Tax Treaty Series

ITQ T-

103

September 24, 2021

Question

ACo, a company resident in A, has a branch in B. The branch has office premises in B and there are 10 employees who are based at the branch.

The branch conducts an investment business – it holds equity and debt instruments issued by numerous companies which are resident in B. In regard to several of those companies, 100% of the issued shares are held by the branch.

The branch wanted to acquire all of the shares in BCo, a company resident in B. Most of BCo's shareholders were resident in A. The transaction was structured as a "share for share" exchange – i.e., ACo issued new shares to the BCo shareholders, in return for 100% of the shares in BCo. After this transaction, the shares in BCo were held by ACo's branch in B.

ACo incurred significant costs in the "share for share" exchange (e.g., time of head office and branch employees, and external costs for capital duty, lawyers, accountants, valuers, etc.). Those costs are tax deductible under the A income tax law.

The A/B treaty is identical to the 2008 OECD model treaty.

In determining the profits attributable to the PE under Art. 7 of the treaty, how should the costs be treated?

Answer

The profits attributable to the PE should be determined using the "authorised OECD approach" which is described in the 2008 OECD report on attribution of profits to PEs. That approach requires the assumption that the PE is an independent and separate enterprise from the remainder of ACo, and the use of a 2-step analysis.

The starting point is the identification of the signficant people functions in regard to the "share for share" transaction. The question indicates that the branch management made the decision to acquire all of the shares in BCo, but there was also some head office employee time spent on the transaction. This suggests that the branch management took primary responsibility for the transaction, but some support was provided by the head office employees – this would need to be confirmed by a functional analysis.

Assuming it is confirmed, then that would probably lead to a conclusion that the PE would notionally be considered to have issued all of the ACo shares and to have incurred all of the costs which relate the transaction. It would also mean that the PE should pay a service fee to the head office to reward the head office for its employee time. Due to the fact that the relevant treaty is identical to the 2008 OECD model treaty (which includes the "old" Art. 7(3) in regard to expenses), and also due to the fact that the head office (I assume) is not in the business of providing such services, the service fee should be at cost.

An important point to note is that there is nothing in the 2008 or 2010 OECD reports on attribution of profits to PEs, which suggests that the usual approach for attributing profits to a PE does not apply to so-called "organ costs" – i.e., costs which relate to the legal entity, such as costs incurred in the legal entity issuing new shares.

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