Our latest episode of “GILTI Conscience” features an in-depth discussion on the complexities of profit attribution to permanent establishments (PEs) under international tax law. Skadden’s Nate Carden, David Farhat and Stefane Victor are joined by EY managing director Mike McDonald and Mary Bennett, former head of tax treaties and transfer pricing at the OECD. The conversation explores a wealth of topics, including practical aspects of the Authorized OECD Approach (AOA), challenges of attributing profits to PEs and the ongoing debates about the appropriate allocation of profits in cross-border transactions.
Episode Summary
When goods, services and rights go back and forth within a company, how do you attribute profit or loss to one part of the company versus another? Former OECD head of tax treaties and transfer pricing Mary Bennett and EY’s Mike McDonald join this episode of “GILTI Conscience” for a detailed discussion on the attribution of profits to permanent establishments. Skadden tax partners David Farhat and Nate Carden and associate Stefane Victor host the discussion, which explores, among other topics, critical differences between Articles 7 and 9 of the OECD Model Tax Convention and why these distinctions matter for multinational businesses.
Key Points
- Origins of the AOA: Mary and Mike discuss the historical development of the OECD guidelines on profit attribution, particularly focusing on the financial services industry. They explain how the U.S. and U.K. were instrumental in driving the initial efforts to address profit attribution in the banking sector, leading to the creation of the Authorized OECD Approach (AOA).
- Article 7 Versus Article 9: While Article 7 borrows insights from Article 9, it is crucial to understand that they are not interchangeable and have distinct applications.
- Practical Implications and Challenges: The episode addresses the practical challenges faced by companies in managing permanent establishments and transfer pricing risks. They discuss the importance of internal documentation and the need for companies to proactively characterize their situations to align with OECD guidelines.
Voiceover (00:00:03):
This is GILTI Conscience, casual discussions on transfer pricing, tax treaties and related topics, a podcast from Skadden, that invites thought leaders and industry experts to discuss pressing transfer pricing issues, international tax reform efforts, and tax administration trends. We also dig into the innovative approaches companies are using to navigate the international tax environment and address the obligation everyone loves to hate. Now your hosts, Skadden Partners, David Farhat and Nate Carden.
Stefane Victor (00:00:36):
Hello and welcome back to another episode of GILTI Conscience with hosts David Farhat and Nate Carden. My name is Stefane Victor. Our most valued host, Iman Kyler is out traveling today, but in her absence we are joined by two extremely special legends, Mary Bennett and Mike McDonald. Mary Bennett worked in private practice before joining the Office of International Tax Council at Treasury. She spent six years as the head of tax treaties and transfer pricing at the OECD in between two stints as a partner at Baker McKenzie. Mary retired in 2022 and we’re so grateful that she’d like to spend some time with us. And we welcome back Mike McDonald, who joined us in 2022 for a conversation on transfer pricing and the arm’s length principle. As some of you may remember or already know, Mike has spent multiple stints each at Treasury and EY, most recently serving as a financial economist in the Business and International Tax division at the Office of Tax Analysis at Treasury. And he’s currently serving as the managing director of International Tax and Transactions Transfer Pricing at EY. Mary, we’ll start with you.
Mike McDonald (00:01:45):
Mary’s much more important. So it’s good that we start with Mary.
David Farhat (00:01:50):
Stefane, I almost wanted to stand up and applaud after that intro. I’m impressed.
Mary Bennett (00:01:56):
Well thanks, Stefane and Mike, I’m glad you remember that much. I guess what we’re talking about today is going to be the attribution of profits to permanent establishments. And it’s an old topic and it’s one that got a lot of attention during the time that I was at the OECD back in the mid 2000s. But even going back before that, of course we had the Transfer Pricing Guidelines for many years, very heavily updated in the 1990s, and they decided at that point at the OECD that they should turn to the topic of how to attribute profits to PEs and try to come up with some more consistent approach to doing it than was the practice of countries around the world.
Mary Bennett (00:02:40):
There really had been, and probably still are, a lot of different approaches to how to attribute profits to PEs. And it’s a tricky issue because what you’re trying to do effectively is isolate profit that should be associated with one particular part of a single corporate enterprise. In simple terms, we always talk about either the branch or the home office pretty much. And how do you do that when there are no legal transactions between the two locations? There are no contracts to look at, for the most part, unless they’re kind of made up because it’s within a single company? Services and goods and rights go back and forth within a company, and how can you figure out how to determine the effects of those and how that results in profit or loss to one part of the company or the other?
Mary Bennett (00:03:38):
So what the OECD did back in the 2000s, early 2000s was work on this for years and years. I think they really started with the banking industry because that was one that was very frequently operated through branches and had raised lots of issues about how to attribute profit. And I think interestingly, probably, and this was before I got to the OECD, but I suspect it was the US and the UK were driving that. Mike, you can confirm this.
Mike McDonald (00:04:08):
Yeah, no, that is exactly right. If you read the Authorized OECD Approach now there’s a general, which is part one, and then they have special for banking, special for global dealing, special for insurance. It wasn’t written that way. The most immediate issue, as Mary said, was in the financial services industry, specifically banking. So the US and some other countries made sure that there were banking specialists in there and then later global dealing and insurance specialists. And it did turn out that they were trying to grapple with the problem, which I think they did so quite successfully in terms of trying to deal with the financial transactions, in particular banks. Banks and insurance I think were the two big things.
Mike McDonald (00:04:57):
And I came on and when I joined the lead person was Tricia Brown from the Treasury, and she and some financial specialists were there and they were really in the process of building what they called the working hypothesis. And it was kind of, I think, Mary, you’re right, I think it was tailored for banking and I think they worked out something well. And when I came on board it was then saying, “Okay, we have sort of these special cases. Let’s try to now write general rules,” which is part one, right? It effectively needs to be consistent, but it has to be able to tell it in some consistent overarching way for which the reader will see banking and global dealing and insurance as special cases of the general rule, even though it wasn’t written that way.
Mike McDonald (00:05:47):
And it was called the working hypothesis for a long time because it was a hypothesis, we weren’t really sure what was going to happen until, Mary, were you there when they decided to give it an official name? And a guy from Canada said, “I think we should call it the Authorized OECD Approach.” I thought that was an awful name. I thought it should be called A9A. The Article 9 Analogy, A9A. And I was the only supporter. It’s possible Mary didn’t even support that.
Mary Bennett (00:06:16):
I wasn’t there, but I wouldn’t.
Mike McDonald (00:06:18):
You would not. That’s right. They saved you the trouble. But it’s so funny, so I’m just a transfer pricing guy, so I came on the project because I was assigned to WP6, which is the transfer pricing group, and both WP6, the transfer pricing group and the treaty group were working on this issue. And again, just being a transfer pricing guy, I have to say I really learned transfer pricing under Article 9 to a large extent because of my experience working, for me it was like eight years, on the AOA, the Authorized OECD Approach and determining Article 7, because it really showed me some of the key differences between the two that nowadays I think a lot of practitioners are conflating the two. They see Article 7, right David, they see Article 7 and it sounds transfer pricey, it sounds arm’s lengthy. And so they’ll just randomly apply Article 9 as if they’re separate legal entities.
Mike McDonald (00:07:27):
And I think I may have been guilty of that too if I were coming into a cold thinking, “Oh, it’s functions, assets and risks.” But it was the work on profit attribution that, at least for me and hopefully for a lot of people that read the two documents, Transfer Pricing Guidelines and AOA, some of the critical differences between the two. And while Article 7 to me truly borrows insights from Article 9, I mean I think, Mary, that to me was one of the key things about the AOA, it uses Article 9 insights to answer the profit attribution question. People also want to do the opposite and apply Article 7 principles to Article 9. And that is also not the way it works. I actually think the AOA was wonderful in clearly trying to articulate in the course of showing how profit attribution should be determined. It also really contrasted Article 7 and Article 9 and I thought that aspect was wonderful.
Mike McDonald (00:08:31):
And Mary, I actually thank you for that. When we were making progress, when Mary came on board, I think we had a lot of the basic ideas in place about what we were trying to do. But Mary took it and effectively, I’m not going to say started from scratch, Mary, but I think it was something like that and really articulated from the beginning, what is it we’re trying to do? What are the steps involved to both determine the separate enterprises... I’m sorry they’re the single enterprises, but the different parts of the enterprise? And exactly when do we apply the Article 9 insights, right? You have to make sure you set the plate before you apply Article 9. And so again, to me, I think the best primer on profit attribution in general and the AOA is chapter one or part one of the AOA. Mary, I think that that’s when you came on board and it’s like light bulbs were going off everywhere as you kind of led the [inaudible 00:09:40].
David Farhat (00:09:40):
What you’re saying, Mike, is Mary came on and fixed you guys’ work, is pretty much what you-
Mike McDonald (00:09:45):
We had some good ideas, they were all over the place, you know. Yes.
David Farhat (00:09:51):
Mary’s the one you always want to team up with for the group project.
Mike McDonald (00:09:54):
Yeah, yeah, yeah.
David Farhat (00:09:55):
But no, I think you made some good points there. And one of the things I want to talk about as we go through this is some of the havoc that the AOA has caused in transfer pricing. Because I think you’re absolutely right. It was a brilliant piece of work kind of talking about the difference between Article 7 and Article 9 and coming up with a good way of profit attribution. And I think it was great work, especially in the financial services area. But I think since BEPS 1.0, some of that has bled over into Article 9 and there’s a misunderstanding of how these principles work, what happens within a single entity versus what happens in separate entities.
David Farhat (00:10:32):
I think it’s the global dealing piece, part three in the AOA where they talk about how you use this transfer pricing in Article 9 specifically around capital, talking about capital not being attributed when you’re in Article 9, and kind of being very careful to draw those lines, right? And coming up with terms like internal dealings where there’s no transactions within a party, but kind of this is how you hypothesize them, and being very careful about that. And I think some of that care is lost when we do some of that application now or kind of pull those Article 7 principles into transfer pricing.
Mary Bennett (00:11:06):
Well, it’s interesting, I mean for us to come back to capital because that was the thing I was going to mention next in fact, was that I think the AOA gets a bit of a rap that it was something that source countries, less developed countries thought was a ripoff to them and so they rejected it and it was the OECD countries that were, at least relatively speaking, more on board. But I think the initial driver for the work on the AOA was going back to the US and the UK thinking that they were respectively getting ripped off by banks from the other country because they were under-capitalizing their branches and taking too big in the way of interest deductions and bad debt deductions, moving bad debt into the branches, and that it was an effort to sort of beef up as source countries, the ability to tax those branches that initiated, I think, a lot of the drive to do the work on Article 7. That even was evident when I was at Treasury in the ‘80s, we were already talking about that at that point.
Mary Bennett (00:12:16):
But getting into a bit of the, okay, so parts two and three on banking and global trading were already finished when I got to the OECD in 2005, and the struggling that was going on was about how to develop part one on the general, applying those rules to general circumstances. And I should maybe preface this by saying that the work was all being done by transfer pricing people. It was Working Party 6 that was working on this and they were... And what that means is you did not have people in the room that were very close to treaties, particular Article 5 and even Article 7. The delegates working on this didn’t have that much background in treaty rules and they had a lot of background in Article 9 transfer pricing rules and they were kind of given carte blanche to come up with an approach. Without-
Mike McDonald (00:13:13):
Can I call a time out here? Because I’m sounding like a real moron so far. Can we start again from the beginning?
Mary Bennett (00:13:19):
Well, I thought that’s how you choose to [inaudible 00:13:22].
Mike McDonald (00:13:19):
Come on, Mary.
David Farhat (00:13:23):
That’s what we’re getting from it, Mike. You guys were running around crazy and Mary came in and brought some order to it.
Nate Carden (00:13:27):
You are here to defend [inaudible 00:13:30].
Mike McDonald (00:13:30):
I compliment Mary and her response is, “Yeah, you’re right, man, you guys were unbelievable.”
David Farhat (00:13:40):
Well, she’s just letting everyone know you’re an honest guy, Mike.
Nate Carden (00:13:41):
We’ll come to the rescue a little bit here. And I actually think the point about part one coming last is super interesting because I guess the question that I have as a little bit of an AOA skeptic outside of the financial services area is especially given the risk control framework, right, the DEMPE rules that are a creation of our guest, Mike McDonald, is the AOA really doing any work that should be different, and emphasis on should be different, from the work that happens under the guidelines at this point? In other words, why should there be a difference outside of a situation where you’re talking about capital and in particular regulatory capital requirements in branches and that sort of thing, why should there be a difference between the Article 7 result and the Article 9 result?
David Farhat (00:14:33):
I would argue that risk, right, Nate, because that’s what the capital really represents.
Nate Carden (00:14:37):
But outside of a capital space, like let’s take a standard tangible goods situation, should the result be different if you’re using an LRD as opposed to operating in a country with a sales office that otherwise is functionally identical to an LRD?
David Farhat (00:14:59):
Well, in the Article 7 context, the sales office would be bearing the same risk as the home office, right? Because it’s one entity. So you have to spread that risk across both jurisdictions.
Mike McDonald (00:15:11):
But that’s what I see as a difference. And to me it’s sort of a difference in framework, right? Because our betters, who sort of write the treaty rules, basically said, “Look, we have rules associated with separate legal enterprises for which things like legal ownership and contracts and contractual allocations of risk have legal meaning.” But we’re then told when we have a single enterprise, effectively we can talk about the assets of the enterprise as a whole. So we can talk about that. But the question is, it always seems in doing this framework that things like the location of the assets, the location of the risks are endogenous. In other words, there’s nothing that inherently tells you where they are.
Mike McDonald (00:16:00):
And Article 7 first had to answer the question of how can we achieve what we legally get in Article 9 in the context in which we don’t have that legal framework? That’s sort of where I was coming from. So Nate, if your question is sort of deeper and a more philosophical one of why is there this different framework, that’s above my intelligence. For me, we have this certain framework that we’re operating under, right? Article 7 and Article 9 are different things. And the question was, can we bring Article 9 insights in order to determine how to locate what is endogenous, that is the location of risks and assets and capital.
Stefane Victor (00:16:49):
So I have a question, maybe a more foundational question, for the listeners who are less experienced, where does this question or these questions about fees and profit attribution, where do they arise? We’ve talked so far about the banking, insurance and industries, but are there other industries as time has gone on that this has become especially important? Or are there aspects about the banking or insurance industries that make this issue especially important or present?
David Farhat (00:17:22):
I’ll answer the second question first. A lot of banks, especially non-US banks, operate through branches, right? And I think they do that for regulatory reasons, they do that for capital reasons. So it becomes more relevant in that space, and financial services in general. I think another place where this is coming up now is in a lot of, I think especially... Well, some Asian but a lot of European audits, you see tax authorities asserting PE. And we can talk about why that is. So now all of a sudden where you would not have had a branch or a PE before, all of a sudden now a tax authority is dragging it in so they can take advantage of some of these Article 7 rules. And I think that’s Nate’s frustration where he was getting to what’s the difference between those two.
Nate Carden (00:18:04):
Let’s unpack that a little bit because what are they saying is the PE? They’re not saying that the PE is the initial entity, they’re saying that the PE is the legally organized entity in their jurisdiction.
Mary Bennett (00:18:19):
Yeah, let’s talk a little bit about what a PE is, and that’s an Article 5 question. And there are different kinds of PEs. And PE can be an office, the foreign company has its own office sales outlet, whatever, of its own in the country, in the source country. That’s really common in the banking industry. Not so common in other industries. But the foreign entity is selling into the source country. Well how’s it doing that? Usually it’s either sending people in or it’s got a local company that’s acting on its behalf selling its goods, services, products, whatever.
Mary Bennett (00:18:59):
And one of the definitions of PE is when you have an agent in country that’s not independent from you, and there’s a whole set of rules about that and in the old days was regularly concluding contracts on your behalf, that would create a PE. And since BEPS, it’s been a little broader than that, like maybe selling things or doing things that lead to the conclusion of contracts or the commissionaire type arrangement, that creates a PE, and then you’ve got... There is a separate entity there and that’s what the guidance that came out of the AOA would refer to as the dependent agent enterprise. But also the activities of that dependent agent enterprise can create a dependent agent PE for the foreign enterprise. And so that is the most common.
Mike McDonald (00:19:57):
And the variant of it now. And in fact, I know the OECD is doing a mobility project. I’m at a conference now in Vienna and they were talking about it, it’s kind of just beginning. But what I was hearing, Nate, is that hey, there are smart people that are going someplace. And I think the idea is if you have enough of those smart people that are moving because they make decisions, it’s like, “Oh, we think we have a PE.” And so Mary, I think they’re bringing the old band back together. WP1 and WP6 are trying to look at it. And like a lot of things, this one could go off the rails, right? Because I do think they’re bringing in WP6 to say, “Hey, when this happens, yeah, let’s look at the Article 7,” but there might also be Article 9 DEMPE related stuff going on here, right? And so it’s like, oh my gosh, here comes another project down the pike.
Mike McDonald (00:20:58):
But let me say this, in defense of what we’ve already... So first I’m a moron, and now I sound defensive. Let’s think of the world prior to the AOA, right? Bob Stack wrote a wonderful article that basically says, “How did we deal with PEs back then?” Because you look at the USTs and they basically said, “Yeah, you know, just apply the ECI rules, apply 864.” Is it 864? See, I’m a transfer pricing guy. And somehow that squares with the arm’s lengthy language. And I’ve also had that question like how exactly is that arm’s lengthy? And then you look at other countries, prior to the AOA, I couldn’t tell you how they do it, right?
Mike McDonald (00:21:47):
The AOA, one of the things to me it was intended to do was impose a little bit of analytical discipline on it. It’s right, “Okay, our betters in WP1, our treaty people tell us that there’s a PE here. Fine, we can’t question that, we’re just transfer pricing people.” But the AOA provides an approach that I think provides a little bit more sanity to the profit allocation issue than was there previously. And to give a couple of examples, when in the BEPS one work, they were modifying the definition of PE to kind of expand it, they called on us to say, “Okay, do the profit attribution.” And we came up with examples. We looked at it that showed under the facts of the examples that there is zero incremental profits in the PE above and beyond what was remunerated in Article 9. And some countries hated that result. They said, “Oh, we’re doing it wrong.”
Mike McDonald (00:22:46):
We weren’t doing it wrong, we were doing it correctly. That to me was kind of the important discipline that the AOA I think properly understood, brings to the table. So to the extent we have runaway PEs or things like that, that makes me happier that we have the AOA rather than going back to the old days. Even though Nate, it’s true, you don’t see the AOA in a lot of treaties. That’s a personal point of disappointment for me. Including the United States. It’s in the model, but a lot of treaties go by where they kind of toss it out and go back to the old ways.
David Farhat (00:23:25):
Well, one bit of good news on that front, Mike, is I think in competent authority the default for PE attribution is the AOA. So that’s some good news. And I think this proliferation of PEs come after BEPS 1.0 with the relaxing of the standards, and making that argument to a lot of tax authorities is very tough. It’s like, “Okay, you can have your PE, but if we look at the rules that we’ve agreed to, zero should be attributed to it.” The response is, “Well, no, you can’t have a PE with zero attributed to it. If there’s a PE, there should be something.” And, you know, sometimes-
Mike McDonald (00:23:57):
And I know that’s going to annoy, Nate, by the way. So even when we say it’s zero, now he’s still annoyed about something else. Why is there a PE in the first place?
David Farhat (00:24:05):
You see, I’m trying to get him going, Mike?
Nate Carden (00:24:07):
I’m perpetually annoyed. It just depends on the day what topic I’m annoyed about. But I guess, let me put the question differently. Why shouldn’t the rule, and why wasn’t the rule under a dependent agent PE go see Article 9? None of the rest of this stuff, there is no such thing as a AOA for a dependent agent PE, go see Article 9, you’re done. Why is that not the right answer?
Mary Bennett (00:24:35):
Well, I think a simple answer would be because you would get totally, totally different results if you sent an employee into the country to do XYZ, or you ask your affiliate in country to have their employee do XYZ for you. You know, in the first case, all of the profit that would be attributable to the activity would be taxable in the PE country but taxable to the foreign entity. In the other case, you would pay a service fee to the local entity, but the profit wouldn’t get taxed to them because they’re doing it on behalf of the foreign company. And if you said, “Gee, the service fee is...” You know.
Nate Carden (00:25:18):
I mean, doesn’t that depend on how much you think the service fee should be?
Mary Bennett (00:25:21):
No, it doesn’t. You pay the service fee to your employee, you pay a service fee to your affiliate, maybe with a little markup for taking care of the guy’s payroll and all of that. But they’re not going to be getting the profit attributable to, you know, whether it’s the use of your intangible or the use of your... Or any of the things that would come back to the non-resident entity.
David Farhat (00:25:44):
So let me ask a question, Nate. Is your question really then if it’s a dependent agent PE, should we just read in the contracts that would be there in an Article 9 situation?
Nate Carden (00:25:53):
Well, I mean if it’s a dependent agent PE, the contracts are already there. That’s kind of the point. But I guess going back to the example, right? And I’m curious as to whether folks think this matters in sort of the risk control framework that we now have under chapter one of the guidelines. But ultimately, I would have thought that the response to you get a different answer if you send an employee into the country versus you have the employee in the country and a local entity and receiving a service fee, is that there shouldn’t be a difference between those two things. And so therefore if there is a difference, right, the problem is the existence of an AOA that is different from the Article 9 transfer pricing rules.
Mary Bennett (00:26:43):
No, I think the question is if you send the employee in, you’re going to get potentially a lot more profit attributable to the PE country than if you said, “We’re going to stop and draw a line around the profit attributable to the PE country by virtue of what we paid to the local company.”
Nate Carden (00:27:02):
Right.
Mary Bennett (00:27:02):
Like you don’t attribute the profit-
Nate Carden (00:27:04):
And I’m saying that’s the wrong answer. From a policy standpoint. Should that be the answer is the question that I’m asking.
David Farhat (00:27:14):
Let me interrupt though, because if you’re talking about a dependent agent PE situation, it’s not a sending of the employee, right, you’re saying-
Mary Bennett (00:27:21):
It can absolutely be.
Nate Carden (00:27:22):
It could be, yeah. It could be.
Mary Bennett (00:27:23):
It could be an individual could be your dependent agent. Yeah.
Mike McDonald (00:27:28):
That’s the mobility project, right, where-
David Farhat (00:27:30):
Okay, so that’s the mobility. But Nate, I think is the situation you’re talking about, you have a separate entity, so country A, country B, home office is country A, you have a separate entity in country B, not the situation where you’re sending the person over. Are you asking that or does it not matter?
Nate Carden (00:27:46):
Sure. My basic position is that you’d think it should not matter.
Mary Bennett (00:27:50):
And that’s what I’m saying it shouldn’t matter. And the only way you can make sure it doesn’t matter is if you go beyond what... The only payment that goes into the PE country is what remunerates the service performed by either your employee or your affiliate’s employee and say what profit is generated by the activity performed by that service.
Nate Carden (00:28:16):
Exactly.
David Farhat (00:28:17):
So what you’re saying, Mary, is the result should be the same if you do a proper AOA analysis with your SPF or internal dealing?
Mary Bennett (00:28:27):
Yeah, I mean whether it’s exactly the same or not, there may be some little bit of friction there.
Mike McDonald (00:28:31):
Can I add also one more example that in the dependent agent PE that turns out to be more of the distributor type, right? I think it’s ultimately the AOA that effectively, Nate, achieves what you think is the right policy outcome because it basically says, “Yeah, figure out the profits attributable to the PE under the rules and it’ll basically be like a full-fledged distributor,” or something like that. That’s what it’s like. But then it says, “Hey, make sure you also take out the Article 9 result you’re paying,” because otherwise there’d be a double payment. So effectively the AOA is something that I actually think helps lead to the right answer in a situation where we have dependent agent PEs and we have PEs that are legally different than associated enterprises.
Nate Carden (00:29:22):
So it sounds like what you’re saying is that the AOA properly applied in the case of our mobile employees should cause an attribution of the same amount of profit to that PE that you would have if the employee was instead employed by the local country entity. And if that’s right, which I absolutely think it is, the question I’m asking is then why are we going through B to get from A to C? Just say like if you’ve got somebody in the country that would otherwise be a PE, but you don’t have a box around them, we’re going to draw a box around them and then we’re going to apply Article 9. Doesn’t that make everybody’s life a lot easier?
Mary Bennett (00:30:04):
You’re going to draw a box around your employee? And what do you mean by apply Article 9? You’re not related parties, you can’t give profit to your employee.
Nate Carden (00:30:12):
But you’re going to say that that employee, right, is a deemed separate entity.
Mary Bennett (00:30:20):
Oh, okay. We do say that.
Nate Carden (00:30:23):
And that’s exactly my point is that that’s what we’re doing anyway, so why have something called the AOA to do it? Just say-
David Farhat (00:30:31):
But that’s what the AOA does. Yeah, it’s a hypothesized separate entity.
Nate Carden (00:30:35):
Yes, that’s exactly... Right, you don’t need to do that, right? You can just say, “Treat it as...” You don’t need all of part one of the attribution of profits and the discussion of dealings and all of that stuff.
Mike McDonald (00:30:48):
Is that a general statement or are we talking just within the sort of four corners of a dependent agent PE examples, or are you saying that as a general matter, Nate, what’s with this part one stuff?
Nate Carden (00:31:00):
Yeah, I mean ultimately dependent agent PE is sort of the limit case, right? Because you’ve already got the box there in most cases.
Mary Bennett (00:31:07):
No, you don’t. You do if it’s a separate entity and you-
Nate Carden (00:31:09):
Separate, yeah. And that’s where you see separate, that’s where you see dependent agent.
Mary Bennett (00:31:14):
But then you only have the box that is the box of how to draw the line between the profits of this entity versus that entity.
Nate Carden (00:31:24):
Right.
David Farhat (00:31:24):
Versus... Yeah.
Mary Bennett (00:31:24):
You don’t have the box that tells you, “Within entity one, how do I determine on this side of the border versus that side of the border?”
Nate Carden (00:31:32):
Right. But Mike just told us that that answer should be zero if there’s nothing on-
Mike McDonald (00:31:39):
No, you’re generalizing. You’re generalizing sort of a specific application of it.
David Farhat (00:31:44):
The answer can be zero, not should be zero.
Mike McDonald (00:31:47):
This guy’s extrapolating beyond what I said. Can he do that?
Nate Carden (00:31:51):
Let’s talk about when it’s not zero.
David Farhat (00:31:53):
Okay.
Nate Carden (00:31:53):
Let’s talk about a situation where you have a separate legal entity and the counterparty country, the principal entity does not have any other activity in the country, because that’s where you actually see in practice fights over dependent agent PE. What’s the case in which that’s not zero?
David Farhat (00:32:13):
Well, but Nate, is that an Article 5 question or an Article 7 question?
Nate Carden (00:32:18):
Well, I mean, the way Article 5 is now structured with the supporting transactions that ultimately lead to contracts, getting to an Article 5 PE seems like falling off the floor, that’s pretty easy. So it’s going to then be an Article 7 question.
David Farhat (00:32:37):
And when you get to those very easy dependent agent PEs, I think that’s where Mike’s point is, sometimes you have that analysis where it’s zero.
Mike McDonald (00:32:46):
I was going to say, but you have situations, and I think the AOA speaks to this, where you have an arrangement where effectively the PE is basically performing a service. Let’s say they’re engaged in selling and they also have activities that are primarily selling, and they get the commissionaire return like a small return based on sales, right? And it trips the PE. So then there’s a question, here’s an example where you would get a different answer under the AOA, a non-zero answer, something that is incrementally above what it gets. It’s like under the AOA you say, “Okay, we have this enterprise that is comprised of the home office and the dependent agent PE. We know that there’s been a sale of something that involves inventory.” And we’ll look at the activities, and if in fact the activities on the ground in terms of the functions performed transcend the legal agreement that for example, puts the inventory in the home office under Article 9, if it transcends that, there could be an allocation of that to the PE. And so the PE may be hypothesized as a full-fledged distributor. And you would get a significant differential there. The differential between the Article 9 commissionaire and the Article 7 hypothesized full-fledged, that is what the AOA would produce. Mary, Mary, did I get that wrong?
Nate Carden (00:34:25):
Let’s unpack that example because that’s a great example. Let’s say we have the box drawn around your sales entity, so that’s your Article 9 transaction, right? Let’s take a tangible example of what else is happening in the country. Let’s posit that there are no humans that are from the home office, from the counterparty country running around, right? It is purely the local activities. What are the circumstances in which you would then say, “Well, what’s going on here should be viewed as a PE of the home office,” rather than, “Look, you’re just not following your agreements. The local country selling entity is just doing more than you say it’s doing,” and you resolve it under Article 9.
Mike McDonald (00:35:20):
No, no, but it’s not necessarily not doing what it said it was doing in the example.
Nate Carden (00:35:25):
Who’s doing the extra stuff? That’s what I’m trying to unpack.
Mike McDonald (00:35:28):
But I think one of the key aspects is the difference between contractual assignment of risk versus something where the risk resides in the enterprise as a whole and we don’t know how to allocate it. So you can have a situation where the entity that is selling is legally the selling entity, right? So that what is a PE doesn’t take title to it is just acting on behalf. But if in fact the entity that is physically doing the selling that is shielded from risk due to the contractual arrangements, and therefore under Article 9 is going to get a small return, if in fact it’s doing activities including warehousing and things like that, under the AOA, they simply say, “Okay, we see both sides are doing something. We don’t care about contractual allocations of risk. We simply see that there are a lot of activities on the ground or there’s activities here, there’s activities in the home office. How can we allocate the two?” And it can definitely be the case that the activities on the ground could tip the scales to say that contractual allocation of risk that we’re completely respecting under Article 9, completely respecting is actually allocated to the other side and therefore they’re going to be attributed to the inventory and the profits. And I think that’s an appropriate result.
David Farhat (00:36:50):
So Mike is this-
Mary Bennett (00:36:52):
And it could be stuff like, you know, the local person in the PE country could be determining how much inventory is there. They could be using marketing intangibles belonging to the foreign company. They could be making credit determinations that create risk for the foreign company. None of that is giving profit or risk to the local entity itself or the employee.
Nate Carden (00:37:15):
Are the people that you’re talking about doing that, are they employed in your example by the local entity?
Mary Bennett (00:37:20):
They could be employed by the local entity or they could also be employed by the foreign entity. And my point in the beginning was it shouldn’t matter either way. Neither way are those people or the local entity that employs them going to get the profit or loss attributable to those activities. It’s the foreign entity that has the profit or loss. But AOA is telling you, “Gee, maybe that loss should be not booked in the home office but booked in the PE jurisdiction because that’s where all the activity functions are taking place.”
Nate Carden (00:37:51):
So this is super interesting. Let me coalesce around this. This is super interesting because this strikes me as really, and I’m curious as to your reaction to this, this strikes me as a debate over how the risk control framework of chapter one should work. Because I would think, unfortunately, in my view that contemporary audit and competent authority experience would suggest that in examples where we’re talking about employees in the local entity that are doing these things, using marketing intangibles, whatever the application of the risk control framework is going to pull the Article 9 answer toward an additional allocation of profit. Mike is shaking his head.
Mike McDonald (00:38:45):
Yeah, no, and I think most of the time the answer is no. It’s a different framework and including the risk control framework. Unlike Article 7, Article 9, I know I’m repeating myself, you guys, but again, I’m the dopey one apparently in the group, so I can do that, Article 9 starts with certain things that are actually important. Remember I said, Nate, that I learned more about Article 9 by spending eight years in the AOA than I definitely would’ve otherwise. Article 9 starts with a key difference, which is respect for separate legal entities, contractual separation of risk. I mean that’s just a fact. That’s a fact. It starts with that and it basically starts with an assertion that, “Hey, we are respecting these things. We have a contractual allocation of assets, contractual allocation of risk, we have legal ownership of assets.” That is the starting point, right? And once that is established, which is again the starting point, we then say, “Okay, what are the transactions? What are the contractual arrangements?”
Mike McDonald (00:39:53):
And at that point, the contractual arrangements, which deals with such things as who’s bearing risk, where do residual returns show. Are subject to a stress test.I think of it as a binary stress test, which basically says, “Hey...” And 4E2-1D3 does the same thing to me. It simply says, “Look, there are certain things that need to be followed. Are the parties doing what they said they would do?” For lack of a better term, let’s call that substance. Although, we’re going to need to find a better term for that. And then the second thing is, okay, do they exercise control? That is there enough decision-making capacity to determine whether to take on a risk and whether or not and how to mitigate the risk? But it doesn’t simply go to things like who is scurrying on the ground and doing R&D, because that is clearly risk-mitigating activities. It doesn’t say that. So if someone says, “Risk control, yeah, that’s just like significant people functions,” that’s just not true. And it is true that yeah, countries, especially in Europe, they’re basically conflating Article 7 and Article 9.
David Farhat (00:41:10):
Yes.
Mike McDonald (00:41:11):
But Nate, that’s the problem, right? That’s the problem.
Nate Carden (00:41:15):
Yeah I wish that were not, this is violent agreement. I wish you were right. But at the end of the day, at the end of the day, if I say European countries are doing it wrong, guess what? I’m wrong. Not them. They’re the authorities. I’m just a guy.
Mike McDonald (00:41:36):
There’s two sides, Nate. And you’re more than just a guy, first of all. There should be two sides of each of these debates, right? There is one side’s saying, “I’m playing games with DEMPE, I see people move and I’m going to move profit.” There should be the other side that’s calling (beep) on that and saying, “No, here’s how Article 9 works.”
Nate Carden (00:42:01):
Actually, I love this conversation because fundamentally I think what we’re getting at, there’s two ways to look at this, there’s absolutely a conceptual difference between AOA and Article 9 and a single enterprise and multiple enterprises. My view is that the practice of the application of the risk control framework has reached a point where that distinction is no longer doing any work.
David Farhat (00:42:34):
100%.
Mike McDonald (00:42:35):
That’s what drives me crazy. Yes. That’s what drives me crazy. Like why the hell does... There’s a solution for this, you guys. Read the AOA and then read chapter one of the Transfer Pricing Guidelines, right? Problem solved.
David Farhat (00:42:49):
Yes. No, 100%, Mike. And I think, Nate, we all share your frustration, but I don’t think you throw the baby out with the bathwater, as they say. I think, and again, Mike, Mary, correct me here, the issue is risk, is how we deal with risk and properly deal with risk and who’s taking on risk and who’s bearing risk, which can kind of create the differences in treatment. But you’re right, I think a lot of jurisdictions have been playing fast and loose with that in order to get a result that they want.
Nate Carden (00:43:18):
But you don’t think they’ll do that with AOA?
David Farhat (00:43:20):
No, they have been doing it with AOA. It’s not that I don’t think that they... And they’ve been using the AOA principles-
Mike McDonald (00:43:30):
It’s endogenous in the AOA. Risk is endogenous in the, right? There’s a disadvantage.
David Farhat (00:43:30):
And they’ve been using those principles in Article 9 to not respect the contracts and the boxes. And I think we can blame Mike for a little bit of that too, for coming up with DEMPE.
Mike McDonald (00:43:40):
Do you want me... I’m sorry. Do you really want me to deal with this or are you just going to sort of gratuitously say that and let it pass? I’m happy to do it either way, you guys. We can simply maybe drop it and I’ll pretend you didn’t say that. In fact, that’s what I’d prefer. [inaudible 00:43:57] just say that. We’ll have another session where we can talk about it. Can I do one thing? There’s one thing I really want to do.
David Farhat (00:44:04):
Yes, please.
Mike McDonald (00:44:05):
I have to tell some of my favorite Mary stories because I was one of the US delegates, right? And let me tell you when I was terrified, because you guys probably can’t believe this because I’m sure you picture me like William F. Buckley in the OECD room making points. But occasionally I’d be a little bombastic. And so, you know, I’d be full of myself. It used to... Okay, all right, Stefane. All right, now that we’re going to cut out, right? We may not cut out my saying (beep) but we’re definitely going to cut out what Stefane just said. It used to strike terror in my eyes where after going off on some bombastic rant, Mary who’s a secretariat would say, “I have a question for the US delegate.” I would be [inaudible 00:44:48].
Mary Bennett (00:44:48):
It was only when you confused me, Mike. You know, that was...
Mike McDonald (00:45:01):
So if I’ve confused you, what do you think the jury’s going to say? That I was making sense or you just didn’t understand my brilliance? Where’s the jury going to come out on that, Mary?
Mary Bennett (00:45:14):
So hard to predict.
Stefane Victor (00:45:15):
So I have a practical question. So how can companies effectively manage some of this DEMPE and PE risk?
Mary Bennett (00:45:23):
It’s interesting. I mean there was, Mike keeps talking about risk being endogenous in Article 7, I had to look that up today to find out what he was talking about. But the question about there not being contracts that you can look to as you can between separate enterprises, because if you actually look at the AOA over and over again, they recommend to companies that they create internal documentation and characterize their situation the way they think it should be characterized and they can be justified by the functions on the ground in both places. And recommendations, beyond recommendations, I mean recommendations in the OECD sense, which means that countries sign up to them, that they should follow that documentation unless there’s good reason that it does not reflect reality. And I don’t think companies do that. I mean I think a lot of the cases you’re trying to say there’s no PE at all probably, but if there is one-
Mike McDonald (00:46:23):
Right, that’s the thing. It’s so-called inadvertent PEs where there is no PE as far as the company is concerned and it’s thrust upon them by some assertion. So I agree, Mary, the idea there is that can we fight that assertion because companies didn’t know there was a PE, it would be hard for them to proactively do what they do to minimize the profits associated with that PE. That’s not a real practical solution though, Stefane, is it? I’m just a theory guy.
Stefane Victor (00:46:52):
It’s a consideration.
Mike McDonald (00:46:52):
Just theory.
Nate Carden (00:46:54):
Well, I guess it kind of comes back to the same question, which is other than the occasional traveling employee, why isn’t it always better to have a box, put the employees in that local country box and rely on Article 9?
Mary Bennett (00:47:17):
Because if they’re doing things that trigger a PE for you, it doesn’t matter. You still have all the same questions.
Nate Carden (00:47:24):
That they’re, yeah-
Mike McDonald (00:47:25):
Trying to rewrite the questions.
Nate Carden (00:47:27):
What that posits, right, is that there should be something, just as a policy matter, there should be something that is incremental to the value that is properly attributable to arm’s length compensation for the activities of that entity under Article 9. And the source country should have additional taxing rights beyond that. I mean that’s fundamentally what that means.
Mike McDonald (00:47:55):
It seems to me the heart of that question will often come down to the notion of is there a contractual separation of risk that we’re respecting under Article 9 properly so that that would not yield the same results if we actually look at the activities being performed by the employee?
Nate Carden (00:48:14):
I mean, by definition, if this is an interesting conversation, there has to be, right? At which point there’s kind of nothing you can do.
Mike McDonald (00:48:22):
What do you mean by that?
Mary Bennett (00:48:24):
I mean, it always seemed to me like the absolutely classic PE, dependent agent PE is your own employee. You send your own employee in, you pay the guy $1,000 a week and he goes around and meets with your customers and shows them all your brochures and da-da-da-da, and makes sales for you. Instead of you paying your employee $1,000 a week, you get your affiliate to send their guy who earns $1,000 a week and they’ve effectively done the HR job for you. So maybe you pay $1,100 a week or something to them, to the local entity to get that. But exactly the same function’s being performed, exactly the same type of PE created for you by the activities of that agent.
Mary Bennett (00:49:09):
Now, should you say that in the first case, the source country can look beyond the $1,000 paid to the employee and say, “Gee, maybe there’s some profit left over after that by virtue of the activities he’s carrying on in our country?” I think everybody would agree, sure they can. That’s absolutely classic. You don’t just say, “Well, we paid a guy in country at the market rate for those services. So obviously we can’t have any sales profits that we earn in the [inaudible 00:49:44] of our foreign entity, none of that can be attributed to the source country.” I don’t think anybody would say that ever. Am I right, Nate?
Nate Carden (00:49:52):
I might. I mean, if I think, right? If I think that the arm’s length compensation for that person, if you put them in the local country would be 1,000 plus a 10% markup, right? So if I actually think the arm’s length compensation under Article 9 is 1,100, then I would think the most the source country should be entitled to for a PE is 1,100. Yes, I absolutely think that should be the limit because of exactly the point that it shouldn’t make any difference. And if you don’t think the 1,100 is an arm’s length price, then that’s an Article 9 question. But otherwise, no, I don’t think the source country has any right to that above and beyond the arm’s length return for the person who’s running around doing stuff.
Mary Bennett (00:50:40):
So if each sale that he’s generating is generating 100,000 of profit for the company, and some of that is attributable to the use of their marketing intangibles in there and to the bearing of risk attributable to holding inventory in the country that the employee’s not bearing that risk, he may be the one that has to find the local insurance provider, but once he’s done that, he’s done his service. But all of that risk is on the foreign entity. You don’t think any of that should be attributable to the country where all that’s taking place?
Nate Carden (00:51:13):
Not if the foreign entity right in the separate entity arrangement or the home office otherwise, based on internal dealings is bearing that risk, no.
Mike McDonald (00:51:23):
I’m wondering, is this more an Article 5 debate than an Article 7 debate
Nate Carden (00:51:28):
Maybe.
Mary Bennett (00:51:29):
No.
Nate Carden (00:51:29):
I think it’s an Article 7 debate. If you’re asking the question how do you know if the PE is bearing the risk or the home office is bearing the risk, because as Mike says, within a single entity, risk is endogenous, the AOA tells you, “Put paper in place.” What’s the difference between paper that is between your hypothetical PE and paper-
Mike McDonald (00:51:55):
That’s not the asset test. It’s not just papering things. The documentation is sort of memorializing of the functions that are performed, right?
Nate Carden (00:52:05):
But we’re positing those functions are exactly the same in both cases. We’re positing we either have person X employed by the local entity or person X running around doing exactly the same thing with a business card that says home office country. And let’s posit that the paper says exactly the same thing. Now, if there’s inventory in the country and that’s owned by the box or owned by the home country entity, right? Fine. Same same. If there’s physical inventory in the country, then you can attribute that to the PE. If there’s physical inventory that is held by the distribution entity or the sales entity, then fine, you’d compensate that under Article 9.
Mike McDonald (00:52:55):
Under Article 9, the inventory is going to be in the... Not in the PE Article 9, in the home office. Although it’s an Article 9 concept. But under Article 7, the inventory could very well not end up in the home office and it could end up and you get a different result. I’m not sure what we’re disagreeing.
Nate Carden (00:53:14):
That’s what I’m pressing. I think fundamentally what we’re disagreeing on is I don’t see as a policy matter the source country’s claim to additional taxing rights depending on whether if you structure things as an arm’s length arrangement under Article 9 or Article 7. And I think, Mary, you’re saying like, “Yeah, that’s right, but that’s why you need to grab additional profit under Article 7.”
Mary Bennett (00:53:40):
Well, I think what you’re saying is you don’t believe in Article 7, you don’t believe in the standard that says that a PE country gets to tax the profits that an independent enterprise would have earned carrying out the same risks and functions. You think that the PE country should only get to tax its local resident entity or someone who comes in and is acting as a resident the way they would be. There’s no reason to have the PE standard at all in that case.
Mike McDonald (00:54:10):
No, but that doesn’t solve the problem, right? Because you still have to sort of define what is the context in which this takes place. Because you’re not going to have contracts to rely on, you’re not going to have any concepts of legal ownership. And you are going to have two sides that are saying, “We have a wild west situation here, so how are we going to do this?” So I don’t see how as a practical matter that’s going to make things better.
David Farhat (00:54:35):
And Nate, to clarify, you’re talking exclusively about a dependent agent PE situation?
Mike McDonald (00:54:40):
I don’t know.
David Farhat (00:54:41):
Yeah, that’s what I need to figure out.
Mike McDonald (00:54:42):
This guy’s crazy. He’s talking in general.
Nate Carden (00:54:44):
No, I’m not talking about that. I’m not-
Mary Bennett (00:54:48):
Suppose they have a sales outlet in country and they’re paying rent to whoever owns the building and they’re paying the sales employees in that country whatever they get, minimum wage for coming in and selling, and then they’re making all this profit there, are you saying that we’ve already paid arm’s length whatever to the local providers of everything needed to produce that, why should there be any more profit attributable to the source country?
Nate Carden (00:55:14):
I think I’m saying if you apply the AOA, if the answer... You’d apply the AOA to that and treat it as draw a box around it, right, David, as you said, right? At which point you wonder what then is the AOA actually doing other than purely outside of the situation where, again, you have capital that is driven by regulatory standards, et cetera, outside of the financial services context, why should it do anything other than what Article 9 does?
David Farhat (00:55:48):
Well, I think, Nate, it’s a two-step process, right? After it tells you what to draw the box around, then you’re going into Article 9. But I think the debate is what’s in that hypothetical box you’re drawing.
Mary Bennett (00:56:00):
Absolutely.
Nate Carden (00:56:01):
Right. But-
Mike McDonald (00:56:01):
And it’s not clear.
Nate Carden (00:56:04):
Well, what they have done though is they’ve said, “Make it clear.” They’ve said, “Put all this paper in place.”
Mary Bennett (00:56:09):
No. No, they’ve not said that.
Nate Carden (00:56:12):
“Record your books and wreck it.” That’s absolutely what they’ve said.
Mike McDonald (00:56:14):
No, Nate.
Nate Carden (00:56:14):
Come on.
David Farhat (00:56:17):
I think the paper is more in the context of financial services where you have a real branch and you have a lot of internal dealings that can be tracked. The situation you’re describing with the dependent agent PE and I think this is what Mike was getting to in answering Stefane’s question, it’s hard to know ahead of time what’s going to be in that box. Because what the paper is doing is basically helping you determine [inaudible 00:56:39] the box.
Nate Carden (00:56:38):
That’s why it shouldn’t exist. That’s why it shouldn’t exist. Because it is an invitation for abuse.
David Farhat (00:56:46):
Well, just because someone abuses something doesn’t mean it shouldn’t exist.
Nate Carden (00:56:50):
Well, I would-
Mike McDonald (00:56:53):
Going beyond this, I mean, one of the things I think the AOA did, and this I think was a practical thing, is prior to the AOA, yeah, it’s true the US interpreted as applied the ECI rules, but there was force of attraction problems in other jurisdictions, right? It’s like once you declare a PE, that’s it. I think the AOA, one of the important things that it did was rein that stuff in, right? I mean, unless they’re going to completely ignore it. And that’s a real issue. It’s so funny. Dependent agent PEs, remember this, Mary, it was like the last part of chapter one.
Nate Carden (00:57:32):
And what I’m telling you is that’s the only thing I ever see that matters is dependent agent PE. So the tail is now wagging the dog.
David Farhat (00:57:44):
Come over to financial services for a little bit, and help you out, it’ll help with some of the anger.
Nate Carden (00:57:50):
It’s the only time... The only thing I ever see the AOA used for is in the dependent agent PE context to try to skirt the Article 9 rules. I never see it applied anywhere else and hence the emotion that I bring to the table.
Mike McDonald (00:58:08):
But again, but I don’t think you have an issue with the AOA. I think you have an issue with a PE being declared in the situation in which Article 9 has, I guess, in your words, already settled the issue.
Nate Carden (00:58:21):
Well, I mean, whether you blame the revisions to Article 5 or you blame the AOA, I’m not sure.
Mike McDonald (00:58:28):
Well, that makes a difference because I was an AOA guy. No, I wasn’t one of those treaty guys.
Nate Carden (00:58:33):
This is what we have going on now.
Stefane Victor (00:58:35):
But I enjoy this part of the episode that we’ve gotten to where Mike diagnoses what Nate has an issue with, or all the things that Nate has an issue with.
David Farhat (00:58:46):
That’s a completely different podcast.
Mary Bennett (00:58:48):
Well, what I’m hearing from Nate is he’s just saying we should go back to drop the part of the AOA that says that there can be any profit attributable to a PE in the form of a dependent agent PE. Although to me, he’s even going beyond that and saying even drop any profit to a PE and go back to what they call the single taxpayer rule, which is you only tax one taxpayer in country. And if that taxpayer is an affiliate, so be it. If it’s not an affiliate, so be it. If it’s your employee, so be it. Just don’t go beyond that at all.
Mike McDonald (00:59:19):
That’s right. That is the single taxpayer rule. That’s exactly right. I have another Mary story to tell at some point, but when we need a comic break from this argument, just cue me up because I have at least one more Mary story.
David Farhat (00:59:32):
Fire away, Mike.
Nate Carden (00:59:33):
Fire away. They’re all good.
Mary Bennett (00:59:33):
This has been pretty funny so far.
David Farhat (00:59:39):
Go ahead, Mike. What’s the story?
Mike McDonald (00:59:40):
Well, can I tell?
David Farhat (00:59:41):
Yes, please.
Mike McDonald (00:59:42):
So this is Mary’s no longer the secretary. I think you were back at Baker McKenzie. So, you know, WP1, the treaty people, as I said, they’re out betters because we’re just transfer pricing people. So they always told us transfer pricing people, us WP6 people, “Hey, you guys, you’re kind of morons. We decide what is a PE. We’re the treaty people. We’ll go through Article 5. And don’t worry, once there’s a PE, we’ll tell you about it. Okay? Then you apply Article 7.” And so there was an exit. The head guy, Jacques Sasseville, brilliant treaty guy, little bit of an attitude though. I’m sorry, right? Just a little bit of an attitude. He says, “We determine what is a PE and then you guys do it.”
Mike McDonald (01:00:30):
And so there was a PE issue and there’s an example in which, “Hey, you’re forced to say this is a PE, you transfer pricing people. Now price it.” And the situation, I’m going to try to avoid the details of the situation, but it was basically a situation in this example, “Hey, hold on a second. The inventory that is the key for the PE has under Article 9 been allocated outside of the enterprise.” And Mary brought that up to basically say, “Hold on here. You basically have determined under Article 9 that the dependent agent enterprise is acting on its own behalf, right? It is taking the inventory. So how can it possibly be the case under this situation that there’s a PE?” Mary, I hope I’m telling this correctly.
Mike McDonald (01:01:24):
So it’s like, “We are telling you, we transfer pricing people are saying there is not a PE here.” And Mary wrote this up, it was a beautiful paper that she wrote explaining why this example proves that Article 5 doesn’t always come before Article 7, and it is not necessarily an independent determination. And so I kept parading this around the halls of the OECD saying, “I’m not a treaty person, right? Everyone’s established I’m a moron. Could someone please tell me how Mary is wrong about this? Please tell me where she’s wrong.” No one could do it. So Mary, you were kind of my hero. Now, I hope I told that accurately, the Article 9 company, that-
Mary Bennett (01:02:09):
The Article 9 company that the contract said it was a sales agent. But in fact, if you looked at the substance under Article 9, it was a buy-sell distributor and it had purchased said Article 9, the inventory. But the one thing you got from me from that, Mike, finally, I did look at the final one.
Mike McDonald (01:02:27):
Oh yeah. How did they resolve that?
Mary Bennett (01:02:29):
They expressly rejected my approach with a whole paragraph.
Nate Carden (01:02:33):
Had they listened to you, this would have been a much shorter episode.
David Farhat (01:02:39):
Yeah, Nate wouldn’t have been as upset.
Nate Carden (01:02:40):
And that’s exactly the challenge.
Mike McDonald (01:02:42):
I’m sorry. But I’m off pissed now. I’m pissed off. You’re right, because I basically paraded that around and said, “Fine, you guys are so much smarter than us. Please tell me page by page, line by line where she is wrong,” and no one could ever do it.
Mary Bennett (01:02:57):
No, they went out of their way to say I was wrong. But in doing that, they put in the important language that we’d been looking for, which was that if you have functions that are both significant people functions for Article 7 purposes, and I’ll say DEMPE for Article 9 purposes, and you attribute those to the local entity under Article 9, you can’t also attribute them to the P under Article 7. You cannot double it attribute, which is what the example has done.
Mike McDonald (01:03:27):
That’s only half a victory though. No, I do agree. But that’s half the victory. I wanted them to eat crow, Mary. That’s what I wanted. I wanted there to be like a little box that said, “Hey, remember how we said Article 5 proceeds Article 7? Maybe not the case all the time.” And I didn’t get that.
Nate Carden (01:03:45):
So if only they’d listened right to Mary on Articles 5 and 7 and to Mike on Article 9 and how DEMPE works, we’d all be good. But instead, here we are.
David Farhat (01:03:59):
And on that note-
Mike McDonald (01:04:00):
I’m sorry, he’s right.
David Farhat (01:04:03):
On that note, Mary, thank you so much for joining. We really appreciate the time. This was a ton of fun. You’re welcome back anytime. We’ll probably ask you to come back if you’re willing to put up with us some more. Mike, as usual, this was a blast. We got to talk about doing it again. But to all the listeners out there, thank you so much. This has been GILTI Conscience. Have a good one.
Mike McDonald (01:04:28):
Thanks, you guys.
Voiceover (01:04:28):
Thank you for joining us for today’s episode of GILTI Conscience. If you like what you’re hearing, be sure to subscribe in your favorite podcast app so you don’t miss any future conversations. Skadden’s tax team is recognized globally for providing clients with creative and innovative solutions to their most pressing transactional, planning, and controversy challenges. Additional information about Skadden can be found at skadden.com.
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