International tax practice continues to grapple with how to attribute profits to permanent establishments (PEs), a challenge central to cross-border branch operations. The Authorised OECD Approach (AOA) remains the prevailing framework, even as the EU explores a head-office taxation (HOT) model for SMEs to simplify branch profit computation.
The AOA treats the PE as a functionally separate entity (FSE), applying a two-step analysis: (1) attributing assets, risks, and “significant people functions” to the PE, and (2) pricing internal “dealings” using OECD Transfer Pricing Guidelines (TPG). Since 2010, Article 7(2) of the OECD Model Tax Convention has embedded this approach, aligning PE attribution with associated-enterprise analysis.
Post-2010, the AOA allowed broader recognition of internal dealings—e.g., notional royalties and interest—within strict limits. For instance, internal interest requires a treasury function and linkage to external borrowing; notional rent is disallowed where the PE economically owns tangible property. The PE’s credit rating mirrors that of the enterprise, precluding notional guarantee fees. These constraints intentionally diverge from full transfer-pricing symmetry.
The treaty text was also revised: prior paragraphs on deductions and formulary apportionment were removed, and a new Article 7(3) was added to address disputes over method selection, acknowledging the AOA’s inherent pluralism. Countries diverge on capital attribution and interest allocation, resulting in multiple “versions” of the AOA.
Banking illustrates both the flexibility and limits of the AOA. Because intra-bank interest is intrinsic to the business, the key issue is how much “free capital” (equity) must be allocated to branches. The AOA permits capital allocation, thin-capitalisation, and regulatory safe harbours. Jurisdictions vary: Germany ties capital to risk-weighted assets and KERT functions; Italy allows multiple methods; Japan distinguishes by sector; the Netherlands and UK apply hybrid approaches. This diversity underscores the AOA’s adaptability but also fuels disputes, highlighting the need for robust resolution mechanisms.
A structural tension persists: intra-enterprise dealings don’t trigger withholding taxes, so notional deductions can erode source-state taxing rights unless counterbalanced by strict recognition rules. Some countries that reject or partially adopt the AOA have introduced
anti-mismatch rules, increasing compliance burdens and reliance on dispute-resolution tools not designed for method disagreements.
The EU’s HOT proposal, introduced in September 2023, targets administrative simplification rather than substantive reform. It allows eligible SMEs operating solely through PEs to apply the head-office Member State’s tax rules across all branches, file a single return, and have that administration allocate revenues to host states. Host states retain audit rights, and the option runs for renewable five-year periods with safeguards to prevent abuse.
The European Parliament’s April 2024 resolution supports HOT but proposes extensions—e.g., including up to two subsidiaries, lengthening eligibility periods, and adjusting renewal conditions. These amendments, though non-binding, reflect a push for broader simplification. As of September 2025, negotiations continue in the Council.
AOA and HOT represent substance versus administration. AOA defines how to attribute profits; HOT streamlines how those profits are computed and reported. For SMEs, HOT could reduce friction by applying one AOA-consistent method across all EU branches, avoiding mismatches in recognition thresholds or capital attribution.
However, HOT is optional and limited in scope. It doesn’t alter treaty-based taxing rights or the AOA’s substantive logic. Political feasibility hinges on Member States’ willingness to accept another’s tax base rules for income taxed in their jurisdiction. Safeguards—eligibility thresholds, audit rights, and termination triggers—aim to build trust but add legal complexity.
Two policy takeaways stand out. First, the AOA’s internal pluralism—especially around capital attribution and internal financial dealings—has proven resilient. While not a flaw, it necessitates clearer tiebreakers and stronger mutual-agreement procedures. Second, HOT highlights that much of the burden in branch taxation is administrative. A unified rulebook and filing point could significantly ease compliance for SMEs without undermining the AOA’s FSE principle. If adopted, HOT would shift many disputes from inter-state to intra-state, where consistency is easier to achieve.
