Business Profits | Article 7 | OECD Model Tax Convention


Article 7 of the OECD Model Tax Convention covers the taxation rights of the business profits of the enterprise. The Article consists of 4 paragraphs. Before venturing into the Article, let us understand the brief history of Article 7.

Present Article 7 of the OECD Model Tax Convention has seen an overhaul for incorporating the inputs from the Report on Attribution of Profits from Permanent Establishments 2008, OECD. Permanent Establishments play a pivotal role in the taxation of the profits of the enterprises, which undertakes business in more than one country; this report seeks to resolve the interpretation issues and legislative issues among various countries.

Business Profits – Article 7 of the OECD Model Tax Convention

For understanding the taxation rights of the Countries, it is crucial to identify the existence of the Permanent Establishment as provided under Article 5. If the Permanent establishment does not exist in the Contracting state, then the question of taxing enterprise profits will not appear.

Podcast for Article 7 is given below

Podcast on Business Profits – Article 7 of the OECD Model Tax Convention
Background Music: Unfolding Mirrors by Shane Ivers –

Which country has the right to tax business profits?

Paragraph 1 of Article 7 of the OECD Model Tax Convention states that the Contracting States has taxing rights on profits attributable to an enterprise only if the Permanent establishment exists in that other State. And it also states that if the enterprise has a Permanent establishment in the other State, then the profits attributed to the Permanent Establishment would be identified as guided by Paragraph 2 of Article 7.

It is the consensus among the countries that an enterprise not having a permanent establishment in a country, will not contribute to the economic value of the country. Hence the taxation rights are provided only if the Permanent establishment exists.


Louis Vuitton Inc is registered in France. It has an outlet in Indonesia, which is not a Permanent establishment as per France – Indonesia Double Tax Avoidance Treaty. The income generated by the Louis Vuitton Inc in Indonesia will not be taxable by Indonesia Tax authorities.

The second principle focuses on the attribution of the income to the enterprise towards the permanent establishment. This principle is critical and has been subject to many differences of opinion among the countries as few countries try to impose the general force of attraction while taxing the income of the Permanent Establishment

The principle of ‘general force of attraction’ entitles the country to tax all the income of the enterprise, which has sources in the territory of the country even though it may not be attributable to the Permanent Establishment.


Louis Vuitton Inc, a handbag specialist, is registered in France. It has an outlet in India, which is a Permanent establishment as per France – India Double Tax Avoidance Treaty. All the income attributable to that outlet will be taxed in India.  Louis Vuitton Inc undertakes the survey in India for the new product ‘Men’s Bag,’ which it plans to launch. Later the bag is launched in Pakistan and Srilanka. Will India have a right to tax the income of Louis Vuitton for ‘Men’s Bag.’

No. As the income is attributable to the Permanent Establishment in India does not include the Men’s Bag, it will not be taxable in India.

Many countries do not support the principle of the general ‘force of attraction,’ and few countries have incorporated the restricted ‘force of attraction’ in their treaty. While taxing the profits of the permanent establishment, countries are expected to apply the Permanent establishment test for every separate source of profit of the enterprise. It allows for efficient tax administration and compliance.


Noodles Inc is registered in China and has set up a noodle manufacturing company in Berlin. It is a Permanent establishment as per the China- Germany Double tax treaty. There are independent agents of Noodles Inc in Berlin who import soups of Noodles Inc from China and sell it at their retail outlets. Which income will be taxed in Germany? It is recommended that the income from the manufacturing of noodles alone be taxed as the soup income is not the Permanent establishment of Noodles Inc

How to compute the profits attributed to the Permanent Establishment?

Paragraph 2 of Article 7 provides the basic rule for determining the profit attributable to the Permanent Establishment. It states that the profits attributable to the Permanent Establishment are the profit it is expected to make if it were a separate independent entity engaged in the same or similar activities, taking into consideration the functions performed, assets utilized, and risk undertaken. The paragraph also specifies that the rule will be applicable for dealings with the permanent establishment and other parts of the enterprise.

The approach provided by Article 7 is to create the fiction of treating the enterprise as a separate entity and then applying the principle of Arm’s length price for determining the profits of the Permanent Establishment. It does not ask for the allocation or the apportionment of the overall profits of the enterprise.

OECD report on the attribution of profits of the Permanent Establishment guides the calculation of profits of the enterprise. It assists in analyzing all activities, including transactions with independent enterprises, transactions with associated enterprises, and dealings with the other parts of the enterprises.

The first step undertakes a functional and factual analysis, resulting in:

  1. Attribution of rights and obligations to the permanent establishment arising out of the transactions
  2. Identification of significant people functions relevant to the risk assumed and attribution of risks to the Permanent Establishment
  3. Identification of significant people functions relevant to the economic ownership of the assets and attribution of economic ownership of assets to the permanent establishment.
  4. Identification of the other functions of permanent establishment
  5. the recognition and determination of the nature of those dealings between the permanent establishment and other parts of the same enterprise that can  appropriately be recognized
  6. the attribution of capital based on the assets and risks attributed to the permanent establishment

The second step involves pricing the transactions undertaken by the enterprise for the permanent establishment. OECD transfer pricing guidelines are referred.

The process involves the pricing of transactions based upon the Arm’s length basis of the recognized dealings through:

  1. the determination of comparability between the dealings and uncontrolled transactions
  2. the application of methodology mentioned in the Guidelines for arriving at Arm’s length price between a permanent establishment and the other parts of the enterprise after undertaking the tests based upon functions performed, assets undertaken and risks assumed.

It is important to note that the fiction of separate and independent entities does not lead to the creation of the notional income for taxation.

How to resolve the issues if the Contracting states tax the same profit?

Paragraph 3 of Article 7 combines with Article 23A and 23B for providing relief from double taxation when the profits of the Permanent establishment of an enterprise are adjusted based upon the application of Paragraph 2 of Article 7. Paragraph 3 restricts the taxing rights of the State where the permanent establishment of the enterprise exists, and Article 23A and 23B obliges the other contracting State to provide the relief from the taxation on the same income.

For the benefit of the taxpayer and non-double taxation, both the contracting states (State in which permanent establishment exists and the State where the enterprise exists) should interpret Paragraph 2 in the same manner. The taxpayer maintains the documentation rationalizing the prices used in the transactions and calculation of Arm’s length price for maintaining the uniform transaction price in all contracting states.


Mango Inc is an enterprise in the USA, which sells mobile handsets. It has opened an outlet in Germany. This outlet is a permanent establishment as per the USA – Germany DTAA, and assuming the USA – Germany has adopted the OECD Model Tax Convention.

Mango Inc transfers mobile handsets to the outlet in Germany. Mango Inc has made comprehensive documentation for the computation of the Arm’s length price based upon the OECD Guidelines and Paragraph 2 of Article 7. Based on the documents and the transaction, the price of one handset is USD 100.

The USA and the Germany tax authorities have accepted the Arm’s length computation and have not made any adjustments in the price.

USA will treat USD 100 as the sales price and tax the income of the enterprise

Germany will treat USD 100 as the cost of acquisition and reduce it from the sales value for computation of the Profit of the Permanent Establishment.

In this scenario, there was no issue from any contracting States (USA and Germany), and hence Paragraph 3 was not resort.

What happens if one country does not accept the price quoted by Mango Inc?

Suppose German tax authorities have reason to believe that the USD 100 is a high price, whereas the price has to be USD 50, they will reject the taxpayer’s quoted price (Mango’s price) and adjust the price. The resulting impact would be higher profit (by USD 50) for the Permanent Establishment in Germany.

Then the USA has to provide relief to the taxpayer and provide the exemption of income under 23A or tax credit under 23B.

But what if the USA tax authorities do not accept the adjustment made by the German tax authorities??

The only resort available by the taxpayer is to move to Article 25 and enter into Mutual Agreement procedure or arbitration guided under Paragraph 5 of Article 25 to decide the Arm’s length price between the two countries.

Paragraph 3 of Article 7  provides no methodology for dealing with the issue of dispute. It does not mandate the automatic adjustment to be made by the other contracting State for the initial adjustment made by the country. But the other State will look into the nature and principle on why the adjustment is made, and if it warrants the change based upon the principle provided by Paragraph 2, the other State may make the changes. In the case of deadlock, the taxpayer has to approach Article 25.

Paragraph 3 of Article 7 of the OECD Model tax convention does not provide a time limit for the adjustments made by the States. It is open to the countries to enter into timelines or the time limits as per their domestic laws.

Does Article 7 override other Articles?

The term profit is not defined under the Model tax Convention and has required broader interpretation. Profits of the enterprise may comprise the dividends, commission, interest, etc. But which Article will apply under such a scenario?

Paragraph 4 of Article 7 is the rule of interpretation. It expressly states that where there exist the Articles where the specific nature of income is covered under the Model Tax convention, it will override the generic Article of business profits.

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