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David Bradbury

Assistant Treasurer, Minister Assisting for Financial Services & Superannuation and Minister for Competition Policy & Consumer Affairs

5 March 2012 - 18 September 2013

Media Release of 24/05/2012


Board of Taxation to review permanent establishment attribution rules

The Assistant Treasurer, David Bradbury, has commissioned the Board of Taxation to investigate the impacts of Australia adopting the Authorised OECD Approach in respect of the attribution of profits to permanent establishments.

The OECD endorsed the 'functionally separate entity approach' in 2010, which differs from the method for attribution of profits to PEs currently used in Australia, however this approach has had uneven take-up internationally.

"It makes sense to ask the Board to look at all the impacts now in a considered way as we move to assess what the right policy response for Australia is in this area," said Mr Bradbury.

As part of the review, the Board will also look at the cap that currently exists on the interest rates on certain international interbank loans, which is currently set by the London Interbank Offered Rate (LIBOR), including those between an Australian bank and its foreign head office.

The Board will report to the Assistant Treasurer by 30 April 2013.

As part of the review, the Board will consult extensively with stakeholders. The Terms of Reference for the Board's review are available in the attachment.

24 May 2012


Terms of reference

Review of Tax Arrangements Applying to Permanent Establishments


In July 2010, the OECD approved a new Article 7 (Business Profits) and Commentary for the Model Tax Convention on Income and on Capital, which incorporated a new authorised approach to the attribution of profits to permanent establishments (e.g. branches).

The new Article 7 more clearly hypothesises the permanent establishment as a separate enterprise from the enterprise of which it is a part and applies usual transfer pricing principles, subject to the required functional analysis determining the recognition of relevant 'dealings' between the permanent establishment and the enterprise's other operations. The new Article 7 Commentary recognises economic differences between permanent establishments and subsidiaries and the new Article is not intended to achieve equality between permanent establishments and subsidiaries in all respects. The 2010 OECD Report on the Attribution of Profits to Permanent Establishments explains in detail how to apply the new authorised approach, which it refers to as the functionally separate entity approach.

Australian tax law currently allocates actual income and expenses of the taxpayer to a permanent establishment using functional analysis and applying the arm's length principle by analogy (which is often referred to as the relevant business activity approach). Australia has not lodged new reservations or observations to the Article or the Commentary at this stage, though from 1994 to 2005 it had an observation to the effect that it applied the relevant business activity approach. Tax treaties continue to be negotiated on the basis of the former OECD Model Article 7, pending final decisions on the functionally separate entity approach.

The issue of attribution of profits to permanent establishments is especially relevant to the finance sector. Given the significance of this sector and the Government's objectives in enhancing Australia's status as a leading regional financial centre, it is important that the policy settings be carefully considered. Of course permanent establishments are a feature of other industries and policy in this area will have to give appropriate weight to impacts beyond the finance sector.

Policy making is complicated by the fact that countries have not universally adopted the new Article 7, or the relevant Commentary. A number of OECD countries (including New Zealand) have entered reservations to the change and the United Nations Committee of Experts on International Cooperation in Tax Matters has not viewed changes as relevant to the United Nations Model Convention.  Importantly a number of key regional economies (China, Hong Kong, Indonesia, Malaysia, Thailand and India) are known to have reserved their position on the new Article 7. 1

On 1 November 2011, the Treasury released a Consultation Paper 'Income tax: cross border profit allocation - Review of transfer pricing rules' examining the need to rewrite Australia's tax law concerning profit allocation. That Paper contained a section dealing with the attribution of profits to permanent establishments in which Treasury sought views on the desirability of adopting the new OECD approach in treaty and non-treaty cases. Treasury also sought views on any potential revenue implications of adopting the new OECD approach. Most submissions did not comment on this aspect and those that did said that in practice little revenue impact would be expected.

Terms of reference

Against this background, the Board of Taxation is asked to examine and report on the advantages and disadvantages of Australia adopting the functionally separate entity approach to the determination of the profits attributable to a permanent establishment in its tax treaty negotiations and in the domestic law.

In making this assessment, the Board is asked to consider:

  • Overall policy objectives for cross-border profit allocation: profits attributed to the Australian tax base should appropriately reflect economic activity undertaken in Australia and as far as practicable the relevant rules should be aligned with and interpreted consistently with international standards.2
  • Implications for granting relief from double tax for Australian multinational enterprises in respect of their income taxable in an offshore branch country under the new OECD Article 7.
  • Evidence on the emergence of, and likely development of, the functionally separate entity approach as a new international standard. In light of this evidence, the Board might also consider the extent to which adoption of the functionally separate entity approach would:
  • affect Australian multinational enterprises in carrying on business through offshore branches in key trading and investment destinations; and
  • benefit foreign groups investing into Australia.
  • Short-term and long-term impacts on taxation revenues of possible options in the context of the Government's fiscal position and strategy.
  •  Implications for the domestic law and for tax treaty policy of adopting the functionally separate approach and in particular whether the approach should be adopted:
    • on a treaty by treaty basis and, if so, the implications of having different rules in different treaties (and respective commentaries to follow in applying those rules); or
    • as part of Australia's domestic law for application in all circumstances, subject to conformity with any relevant treaty.  
  • Whether adopting the functionally separate entity approach would bring greater certainty to stakeholders and reduce compliance and administrative costs.
  • Specific implications in the practical application of the functionally separate entity approach and for compliance with relevant methodologies including:
    • whether granting Australian tax recognition for particular intra-entity dealings that meet the requirements of the new OECD Article 7 may pose risks and how those risks could be managed. Internal derivatives and foreign currency exchange rate gains or losses are two areas that should be examined in particular3;
    • any special requirements for businesses both in the finance and non-finance sectors, and the corresponding implications for the administration of the law, in relation to the functional analysis and evidence required to meet the OECD standard for recognition of their intra-entity dealings.

The Board is also asked to advise what principles should be followed in amending the income tax legislation if the Government were to adopt the OECD functionally separate entity approach. In particular, this advice should cover the implications of adopting the new approach for the special rules dealing with Australian permanent establishments of foreign financial institutions.4 The Board's report could usefully include worked examples of how a range of intra-entity dealings in financial arrangements commonly undertaken (such as internal loans, internal derivatives and foreign exchange arrangements undertaken by financial entities) would be treated for tax purposes under the functionally separate entity approach.

LIBOR cap on intra-entity loans

Specific to the finance sector, the Board is additionally asked to review the current special rule that limits the deemed interest deduction on internal funds used by foreign banks in their Australian branches to the London Interbank Offer Rate (LIBOR). This rule was introduced as part of the elective arrangement that allows foreign banks to claim interest deductions in respect of the internal funding of the Australian branch.

Australia as a Financial Centre: Building on our Strengths ('the Johnson Report') noted that in periods of financial stress there can be appreciable differences between LIBOR and commercial rates for intra-bank lending. In the context of retaining this specific domestic rule, Johnson recmmended the removal of the limitation and reliance on the usual transfer pricing rules to determine the amount of the deemed interest deduction.5

The Board is asked to advise on the continued appropriateness of having a safe harbour for the interest rate that may be charged for the use of internal funds by foreign banks in their Australian branches, as a proxy for arm's length interest rates, and if so the suitability of the LIBOR cap for that role. This advice should take account of, among other things, the impact of any change to the cap on banking competition and on tax revenues.


The Board of Taxation is required to provide the Government with a report on these issues by 30 April 2013.

1 Complicating matters further, it is understood some countries consider the revised Article 7 Commentary is consistent with the wording of the former Article 7. Consequently they may interpret treaties based on the former Article 7 consistently with the revised Commentary. They may consider it unnecessary to change their treaty practice to adopt the new Article 7.

2 See Income tax: Cross Border Profit Allocation — Review of Transfer Pricing Rules, The Treasury 1 November 2011, paragraphs 25 – 27.

3 There is currently no OECD guidance that deals specifically with internal derivatives and foreign currency exchange rate gains or losses.

4 Part IIIB of the Income Tax Assessment Act 1936.

5 The Senate Economics Committee Inquiry into the Banking Sector has also called for a review of the LIBOR cap.