Once a foreign enterprise is found to have a permanent establishment (PE) in a jurisdiction, whether through a fixed place of business, a dependent agent, or increasingly a digital or service PE, a second and separate question arises: how much of the enterprise's profit should that PE be taxed on. The Authorised OECD Approach (AOA) answers this by treating the PE, functionally, as if it were a distinct and separate enterprise dealing with the rest of the head office on arm's length terms.
The Functionally Separate Entity Fiction
The AOA's central move is to apply the same functional, asset, and risk analysis used in conventional transfer pricing to the internal relationship between the PE and the rest of the enterprise, hypothesising a set of dealings between them as if they were separate legal entities. This is a genuine conceptual departure from the older, more mechanical formulary approaches some treaties and domestic laws still use, and it means a PE attribution exercise now largely mirrors a standard TP functional analysis, applied internally rather than across group entities.
Step One: The Functional and Factual Analysis
The first stage attributes to the PE the significant people functions actually performed there, meaning the people whose decisions genuinely create or manage risk and use assets, not merely administrative or support staff physically located at the PE. Where key decision-makers, such as traders taking on market risk or senior personnel negotiating material contracts, are located at the PE, the risks and assets associated with those decisions are attributed there even if formal legal documentation assigns them to the head office.
Step Two: Pricing the Internal Dealings
Once functions, assets, and risks are attributed, the second stage prices the notional dealings between the PE and the rest of the enterprise using conventional transfer pricing methods, CUP, cost-plus, TNMM, or profit split, exactly as would be applied to a genuine intercompany transaction. A PE that performs limited distribution functions on behalf of the head office would, under this fiction, be attributed a routine distributor-type return, while a PE housing the enterprise's key trading or decision-making function would be attributed a much larger share of overall profit.
Capital Attribution and Free Capital
Because a PE has no separate legal capital structure of its own, the AOA requires a notional allocation of 'free capital', capital not associated with a specific liability, sufficient to support the assets and risks attributed to it, using methods such as the capital allocation approach or a thin-capitalisation approach benchmarked against comparable independent enterprises in the same industry. Under-capitalising a PE relative to the risk profile attributed to it distorts the resulting profit attribution and is a frequent point of dispute in financial-sector PE cases specifically.
Where Domestic Law Still Diverges from the AOA
Not every jurisdiction has adopted the AOA in its full form; some continue to apply older treaty language based on Article 7 of the pre-2010 OECD Model, which attributes profit based more narrowly on the actual activities of the PE without the full functionally-separate-entity fiction, or apply a relevant business activity approach limiting attribution to profits from the PE's specific line of business. Groups need to confirm which version of Article 7 governs the specific treaty in point before assuming the full AOA methodology applies, since the two frameworks can produce materially different attribution outcomes for the same PE.
Conclusion
PE profit attribution under the AOA is, in substance, a transfer pricing exercise conducted inside a single legal entity, turning on the same significant-people-functions and risk-control analysis that governs conventional intercompany dealings. Enterprises with PE exposure should run the two-step AOA analysis, and confirm which Article 7 framework their relevant treaty actually adopts, well before a revenue authority runs the same exercise unilaterally during an audit.
