Income tax: international transfer pricing - operation of Australia's permanent establishment attribution rules

This Ruling deals with: (a) the application of Division 13 of Part III of the Income Tax Assessment Act 1936 ('ITAA 1936') in determining the income and expenditure of permanent establishments (PEs); and (b) the attribution of profits to PEs under Australia's double tax agreements (DTAs) which are schedules to the International Tax Agreements Act 1953 ('Agreements Act').

The specific provisions analysed are subsections 136AE(4) to (7) in Division 13 [F1] and the business profits articles in DTAs (usually Article 7 in Australia's recent DTAs). [F2] Together these provisions are referred to as Australia's PE attribution rules.

This Ruling focuses on attribution issues where the relevant parts of a multinational enterprise (MNE) are structured as a single legal entity carrying on business operations through a PE. The results and methodologies involved are similar to those in applying Australia's transfer pricing rules to international dealings between separate legal entities, as per Taxation Rulings TR 94/14, TR 97/20 and TR 98/11. There are, however, differences between the two groups of rules that may produce different outcomes in the PE setting.

In considering the taxation of PEs, this Ruling takes the following approach: (a) the arm's length principle provides the economic foundation for taxation of PEs and the interpretation must be consistent with that principle as embodied in Australian law. The operation of the arm's length principle is explained in Taxation Rulings TR 94/14, TR 97/20 and TR 98/11 in relation to separate legal entities; (b) this Ruling follows relevant guidance provided by the OECD [F3] except: (i) where special provisions in Australia's DTAs and domestic law require or permit a different approach; and (ii) where there is no consensus within the OECD on a particular matter or issue relevant to attributing profits to a PE; (c) the same principles apply to all dealings where the taxpayer has a PE, either in Australia or overseas.

This Ruling does not discuss in detail whether a PE is in existence. [F4] A fixed place of business of an enterprise through which its business is wholly or partly carried on will generally be a PE. Each place of business in a country will constitute a separate PE.

This Ruling does not address PE attribution issues that are of special importance to, or are particular to, financial institutions, including capital allocation for multinational banks, interbranch lending and global trading. The ATO intends to issue a separate Ruling dealing with these issues.

This Ruling applies to years commencing both before and after its date of issue. However, the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of the Ruling. [F5]

As there has been a progressive development of the approaches outlined in this Ruling and as these approaches are only intended as a guide, the fact that a taxpayer has not applied them is not critical provided the result is consistent with Australia's PE attribution rules. Having regard to the recommendations of the Review of Business Taxation (J.T. Ralph Chairman), Report. A Tax System Redesigned, July 1999 (Ralph Report), [F6] further developments (possibly including legislation) may be expected.

Below is a detailed contents list for this Ruling: Paragraph What this Ruling is about 1 Class of person/arrangement 1 Date of effect 7 Detailed contents list 9 Ruling and explanation 1.1 Chapter 1: The role and structure of Australia's PE attribution rules 1.1 Attribution rules under ITAA 1.1 Attribution rules under DTAs 1.12 The ATO approach 1.15 Alternative approach adopted by some countries 1.18 Chapter 2: The interaction between tax rules that affect PEs 2.1 Relationship of subsection 136AE(4) and the business profits article of DTAs 2.1 Relationship of subsection 136AE(4) and section 136AD 2.10 Relationship of business profits and associated enterprises articles of DTAs 2.13 Example 2.15 Charge between head office and PE 2.17 Charge between PE and HK Co 2.18 Relationship of subsection 136AE(4) and ITAA sections 38-43 2.20 Chapter 3: Concepts and interpretation of PE attribution rules 3.1 Tax result 3.1 ITAA 3.1 DTAs 3.5 Mandatory or discretionary application 3.6 ITAA 3.6 DTAs 3.7 Types of taxpayers 3.8 ITAA 3.8 DTAs 3.10 Attribution 3.15 Source of income and allocation of expenditure 3.20 ITAA 3.20 DTAs 3.23 Income and profits 3.25 ITAA 3.25 DTAs 3.28 Expenditure 3.30 ITAA 3.30 DTAs 3.33 Paragraph 3 3.33 Only actual deductions allowed 3.36 Attribution of interest expense 3.41 Capital (interest free funding) 3.45 Losses 3.46 ITAA 3.46 DTAs 3.47 Exempt Income 3.53 ITAA 3.53 DTAs 3.55 Duration of the PE 3.56 ITAA 3.57 DTAs 3.59 Research and development ('R&D') 3.61 Intermittent PEs 3.64 Example 3.66 Chapter 4: Methodologies 4.1 Introduction 4.1 Segmentation - Accounting practice and taxation 4.6 Stage 1: Identify the segments 4.8 Stage 2: Assemble financial data for segments 4.10 Stage 3: Determine inter-segment charges 4.13 A Structured Process for Modelling Attribution Issues 4.17 Step 1.1: Identify the economically significant activities of the entity 4.23 Step 1.2: Postulate the existence of the relevant PE 4.26 Step 1.3: Identify the activities where the PE plays a role 4.29 Step 1.4: Identify the scope, type, value and timing of the dealings of the PE 4.39 Step 1.5: Determine the character and structure of the PE business 4.40 Step 2: Select the most appropriate methodology for attribution purposes 4.43 Step 3: Apply the most appropriate methodology and determine the arm's length outcome 4.45 Step 4: Implement support process and install review process 4.46 Documentation 4.46 Examples 4.52 Example 1: Functional Analysis - Installation Project 4.52 Aspects of Functions, Assets and Risks 4.60 Example 2: Use of accepted transfer pricing methodologies to allocate income and expenditure to PEs 4.66 Chapter 5: Application 5.1 Introduction 5.1 Trading stock 5.5 Asset allocations and capital allowances 5.17 Capital allowances under Australian law 5.22 Services 5.27 Deemed PEs 5.37