Portugal has become a prime destination for many EU and non-EU citizens to establish their residence. In recent times, an increasing number of companies around the world have faced the dilemma of whether the change of residence of their board members to Portugal constitutes a permanent establishment (PE) in that country.
In most cases, however, these companies do not generate profits in Portugal or maintain any physical presence. Nevertheless, board members who relocate to Portugal often take day-to-day and strategic management decisions and sign contracts while in the country, which frequently triggers the creation of a PE.
Determining the allocation key in such cases can be particularly challenging, especially given that the Portuguese tax authorities have not issued any guidelines on profit allocation for these scenarios.
Hence, one can only rely on the OECD guidelines – specifically, the principles outlined in the Report on the Attribution of Profits to Permanent Establishments combined with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations – to provide a framework for addressing these issues, but practical application can be fraught with difficulties.
Challenges in allocating taxable income
The primary challenge is determining the appropriate allocation of taxable income to the PE. The OECD’s “functionally separate entity” approach requires treating the PE as if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions. This involves a two-step analysis:
Functional and factual analysis – this step involves identifying the functions performed, assets used, and risks assumed by the PE. In the case of a board member working from home, the analysis would focus on the specific activities undertaken by the board member and their economic significance to the foreign company.
Attribution of profits – the second step involves applying the arm’s-length principle to attribute profits to the PE. This requires comparing the dealings of the PE with those of independent enterprises performing similar functions, using similar assets, and assuming similar risks.
Allocation keys and cost attribution
Given that the foreign company does not sell goods or provide services in Portugal, or have any assets therein, the allocation key becomes particularly challenging. The OECD guidelines suggest that the allocation should be based on the functions performed, assets used, and risks assumed by the PE. In this case, the primary function is the board member’s activities.
A straightforward approach involves attributing the costs associated with the board member’s salary to the PE as the board member’s activities are the primary economic activity occurring in Portugal. However, this approach may not fully capture the economic reality of the situation. The board member’s activities may contribute to the overall strategic direction and management of the foreign company, which could have broader implications for the company’s profitability.
Key considerations and difficulties
The main considerations include the following:
Economic ownership of assets – the OECD guidelines emphasise the importance of economic ownership of assets in attributing profits. In this case, the foreign company does not have any assets in Portugal, complicating the attribution of profits based on asset use.
Significant people functions – the guidelines also emphasise the role of significant people functions in determining risk assumption and economic ownership of assets. The board member’s activities may involve significant decision-making functions, but attributing profits based solely on these activities without considering the broader context of the company’s operations can be problematic.
Comparability analysis – conducting a comparability analysis to determine an arm’s-length remuneration for the board member’s activities can be challenging. Finding comparable independent enterprises performing similar functions under similar conditions may be difficult, especially when the board member’s activities are strategic and high level.
Documentation and compliance – ensuring adequate documentation to support the allocation of profits and costs is crucial. The lack of physical presence and tangible assets in Portugal may complicate the documentation process, increasing the risk of disputes with tax authorities.
Key takeaways
Allocating taxable income and costs to a PE in Portugal, arising from the residency of a board member, requires careful adherence to OECD guidelines and a comprehensive functional and factual analysis.
While attributing the board member’s salary costs to the PE is a logical starting point, it may not fully capture the economic contributions of the board member’s activities. The lack of physical presence, assets, and business activities in Portugal further complicates the allocation process. A critical approach, considering the broader context of the company’s operations and ensuring robust documentation, is therefore essential to navigate these challenges effectively.
