The recent overhaul in the Spanish Tax system has introduced several new rules whose consequences are still to be analyzed. I am writing today about an apparently innocuous change in arm’s length rules applicable to the internal dealings between a foreign entity and their Spanish branches or, more generally, Permanent Establishments.
Before the Law changed, internal dealings between a foreign entity and a Permanent Establishment located in Spain were compulsory valued at fair market value. In case the Spanish branch was selling goods “bought” from the head office, this rule implied that the tax basis of the goods for the Spanish branch was the market value, thus incorporating a markup on the cost and reducing the taxable profit in Spain.
The new wording of the Corporation Income Tax (which is applicable as well to branch and other Permanent Establishment of foreign entities) has completely eliminated this rule. Now, the Law says nothing about the matter. There is therefore a legitimate doubt about the valuation of internal dealings between a branch and its head office. Regarding trading activities, it is arguable if the tax basis for the branch should include a reasonable mark up or, on the contrary, should only be the cost at which the head office acquired such goods.
I personally have little doubt that the intention of the Law makers has been to broaden the taxable base in Spain. The former wording of the Law clearly hindered the possibility of taking as tax basis the cost of the goods, so they have just eliminated it. They did not have the courage to go a step further and expressly say that the tax basis is the cost because it would have been scandalous and a clear breach of most, if not all, the Tax Treaties signed by Spain.
Article 7 of the Tax Treaties says that the profits to be attributed to a permanent establishment must be determined as if it were a distinct and separate enterprise 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.
In my view, at least when a Tax Treaty is applicable, the valuation of internal dealings between a Spanish branch and the head office must be performed at arm’s length basis; in case of trading activities this means that the tax basis for the branch must include a reasonable mark up. Otherwise, Spain will be breaching not only the wording of the tax treaties, but also their basic goal, because it could cause double taxation in the likely event that the head office is obliged to recognize a profit on the internal sales to their foreign branches. Sadly, if no Tax Treaty is applicable, the risk of double taxation seems difficult to avoid.