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Double Taxation Relief Manual

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Double Taxation Relief Manual: Guidance by country: United States of America: Attribution of profits to permanent establishments

Article 7 follows very closely the business profits article in the OECD Model Tax Convention. However it does include new language concerning the attribution of business profits to permanent establishments and the Exchange of Notes to the treaty comments on the attribution of capital to permanent establishments. Both generated comment, particularly in the context of the measure introduced in Finance Act 2003 relating to the attribution of capital to branches.

Does the new language signify a change in the way the UK will attribute business profits to UK permanent establishments of US corporations?

The new language in paragraph 2 (“the business profits to be attributed to the permanent establishment shall include only the profits derived from the assets used, risks assumed and activities performed by the permanent establishment”) does not signify a change in the UK’s approach to attributing profits to permanent establishments. It clarifies that approach by describing the characteristic features of profit generating activity that are typically taken into account when determining attributable profits.

It also makes clear that only profits derived from the assets used, risks assumed and activities performed by the particular permanent establishment will be attributed to that permanent establishment.

Consequently, profits derived from assets used, risks assumed and activities performed by the head office of a US corporation or by a second UK permanent establishment of the US corporation of which the first UK permanent establishment is part, will not form part of the first UK permanent establishment’s attributable profits. Again, this does not represent a change in the UK’s approach.

Provisions in FA 2003: interaction with new Agreement

The treaty also provides that, in arriving at the amount of profits to be attributed to the permanent establishment, the permanent establishment shall be treated as having the same amount of capital that it would need to support its activities if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions

UK Domestic legislation to enable the UK to attribute capital in this way was introduced in Finance Act 2003 and applies to accounting periods starting on or after I January 2003.

These provisions modernise the UK’s rules for taxing foreign companies operating in the UK through permanent establishments. The old rules were out of line with international practice and the measure created a more level playing field between foreign companies , with UK permanent establishments and their UK-incorporated competitors. The legislation will primarily effect foreign banks as it is mainly banks that operate in the UK through permanent establishments.

The measure provides that a UK permanent establishment of a foreign company will be assumed to have, for the purpose of determining the amount of profits for tax purposes, the amount of equity capital and loan capital that it would have if it were a distinct and separate company trading in the UK engaged in the same or similar activities under the same or similar conditions.

By contrast, the treaty does not of itself create a domestic taxing right to attribute capital to UK branches of US corporations. Rather, it provides that now that the UK has that taxing right, then any capital attributed to a UK permanent establishment of a US corporation for the purposes of determining branch profits can be attributed on the basis that the branch is treated as a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions.

Does the treaty provide a choice between a “thin capitalisation” and a regulatory capital approach to the measurement of profits attributable to a permanent establishment of a financial institution?

The treaty is not prescriptive. The Exchange of Notes cites allocation of regulatory capital as a method either country may use to determine the amount of capital to be attributed to the permanent establishment of a financial institution (other than an insurance company). But other methods, including one based on the amount of equity capital that the entity would have if it were an independent enterprise acting at arm’s length, engaged in the same or similar activities under the same or similar conditions, may be used.