The previous Snippets in this series primarily focused on whether a permanent establishment (PE) may be considered to exist. Once a PE is present, the next question is how much profit should be allocated to it from an arm’s length perspective. Many European countries apply the Authorised OECD Approach (AOA) to determine the allocation of profits to a PE. Under the AOA, a PE is hypothesised as a separate and independent enterprise. Profit attribution is determined through a two-step analysis:

  1. a functional analysis of the functions performed, assets used, risks assumed, and taking the significant people functions into account; and
  2. the application of transfer pricing methods to determine the arm’s length profit allocable to the PE.

A key question is whether the PE has employees who control economically significant risks or perform strategic, high value-creating functions. In early-stage expansion scenarios of US multinationals (US MNEs) in Europe, this will often not be the case, with the local presence typically limited to more supportive activities. In those cases, the PE will frequently be remunerated on a cost-plus basis for routine services provided to the head office, while entrepreneurial risks and residual profits remain at head office level. For routine sales or distribution activities, a sales-based remuneration may be more appropriate than a cost-plus return.

Where local employees perform more strategic, high value-creating functions or contribute to key business drivers, a different remuneration approach may be required. Depending on the specific facts and circumstances, a profit split method may be appropriate where both the PE and the head office make unique and valuable contributions. This could, for example, be the case where senior employees are strategically involved in IP development or key commercial decision-making.

Once a European PE is considered present, US MNEs are recommended to assess and carefully document the profit allocation. A robust, well-documented analysis can help mitigate discussions and tax risks. Where appropriate, US MNEs may also seek advance tax certainty. Several European jurisdictions, including the Netherlands, are open to issuing rulings confirming the allocation of profits to a PE and the related compliance implications.

Want to know more about this topic? Read more of our New York office Snippets or reach out to one of our advisers mentioned below.