Having identified considerable variation in the practices of OECD and non-OECD countries regarding the attribution of profits to permanent establishments (PE) and in countries’ interpretation of Article 7 (Business Profits) of the OECD Model Tax Convention, the OECD launched a major project to examine how to apply by analogy the arm’s length principle and the guidance contained in the OECD 1995 Transfer Pricing Guidelines to the relationship between a PE and the rest of the enterprise to which it belongs.

Under the authorised OECD approach, the PE is first hypothesised as a distinct and separate enterprise, through a functional and factual analysis to determine its functions and attribute to it assets, risks and free capital. The second step consists in applying by analogy the 1995 Transfer Pricing Guidelines to the “dealings” that are recognized between the PE and the rest of the enterprise to which it belongs.

In December 2006 the OECD published the first 3 parts of a final report describing the authorised OECD approach for attributing profits to PEs. Part I of the report examines the general approach, Part II looks at PEs of banks and Part III looks at PEs performing global trading activities. Part IV, which is applying the approach to insurance companies, is expected in early 2007. The report is based on discussion drafts that were released for public comment in February 2001, March 2003 and August 2004 and takes into account the outcome of private sector consultations.

Work is now being done on how to implement the conclusions of the report in the Model Tax Convention. It was decided to proceed in two phases: (1) to provide maximum certainty, a new Article 7 and its Commentary will be drafted in a way that enables the full implementation of the conclusions of the report in future treaties and (2) the Commentary to the existing Article 7 will be revised to incorporate those conclusions that do not conflict with it. The intention is to publish an implementation package in 2007 for public comment.