Cost of funding in a Permanent Establishment: recognition of notional interest

Facts

A UK company operates a branch in the UAE that qualifies as a Permanent Establishment (PE) under the relevant tax definitions. The Head Office (HO) provides funds to the UAE Branch, which are then invested in financial instruments within the UAE.

These investments generated income. The funding of the Branch was not accompanied by any external borrowing, i.e. the Head Office did not take out a loan to finance the Branch’s activities.

The Company and its Branch are not engaged in banking or any other financial institution activities.

Questions

1. How should the income attributable to the Permanent Establishment in the UAE be determined?
2. For the purposes of such attribution, can the income generated through the Branch be reduced by a notional interest amount, calculated at arm’s length, i.e. as if the PE had borrowed the funds from the Head Office at a market-level interest rate?

Summary

Following a review of the applicable legislation and guidance, we find that:

• The treatment of interest in this case is straightforward: since no third-party borrowing occurred and the enterprise incurred no actual external interest expense, no interest on funds provided to the PE can be recognised or deducted.
• With respect to profit attribution, the analysis identifies five potential functional models ranging from a PE operating as a treasury centre to a purely nominal presence with no compensable internal dealing. The factual record in this case study is insufficient to conclusively select among these models. Each remains, in principle, a possible outcome depending on further evidence concerning Significant People Functions, control over risks, economic ownership of capital, location of personnel and assets, and the commercial rationale for the PE’s involvement. This case study therefore serves as a framework for analysis, rather than a definitive determination, and highlights the range of potential outcomes under the AOA given different factual scenarios.

Analysis

In Section 7.6.1 of the Corporate Tax Transfer Pricing Guide No. CTGTP1, the Federal Tax Authority (FTA) recognizes and permits the use of the separate entity approach, also known as the Authorised OECD Approach (AOA), for attributing profits to Permanent Establishments (PEs).

In Sec 7.6.2 of the Guide, “in situations where an issue is not addressed within this guide”, the FTA encourages “Taxable Persons … to refer to the 2010 report and the 2018 report on the attribution of profits to PEs issued by the OECD”.

The separate entity approach treats the PE as if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions. This requires a two-step process:

• first, a functional and factual analysis to identify the activities performed, assets used, and risks assumed by the PE and the Head Office, each considered as distinct parts of the enterprise; and
• second, the pricing of internal dealings between them on an arm’s length basis.

The methodology given in Section 7.6 of CTGTP1 follows the principles set out in the OECD PE Report 2010 and is fully aligned with international transfer pricing standards. While CTGTP1 does not address all aspects of profit attribution in the depth found in the OECD PE Report 2010, it expressly encourages taxpayers to undertake the detailed, two-step analytical process developed under the AOA.

The considerations below set out the key elements under the AOA for such transactions and illustrate, in broad terms, the possible functional models that may emerge from their application.

The first step in attribution the profits involves conducting a Functional Analysis to identify the activities performed by the PE on one side, and the head office on the other side, treating each as separate to the other.[1]

Under the OECD Authorised Approach and FTA’s guidance in Sec. 7.6.2 of CTGTP1, the characterization of a transaction in which capital is the subject must reckon with:

• Significant People Functions (SPFs) relating to capital, i.e. determining who makes decisions on the acquisition, deployment, and management of capital, including investment strategy, allocation, and risk assumption.
• Control over risks associated with capital, that is identifying which entity actually controls and bears the risks tied to the holding or deployment of capital, such as market risk, liquidity risk, counterparty risk, and operational risk.
• Attribution of economic ownership with assessing where the economic ownership of the capital resides, which depends on the location of SPFs and the ability to manage and control risks regardless of legal title.
• Supporting and auxiliary functions, that is distinguishing substantive functions that influence return generation from purely administrative or facilitation activities, which under the AOA may warrant only a limited, cost-based remuneration.
• Location of assets and people, i.e. establishing whether the assets and the people performing relevant functions are physically located in the PE jurisdiction, as opposed to being directed or executed entirely from the Head Office.
• Commercial rationale for PE involvement with considering whether the PE’s formal role in the capital-related transaction is commercially necessary or purely administrative/formalistic to meet regulatory or procedural requirements.

Based on these factors, a PE dealing with capital can, in principle, operate under different functional models. For instance:

• Model 1: PE as a treasury function on behalf of Head Office.

In this model, the PE manages surplus funds belonging to the enterprise on behalf of Head Office. It places deposits, manages liquidity, negotiates terms with financial institutions, and ensures alignment with group treasury policies. The PE controls and bears the risks associated with these funds, has operational authority, and undertakes the SPFs related to capital deployment. Under the AOA, such a PE would generally be allocated a substantial share of the profit from managing the funds, reflecting its economic ownership of the capital during the placement period.

• Model 2. PE conducting its own investment business, with Head Office treasury securing funds

Here, the PE already operates an investment or capital-intensive business in its jurisdiction and requires funding to develop or expand these activities. Head Office’s treasury function is responsible for sourcing, securing, or reallocating the necessary funds and making them available to the PE.

The internal dealing in this case is the provision of funds from Head Office to PE for the PE’s own business activities. The PE assumes the commercial risks and performs the SPFs over the use of the funds, while Head Office treasury earns a return commensurate with its role in arranging and providing the financing.

This differs from Model 1 in that here the PE is not acting as the treasury for Head Office. Instead, Head Office is enabling the PE’s own investment activities by supplying it with capital. i.e. Head Office performs treasury fuctions.

• Model 3. Hybrid or Delegated Treasury Models

In this model, certain treasury functions are split between Head Office and PE. The PE may have authority over day-to-day or short-term cash management, local deposit placement, or liquidity adjustments, while Head Office retains control over strategic investment decisions, capital allocation, and major risk assumptions. Profit attribution would be split based on the respective SPFs, risk control functions, and economic ownership of funds between Head Office and PE.

• Model 4. Head Office providing treasury functions to a passive or administrative PE.

Head Office retains full strategic and operational control over capital-related decisions, while the PE’s role is limited to formal, administrative, or local compliance functions. The PE does not exercise any SPFs over capital, nor does it bear any financial, operational, or compliance risk.

Any internal dealing recognition (if allowed) would be confined to a cost-plus return for low value-adding support services, consistent with Sec. 7.2.3.5 of CTGTP1 safe harbor provisions. This model results in the smallest profit allocation to the PE, typically unrelated to the returns on the capital itself.

• Model 5. Head Office with no compensable internal dealing due to lack of functional contribution by PE.[2]

In this model, the PE performs no SPFs over capital and undertakes no economically significant activity within its jurisdiction. All decision-making, capital deployment, and risk control are handled exclusively by the Head Office, with no involvement from the PE in initiating, managing, or executing the transactions. Any local role is purely formalistic (akin to a nominee or postbox function) serving only to meet procedural or documentary requirements.

Under the AOA, an internal dealing can only be recognised if it is supported by actual functions performed, assets and people located in the PE’s jurisdiction, and control over relevant risks. Where none of these conditions are met, no internal dealing should be recognised. Consequently, no profit (whether interest, fee-based, or otherwise) should be allocated to PE. Instead, all returns from the capital-related activity remain attributable to the Head Office, which performed all economically significant functions and bore all associated risks.

While Model 4 recognizes a minimal cost-plus return for low value-adding support services performed locally (such as contract hosting, administrative facilitation, or compliance activities), Model 5 applies where even those support functions are absent or are performed entirely outside the PE’s jurisdiction. In Model 5, the PE’s local presence is purely nominal, with no on-the-ground personnel or functions contributing to the activity, and therefore not even cost-based remuneration is warranted.

In the present case study, the factual record does not permit a conclusive selection among these models. Each remains, in principle, a possible characterization, and the appropriate attribution would depend on a more granular factual examination of the functions performed, assets used, and risks assumed, consistent with the AOA framework and the principles outlined above. The discussion here is intended to illustrate the range of potential outcomes rather than to prescribe a definitive attribution for the case at hand.

[1] CTGTP1, Sec. 7.6.2.

[2] OECD Report 2010, para. 153.

Notional interest deduction in the absence of external debt

The second question in this case study concerns whether the income generated through the Branch could be reduced by a notional interest charge, computed at an arm’s length rate, under the assumption that the PE borrowed the funds from the Head Office, even where no actual loan or external interest-bearing debt exists.

A key feature of the AOA as it applies to funding costs is that it moves the focus away from the recognition of dealings as such to a wider consideration of determining an allowable interest deduction for the permanent establishment. The objective of the AOA is to establish, using one of the authorised approaches described below, an arm’s length amount of interest in the PE, commensurate with the functions, assets and risks attributed.[1]

OECD recognises that “movements of funds between parts of the enterprise do not necessarily give rise to dealings”. Nevertheless, there would be circumstances where they “could be recognized as internal interest dealings within non-financial enterprises, for the purposes of rewarding a treasury function”.[2]

There are two approaches authorised in 2010 Report “for attributing the external interest expense of the enterprise to its permanent establishment”:[3]

• The tracing approach.

Under a pure tracing approach, any internal movements of funds provided to a PE are traced back to the original provision of funds by third parties. The interest rate on the funds provided to the PE are determined to be the same as the actual rate incurred by the enterprise to the third party provider of funds.

A tracing approach could, in certain circumstances, be evidenced by internal dealings that allocate the actual interest expense of the enterprise to the PE.

• The fungibility approach.

Under a pure fungibility approach, money borrowed by a PE of an enterprise is regarded as contributing to the whole enterprise‘s funding needs, and not simply to that particular PE‘s funding needs. This approach ignores the actual movements of funds within the enterprise and any payments of inter-branch or head office/branch interest. Each PE is allocated a portion of the whole enterprise‘s actual interest expense paid to third parties on some pre-determined basis. Hence, there would be no need under a fungibility approach for any recognition of internal interest dealings.

Both of these approaches are premised on the recognition of actual interest expense paid to third parties, rather than on the creation of a purely notional internal interest charge. Consequently, where no such third-party borrowing exists, neither the tracing nor the fungibility approach would yield any interest allocation to the PE.

The above interpretation is supported by the tax authorities in jurisdictions which also adhere to AOA.

For instance, the Inland Revenue Department in Hong Kong in its Interpretation and Practice Note No. 60 of July 2019 clarifies:

• “The transfer of capital against the payment of interest and an undertaking to repay in full at a future date does not fit with the true legal nature of a permanent establishment.
• Where no business of banking is involved, internally charged interest is non-deductible to a permanent establishment apart from the cost of funds incurred when borrowed from third parties and used in the permanent establishment’s business” (para 67).
• “Special considerations apply to payments of interest made by different parts of a financial institution to each other on advances. Making and receiving advances are closely related to the ordinary business of such enterprises so market interest rates may be acceptable” (para 68).
• “The notional interest and other borrowing costs applicable to the permanent establishment loan capital requirement should be derived mainly from the actual terms, including interest rates and other charges, of actual loans borrowed by the non-Hong Kong resident person and permanent establishment. Other factors may then require adjustment such as where the actual loan currency differs from the functional currency of the permanent establishment” (para 77).

In para 3.43 of Taxation Ruling TR 2001/11 the Australian Taxation office sets out that “intra-entity interest charges between a PE and its head office or another PE are recognised under Australia's PE attribution rules only for purposes of attributing to the PE interest expense of the entity on borrowing's from third parties”. Thus:

• “If the entity borrows funds through its head office and those funds are transferred to a PE for its use, a notional interest charge made by the head office to the PE may be recognised to attribute to the PE the amount of interest payable to the third party lender.
• On the other hand, if there is no actual interest cost to the entity attaching to the funds transferred (i.e., if the funds are internally generated rather than borrowed from a third party), then there is no interest expense to be attributed to the PE, and hence no notional interest charge can be recognised between head office and PE”.

In Japan, deductibility is denied for interest expenses on funding or on royalty payments from use of intangible assets provided by head office (or another PE).[4]

In Sweden, the “courts have established that foreign headquarters and a Swedish permanent establishment cannot enter into a loan agreement, and therefore, the permanent establishment cannot deduct interest paid to the foreign headquarters”.[5]

The above comparative review of jurisdictions applying the AOA underscores a consistent principle: where no actual third-party borrowing exists, and the enterprise has not incurred an external interest expense, internal notional interest charges between a Head Office and its PE are not deductible.

In the present case, the capital provided to the PE is internally generated, and no external cost of funds can be traced or proportionally allocated. Consequently, any recognition of internal interest would lack both legal and economic basis.

[1] OECD Report 2010, Para. 152.

[2] Ibid.

[3] Ibid.

[4] https://www.pwc.com/jp/en/tax-focus-on/assets/attribution-of-profit-to-permanent-establishments-asia-overview.pdf

[5] Antonio Faúndez Ugalde, “Control of Expenses Computed by Permanent Establishments under the OECD Model Agreement”, Tax Administration Review CIAT/AEAT/IEF No. 30, p. 67.

The disclaimer

Pursuant to the MoF’s press-release issued on 19 May 2023 “a number of posts circulating on social media and other platforms that are issued by private parties, contain inaccurate and unreliable interpretations and analyses of Corporate Tax”.

The Ministry issued a reminder that official sources of information on Federal Taxes in the UAE are the MoF and FTA only. Therefore, analyses that are not based on official publications by the MoF and FTA, or have not been commissioned by them, are unreliable and may contain misleading interpretations of the law. See the full press release here.

You should factor this in when dealing with this article as well. It is not commissioned by the MoF or FTA. The interpretation, conclusions, proposals, surmises, guesswork, etc., it comprises have the status of the author’s opinion only. Furthermore, it is not legal or tax advice. Like any human job, it may contain inaccuracies and mistakes that we have tried my best to avoid. If you find any inaccuracies or errors, please let us know so that we can make corrections.