Article 7. BUSINESS PROFITS

This Article provides the rules for the taxation by a Contracting State of the business profits of a resident of the other Contracting State. The general rule under paragraph 1 is that business profits (as defined in paragraph 6) of a resident of one Contracting State may not be taxed by the other Contracting State unless the resident carries on or has carried on business in that other Contracting State through a permanent establishment (as defined in Article 5 (Permanent Establishment)) situated in the latter State. Where that condition is met, the State in which the permanent establishment is situated may tax the business profits attributable to the assets or activity of that permanent establishment.

Subparagraph a) of paragraph 2 of the Protocol to the Convention provides an example of the "attributable to" concept. The example concerns a company that is engaged in oil production through wells located in the other State. The company also carries on exploration activities at another location in that other State using assets and employees not connected with the production activities; the activities last less than 6 months. The company also occasionally leases drilling equipment to third parties. The three activities are separate. The oil production constitutes a permanent establishment and the resulting profits are taxable in that other State. The other two activities do not constitute permanent establishments, and any resulting profits may not be taxed in that other State.

Paragraph 2 provides that the Contracting States will attribute to a permanent establishment the profits that it would be expected to make if it were an independent entity, engaged in the same or similar activities under the same or similar conditions, and dealing wholly independently with the enterprise of which it is a permanent establishment and any other enterprise that is an associated enterprise within the meaning of Article 9

(Associated Enterprises). Profits so attributable to a permanent establishment are taxable in the State where the permanent establishment is situated or was situated at the time the profits were made. This rule incorporates the rule of section 864(c)(6) of the Internal Revenue Code with respect to deferred payments, which is also reflected in the provisions of Articles 11 (Interest), 12 (Royalties), 14 (Independent Personal Services) and 21 (Other Income) dealing with amounts attributable to a permanent establishment or fixed base. If the income was attributable to a permanent establishment or fixed base when earned, it is taxable by the State where the permanent establishment or fixed base was located, even if receipt of the income is deferred until the permanent establishment or fixed base has ceased to exist.

The profits attributable to a permanent establishment may be from sources within or without a Contracting State. Thus, certain items of foreign source income described in section 864(c)(4)(B) or (C) of the Code may be attributed to a U.S. permanent establishment of a Ukrainian resident and subject to tax in the United States. The concept of "attributable to" in the Convention is narrower than the concept of "effectively connected" in section 864(c) of the Code. The limited "force of attraction" rule in Code section 864(c)(3), therefore, is not applicable under the Convention.

Paragraph 3 provides that the tax base must be reduced by deductions for expenses incurred for the purposes of the permanent establishment. These include expenses directly incurred by the permanent establishment and a reasonable allocation of expenses incurred by the home office, or by other parts of the enterprise company, as long as the expenses were incurred for the purposes of the permanent establishment. Allocable expenses include executive and general administrative expenses, research and development expenses, interest, and charges for management, consultancy, or technical assistance, wherever incurred and without regard to whether they are actually reimbursed by the permanent establishment. As indicated in paragraph 2(b) of the Protocol, the expenses may be incurred by the home office of the permanent establishment, other permanent establishments in third countries, or the permanent establishment itself. The permanent establishment must be able to document such expenses, if so requested by the tax authorities of the State in which it is located. In no case, however, will deductions be allowed for amounts paid by the permanent establishment to the home office or other permanent establishments in respect of deductible expenses such as interest, royalties, and service fees. Rather, the permanent establishment will be allowed deductions for such expenses only to the extent they are reasonably allocable to the permanent establishment, as described above.

Paragraph 4 provides that the business profits attributable to a permanent establishment shall be determined by the same method from year to year unless there is a good and sufficient reason to the contrary.

Paragraph 5 provides that no business profits will be attributed to a permanent establishment merely because it purchases goods or merchandise for the resident of which it is a permanent establishment. This rule refers to a permanent establishment that performs more than one function for the enterprise, including purchasing. For example, the permanent establishment may purchase raw materials for the enterprise's manufacturing operation and sell the manufactured output. While business profits may be attributable to the permanent establishment with respect to its sales activities, no profits are attributable with respect to its purchasing activities. If the sole activity were the purchasing of goods or merchandise for the enterprise, the issue of the attribution of income would not arise, because under subparagraph 4(d) of Article 5 (Permanent Establishment) there would be no permanent establishment.

Paragraph 6 illustrates the meaning of the term "business profits" as used in this Article. It includes income from the active conduct of business, such as rental of tangible movable (personal) property and income from furnishing the services of others. It does not include compensation for personal services of individuals, whether self-employed or as employees.

Paragraph 7 coordinates the provisions of this Article and other provisions of the Convention. Under paragraph 7, where business profits include items of income that are dealt with separately under other articles of the Convention, the provisions of those articles will, except where they specifically provide to the contrary, take precedence over the provisions of Article 7 (Business Profits). Thus, for example, the taxation of interest will be determined by the rules of Article ll (Interest) except where, as provided in paragraph 3 of Article 11, the interest is attributable to a permanent establishment, in which case, the provisions of Article 7 apply.