected with the other state involved.
The study can be downloaded here.