The Netherlands recently published its new guidance on allocation of profits to a Permanent Establishment (“PE”). The existing guidelines for such profit allocation already showed that, next to the discussion on the existence of a PE the profit allocation itself, it is often not an easy exercise and has an embedded tax audit risk. This is also due to the potential differences in approaches that can be taken by the tax authorities of countries. The Netherlands has stated that it will typically follow the approach chosen by the other country. An important condition hereto is that the outcome is at arm’s length, which is in fact the underlying discussion. Given the importance of the result that can be allocated to a PE the new Dutch authorities’ guidance sheds some more light on its preference, which is in itself positive. However it does narrow the choices that can be made from a Dutch perspective. Therefore we think that it’s even more important to again look into your strategic choices on the handling of PE’s, to analyze the countries involved and to review the existing documentation. Next to this, a pro-active communication with the local tax authorities could be advisable, also since next to the allocation of profits this could also be used for obtaining more certainty on topics like payroll tax for employees involved. Furthermore we would advise to start on time with the determination of the potential P&L and balance sheet of the PE.
Please find below a high level summary of the new Dutch decree on profit allocation to a PE.
The Netherlands still follows the main choices given by the OECD in their report (2010). In this OECD report countries were given de facto three approaches for profit and interest allocation.
The “Capital Allocation Approach”, which seeks to allocate the “free” capital of an enterprise to a permanent establishment based on the attribution of assets owned and risks assumed. The second option is the “Economic Capital Allocation Approach”. This approach is explicitly based on measuring risks that cause concern for the regulators. In line with the measuring of the risks a “free” capital is established after which the interest allocation can be made for the permanent establishment. The “Thin Capitalization Approach” is the third method, which requires to have the same amount of “free” capital as an independent enterprise with the same activities and under the same circumstances.
The Netherlands now declares a preference for as a first step the capital allocation approach.
For this approach a functional analysis is of importance to identify the assets and risks and determine what can be attributed to the PE. This step provides the base line of “free” capital which can be changed depending on the outcome of the second step, the usage of the “Fungibility Approach”. This approach is quite similar to the economic capital allocation approach from the OECD.
If the risks of the PE are similar to the risks of the entity, then the fungibility leads to the same conclusion as the capital allocation approach. If, however the risks of the PE differ from the risks of the entity, then the amount of “free” capital of the PE must be adjusted according to the risk profile of the PE.
Because the PE-report by the OECD does not specify a single method this could lead to a different approach taken by the involved countries. The Netherlands has stated that it will follow the approach chosen by the other country if the following three conditions are being met. Firstly, the chosen approach must be embedded in the law of the other country. Secondly, the chosen approach must be authorized by the OECD. And finally, the chosen approach must lead to a result which can be seen as at arm’s length.
The impact of this Resolution might affect your specific transfer pricing situation and can require an evaluation to learn whether action needs to be taken.
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By: Rudolf Sinx, Theo Elshof, and Irfan Mecek