What is Permanent Establishment and Why Does it Matter?

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‘Permanent establishment’ is an important international tax concept, meaning a fixed place of business in another country or state, resulting in an income or value-added tax liability in that country or state. In this guide, we explain what permanent establishment is, and why any enterprise seeking to expand globally needs to understand it.

Once you have worked out whether your enterprise does or will constitute a permanent establishment in another country, you can determine whether outsourcing a function or incorporating a company in another country is a good idea for you.

In this article, we look at:

  • How the concept of permanent establishment relates to international tax treaties;
  • The precise meaning of ‘permanent establishment’;
  • Activities that are excluded from the definition of ‘permanent establishment’;
  • Construction projects and permanent establishment;
  • The relationship between permanent establishment and agents;
  • Permanent establishment and COVID-19;
  • Why permanent establishment matters;
  • How profits are attributed to a permanent establishment.

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.

The definition of permanent establishment

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:

  • There exists a “place of business”
  • The facilities must be “at the disposal” of the enterprise. This means, for example, despite regularly meeting at a customer’s premises, those premises will not be a PE, as they are not ‘at the disposal’ of the enterprise;
  • The place of business is fixed
  • There must be a connection between the premises and some geographical position, as well as a ‘degree of permanence’ to that location;
  • The business is wholly or partly carried on through that fixed place.

Some locations are specified as prima facie PEs. This list captures:

  • A branch;
  • A warehouse;
  • A factory;
  • A mine or place of extraction of natural resources;
  • A place of management.

Despite being listed as examples, each location must still meet the standard definition of a PE.

Which activities exclude your business from being a permanent establishment?

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:

  • The use of a storage facility solely for the delivery of goods to customers;
  • The maintenance of a stock of goods owned by the enterprise, held solely for processing by another enterprise;
  • The maintenance of a fixed place of business solely for the purpose of purchasing goods, or merchandise, or of collection of information for the enterprise;
  • Any other activity of an incidental, preparatory, or ancillary nature.

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.

Construction projects and 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?

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.

Why does permanent establishment matter?

Once you have established that your enterprise includes a PE in a source country, what next? You will likely need to consider:

  • Filing a tax return;
  • Attribution of Profits. You will need documentation justifying why profits were attributed in that way;
  • Working out which types of tax apply. In addition to corporate income tax, you need to consider the possibility of turnover (i.e., sales) taxes or withholding tax;
  • Compliance obligations. Having a PE in a source country may also result in a range of other non-tax compliance obligations.

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.


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:

  • Work out whether activities that would be a PE, meet the ‘ancillary activities’ exception;
  • If you are a PE, establish what your tax and compliance obligations are in the source country;
  • Where income tax is owed, ensure you apply the correct model of profit attribution.
In carrying out these tasks, please note that under recent reforms, such as the BEPS Action Plan, there is a move towards preventing enterprises from ‘islanding’ parts of the business for tax purposes.

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.

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