Article 7 Commentary

Key Explanation Focus

Paragraph Paras

Taxation of business profits; PE requirement;

7(1) 1–10
general principles

Profit attribution to PE; arm’s length principle;

7(2) 11–26
functional analysis

Deduction of expenses by PE, including

7(3) 27–31
management fees

Preparatory/auxiliary exceptions; anti-

7(4) 32–77 fragmentation; detailed profit attribution and
anti-abuse

Excellent question, Nida — the Authorized OECD Approach (AOA) is

central to Article 7 of the OECD Model Tax Convention, especially after its
2010 revision, and is a must-know concept for the ADIT exam.

🔹 What is the Authorized OECD Approach (AOA)?

The Authorized OECD Approach (AOA) is a two-step method

developed by the OECD to determine how profits are attributed to a
Permanent Establishment (PE) under Article 7 of the OECD Model Tax
Convention.

📌 Definition:

The AOA treats a PE as a hypothetical separate and independent

enterprise, which performs functions, uses assets, and assumes risks,
just like an associated enterprise under transfer pricing rules.

🧭 Why AOA Was Introduced?

Before the AOA, countries used varied methods to attribute profits to

PEs (e.g., force-of-attraction rule, books-of-accounts approach, indirect
methods). This led to inconsistencies and double taxation.

So, in 2010, the OECD revised Article 7 and introduced the AOA to:

 Align PE profit attribution with transfer pricing principles (Article

9)

 Provide uniform guidance

  Ensure tax neutrality between subsidiaries and PEs

🔄 AOA — The Two-Step Approach

✅ Step 1: Functional and Factual Analysis

Determine the functions performed, assets used, and risks assumed

by the PE.

This step involves:

 Understanding the significant people functions (SPFs) relevant

to risk and asset ownership

 Identifying internal dealings (e.g., internal services, notional

royalties, interest, etc.)

 Performing a functional analysis similar to TP documentation

🧠 You’re basically creating a profile of the PE as if it were a separate

enterprise.

✅ Step 2: Application of Transfer Pricing Methods

Apply OECD-approved transfer pricing methods (CUP, Resale Price,

TNMM, etc.) to price the dealings between the PE and other parts of the
enterprise.

Key points:

 Only arm’s length profits should be attributed to the PE.

 Internal dealings must be consistent with what independent

enterprises would have agreed upon.

 Even if internal payments are not recognized under domestic law

(e.g., no actual interest paid), they may be used for attribution if
they reflect real economic activity.

🏢 Example:

A UK company has a PE in India. The Indian PE performs software

development services. The AOA requires:

1. Step 1: Identify what functions the Indian PE performs (coding,

quality control), assets it uses (servers, IP), and risks (project
delivery).
 2. Step 2: Apply a TP method (e.g., TNMM) to attribute a margin (say,
15%) to the costs incurred by the Indian PE — even if no formal
inter-company agreement exists.

🔐 Key Features of AOA:

Feature Explanation

PE as a separate
Hypothetical independence for profit attribution
enterprise

Alignment with TP
Same rules as Article 9 & OECD TP Guidelines
principles

Internal dealings Notional charges (e.g., for services, royalties,

recognized interest) are accepted

Economic substance
Functional analysis is the core driver
over form

❗ADIT Exam Tip:

Common questions:

 “Explain the Authorized OECD Approach and how it affects profit

attribution under Article 7.”

 “How does AOA deal with internal dealings between a PE and head
office?”

Include:

 2-step method

 Internal dealings at arm’s length

 Functional & factual analysis

 Comparison with pre-2010 methods

📘 Reference:

 OECD 2010 Report: “Report on the Attribution of Profits to

Permanent Establishments”

 Article 7 Commentary, especially Paragraphs 9–10 and 11–26

Great, Nida. The force-of-attraction rule is a key concept to contrast
with the Authorized OECD Approach (AOA), and is relevant for ADIT
when comparing the OECD Model Tax Convention (MTC) with the UN
Model or older treaties.

🔴 What is the Force-of-Attraction Rule?

Under the force-of-attraction rule, once an enterprise has a

Permanent Establishment (PE) in a country, all profits from similar
activities in that country — even if not conducted through the PE —
may be taxed by the source country.

This contrasts with the OECD approach, which only allows the source
country to tax profits attributable to the PE.

📘 Where Is It Used?

 NOT in the OECD MTC (2010 onward)

 Included in Article 7(1) of the UN Model Convention

 Still found in some older or developing country treaties

✅ Force-of-Attraction Rule — Example

🌍 Scenario:

 AlphaTech Ltd. is a company resident in the UK.

 It sets up a sales office in India = PE in India.

 The Indian PE earns ₹50 lakhs selling laptops in India.

 Separately, AlphaTech also sells laptops directly to Indian

customers online, not routed through the PE, and earns ₹70 lakhs.

🟢 Under OECD MTC (No Force of Attraction):

India can only tax ₹50 lakhs — i.e., profits attributable to the Indian
PE.

The ₹70 lakhs earned from direct online sales without involvement of
the PE are taxable only in the UK (residence state).
🔴 Under UN MTC (With Force of Attraction):

India can tax both ₹50 lakhs + ₹70 lakhs = ₹1.2 crores, since the
total income arises from the same or similar activities (sale of laptops)
within India, where a PE exists.

The mere presence of a PE "attracts" all related Indian profits to Indian

taxation — even if not conducted through the PE.

🔍 Key Conditions for Force of Attraction Rule:

Condition Description

PE exists in source
A permanent establishment must be present
country

Same or similar The non-PE income must relate to the same kind of
activities business

Profits from source The additional profits must arise from business
country conducted in the source state

🧠 ADIT Tip:

In exam questions, if a treaty is based on the UN MTC or specifically

mentions the force-of-attraction rule in Article 7(1), you must apply it.

Always check:

 Is there a PE?

 Is there other income from similar activities in the source

country?

 If yes → Force-of-attraction may apply.

📌 Summary Table: AOA vs Force-of-Attraction

Authorized OECD
Feature Force-of-Attraction Rule
Approach (AOA)

Source taxing Limited to profits Broader: Includes similar

rights attributable to PE activities outside PE

Based on
✅ Yes ❌ Not always
economic nexus
 Authorized OECD
Feature Force-of-Attraction Rule
Approach (AOA)

Internal dealings
✅ Yes (at arm’s length) ❌ Usually ignored
allowed

UN MTC and older bilateral

Found in OECD MTC (post-2010)
treaties

Absolutely correct, Nida — you've captured the core concept very well.
Let's now consolidate and clearly structure the logic for your ADIT
answer sheet:

✅ OECD Model Convention – Treatment of Income With and

Without a PE

🔹 1. When There Is a PE (Article 7 applies)

✅ Authorized OECD Approach (AOA) used:

 PE is treated as a hypothetical separate and independent

enterprise.

 Internal dealings (e.g. notional interest, royalty, management fees)

are allowed if they have economic substance and can be priced
at arm’s length.

✅ Tax implications in Source Country (e.g., India):

 No Withholding Tax (WHT) on notional payments (interest,

royalty, etc.)

 All notional income/expense is simply included in the attributable

profits of the PE.

 India taxes the net profit of the PE under corporate income tax.

 Example: If a PE earns ₹2 crore revenue, incurs ₹1.35 crore in costs

(including notional royalty/interest), then ₹65L is profit. Arm’s length
markup is applied (TNMM or PSM) → net ₹27L taxed at 30%.

✅ No separate Article 10 (Dividends), Article 11 (Interest), or

Article 12 (Royalties) application on intra-entity notional
payments.
🔹 2. When There is No PE (Articles 10, 11, 12 apply)

 Since the foreign enterprise has no PE in India, the income is not

taxed under Article 7.

 Instead, withholding tax (WHT) applies at treaty rate or

domestic rate, whichever is lower.

 The gross payment (interest, royalty, dividend) is subject to tax

without allowing for deductions.

✅ WHT Examples in India:

Income OECD Typical WHT Rate under Indian Domestic

Type Article treaty WHT

20% (for non-

Dividends 10 5%–15%
treaty)

Interest 11 10%–15% 20% (Sec 195)

Royalties 12 10%–15% 10%–20%

✅ Example:

 UKCo receives ₹10L royalty from India without a PE

→ India withholds 10% WHT = ₹1L
→ UKCo pays ₹1L Indian tax, may get credit under Article 23B in
the UK

🔁 Side-by-Side Summary

PE Exists in Source No PE in Source

Situation
Country Country

Applicable Article Article 7 Articles 10–12

Notional Payments ❌ No (only actual

✅ Yes (under AOA)
Allowed payments)

❌ No WHT on notional ✅ Yes WHT on gross

Withholding Tax (WHT)
dealings income

Tax Base Net attributable profit Gross income

Deductions allowed
✅ Yes ❌ No
(e.g., costs)

Tax rate applied Corporate Tax (e.g., 30%) WHT rate (treaty or
 PE Exists in Source No PE in Source
Situation
Country Country

domestic)

🧠 ADIT Writing Tip:

“Under the OECD Model Convention, when a PE exists, Article 7 applies

and the Authorized OECD Approach permits profit attribution through
recognition of notional dealings. These notional amounts are not subject
to separate withholding tax. In the absence of a PE, the relevant passive
income articles (Articles 10–12) apply, and source state taxation is by way
of gross withholding tax.”

Excellent question, Nida — and a very important one for ADIT, especially
when applying the Authorized OECD Approach (AOA) under Article 7
of the OECD MTC.

Let’s address this point-by-point:

✅ Question:

If notional payments (e.g., interest, royalty, dividends) are

recognized under AOA between the PE and head office, do they
attract withholding tax (WHT) in India?

🔍 Answer Summary:

No, these notional payments (like interest, royalty, dividend) made by a

PE to its head office do not trigger withholding tax (WHT) in the
source country (India).
Instead, they are recognized only for profit attribution under Article 7
and are subject to corporate income tax in aggregate.

🧠 Why?

1. PE and HO are a single legal entity

 Under domestic law, there's no legal separation between PE and

HO.

 There is no “actual” payment — it’s a construct under the AOA.

  Therefore, no contractual payment to a non-resident = no
WHT.

2. AOA treats PE as a separate enterprise for attribution only

 Under the Authorized OECD Approach, these notional dealings

help determine arm’s length profits.

 They increase or decrease PE’s profit, but do not create

separate taxable income streams for WHT purposes.

🔢 Example (Revisited):

Item Tax Treatment in India (Source Country)

₹10L Notional Deducted from PE’s profits (as expense) — NOT

Royalty subject to WHT

₹5L Notional Deducted from PE’s profits (as expense) — NOT

Interest subject to WHT

₹27L Net Profit

Taxed under corporate tax at 30%
(TNMM)

✅ No separate WHT applies on the ₹15L of notional dealings.

⚖️Contrast: Real payments vs Notional dealings

WHT
Type of Payment Between Whom
Applies?

Real interest/royalty Indian Co → UK Co ✅ Yes

Notional royalty/interest Indian PE → HO ❌ No

Indian Co (subsidiary)
Dividends (if remitted to HO) ✅ Yes
→ HO

Dividends from PE to HO
Notional/Not possible ❌ No
(same entity)

🧾 Indian Corporate Tax Includes:

 Total PE profits after adjusting for notional royalty, interest, etc.

 These adjustments are for accurate attribution, not separate

taxability.
🧠 ADIT Key Line:

"Notional dealings between PE and head office under the AOA are
included in the determination of taxable business profits under Article 7
and are not subject to separate withholding tax in the source country."

Would you like a 1-pager “WHT vs AOA” comparison table for ADIT
revision?

Great, Nida — let's extend the example to show:

1. Residence Country (UK) taxation of HO income,

2. Foreign Tax Credit (FTC) relief to avoid double taxation.

This is exactly the type of integrated, Article 7 + Article 23 question

that appears in ADIT case studies.

🧮 RECAP: Summary of Attributable Profits

Amount
Item
(₹)

₹2,00,00,0
Total revenue (PE)
00

Total costs (with internal ₹1,35,00,0

dealings) 00

Arm’s Length Profit

₹27,00,000
(TNMM)

Taxable in India (PE

₹27,00,000
profit)

🇮🇳 India (Source Country)

Under Article 7 OECD MTC, India taxes ₹27 lakhs — profit attributable to
the Indian PE, using the Authorized OECD Approach (AOA).

Assume:

 Indian corporate tax rate = 30%

🧾 Indian tax liability = ₹27L × 30% = ₹8.1 lakhs

🇬🇧 UK (Residence Country)

UKCo's worldwide income includes:

 Profits earned by the PE in India = ₹27 lakhs

 Notional payments received by HO:

o Royalty from PE = ₹10L

o Interest from PE = ₹5L

Total income taxed in UK:

→ ₹27L (PE) + ₹10L (Royalty) + ₹5L (Interest) = ₹42 lakhs

Assume UK corporate tax rate = 25%

🧾 UK base tax on ₹42L = ₹10.5 lakhs

🔄 Relief Under Article 23 – Elimination of Double Taxation

UK allows foreign tax credit for tax paid in India on PE income (₹27L).

🟢 FTC available = actual tax paid in India = ₹8.1 lakhs

(but limited to UK tax on same income)

👉 UK tax on ₹27L @ 25% = ₹6.75 lakhs

→ FTC allowed = ₹6.75 lakhs only (not ₹8.1L)

🎯 Final UK tax =
= ₹10.5L (total UK tax)
− ₹6.75L (FTC allowed)
= ₹3.75 lakhs payable in UK

📌 Final Tax Position:

Countr Tax
Tax Base Tax Payable
y Rate

India ₹27L (PE profit) 30% ₹8.1 lakhs

₹42L (global income ₹10.5L − ₹6.75L (FTC) =

UK 25%
incl. PE) ₹3.75L

✅ Total Global Tax = ₹8.1L (India) + ₹3.75L (UK) = ₹11.85 lakhs

Double taxation is eliminated by UK giving credit relief under Article
23B.

💡 ADIT Tip: If asked to apply AOA + FTC

1. Attribute profit to PE using arm’s length methods

2. Recognize notional dealings

3. Compute tax in source country (Article 7)

4. Apply foreign tax credit relief (Article 23A/B) in residence

country

5. State limits on FTC: relief capped to tax that would have been
paid in residence state

Tolly Material Summary Sure! Let's go through the content paragraph by

paragraph and break it down into simple, clear explanations:

Paragraph 1:

"The business profits article in a tax treaty sets out the limits of the
source state's taxing rights in relation to business profits..."

Explanation:

 Article 7 of the OECD Model Tax Treaty talks about how and when
a country can tax business profits.

 A country (called the source state) can only tax profits of a foreign
business if that business has a Permanent Establishment (PE) in
that country.

 Updates were made to this article over the years (2010, 2014, and
2017), but the actual wording of Article 7 didn't change after 2010—
only minor commentary updates were made in 2017.

Paragraph 2:

"If an enterprise resident in a contracting state has a PE in the other state

through which it carries on business..."

Explanation:
  If a company from one country (say Country A) has a PE in another
country (Country B), then Country B can tax the profits
attributable to that PE.

 But the company is also taxed in its home country (Country A), so
it’s eligible for double tax relief to avoid being taxed twice.

 If there is no PE in Country B, then Country B cannot tax the

company’s profits—only the home country (Country A) can.

Paragraph 3:

"With reference to establishing the profits of a PE, where there is one, and
for the purposes of the double tax relief..."

Explanation:

 When a PE does exist, tax treaties assume the PE to be a

separate and independent enterprise from the parent company.

 This is to ensure arm’s length pricing is used—meaning, the

internal dealings between the PE and the head office are treated as
if they were between unrelated parties.

 The OECD encourages distinguishing between:

o Internal dealings (e.g., transfers between PE and head

office), and

o External transactions (e.g., with outside legal entities).

 This helps prevent manipulation of profits by shifting them across

borders.

Paragraph 4:

"The PE is to be treated as carrying on the same or similar activities under

the same conditions..."

Explanation:

 A PE should be considered as operating under the same business

conditions as the main company.

 Article 7(2) emphasizes this.

 The OECD’s concept of a “separate and independent enterprise” is

central here.
  In 2010, the OECD issued a Report on Attribution of Profits to
PEs to explain how transfer pricing principles apply to PEs.

 A new version of this Report came after BEPS (Base Erosion and
Profit Shifting), which clarified things further.

Paragraph 5:

"The separate and independent enterprise fiction found at paragraph 2 is

restricted..."

Explanation:

 Article 7(2)’s idea of a “separate and independent” PE has limits.

 Article 7(3) clarifies that this doesn’t allow you to create non-
existent income just to tax it.

 For example: You can’t pretend there’s profit just because the PE
exists.

 The PE must be actually earning profits in a real business sense

for the source country to tax it.

 This prevents abuse where countries might tax hypothetical income

using the fiction of “independent enterprise.”

Let’s now go through this second part paragraph by paragraph,

breaking it down into detailed, simple explanations:

Paragraph 1:

"Paragraph 2 does not specifically deal with the issue of whether

expenses are deductible..."

Explanation:

 Article 7(2) (which treats the PE as a separate and independent

entity) doesn’t explicitly say which expenses are deductible when
computing PE profits.

 So, Paragraph 30 of the Commentary clarifies that this issue

should be decided using domestic tax law of the country where
the PE is located, unless the tax treaty says otherwise (e.g., under
Article 24(3), which deals with non-discrimination).
  Basically, a PE should get the same rights as a local resident
company in that country when it comes to deducting business
expenses.

 However, only those expenses that are normally allowed under

local law should be deducted.

 The arm’s length principle is considered a good enough standard

to decide if an expense should be allowed.

 More detailed discussion is in paragraphs 38 to 40 of the OECD

Commentary.

Paragraph 2:

"Paragraph 3 of Article 7 deals with reciprocal adjustments to the profits

calculated..."

Explanation:

 Article 7(3) is about making adjustments to avoid double

taxation.

 If two countries disagree on how much profit is attributable to a PE

(because of different interpretations of Article 7(2)), Article 7(3)
allows them to adjust the amount so the same profit isn't taxed
twice.

 This article works together with Articles 23A and 23B, which are
about relief from double taxation.

 It’s important for the two tax authorities to coordinate and resolve
any mismatches in profit attribution.

 So, paragraph 3 helps maintain fairness by encouraging

consultation between the two states to avoid taxing the same profit
twice.

Paragraph 3:

"Generally, interest, royalty and similar payments made by the PE to its

head office..."

Explanation:

 Payments like interest or royalties made by a PE to its own head

office are not allowed as deductions, because these are
internal dealings.
  You can't treat internal transactions (within the same legal entity) as
if they were external and deduct them.

 But, exceptions exist:

o If a PE takes a real loan from a third party, the interest

might be deductible.

 The 2010 OECD Report on Attribution of Profits to PEs provides

guidance on when such deductions may be allowed.

 Article 7 doesn’t go into detail about what deductions are

allowed, so the OECD Report and Transfer Pricing Guidelines
are used to guide this area.

Paragraph 4:

"In practice, for example in the US, certain excess interest payments to
third parties..."

Explanation:

 In some countries like the United States, interest paid to third

parties may still be disallowed if the PE doesn’t have enough
capital to justify the borrowing.

 This is about checking if the PE has a reasonable share of the

overall capital of the business.

 If it doesn’t, then the PE cannot deduct interest payments, even if

made to unrelated parties.

 This is to prevent base erosion (shifting profits out by overloading

the PE with debt).

 The authorities look at whether the PE’s share of total company

assets supports its level of debt, and only allow a proportionate
deduction.

Paragraph 5:

"Finally, importantly, Article 7(4) of the OECD Model Treaty cedes

priority..."

Explanation:
  Article 7(4) makes it clear that if another article in the treaty
specifically applies to a type of income, that article takes
priority over Article 7.

 For example, if income is interest or royalty, and it fits into Article

11 or 12, then those articles will apply instead of Article 7.

 This avoids overlapping taxation and ensures income is taxed

under the most relevant article.

 So, Article 7 only applies if no specific article applies to that

income.

Let’s now break down this continuation of “11.2 2010 and 2017
Updates to the Model Convention” paragraph by paragraph with
detailed explanations:

Paragraph 1:

"Considerable changes were made in 2010 to Article 7 and the

commentary..."

Explanation:

 In 2010, the OECD made major changes to Article 7 and its

commentary.

 These changes included a new methodology for attributing profits

to a Permanent Establishment (PE).

 The updated method is laid out in the 2010 PE Profits Report,

which should be read alongside Article 7.

 Paragraph 9 of the commentary explicitly says that the revised

Article 7 reflects the guidance in the 2010 PE Profits Report—
so the two are meant to be used together.

Paragraph 2:

"The OECD’s principal aims are to: (i) develop a methodology of

attributing profits..."

Explanation:

 The OECD had two key goals with these updates:

 1. Minimize double taxation – so that the same income isn’t
taxed in two countries.

2. Harmonize PE taxation – so that PEs are taxed in a more

consistent way across countries.

Paragraph 3:

"The key concept underpinning the 2010 PE Profits Report is that a PE

should be considered..."

Explanation:

 The main idea behind the 2010 PE Profits Report is to treat a PE

like a separate and independent company from its parent.

 This concept is reflected in Article 7(2).

 The 2018 guidance (issued after BEPS) also supports this idea—
even though it came after the 2017 changes to Article 5 (definition
of PE).

 The goal is a consistent framework regardless of how the PE is

defined.

Paragraph 4:

"The effect of this analysis is that the PE will be attributed with the
profits..."

Explanation:

 As a result of treating the PE as an independent enterprise, the PE

should be taxed on the profits it would have earned if it were
really a separate business.

 This assumes all dealings between the PE and the head office are
done at arm’s length (fair market terms).

 This idea is in line with the transfer pricing principle.

Paragraph 5:

"This approach under Article 7, combined with the application of the 2010
PE Profits Report..."

Explanation:
  This profit attribution method is called the Authorised OECD
Approach (AOA).

 AOA combines:

1. The updated Article 7 (2010),

2. The 2010 PE Profits Report, and

3. The OECD Transfer Pricing Guidelines.

 It applies to internal dealings between the PE and the rest of the

company, treating them as if between separate parties.

Paragraph 6:

"Analysis of the PE as a separate entity means that the economic

ownership..."

Explanation:

 Treating the PE as a separate business also means:

o You have to decide which part of the business owns assets

and bears risks.

o This affects how profits are attributed—based on economic

ownership and assumption of risk.

o Profits are apportioned between the PE and head office

based on these factors.

Paragraph 7:

"Paragraph 20 of the treaty commentary contains a two-step approach..."

Explanation:

 The 2010 commentary introduces a two-step test to attribute

profits:

1. Functional and factual analysis – Determine what the PE

does and what assets and risks it controls.

2. Apply transfer pricing principles – Allocate income based

on dealings at arm’s length.

 This is consistent with the Transfer Pricing Guidelines.

Paragraph 8:

"In identifying the functions performed, it is necessary to consider..."

Explanation:

 When analyzing what a PE does, look at:

o Risks assumed,

o Assets used,

o And the economic reality.

 This helps identify key people or locations driving those activities—

this is where the profits should be taxed.

Paragraph 9:

"Determining the functions, assets and risks of the PE..."

Explanation:

 Based on the functions, assets, and risks:

o You determine the rights and obligations of the PE.

o You also identify dealings between the PE and head office.

o This step forms the basis for profit attribution.

Paragraph 10:

"The second part of the attribution mechanism will lead to..."

Explanation:

 Once the functions/assets/risks are understood:

o You apply transfer pricing rules to allocate income.

o This involves pricing the internal dealings between the PE

and head office at arm’s length.

o Ultimately, this ensures the correct amount of profit is

attributed to the PE based on its true role.
Here's a detailed paragraph-by-paragraph explanation of the
continuation of Section 11.2 (2010 and 2017 Updates to the Model
Convention) from the latest image:

Paragraph 1:

"...the recognition and determination of the nature of those dealings

between the PE and other parts of the same enterprise..."

Explanation:

 This paragraph emphasizes two key outcomes of the first step in the
Authorised OECD Approach (AOA):

1. Identify the nature of internal dealings between the PE

and the rest of the enterprise.

2. Attribute assets and risks to the PE, depending on the

functions performed.

 These are foundational for accurately attributing profit in step two.

Paragraph 2:

"The reference to ‘significant people functions’..."

Explanation:

 The term “significant people functions” refers to key functions that

help determine:

o Who owns assets, and

o Who bears the associated risks.

 The 2010 PE Profits Report (especially Part I, paragraph 15) says

these functions must be performed by people in the PE to count
toward profit attribution.

 Since business sectors differ, the actual relevant functions vary

accordingly.

Paragraph 3:

"Then under the second step, such dealings will be priced..."

Explanation:
  Once functions, assets, and risks are determined (Step 1), Step 2
involves:

o Pricing those dealings at arm’s length.

 This is done using transfer pricing principles (i.e., how two

independent entities would price the same transaction).

 This pricing takes into account the functions, assets, and risks of
both the PE and the rest of the enterprise.

Paragraph 4:

"With reference to the 2010 PE Profits Report, in the case of dependent

agent PEs (DAPEs)..."

Explanation:

 This paragraph discusses Dependent Agent PEs (DAPEs) – where

an agent in a country creates a PE for the foreign enterprise.

 The functions of the agent are analyzed from two perspectives:

1. What the agent does for itself, and

2. What the agent does on behalf of the foreign enterprise.

 The agent may have its own assets/risks, but if it also performs key
functions for the foreign enterprise, the DAPE is attributed assets,
risks, and functions of the non-resident enterprise it represents.

 In such cases, the PE gets attributed profits based on what it

actually contributes.

Paragraph 5:

"The OECD also considered how internally developed intangible assets

should be treated..."

Explanation:

 This part addresses intangible assets (like patents, software,

trademarks).

 If the PE is actively involved in developing such assets, it should

be attributed profits accordingly.

 Profit attribution depends on whether people in the PE performed

the key decisions/actions.
  The 2010 PE Profits Report (especially Chapters VI and VII) and the
2022 version of the TP Guidelines provide detailed guidance.

Paragraph 6:

"Consideration would also be given to where the economic ownership of

the asset lies..."

Explanation:

 Even if the legal ownership of an asset lies elsewhere, the PE

might be considered the economic owner if:

o It controls or uses the asset in a way that contributes to

generating income.

 For example, even if the head office owns a machine, if the PE uses
it to generate revenue, the economic ownership might rest with
the PE.

 This means profits will be attributed to the PE accordingly.

Paragraph 7:

"In terms of the operation of Article 7(2), the commentary makes it

clear..."

Explanation:

 This clarifies that domestic tax law still plays a role.

 Even though tax treaties guide how profits are attributed, the
specific deductibility of expenses is subject to the domestic
law of the source state, provided it doesn't result in
discrimination (per Article 24, Non-discrimination clause).

Paragraph 8:

"The question of deductions for interest is looked at in more detail..."

Explanation:

 This paragraph refers back to a key issue: interest deductions on

internal loans.
  In most cases, the 2010 PE Profits Report says no deduction
should be allowed for ‘internal’ interest payments (e.g., from the
PE to the head office).

 Exception: If the PE has external third-party borrowings, then

deduction might be allowed.

 This issue arises from the concept of ‘internal dealings’, which

aren’t considered actual third-party transactions.

Here is a paragraph-by-paragraph detailed explanation of the

content shown in your uploaded image, continuing from the OECD Article
7 / PE profit attribution discussion:

Paragraph 1:

"When booking a notional interest charge to a below-the-line PE..."

Explanation:

 This refers to situations where a PE is funded by internal capital

(from head office), and there's a desire to calculate a notional
interest charge (as if the PE had borrowed funds).

 The 2010 PE Profits Report allows for a PE to be allocated a

notional amount of “free capital” (capital not bearing interest).

 The purpose is to assess what amount of equity funding the PE

would require to support its functions, assets, and risks — and to
avoid over-deducting “interest” on notional internal loans.

Paragraph 2:

"To deal with the different measures of free capital that may apply..."

Explanation:

 The 2010 PE Profits Report acknowledges that different countries

have different methods for determining free capital.

 It suggests that the rules of the PE’s host country (i.e., source
state) should apply — but only if they meet certain conditions and
don’t contradict Article 7.

 Essentially, this gives some deference to domestic rules, but

within OECD boundaries.
Paragraph 3:

"The 2017 case BNP Paribas..."

Explanation:

 This discusses a real-life tax dispute involving BNP Paribas (a

French bank with branches in India, China, the Philippines).

 These branches received internal loans from their head office,

and were charged interest.

 However, since head offices and branches are part of the same
legal entity, many countries don’t allow such internal interest
charges.

 Still, India, China, and the Philippines taxed those interest

payments, treating them as real income.

 The bank tried to get a tax credit in France for this foreign
withholding tax, but it was denied because the PE is not treated as
a separate taxpayer.

 The core problem: tax was paid, but no corresponding credit

was allowed — leading to double taxation.

Paragraph 4:

"The difficulty, of course, was that the PEs were not residents..."

Explanation:

 The problem was that PEs are not separate tax residents, so
credit for foreign withholding taxes (on “interest” paid to the head
office) couldn’t be claimed in France.

 Article 23 of the OECD Model doesn’t specifically address such

mismatches, creating a gap in relief mechanisms.

 This shows a systemic issue with Article 7 and its interaction with
residence-based credit systems.

Paragraph 5:

"While it may be that it is only banks and insurance companies..."

Explanation:
  This type of issue (internal dealings with notional charges) mostly
affects banks and insurers due to their international branch
structures.

 The problem is not unique, though — it's recurring enough to

justify clarity in interpretation.

 The Authorised OECD Approach (AOA) offers a standardized

solution and is increasingly relied upon by countries in audits and
disputes.

Paragraph 6:

"Both Irish Bank and Irish Nationwide..."

Explanation:

 This is a case from the UK involving Irish banks with branches in

the UK.

 The UK tax authority (HMRC) examined how the loan capital was
structured and how interest was deducted by the PE.

 The Irish companies allegedly understated equity and

overstated debt, inflating the interest deduction in the UK.

 HMRC rejected the excess interest deduction, arguing that the

capital structure was not consistent with the actual economic
reality or legal requirements.

 This is another example of the importance of appropriate

capital attribution to PEs, based on real functions, not just tax
planning.

Here is a detailed paragraph-by-paragraph explanation of the

content shown in your uploaded image:

Paragraph 1: Irish Bank and Irish Nationwide case continued

"Irish Bank and Irish Nationwide contended that the treatment of their tax
returns was so to disallow..."

Explanation:

 The Irish banks argued that HMRC’s adjustment (to reduce interest
deductions by re-calculating the PE’s capital) violated the tax treaty.
  HMRC applied a "notional free capital" concept, even though it
was only formalized in the 2010 Treaty update.

 The banks felt this unfairly deviated from their actual books and that
it conflicted with treaty obligations.

 HMRC, however, claimed that economic reality and arm’s length

principles justified their approach.

Paragraph 2: Tribunal decision on the Irish bank case

"The Upper Tribunal observed that the starting point was indeed the
actual records..."

Explanation:

 The UK Tribunal agreed that the PE’s own books should be the
starting point.

 However, Article 8(2) of the treaty (likely referring to the old UK-
Ireland treaty) allows adjustment if actual records mismatch with
what an independent enterprise would show.

 UK legislation assumes PEs operate independently — thus,

separate enterprise principles apply.

 The decision upheld the HMRC’s stance that the PE needed more
equity and less debt, and this justified the interest deduction
denial.

 The decision was also upheld on appeal in August 2020.

Paragraph 3: 2014 and 2017 Updates to the Model Treaty

"The 2014 update to the Model Treaty made only minor amendments..."

Explanation:

 In 2014, the OECD made minor updates to Article 7 commentary:

o Replaced “income” with “profits”

o Added clarification around non-deductible credits and

mining/extractive industries.

 The 2017 update also brought minor clarifications.

 Importantly, changes to Article 5 (PE definition) led to

paragraph 59.1 in the commentary.
 o This explained when adjustments under Article 7 should
happen.

o Also clarified coordination between Article 5 and Article 7 (i.e.,

when a PE is newly created by changes in definition, how
profit attribution must adjust).

Heading: March 2018 Additional Guidance

"March 2018 Additional Guidance on Attribution of Profits to a PE"

Explanation:

 This guidance was issued to align profit attribution rules with

the new Article 5 definition (which had changed post-BEPS).

 It reinforced the AOA (Authorised OECD Approach) principles

and focused on applying:

o The arm’s length principle

o The separate enterprise fiction for the PE

 The guidance emphasized how profits should be attributed logically

and fairly, accounting for significant people functions (SPFs),
assets, and risk ownership.

Last Paragraph: Article 7 vs Article 9

"The report does not address the interrelationship between Article 9 and
Article 7..."

Explanation:

 This warns about potential double taxation or double deduction

when both Article 9 (associated enterprise transactions) and
Article 7 (PE attribution) are applied together without
coordination.

 Key point: risks and functions once attributed under Article 9

should not be re-allocated under Article 7.

 Example: If a risk is already allocated to a subsidiary under Article 9,

it should not again be assigned to the PE under Article 7 — this
avoids duplication and tax base overlaps.

 The OECD urges careful coordination between both articles to

maintain consistency and prevent disputes.
Here’s a detailed paragraph-by-paragraph explanation of the
content in the image:

Paragraph 1: Introduction to AOA application and anti-

fragmentation rule

"The report does clearly indicate... with analysis of the 2017 changes
made to Article 5."

Explanation:

 This paragraph emphasizes that even if the PE makes payments to

intermediaries (e.g., for services), the arm’s length principle may
result in zero or low profits for the PE if it effectively made no
economic contribution.

 This position is considered fair and was well received.

 The paragraph then transitions into a discussion of examples,

specifically to support analysis of 2017 Article 5 updates (e.g.,
dealing with the definition and scope of PEs, particularly under BEPS
Action 7).

Paragraph 2: First example — Warehouse and information office

"In the first example examines the anti-fragmentation rule at Article

5(4.1)..."

Explanation:

 This introduces a practical example involving an internet-based

business:

o It operates a warehouse and a merchandising/information

office in a host country.

o These are geographically separate, but functionally connected

to business operations.

 Article 5(4.1) is mentioned — which prevents a taxpayer from

artificially fragmenting activities across multiple locations to
avoid having a PE in the host country.

 Paragraph 14 of the Commentary is used to support the idea that

even seemingly auxiliary functions (like a warehouse or data
 office) can together create a PE when part of a cohesive business
operation.

 Since the warehouse and office are essential to operations, they are
not considered "preparatory or auxiliary" — meaning they qualify
as PEs.

Paragraph 3: Attribution of profits to warehouse PE

"For the warehouse: Under step one, the functional and factual analysis
shows..."

Explanation:

 This applies the Authorised OECD Approach (AOA) to the

warehouse:

o The head office sources goods and manages customer

relationships.

o The warehouse staff store and handle goods, manage third-

party logistics, and support local deliveries.

 The warehouse is thus hypothesized to have its own economic

ownership of the goods, and its personnel perform significant
functions.

 The warehouse PE is therefore attributed:

o The risks and functions relating to the final delivery and

storage.

o A hypothetical arm’s length return for providing

storage/delivery, as if it were an independent logistics
company.

 This means profits must be attributed accordingly.

Paragraph 4: Attribution to the merchandising and information

office

"For the merchandising and information gathering office: Under step

one..."

Explanation:

 Here, the functional analysis focuses on the information office.

 o Staff in the office collect market data, negotiate with
suppliers, and manage purchasing activities.

 Although final decisions may be made at the head office, the

economic ownership of the purchasing function is attributed to
the PE because the staff perform key support activities.

 Consequently, the PE gets attributed:

o Ownership of the purchasing function.

o The related risks (e.g., supplier contract risks).

 Under AOA, the arm’s length price would reflect the value of these
services — like an independent procurement agency would charge.

Let me know if you'd like:

 A diagram summarizing these flows (functions, assets, risks).

 A comparison between 2010 vs 2017 Article 5 and 7 treatment.

 Help with understanding anti-fragmentation rule under Article

5(4.1) with other examples.

Here is a detailed paragraph-by-paragraph explanation of the

content from your latest image, which discusses Shipping and Air
Transport under Article 8 of the OECD Model Treaty (Section 11.3):

Paragraph 1: Pre-2017 rules – taxation based on “place of

effective management”

"Prior to the 2017 update... international operating agency” (Article 8(4))."

Explanation:

 Before 2017, Article 8 governed how income from shipping and

air transport (including inland waterways) was taxed.

 Taxation was based on the place of effective management — i.e.,

where the business decisions were made.

 The rule applied to profits from:

o Operating ships/aircraft in international traffic.

o Participating in a pool, joint business, or international

operating agency.
  Article 8(1) and 8(4) provided this framework.

Paragraph 2: Inland waterway profits – taxed only in state of

effective management

"Similarly, profits from inland waterway boat operations..."

Explanation:

 This reaffirms that even for inland waterway operations, the rule
was the same:

o Profits are only taxable in the state where effective

management is located — preventing double taxation and
aligning with international norms.

Paragraph 3: Clarifying the location of effective management

"If the shipping or aircraft operations..."

Explanation:

 This clarifies that if effective management (EM) was on a ship or

aircraft itself, then:

o The ship/aircraft's location determined where the EM was

considered to be.

o Accordingly, this would establish tax residence and taxing

rights under Article 8(3).

Paragraph 4: 2017 update – shift from “effective management” to

“Contracting State”

"However, Article 8 and the commentary were changed..."

Explanation:

 In 2017, a major update was made:

o Instead of focusing on where effective management was

located, the new rule taxes profits in the Contracting State
of residence of the enterprise.

o So now, residency of the enterprise (as per tie-breaker

rules in Article 4) determines taxing rights.
 o Article 8(1) thus simplifies taxation by applying it only in one
country — the residence state — avoiding tax disputes about
where the EM was.

Paragraph 5: Residency clarification and tie-breaker rule

"If there are concerns as to where the enterprise is tax resident..."

Explanation:

 Sometimes it's hard to determine where a company is tax

resident (especially in dual-residence scenarios).

 In such cases, Article 4 tie-breaker rules help decide the correct

state of residence.

 Once residence is determined, Article 8 applies to allow taxation

only in that one state.

Paragraph 6: Article 8(4) on pooled operations still applies

"It should also be noted that the final paragraph..."

Explanation:

 This confirms that even after the 2017 changes, Article 8(4) still
allows states to tax profits from:

o Participation in joint ventures, international pools, or

operating agencies.

 These provisions remain unchanged.

Paragraph 7: Policy rationale for change in 2017

"The reason for the 2017 update..."

Explanation:

 The final paragraph explains why this shift happened:

o The effective management standard was difficult to apply.

o Enterprises could structure themselves to place EM in a low-

tax state, even if real economic activity occurred elsewhere.

 Moving to residence-based taxation under Article 8 helps avoid

tax planning and ensures clarity and fairness.
Let me know if you’d like:

 A comparison table of Article 8 pre-2017 vs post-2017,

 Simplified flowchart of how taxation applies under Article 8,

 Or examples of how a shipping/airline business would be taxed

under both versions.