I. Case Overview
A foreign company, referred to as Company A, set up a permanent establishment (PE) named B in Finland and acquired shares in a Finnish resident company, C, under B’s name. Company A then allocated the shares of Company C and the associated loans to B, with B paying the interest on the loans and deducting this interest for tax purposes when calculating corporate income tax. The Finnish tax authorities questioned the legitimacy of this debt push-down arrangement, arguing that B had very limited functions and staff. They contended that Company A should not have allocated Company C’s shares and related loans to B, and thus, B should not be deducting the loan interest. The disagreement between the tax authorities and Company A led to a lawsuit filed with the Finnish Supreme Administrative Court.
II. Key Point of Dispute
Company A argued that if it had set up a subsidiary in Finland, it could have allocated the shares of Company C and the loans to the subsidiary, which would hold the shares, pay the loan interest, and deduct that interest for tax purposes. Similarly, if a permanent establishment is established, it should be able to deduct loan interest in the same way as a subsidiary; otherwise, this would violate the freedom of establishment under the Treaty on the Functioning of the European Union. Therefore, the taxpayer requested that the Finnish Supreme Administrative Court refer the case to the European Court of Justice.
The Finnish Tax Administration argued that, based on the functions, assets, and risks of the permanent establishment, having B hold the shares of Company C and assume the loan interest related to the acquisition did not align with the business activities of the PE. Therefore, the shares and related loans should not have been allocated to B, and B should not be allowed to deduct the loan interest.
III.Final Ruling
The Finnish Supreme Administrative Court sided with the Finnish Tax Administration.
The court determined that B had only limited functions and few employees, and there was no evidence to suggest that B had control over the shares of Company C or that its staff performed any significant roles related to the ownership of C’s shares. Additionally, the dividends received by B from Company C were not retained by B but were immediately transferred to Company A. Based on these facts, and according to the Authorized OECD Approach (AOA) for attributing profits to permanent establishments under Finnish tax law, the court concluded that the dividends from Company C were not part of B’s business activities, and thus, the shares of Company C should not have been allocated to B. The court found that Company A’s allocation of Company C’s shares, loans, and interest to B was an artificial arrangement and lacked economic justification.
Regarding whether the Finnish Tax Administration’s stance violated the freedom of establishment provisions of the Treaty on the Functioning of the European Union, the court also ruled against this claim. The court reasoned that the difference in tax treatment between acquiring shares in the name of B and doing so through a subsidiary was due to the artificial nature of allocating Company C’s shares to B, not simply because of different legal forms.
IV. Insights for International Businesses
The core issue of this case is correctly understanding the Authorized OECD Approach (AOA).
The AOA is a method for allocating profits to permanent establishments, officially introduced by the Organization for Economic Co-operation and Development (OECD) in its 2010 Report on the Attribution of Profits to Permanent Establishments. The core idea of this approach is to treat the permanent establishment as a separate entity and determine the profit allocation between the permanent establishment and the head office accordingly, known as the “functionally separate entity approach.” All transactions between the permanent establishment, the head office, or other permanent establishments and related entities should be calculated according to the arm’s length principle to determine the profits attributable to the permanent establishment. The AOA usually involves a two-step process: first, determining the functions, assets, and risks of the permanent establishment; second, considering these factors comprehensively to establish the appropriate transfer pricing within the group.
The Base Erosion and Profit Shifting (BEPS) project has highlighted that the AOA is the preferred method for allocating profits to permanent establishments. Some countries (mainly developed ones) have incorporated the AOA into their domestic laws and have pushed to include it in the “Business Profits” article of tax treaties during negotiations. However, the AOA requires a high level of tax administration capability, and many countries have not adopted it for various reasons.
From the perspective of companies expanding internationally, this case offers the following insights:
（A）Conduct Thorough Due Diligence and Choose the Appropriate Legal Structure
Whether to establish a representative office, branch, or subsidiary depends on various factors, including the company’s specific business needs, risk tolerance, and tax considerations. Tax planning should consider not only the host country’s domestic laws but also tax treaties between the home country and the host country. Multinational groups should also consider the host country’s network of tax treaties and other relevant factors.
（B）Tax Considerations for Permanent Establishments Holding Shares and Assuming Loans
As seen in this case, while it is not strictly impossible for non-resident companies to allocate the shares of an acquired subsidiary and the related loan interest to a permanent establishment, it is crucial to appropriately arrange the functions, personnel, assets, and risks of the permanent establishment to mitigate the risk of anti-avoidance investigations.
