‘Permanent establishment’ is an important international tax concept, meaning a fixed place of business in another country or state, resulting in an income tax liability in that jurisdiction. In this guide, we explain what permanent establishment is, and why any enterprise seeking to expand globally needs to understand it.
In June 2021, at a meeting of the finance ministers of G7 — the world’s seven most advanced economies — an agreement was reached for a global minimum corporate tax rate of 15 percent. The intention of this agreement is to combat corporate tax avoidance through companies setting up their ‘permanent establishment’ in a low tax jurisdiction, but making enormous profits in higher-tax jurisdictions.
With the issue of permanent establishment so prominent on the international agenda, it is worth taking a look at how permanent establishment is defined, the concept of permanent establishment risk, and steps you can take to manage permanent establishment when expanding internationally.
How is Permanent Establishment Regulated Internationally?
Permanent establishment (‘PE’) is defined by the tax law of each jurisdiction (such as a country, state, province, territory, or autonomous region), usually as a consequence of bilateral tax treaties entered into between the two jurisdictions. We can call the country where the enterprise is primarily based, the ‘residence country’, and the other country where activity is occurring the ‘source country’.
Tax treaties themselves, almost universally, define PE based on the concept as set out in either one of two models for international tax treaties: the OECD Model Tax Convention on Income and on Capital (the OECD Model) and the United Nations Model Double Taxation Convention between Developed and Developing Countries.
Summing up the overall purpose of international tax treaties, Michael Lennard, Chief of International Tax Cooperation and Trade in the Financing for Development Office (FfDO) of the United Nations, stated that they are about working out: “whether and to what extent, in respect of particular income profits or gains, the source country (the host country of an investment) will relinquish its taxing rights. If it does, the residence country of the investor may fully tax the profits of the investor”. PE is the principal mechanism in which a source country can ‘claw back’ tax from an enterprise based in the residence country.
Our focus here is on the requirements of the OECD Model, in particular article 5, which defines PE, as well as the commentary that accompanies it. The OECD model is by far the most common basis for defining PE internationally, and is implemented in nearly 3000 tax treaties. In addition, more than 80 countries are signed up to the OECD’s Inclusive Framework on Base Erosion and Profit Shifting (BEPS) and the associated BEPS Action Plan, which has recently altered the definition of PE.
Note that individual countries need to incorporate the definition of PE within their domestic law for it to have legal effect. To determine where your enterprise constitutes a PE you will need to seek professional advice on the laws of the source country.
Is Permanent Establishment the Only Mechanism for Taxing Foreign Companies?
No. Partially in response to perceived tax avoidance using the concept of permanent establishment, many countries have introduced ‘digital services taxes’. While the details vary by country, generally speaking these taxes apply to the revenues of digital services companies that are connected to users located in a source country. For example, the UK’s digital services tax applies applies a 2 percent tax on the “revenues of search engines, social media services and online marketplaces which derive value from UK users.”
The History of the Concept of Permanent Establishment
Many concepts in international commercial and taxation law have their origins in the ‘common law’ (that is, case-based) legal systems of English-speaking countries.
Not so with permanent establishment.
There is no specific date when the concept of permanent establishment came into existence. Rather, it developed incrementally over decades, in the laws that regulated trade between different German states in the late nineteenth century and the early 20th century.¹
The original problem (which permanent establishment stood as a solution to), was how to deal with double taxation: In trade between or within two tax jurisdictions, which tax authority has the right to tax a business? If both tax authorities were to fully tax the business, the enterprise would face a crippling tax burden which would discourage international or inter-state business.
In 1869, the tax treaty between the German states of Prussia and Saxony spelled out the concept of stehendes Gewerbe. At the time, this was used to refer to a ‘stationary place of trade’. The treaty provided that a business from one of the states could only be taxed in the other state where it had a stehendes Gewerbe there.
It was in 1909 that the concept most closely resembling the modern concept of permanent establishment, Betriebsstätte, was codified in the Empire-wide double taxation law, which applied to business between German states. It is at this point that the key elements of permanent establishment were codified in law: a place of business, fixed in a particular geographical spot, with a degree of permanence.
What is the Definition of ‘Permanent Establishment’?
So what exactly does ‘permanent establishment’ mean? Article 5(1) of the OECD Model provides: “The term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on”. Taken together with the commentary to this article, we can establish three key elements:
Some locations are specified as prima facie PEs. That is, they will be presumed to be a PE unless the organization can establish to the contrary. This list captures:
What is Permanent Establishment Risk and Why Does it Matter?
Permanent establishment risk (or ‘PE risk’), is the risk that the presence of an enterprise in a foreign country has inadvertently created a ‘permanent establishment’ in that country. Meaning the enterprise may inadvertently be liable for corporate income tax and any attendant penalties and interest charges.
In addition to the potential financial burden, there are several reasons why PE risk should be a serious concern for your business:
Which Activities Exclude Your Business from Being a Permanent Establishment?
Given the consequences of an unmanaged permanent establishment risk, a business should carefully consider whether its activities exclude it from PE classification.
Even if an enterprise would otherwise meet the definition of a PE, certain activities are ‘exempted’ from the application of the PE rules. Under Article 5(4), if the location would be a PE, but it is used solely for an activity which has for the enterprise an “incidental, preparatory or ancillary” character, it is deemed not to be a permanent establishment. This includes:
All these activities are often referred to collectively as “ancillary activities”.
Note, a recent change to these exclusion rules has been introduced as a result of the BEPS Action Plan, known as the ‘anti-fragmentation’ rule. Historically, many businesses have used the ancillary activities exception to ‘fragment’ their business into separate entities, in order to claim that the business is ‘solely’ ancillary. This new rule provides that, even though activities might appear preparatory or auxiliary, when viewed in isolation, this is not enough. If the activities “constitute complementary functions that are part of a cohesive business operation“, that is not solely ancillary, the exception cannot be used.
Do Construction Projects Count as a Permanent Establishment?
Article 5(3) provides that “A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.” This means that even if a construction project would otherwise meet the definition of a PE, it still needs to meet a duration threshold.
Note that, in the past, some businesses have attempted to get around this by contract or project-splitting: Splitting up a construction project that would have lasted longer than 12 months, into multiple smaller projects with the same effect. The new test requires that contracts have to be considered as a whole to determine whether a PE exists.
Can Permanent Establishment Be Avoided by Using an Agent?
It might be thought that the existence of PE could be avoided by using an agent in the source country. As the enterprise itself is not doing the actual work in the source country, one might think, no PE arises. But this is not necessarily true. Article 5(5) provides that a “dependent agent” can constitute a PE if they habitually exercise their authority to enter into contracts in the name of the enterprise.
Under BEPS Action 7, this definition has been extended to include not just someone who signs the contracts on behalf of the enterprise, but also to someone who habitually plays the ‘principal role’ in the formation of contracts, that are then formally concluded by the enterprise.
Read more about the connection between ‘contracting’ and PE risk read How to Convert Contractors to Employees and What Are the Best Tools for International Human Resource Management?
How Will I Attribute Profit to a Permanent Establishment?
Under article 7 of the OECD Model, business profits are taxable in the resident country, unless there is a PE, and then profits attributable to that PE may be taxed in the source country. So how do we work out which profits are attributed to that PE?
Once it has been established that PE exists due to relevant activities, and no exclusion applies, the attribution of profits is to be determined by treating the PE as if it were a “separate and independent enterprise”.
Thus, after it has been established that a PE exists due to activities specified in Article 5(4) that are not preparatory or auxiliary in nature, the attribution of profits to the PE should be determined by an analysis of the revenues and expenses incurred by that PE, treating it as if it were a separate and independent enterprise. This is likely to be a complex task, so expert accounting advice is likely to be necessary.
What Does the COVID-19 Pandemic Mean for Permanent Establishment?
In response to COVID-19, the OECD Secretariat released an Analysis of Tax Treaties and the Impact of the COVID-19 Crisis. This considered whether or not new remote working situations may inadvertently give rise to PE status. It considers the case of ‘home offices’ in foreign countries, due to the pandemic, and individuals overseas becoming ‘dependent agent PEs’ through their presence in another country.
The OECD is of the view that a temporary home office overseas likely lacks the degree of permanence, and being ‘at the disposal’ of the enterprise, to count as a PE. In the case of an agent or employee overseas, the OECD is of the view that this is likely to lack the ‘habitual’ character to count as a dependent agent.
If I Have a Permanent Establishment, What is My Next Step?
Once you have established that your enterprise includes a PE in a source country, what next? You will likely need to consider:
Is There Any Way to Manage Permanent Establishment Risk?
Ultimately, it is a factual matter whether any individual business operation in a country will constitute a permanent establishment. Keep in mind also, that this may differ depending on the individual tax laws of that country. Some options to consider include:
PE is an important concept to understand for any enterprise that operates across borders. This is the principal means through which your enterprise may become liable for corporate income tax, value-added tax, filing tax returns, and compliance with a range of other obligations.
The key steps you need to take are:
While we hope that this general information is useful, the definition of PE in different countries can differ, and you need to seek professional advice relevant to the specifics of your situation.
This is where you need professional advice. New Horizons Global Partners provides expert advice on how to set up your business operations in another country. We can advise on the best set up for your business to manage your ongoing tax and compliance obligations overseas.
Note: This article provides general information only, for advice on your specific situation be sure to seek out professional advice.
¹For an in-depth discussion of the development of this concept, both in German law and internationally, see Skaar, Arvid A., (2020). Permanent Establishment: Erosion of a Tax Treaty Principle, Second Edition. Kluwer Law International.