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Florida Tax Review

Abstract

One of the vexing questions in tax law is whether or not the legal form should make a difference in taxing companies. This question arises amongst others when companies do business outside their country of residence.

Companies may set up a subsidiary. The subsidiary, being a separate legal person, will in most countries be taxed as a resident company in the state of incorporation and/or in the state in which it has its effective management. It will be taxed as if it acts on an arm's length basis with the parent company and other associated companies. In case the taxpayer performs its foreign activities without setting up a subsidiary the income derived from these foreign activities may also be taxed in the country where the activity is performed. Most countries tax non-residents on income derived from sources in their country including income derived from permanent establishments situated in that country. These countries generally use the concept of permanent establishment both in their domestic law and in tax treaties. A permanent establishment generally is defined as a fixed place of business through which the business of an enterprise is wholly or partly carried on. PE-profits are determined on the basis of the separate enterprise theory for allocating profits to permanent establishments: the PE-state taxes the profits which the permanent establishment might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. Important exception is the United States. In its tax treaties the United States uses the PE-concept. However, in its domestic law the United States uses the fixed place of business concept in combination with the "income effectively connected with a trade of business" rule.

This article focuses on the question of whether or not, and if so to what extent, differences in profit allocation may influence a taxpayer's choice between permanent establishment and subsidiary in case the PE-concept is used. Contrary to the historical reasons for adopting the separate enterprise theory as leading doctrine for allocating business profits permanent establishment and subsidiary are not treated neutral. Recent developments in respect of profit allocation for tax treaty purposes presumably will make the differences smaller as the OECD in 2008 adopted a new approach to the separate enterprise theory and revised the Commentary to Article 7 OECD in as far as the changes required to incorporate the new approach are in line with the text of the present Article 7OECD. Moreover the OECD published a proposal for a new Article 7 OECD and Commentary on 7 July 2008 which was revised on 24 November 2009.This new approach takes a functional and factual analysis followed by a comparability analysis as starting point for allocating profits to a permanent establishment. In paragraph 224 of the Report on the attribution of profits to permanent establishments of 17 July 2008 the OECD states that the Transfer Pricing Guidelines drafted for determining the arm's length price in intercompany relations will be applied by analogy to dealings between the permanent establishment and the other parts of the enterprise of which it is apart.

This article raises the issue of which justification grounds for these differences in treatment can be pointed out and whether the arguments raised by the OECD are solid.

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