General Guidelines for the Attribution of Income to Permanent Establishment

This is an unofficial translation. The official instruction (record number VH/8407/00.01.00/2020) is drafted in Finnish and Swedish languages.

These guidelines address, at a general level, the attribution of income of a nonresident foreign corporate entity to its permanent establishment in Finland.

The guidance is updated as of 1 January 2021 due to an amendment in section 9 of the act on income tax. As section 9, subsection 1 is now amended, the tax authority will treat a foreign corporate entity as a tax resident of Finland if the entity’s place of effective management is in Finland. Section 9 of the act on income tax came into force on 1 January 2021 as amended, and the first tax year when section 9 is applied is the 2021 tax year. For more information on how a foreign corporate entity’s tax residency status and the location of its place of effective management are determined, see the Tax Administration guidance on Resident and non-resident corporate taxpayers.

1 Foreword

A nonresident foreign corporate entity with a permanent establishment in Finland must pay taxes to Finland on the income received by the permanent establishment. The income of a permanent establishment is defined by the ‘arm’s length principle’, derived both from Finland’s internal legislation and tax treaties between states. 

In the interpretation of tax treaties, the OECD Commentary of the Model Tax Convention (Model Tax Convention on Income and on Capital), OECD Report on the Attribution of Profits to Permanent Establishments, 2008 and 2010; OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, and supplementary BEPS report are applied¹. The above-mentioned OECD guidelines have been used in the preparation of these guidelines.

The starting point of the OECD’s attribution report is the specification of income attributed to a permanent establishment as a two-step process. During the first step, a functional and factual analysis is performed, in which the operations and responsibilities of a permanent establishment are determined so that the permanent establishment can be assessed for taxation as an independent, separate enterprise. During the second step, the arm’s length profit of the permanent establishment is determined by means of a comparability analysis.

In this guideline, the attribution of income is addressed in accordance with the principles presented in the attribution report by the OECD. The functional and factual analysis is reviewed on a general level, as well as the preparation of a comparability analysis. At the end of the guidelines, the attribution of income to a permanent establishment is demonstrated through simple examples.

Special features of permanent establishments in the financial and insurance field are not addressed in these guidelines.

The constitution of a foreign corporate entity’s permanent establishment has been discussed in the Tax Administration guidelines: Income taxation of nonresident foreign corporate entities.

¹ OECD/G20 Base Erosion and Profit Shifting Project: Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10-2015 Final Reports

2 Rule of law

2.1 Finland’s internal legislation

According to the Income Tax Act (Tuloverolaki (TVL) 1535/1992) section 9 (1) sub-section 2, a nonresident foreign corporate entity must pay taxes on income obtained here (limited tax liability). According to TVL 10 (1) sub-section 2, income obtained from Finland is, among other things, income obtained from Finland from a business activity practised here. If the nonresident foreign corporate entity has a permanent establishment for engaging in business activity in Finland in accordance with TVL 13 a, the corporate entity must pay taxes on all income respective to the income belonging to the permanent establishment (TVL 9 (3)).

The taxable income from the permanent establishment of the nonresident foreign corporate entity is calculated in a manner similar to that of the taxable income of a Finnish limited liability company. In calculating the taxable income from a permanent establishment practising a business activity, the Finnish Business Tax Act (Laki elinkeinotulon verottamisesta (EVL) 24.6.1968/360) is applied. All proceeds generated from the operations of a permanent establishment are regarded as the income from the same. Interest charges, dividends, royalties and capital gains are also regarded as income. Expenses incurred by the acquisition and maintenance of permanent establishment income are, for their part, deductible.

In the determination of permanent establishment income, the ‘arm’s length principle’ must be observed as provided in the Act on Assessment Procedure (Laki verotusmenettelystä (VML) 18.12.1995/1558), section 31. The ‘arm’s length principle’ refers to the obligation of associated enterprises (companies of the same group), in accordance with Act on Assessment Procedure § 31.1, to observe terms and conditions in joint transactions which mutually independent parties in similar situations would have otherwise agreed to. According to the Act on Taxation Procedure § 31.3, what is legislated in sub-section 1 should also be observed in the dealings between the enterprise and its permanent establishment.

2.2 Tax treaties

Finland has a tax treaty with respect to income tax with over 70 nations. The tax treaties can restrict but not expand the right to taxation based on Finland’s national legislation. Finland’s tax treaties are primarily based on the OECD (Organisation for Economic Co-operation and Development) Model Tax Convention. In the OECD Model Tax Convention, the taxation of permanent establishment business income is specified in Article 7.

In taxation and judicial procedures, it is deemed possible to use the OECD Commentary of the Model Tax Convention when interpreting tax treaties (for a court ruling discussing this matter, see case KHO:2002:26 of the Supreme Administrative Court). In the interpretation of tax treaties, the OECD Report on the Attribution of Profits to Permanent Establishments and OECD transfer pricing guidelines are used as adjuncts to the OECD Commentary of the Model Tax Convention. The Supreme Administrative Court of Finland has determined that, when the terms and conditions of an implemented transaction are examined in terms of the ‘arm’s length principle’, OECD transfer pricing guidelines-compliant arm’s length principle assessment methods must be regarded as significant interpretation sources (KHO:2013:36 and KHO:2014:119). According to the OECD transfer price guidelines, however, the interpretation-steering impact must only be examined within the sphere of application of the legislation on transfer pricing. Conversely, the transfer pricing guidelines do not have this kind of regulation-based sphere of application-expanding impact, when taking into consideration the requirement of the existence of  a proper legal basis (KHO:2014:119). In the case of the Supreme Administrative Court (KHO:2016:72), it has been noted that the attribution report and the OECD’s transfer pricing guidelines have a similar position in determining permanent establishment income.

The positions connected with the interpretation of Article 7 in the attribution report issued on 17/07/2008 were included in the OECD Commentary of the Model Tax Convention for the 2008 update. The commentary was further elaborated in this respect only to the extent that the attribution report would not conflict with the earlier commentary version. In 2010, the OECD amended Article 7 of the Model Tax Commentary, with respect to which the OECD Commentary of the Model Tax Convention was also updated, as was the attribution report. The OECD Commentary of Model Tax Convention 2010 can be applied only to those tax treaties that contain the amended Article 7, in compliance with the new Model Tax Convention.

2.3 The ‘arm’s length principle’ and the separate entity approach

In section 1 of Article 7 in the Model Tax Convention, the right of taxation between the country of residence and income source country is determined. According to the section concerned, business income is taxed only in the income recipient's country of residence if the operations are not conducted from a permanent establishment located in another contracting state. In the section pertaining to Article 7 (2) of the Model Tax Convention, income attributed to the permanent establishment in accordance with the arm’s length and separate entity approach is defined. According to Article 7 (2) of the Model Tax Convention, that share of the corporation’s income and expenditure is attributed to the permanent establishment which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions. The definition corresponds to the arm’s length principle in Article 9 of the Model Tax Convention, which is applied to transactions between associated enterprises. Under the separate entity approach, it is intended that a permanent establishment should be considered as a separate entity from the head office for the purpose of taxation. As a result, a permanent establishment can generate a profit, even if the company as a whole were to generate losses or, correspondingly, income does not necessarily belong to the permanent establishment, even if the business enterprise as a whole were to generate a profit.

The starting point for the attribution of income is the so-called ‘direct method’, in accordance with Article 7 (2). According to Article 7 (4) of the Model Tax Convention of 2008, income can also be attributed to the permanent establishment by distributing the company’s total income amongst the various sections of the enterprise. In most tax treaties concluded in Finland, there is mention of the option to use the so-called ‘indirect method’. When using the indirect method, however, the direct method must be resorted to in order to obtain an arm’s length result. The section concerned has been removed from the 2010 version of the Model Tax Convention. According to the 2010 OECD Commentary of the Model Tax Convention, the section was removed from the new Model Tax Convention because it is very challenging to ensure arm’s length outcome, when applying the indirect method.

2.4 Required Documentation

The documentation obligation with regard to transfer pricing is prescribed in the Act on Assessment Procedure, sections 14 a – 14 c.

Documentation of transfer pricing refers to a written explanation by the taxpayer concerning the pricing of transactions between associated enterprises. The documentation obligation also concerns transactions by the permanent establishment in Finland, as well as dealings with the head office. The foreign enterprise and its permanent establishment located in Finland must prepare the same kind of documentation which the independent company would prepare under similar circumstances in which the operations would be practised under a separate enterprise, and this separate enterprise would have transactions with the foreign associated enterprise. Additionally, the permanent establishment located in Finland must document cross-border transactions with other associated entities.

The documentation obligation pertaining to the permanent establishment is not, however, applied to operations between a domestic company and its permanent establishment located abroad. Transfer pricing documentation is addressed in Transfer pricing documentation in the guidelines of the Tax Administration (available in Finnish and Swedish, link to Finnish).

3 Functional and factual analysis

3.1 Purpose of the functional and factual analysis

According to the OECD’s attribution report, the first step of income attribution is the completion of functional and factual analysis. The permanent establishment is defined as a separate entity through functional and factual analysis. The second step of income attribution is the performance of a comparability analysis. In a comparability analysis, the comparability of the comparables is assessed with the help of performed functional and factual analysis. This being the case, the functional and factual analysis has the same purpose as the OECD’s transfer pricing guidelines prepared for transactions between associated enterprises. The transfer pricing guidelines can also be utilised in the applicable sections when preparing functional and factual analysis for the permanent establishment.

In the functional and factual analysis, information is collected on the operations of the company and its permanent establishment, facts and circumstances; as well as on which of the company’s economically significant functions and responsibilities belong to the permanent establishment. According to the OECD attribution report, the purpose of a functional and factual analysis is to identify and attribute the permanent establishment’s:

• functions
• risks
• assets
• capital
• transactions with associated enterprises
• transactions with external companies
• dealings with the head office 

In preparation of the functional and factual analysis, attention should be paid to documents connected with the permanent establishment, such as the employees’ employment contracts and permanent establishment accounting. It should be noted that these documents should match the factual situation, so that they can be used in the formulation of the functional and factual analysis. To enable allocation of the functions that actually belong to a permanent establishment, the functions that the company’s other sections engage in should also be clarified. The preparation of a successful functional and factual analysis requires a description of the company’s business activity that is broader in scope than from the perspective of a permanent establishment alone. The following questions can be asked during the preparation of a functional and factual analysis:

• What is the role of the principal company and Finland’s permanent establishment in the entire Group?
• Which functions exist in the head office?
• Which functions are located in the permanent establishment?
• What are the duties, authorities and responsibilities of the head office employees?
• What are the duties, authorities and responsibilities of the permanent establishment’s employees?
• What decision-making is actually performed in the head office in connection with pivotal risks from the perspective of the business activity and, conversely, which are performed at the permanent establishment?
• To whom does the permanent establishment sell goods and/or offer services?
• From whom does the permanent establishment purchase goods and/or services?
• Which assets does the permanent establishment use, and how are the assets concerned linked with its operations? Who owns the assets?

By means of functional and factual analysis, the permanent establishment can be assessed in taxation as a separate enterprise. Although for the purpose of taxation a permanent establishment is addressed as a separate enterprise, judicially speaking all functions, risks and assets belong to the enterprise as a whole, because a permanent establishment is not an independent legal entity. According to the attribution report, the allocation of functions, risks and assets to a permanent establishment occurs on the basis of the functions performed by the company’s personnel. The tasks performed by the company’s personnel are in a pivotal position that have significance from the perspective of the constitution of the company’s income. These operations are termed significant people functions. Above all, significant people functions refer to the employees at the company who make decisions from the perspective of the company’s business activity relative to pivotal risks.

3.2 Functions

The goal of the functional and factual analysis is to specify the functions actually engaged in at a permanent establishment. The starting point in identifying functions concerns those functions on whose basis the permanent establishment is regarded as having been constituted. When a permanent establishment is constituted through a fixed place of business, functions that are conducted from there belong to the named permanent establishment. In constituting a permanent establishment on the basis of a dependent agent, those functions are included in the permanent establishment which are connected to the operations of a dependent agent's functions, including those of the head office.

Functions respective to the business activity of the companies could be, e.g. manufacture, marketing, sales, transport, storage, product development and financial management. Management of an enterprise or part of it is also regarded as a business activity. The allocation of functions into various parts of an enterprise occurs on the basis of the employees performing the functions concerned. The function belongs to that section of the enterprise in which the person who performs it is located. With regard to functions, the components included in each one should also be itemised. If, in connection with the functional and factual analysis, it is demonstrated that sales are conducted, for example, at the permanent establishment, clarification should also be obtained on which employees are responsible for the various steps of each sales process concerned. These steps may include, for instance, contact with customers, the preparation of tenders, making contracts, invoicing, post-marketing, and maintenance operations.

3.3 Risks

In connection with the functional and factual analysis, the risks borne by the company are defined, as well as how they are allocated within the company. The distribution of risks affects the income expectation with regard to the various parts of the company: the part to which the risk applies also bears the risk in terms of profit or loss. Typical risk-related entrepreneurial activities include price-, product range-, product liability-, credit- and foreign currency-related risk, as well as general market risk. The allocation of risks between parts of a business enterprise occurs on the basis of significant people functions. Those risks are regarded as allocated to a permanent establishment whose decisions concerning control (risk-taking, lay off the risk, risk minimising) can actually be made by the permanent establishment personnel, and they also make them.

The distribution of risks in the OECD attribution report is described by means of examples. For instance, inventory risk can be regarded as allocated to that part of an enterprise in which decisions are actively made with regard to inventory. On the other hand, credit risk generally applies to that part of the enterprise in which the customer’s creditworthiness is examined before signing a sales agreement. If these functions are performed in various parts of the enterprise, so that a creditworthiness review occurs in a permanent establishment and the sales contract is signed separately in the head office, a functional and factual analysis should be used to determine whether the decision to take a credit risk is made in the permanent establishment or offered only to the head office for support services, whereby the head office bears the credit risk.

3.4 Assets

According to the separate enterprise principle, balance sheet assets should be attributed to the permanent establishment. The judicial owner of assets in the operations of a business enterprise is the enterprise, even if assets are used only in a certain part of the enterprise. The allocation of assets amongst various parts of the enterprise is therefore not based on judicial ownership, but on economic ownership. The expenditure incurred by the financial owner of the assets as well as, for example, profit obtained from sales apply to the financial owner of the assets.

According to the OECD attribution report, the economic ownership of tangible assets can be defined in accordance with the significant people functions or use of assets. According to the significant people function specification, that part of the enterprise where decisions concerning the procurement and the use of assets are made can be regarded as specific to the economic owners of the assets. Economic ownership defined in accordance with the use of assets refers to the fact that the economic owner of production machinery, for instance, is a permanent establishment in the event that the machine concerned is used at the permanent establishment for the manufacture of products. In this respect, the permanent establishment can deduct depreciation from the production machinery in the permanent establishment's taxation, and the capital gain obtained from selling the machine can be regarded as belonging to the permanent establishment.

The income derived from the use of the assets does not necessarily belong to the economic owners of the assets. If the permanent establishment acts only as a service provider comparable to a contract manufacturer for the head office, the income obtained from the sale of products does not belong to the permanent establishment, even if the permanent establishment is the economic owner of a machine used in the manufacture of the product. This being the case, the sales revenues from the products belong to the head office in the event that the functional and factual analysis shows that significant  people functions connected with selling the product are performed at the head office. In this situation, arm’s length compensation intended for the head office is attributed to the permanent establishment for services rendered.

The question of whether intangible property is to be attributed to the permanent establishment should also be determined in the functional and factual analysis. The attribution of intangible property to various parts of the company is also based on the determination of economic ownership with respect to property. Economic ownership is determined on the basis of significant people functions. The financial owner of intangible property represents that part of the enterprise where decisions on the development and procurement of intangible property are actively made, as well as the related risk-taking and administration.

The OECD Attribution Report does not separately mention how subsidiary shares are attributable to the branch. However, the attribution of shares as assets of the PE is mentioned in the Supreme Administration Court yearbook resolution KHO:2016:71. That decision concerned whether the subsidiary shares could be attributed to the Finnish branch of a foreign company, and if the interest on the procurement debt of these shares could be deducted from the profits of the branch.

According to the resolution, the functions and personnel of the subsidiary were transferred to the branch only to a minimal extent. Moreover, it was established that the representatives of the branch did not wield the authority of the subsidiary. Rather, it was concluded that this authority belonged to the board of directors of the head office or the parent company of the corporation. The shares of the subsidiary could not be allocated to the permanent business activities of the branch, and thus could not be regarded as funds belonging to the branch. Therefore, nor the debt from the share acquisition or the deductions on the interest rate of the debt could be allocated to the subsidiary. This being the case, the attribution of subsidiary shares as assets of the permanent establishment is performed in compliance with the same principles as the attribution of other assets, and significant people functions play a significant role in this attribution. As a starting point, the attribution of subsidiary shares to a permanent establishment thereby requires that the significant people functions linked with the ownership of the shares are located in the permanent establishment. When assessing the attribution of subsidiary shares to a permanent establishment, the regulation on tax evasion in section 28 of the Act on Taxation Procedure should also be taken into consideration in the matter (see, e.g. SC 2016:72).

3.5 Capital structure and attribution of interest expenses

Enterprises require capital for the funding of daily entrepreneurial activities, the acquisition of assets and the upkeep of expenses incurred, as well as for bearing the risks associated with business activity. The starting point of the OECD attribution report is that capital should also be allocated to the permanent establishment as support for its operations, as well as for assets applied and risks borne. In the attribution report, capital is divided into “free” and interest-bearing debt. In the report, “free” capital is referred to as capital on which interest is not paid. Interest-bearing debt is loan-based capital.

The attribution of free capital to a permanent establishment occurs in two stages. In the first stage, the risks are measured and the assets valued which are attributed to the permanent establishment. In the second stage the amount of free capital to support the risks and assets is determined. In the attribution report, various methods are described for the attribution of free capital in the permanent establishment. According to the attribution report, each method has its own strengths and weaknesses, which should be taken into account when selecting the method; no one method can be indicated as being applicable to all situations.

In the attribution report, two approaches are presented for the attribution of the external interest expenses incurred by the permanent establishment due to the company's interest-bearing debt – the tracing approach and fungibility approach. According to the tracing approach, the real interest on a loan, i.e. the interest which the company actually pays to the loan provider, is attributed to the permanent establishment. According to the fungibility approach,a part of the entire company’s actual interest expenses are attributed to the permanent establishment.

According to section 18 of the Business Income Tax Act (Laki elinkeinotulon verottamisesta 360/1968), interest on the debt derived from a business activity is deductible. Interest deductibility in the functions of the permanent establishment is linked with the connection of the debt to the business activity of the permanent establishment.

The OECD Commentary of the Model Tax Convention does not, as a rule, recognise the loans and interest between the company and its permanent establishment, because the permanent establishment is juridical part of the enterprise. The permanent establishment thereby cannot, as a rule, take a loan from the enterprise that it belongs to and then pay interest on the loan.

3.6 Transactions and dealings

The profit or loss of the permanent establishment is made up of all its activity as practised. This activity includes transactions with independent enterprises, transactions with associated enterprises, and dealings with the head office. In a functional and factual analysis, the transactions of the permanent establishment are thereby itemised alongside the independent and associated enterprises.

In addition, the functions of the permanent establishment, conducted alongside the head office, are recognised. The dealings between the company and its permanent establishment can be highly diverse. According to the OECD attribution report, dealings are constituted when, for example, a permanent establishment uses a service offered by the head office, or when the permanent establishment manufactures commodities for another part of the enterprise or sells commodities manufactured by the head office to a third party.

Transactions between associated enterprises always have juridical impacts. Instead, dealings between the enterprise and its permanent establishment are defined for taxation purposes only and assessments respective to them in civil law are non-existent. The dealings between the enterprise and its permanent establishment nevertheless have the same impact on the composition of the income of the permanent establishment as transactions between associated enterprises have on the constitution of their income.

In the transfer pricing guidelines, the starting point for the assessment of transactions between the associated enterprises is the contracts made between the enterprises. In the dealings between an enterprise and its permanent establishment, the starting point of assessment can be regarded as e.g. accounting materials and other internal documents in which the distribution of responsibilities within the company is depicted. Nevertheless, documentary evidence is not as important as the actions actually performed, which should become clear in the functional and factual analysis.

4 Comparability analysis

4.1 Preparation of comparability analysis

According to the OECD attribution report, arm’s length profit from a permanent establishment is specified in two steps. After the first step – i.e the preparation of the functional and factual analysis – permanent establishment arm’s length income is determined by means of a comparability analysis. In the comparability analysis, the price of dealings and transactions with the associated enterprises are specified. The purpose of the comparability analysis is to clarify whether the terms and conditions of the dealings and the transaction with associated enterprises have been of the type that would have been applied in similar business activities under independent circumstances. If the permanent establishment has no dealings alongside the company’s other parts or associated enterprises, there is no need for a comparability analysis.

OECD’s Transfer Pricing Guidelines contains instructions on the comparability analysis. The principles derived from the OECD’s Transfer Pricing Guidelines are used when making the comparability analysis of the permanent establishment.The Tax Administration has provided more extensive guidelines on the performance of a comparability analysis, in the guideline Siirtohinnoittelun dokumentointi. In addition, the matter has been discussed on the vero.fi website in the section “What is transfer pricing?”

The tested party should be selected for the purpose of performing a comparability analysis and depending on the transfer pricing method. ‘The tested party’ refers to the transaction party – e.g. the permanent establishment or head office – whose key figures, for instance the operating profit level, is tested. There is good reason to select the party for testing on the basis of a functional and factual analysis whose functions are simpler and whose operations are unrelated to unique intangible property. For the functionally less complicated party, it is normally easier to find comparables that engage in comparable operations. In clarifying the arm’s length principle in the operations occurring between a business enterprise and its permanent establishment, the tested party is therefore usually the permanent establishment. Not all transfer pricing methods require the selection of a party in order to be tested.

The first step of comparability analysis is the specification of potential comparables for a comparative transaction. The comparables can be internal or external. ‘Internal comparable means a comparable transaction between one party to the controlled transaction and an independent party. ‘External comparable means comparable transaction between two independent enterprises, neither of which is a party to the controlled transaction. According to the transfer pricing guidelines, the main goal is to perform a comparability analysis primarily by means of internal comparables, but if these are unavailable in practice, it is also possible to use external comparables.

External comparables can be sought from various sources, such as commercial databases, databases under development by companies, or public information. Information collected from an information source must always be of the kind that can be submitted to a tax official. Comparables cannot subsequently be based on confidential information, because all parties must be privy to the same information. Public information is available from sources such as annual reports, research studies and official sources that are publicly accessible. Public information reported to commercial databases has been compiled for corporate officials, such as the Finnish Patent and Registration Office.

When using databases, it should be noted that deficiencies may exist in their information content. For example, business descriptions, sector codes and shareholder information may be erroneous. A search result may include companies that are not valid for comparison and therefore should be supplemented with other public information, e.g. websites, when databases are used to search for comparables

Searching for comparables is always based on case-specific facts and conditions. For this reason, the search terms must be set so that the search generates sufficient comparables with regard to tested party. Comparables are primarily sought from the market region and field of the tested party. In the search terms for database searches, particular consideration must be taken of the functions, assets and risks of the comparables, as well as the market region. Validity for comparison must also be observed, as well as the scale of the enterprise and the economic circumstances. Generally comparables should not be selected from companies that are in the start-up phase or those whose financial result has been unprofitable for several inspection period years, or where the losses during a single year have been caused by exceptional circumstances such as the liquidation of the comparable. With regard to a low-risk company, references should have no losses per se with respect to the range of years concerned. In seeking comparison information, information pertaining to a period of several years should be used, so that it is possible to assess whether the comparables are similar in terms of the business activity cycle.

4.2 Transfer pricing methods

In the comparability analysis, the arm’s length principle with regard to transactions is verified by applying one of the transfer pricing methods described in the OECD transfer pricing guideline. Guidelines have been provided regarding methods and their applicability at vero.fi “Transfer pricing”. It is possible to apply any of the OECD transfer pricing methods,  but the perspectives presented on the application of methods in the OECD guidelines should be taken into account.

Comparable uncontrolled price method (“CUP”) compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. In order for the comparable uncontrolled price method to be applied, the markets, product, delivery chain steps, sales volume and other conditions of the companies being compared should be known and should be similar from the perspective of the transaction.

In the cost plus method, expenses linked with a transaction inside the Group with respect to goods or services, to which an arm´s lenght mark-up is added, are inspected. The arms`s lenght transfer price is comprised by the cost base and mark-up. The mark-up is compared to an internal or external reference. When using the cost plus method, the cost base should be assessed in a specific manner.

The resale price method examines the price which is used when a product that has been bought from one intra-group company is re-sold to an external client. The margin respective to the retailer is deducted from the retail sale price. The margin is compared to the internal or external reference, in order to ensure market conformity.

The profit split method determines the profit that has been created from the business activities practiced jointly by associated enterprises. Profit is distributed to the associated enterprises on economically acceptable grounds, such as parties that are independent would distribute generated profit from similar activity. The profit split method is appropriate for situations in which both parties are equal in terms of their functions, risks and assets.

When applying the transactional net margin method (“TNMM”), the net profit of the associated enterprise is examined in relation to a suitable base, i.e. the denominator. The denominator can be the company’s turnover, business costs or assets used in a business activity. By reference to the net profit and circumstances of the case, the relationship of a suitable denominator is compared with the net profit received under corresponding conditions and the relationship of the corresponding denominator. The TNMM method is highly suitable for situations in which the other party to the transaction is simpler than the other in terms of functions and risks. In many cases, a permanent establishment generates services routinely for the principal company, the latter being responsible for the most demanding functions and bearing the most pivotal risks. The benefits of the TNMM method also include the fact that reliable information can be found from public databases regarding the companies’ operating profit level.

5 Example situations

5.1 Foreword

In this section, the process of income attribution to the permanent establishment is illustrated by means of examples. The emphasis in these examples is not on the facts serving as the requirement for the creation of a permanent establishment, but rather on how income is allocated to the permanent establishment in the given situation. In the examples, a description is given of a business activity practised in Finland and the basis on which a permanent establishment has been constituted. A functional and factual analysis has been formulated on the basis of an activity practised in Finland. On the basis of the conclusions drawn from the functional and factual analysis, verification is obtained of whether or not there is a need for a comparability analysis and, if so, which parts are concerned. With regard to the benchmark study, conclusions are drawn on which search criteria should be taken into consideration, and what would be a suitable transfer pricing method for the case in question. The assumption is that transfer pricing methods other than those given in the example have proven to be inappropriate.

When checking the examples, it should be noted that the facts therein have been simplified: in reality, a broader and more thorough functional and factual analysis may be necessary..

5.2 Engaging in sales operations

Description of operations and constitution of the permanent establishment

Housewares Group sells and manufactures household items. Housewares Ltd is the parent company of the Group and it is located in country A. The products are manufactured in another Group company in country E. Housewares Ltd has a branch in Finland that sells items manufactured by the Group to retailers in Finland. There is a warehouse and office in Finland, where sale and purchase personnel as well as the branch manager work. The branch purchases products from the manufacturing company in country E. A permanent establishment is constituted for Housewares Ltd in Finland, compliant with Article 5.1 and 2 of the tax treaty on the basis of a fixed place of business

Functional and factual analysis

The functions are distributed as follows between a permanent establishment in Finland and country A.

Table of distributing functions

Functions	Country A	Finland’s permanent establishment
Management	X
Financial and Human Resources Management	X
Marketing and sales strategy creation	X	X
Responsibility for terms and conditions of sale as well as pricing	X	X
Customer meetings and product presentation		X
Upkeep of customer relations		X
Reception and handling of orders		X
Preparation of sales contracts		X
Procurement of goods for sale in Finland		X
Storage of goods for sale in Finland		X

Sale of goods with reference to significant people functions is located at the permanent establishment in Finland. The branch purchases products from a Group company in country E and is responsible for their storage and sales process. The branch has joint responsibility alongside the head office for the marketing and sales strategy, as well as the terms and conditions of sales and pricing. In addition to administrative functions, the senior operational and strategic management is concentrated in the head office. Risks associated with business activity – market risk, credit loss risk and inventory risk – are borne by the permanent establishment in Finland. For example, the marketing risk is split between the head office and the permanent establishment.

Benchmark study

Because the permanent establishment acts as an independent, full-risk sales company, it accrues the sales revenue from products sold in Finland. Since it purchases products from a Group company, it engages in transactions with the associated enterprise. It also uses marketing and sales services offered by the head office, as well as administrative services: i.e. it engages in dealings with the head office. Transactions with the associated enterprise and dealings should be arm’s length. If no other method is available for definition of the the arm’s length price of transactions and dealings, the arm’s length result of the permanent establishment can be determined using the transactional net margin method, in which operating profit is divided by turnover.

For the purpose of benchmark study, enterprises practising sales operations are sought from the database, where the public financial statements of European companies have been compiled alongside other information on enterprises from commercial registers, for example.

When seeking a benchmark group, the following search criteria are applied among others:

• enterprises that do not belong to the Group
• search period: the last three years for which financial statements can be found
• Finnish/Nordic enterprises
• operations well-established, enterprises that have just begun operating are not included
• sector: wholesale of household goods (NACE Rev. 2 sector code 471)

Enterprises that deviate considerably from the permanent establishment, as well as enterprises with regard to which information cannot be found have been excluded the search. In the case of the example, enterprises found using a benchmark study can be restricted on the basis of turnover, as well as by eliminating enterprises that have significant intellectual property.

It is assumed that the final benchmark group found for the permanent establishment in the example includes seven enterprises, in accordance with the table given below. The median of operating margins’ average in the reference group is 8.6 per cent during the inspection period.  The range of average values of the benchmark group is 3.4–14.6% as well as the interquartile range, i.e. the range in which 50% of the values is 3.8–14.0 per cent.

Operating margin
Benchmark group	Average	Year 3	Year 2	Year 1
Enterprise 1	3,4	3	2,3	5
Enterprise 2	3,8	2,3	8	1
Enterprise 3	14,6	12,4	22,6	8,9
Enterprise 4	8,6	9,5	6	10,3
Enterprise 5	14,0	10,7	9,7	21,5
Enterprise 6	12,9	15,8	11,7	11,2
Enterprise 7	8,1	8,1	10,1	6,1

 

Highest value	14,6
Top quartile	14,0
Median	8,6
Bottom quartile	3,8
Lowest value	3,4

Verification of arm’s length price

One point is selected in the range as an indicator of the arm’s length point. In the example case, median can be regarded as the indicator of an arm’s length point if no other point can be indicated in the range that would be more suitable for the circumstances in question. This being the case, the arms’ length operating margin of the permanent establishment is 8.6%.

5.3 Sales service provision

Description of operations and constitution of the permanent establishment

Retail Company Ltd is situated in country B. The company purchases grocery items from the parent company of the Group in country F, which it sells onwards to external retail merchants in Finland, for example. The company has an office in Finland, where two sales persons are employed. A permanent establishment in Finland is constituted for the company on the basis of article 5.1 and 2 of the tax treaty.

Functional and factual analysis

The functions are divided as follows between the permanent establishment in Finland and country B.

Functions	Country B	Finland’s permanent establishment
Management and administration	x
Marketing and sales strategy creation	x
Preparation and pricing of sales contracts	x
Search for and contact with customers		x
Customer meetings and product presentation		x
Upkeep of customer relations		x
Reception of orders and formal complaints		x
Handling of orders and concluding contracts	x
Delivery of goods	x
Storage	x

Sales promotion is practised from a permanent establishment in Finland. The employees at the permanent establishment seek new customers, demonstrate products and receive orders. The important significant people functions connected with the sale of products – such as the creation of a sales strategy, handling of orders and co-signing of sales contracts – are located in the head office. The pivotal risks linked with business activities such as market, credit and inventory risk are also borne by the head office. The activity performed by the permanent establishment in Finland concerns sales-promoting services in association with the head office.

Benchmark study

The head office handles the sale of products, and sales revenues from products are allocated to it. Compensation for the sales promotion services provide should be attributed to the permanent establishment. The arm’s length profit of the permanent establishment is determined on the basis of a benchmark study by means of the transactional net margin method, in which the permanent establishment’s operating profit is divided by the costs of the operating costs.

For the purpose of a benchmark study, enterprises offering low-risk sales services are sought from the database, in which public financial statements from European businesses as well as other corporate information – from local commercial registers, for instance – are collected.

When seeking a reference group, search criteria such as the following are applied:

• enterprises that do not belong to the Group
• search period: the last three years for which financial statements can be found
• Finnish/Nordic enterprises
• operations that are well-established; enterprises that have just begun operating are not included
• sector: sales service (NACE Rev. 2 sector codes 461)

Enterprises substantially deviating from the permanent establishment are eliminated from the search by setting conditions on factors such as turnover, total number of personnel and size of inventory. Companies that do not yield information with regard to their activity and enterprises that are unprofitable are eliminated from the benchmark group, because companies that engage in limited-risk operations do not generally operate at a loss.

It is assumed that the final benchmark group in the example found of a permanent establishment include 10 enterprises whose net cost-plus margin (operating profit/total operating costs) based median of average values is 9.3 per cent and whose interquartile range is 6.5–15.7 per cent during the inspection period.

Verification of the arm’s length price

One point is selected in the range as an indicator of the arm’s length point. In the example case, median can be regarded as the indicator of an arm’s length point if no other point can be indicated in the range that would be more suitable for the circumstances in question. This being the case, the permanent establishment’s arm’s length net cost-plus margin level is 9.3 %.

5.4 Building service provision

Description of operations and constitution of the permanent establishment

Installation Services Ltd manufactures and installs modular elements for the construction of buildings. The company’s headquarters and factory are located in country C. The company installs the elements in Finland on the work site of the Finnish principal. The building elements are manufactured at the company’s factory in country C. Employees who perform installation work do so in Finland, where the site management and supervision staff are also located. A permanent establishment is constituted for the company in accordance with Article 5.3 of the tax treaty, on the basis of the duration of the installation work.

Functional and factual analysis

The functions are divided between Finland’s permanent establishment and country C as follows:

Functions	Country C	Finland’s permanent establishment
Installation work		x
Installation management and work supervision		x
Installation project planning and management	x
Contractual negotiations and co-signing of contracts	x
Manufacture of modular elements and related site management	x
Transport of modular elements	x

The installation work and the related site management as well as work supervision are performed at the permanent establishment in Finland. Significant people functions concerning the planning and implementation of the installation project and the manufacture of elements are located in the head office. All risks with regard to business activity are borne by the head office. In the first instance, the permanent establishment bears the risk associated with the activities of employees. The income of the permanent establishment derives from the element installation service provided to the head office.

Benchmark study

The head office is responsible for the installation project and sales revenue is allocated to head office. Compensation should be paid to the permanent establishment for services provided to its head office. The permanent establishment’s arm’s length profit is determined on the basis of a benchmark study using the transactional net margin method, in which the operating profit of the permanent establishment is divided by the operating costs.

For the purpose of a benchmark study, enterprises offering low-risk building services are sought from the database, where the public financial statements of European companies as well as other corporate information – such as local commercial registers – have been collected.

In seeking a benchmark group, search criteria such as the following are applied:

• enterprises that do not belong to the Group
• search period: the last three years for which financial statements can be found
• Finnish/Nordic enterprises
• operations that are well-established; enterprises that have just begun operating are not included
• sector: building services (NACE Rev. 2 sector codes 332, 412, 433)

Enterprises substantially deviating from the permanent establishment are eliminated from the search by setting conditions for factors such as turnover, total number of personnel and size of inventory. Those companies whose operations do not yield information, as well as enterprises that are unprofitable, are eliminated from the benchmark group, because companies that engage in limited-risk operations do not generally operate at a loss.

It is assumed that the final benchmark group found for the permanent establishment in the example includes 8 enterprises whose net cost-plus margin (operating profit/business activity costs-) based median of average values is 7.6 per cent, and whose interquartile range is 4.7–13.5 per cent during the inspection period.

Verification of arm’s length price

One point is selected in the range as an indicator of the arm’s length point. In the example case, median can be regarded as the indicator of an arm’s length point if no other arms’ length point can be indicated in the range that would be more suitable for the circumstances in question. This being the case, the permanent establishment’s arm`s length net expenditure cost-plus allowance level is 7.6 %.

5.5 Engaging in construction activity

Description of operations and constitution of the permanent establishment

Raksa Ltd is registered in country D. The company engages in building activity in Finland at various construction sites. P – a member of the company’s Board of Directors – resides permanently in Finland and is the company’s only permanent employee. P manages the company’s operations, makes contractual agreements, and administers construction contracts directly from his home office. The company hires or rents the labour required for each building project. The company has no office premises in country D. Only the company’s accounting is handled in country D and it is outsourced. On the basis of the place of management, a permanent establishment is constituted for the company in Finland, in accordance with Article 5.1 and 2 of the tax treaty.

Functional and factual analysis

All functions of the company, such as marketing and sales, the procurement of building supplies, the recruitment of employees, the management of construction work and invoicing are performed from the permanent establishment in Finland. Since the company’s director is in charge of these functions, the pivotal significant people functions are also located in Finland from the perspective of the company’s activity; in addition, all business activity-related risks are borne from the permanent establishment. The permanent establishment is also the economic owner of the assets used in the company’s operations, such as the machines and equipment employed in the construction activity.

Benchmark and verification of the arm’s length price

There is no need for a benchmark, because the permanent establishment conducts transactions only with external companies, so its business activities are arm’s length. All income obtained from business activity is attributed to the permanent establishment.

6 Guidance, tax control, and consequences of taxpayer's non-compliance

When a permanent establishment is constituted for a nonresident foreign company in Finland, the company should submit a tax return with respect to the activity of the permanent establishment. Instructions for the submission of a tax return are provided in the Tax Administration guidelines: Income tax returns from foreign companies. 

Upon the request of the Tax Administration, the company must clarify how it has attributed income to the permanent establishment. The attribution of income to the permanent establishment applies the arm’s length principle, even if the company has no documentation obligation in legal terms. The Tax Administration can adjust the income of the company if the Tax Administration considers the income attributed to the permanent establishment not to be arm’s length. In this case, the adjustment is based on the functional and factual analysis, comparability analysis, or both as performed by the Tax Administration, depending on the information available to the latter. It is possible to impose a tax increase (§ 32, 32a, 32b, Act on Assessment Procedure) or a late-filing penalty (§ 33, Act on Assessment Procedure) on a foreign company in a case of failure to observe the obligation to notify. More information on penalty fees imposed as a consequence of non-compliance in reporting is available in Tax Administration’s instruction Seuraamusmaksut tuloverotuksessa (available in Finnish and Swedish, link to Finnish).

Estimated tax in accordance with the Act on Assessment Procedure (Laki verotusmenettelystä 1558/1995) may become relevant when the taxpayer has not provided a tax return, or if the tax return cannot be used even when adjusted as the basis for taxation. In addition, a punitive tax increase with § 32.1 subparagraph 1 of the Act on Assessment Procedure is always associated with estimated taxation. The amount of tax increase is legislated in § 32 a Act on Assessment Procedure. In every case, the Tax Administration allows the company to be heard before applying a tax adjustment and estimated taxation.

The Tax Administration guides and advises companies on issues related to attribution of permanent establishment income. The company may also apply to the Tax Administration in writing for a preliminary ruling subject to a charge on an itemised enquiry concerning the attribution of income. Instructions on applying for an anvance ruling are provided in the Tax Administration's guidelines Application for an advance ruling – corporate entities.