What is a Permanent Establishment?
Permanent establishment or PE is a vital concept defined by international tax treaties. A PE refers to a fixed business entity with income tax accountability within a particular jurisdiction. Through a PE, an enterprise can conduct its business obligations wholly or partially. PE definitions under the tax treaties usually encompass specific exclusions and inclusions.
The Concept of Permanent Establishment: A Brief History
Two fundamental taxation principles followed globally are residence-based taxation and source-based taxation. While the residence-based system taxes residents of a country on their global income, source-based taxation is for non-residents with their income source in that particular country. However, this gives rise to double taxation when the resident of one country generates income from a source in a different country. Thus, PE came into existence to solve this double taxation problem.
Let’s look at the history of permanent establishments.
Unlike the roots of every other international taxation or commercial law, the foundation of the permanent establishment does not lie in the case-based legal structure or ‘common law structure’. There is no particular date denoting the existence of PE – the concept evolved in phases over the decades. The source of this evolution is the trade laws of the late 19th century to early 20th century operating within the various German states.
Here’s an important question concerning the PE: If there is a trade relationship between two tax jurisdictions, which authority is liable to charge tax?
In 1869, the Stehendes Gewerbe concept came to the forefront via a tax treaty between the German states of Saxony and Prussia. The term indicated a ‘stationary trade location’. The treaty explained that a firm from one state is only liable to taxation in another state holding a stehendes Gewerbe.
Later in 1909, Betriebsstätte came to prominence, which is synonymous with the modern PE concept. Nation-wide codification of Betriebsstätte took place, and it applied to every trade occurring between German states. Finally, the core permanent establishment elements were systematized in law, and the elements were:
- A fixed geographical spot
- An official business place
- Performance degree
Importance of the Concept of a Permanent Establishment
The concept of permanent establishment is the thumb rule determining if any country is liable to levy taxes on the business revenue of a non-resident tax payee. If your enterprise has trade relations in a foreign land, knowing this concept will help you understand the conditions under which an enterprise is labeled a permanent establishment.
The concept of PE allows a country only to tax the non-resident business profits earned by organizations due to permanent establishments. Essentially, it helps to divert unintended tax burdens and penalties since many enterprises aren’t aware of their overseas presence, triggering PE risks. Furthermore, PE can also help determine if royalties, dividends, interests, etc., attract taxes for being included in business profits or if they’re exempted from it.
Permanent establishment also forms a crucial part of treaty-based international fiscal law. The OECD (Organization for Economic Co-operation and Development) Model, UN (United Nations) Model, and the US (United States of America) Model utilize PE as a foundation for establishing tax jurisdiction over business activities of non-residents.
How Does Permanent Establishment Function?
A firm is considered a permanent establishment abroad if they have a fixed location in a foreign country and also generates business profits there. Thus, it is subject to tax schemes in the particular jurisdiction.
While the permanent establishment concept was introduced to remove the double taxation burden, today, it has varying tax schemes between host (also, source country) and home countries (also, residence country) with different tax rates. Most corporations registered in a foreign country are charged with indirect taxes like VAT (also termed as goods and service tax).
Individual countries must incorporate the PE definition in their domestic law, failing which it will not have any legal effect. Most countries define PE in their domestic laws either on the basis of the OECD or the UN model. These models may be relevant when a tax treaty does not mention newer revenue generation forms, including cross-border digital transactions and e-commerce. The OECD model is more commonly followed, and it defines PE as “a fixed place of business through which the business of an enterprise is wholly or partly carried on.”
Certain locations are also classified as ‘prima facie permanent establishments’, meaning these entities are considered a PE if not proven otherwise by the parent organization. This list encompasses branches, factories, warehouses, management places, mines, etc.
What are the Different Types of Permanent Establishments?
Various forms of permanent establishments have evolved due to technological advancements, fast-changing mediums of businesses, etc. Although they are ever-changing, here are a few common types of permanent establishment:
Fixed place of business
It is the most common form of PE and indicates the presence of a physical business enterprise in a foreign land. These can include offices, factories, branches, workshops, etc.
Example: The ideal example can be fashion companies. These companies usually build their offices in their homeland, but their factories are located in foreign countries. In both territories, the fashion company will be charged different taxes as it conducts business in both places and generates revenue in the foreign country.
However, certain general locations used for various business purposes aren’t considered PEs, such as:
- A facility used for storing, displaying, or delivering a corporation’s products
- A facility used as a fixed business location for purchasing products for a company
- A facility used as a fixed business location for a company to conduct auxiliary operations
- A facility used for inventory purposes of a company’s goods primarily for storage, display, or delivery
- A facility used for maintaining inventory of goods of a company to be processed by another firm
Service permanent establishment
This permanent establishment provides technical or managerial services to organizations outside their homeland. Thus, it creates a PE without any physical evidence in another country.
Example: Consulting services are a common example of service permanent establishment. It provides services to a non-native country, generating profit in the homeland. Thus, its home country can levy taxes on the firm’s operation.
If any sales agent is assigned any project on the company’s behalf in a foreign land, the firm may have formed a PE overseas. However, certain factors determine this establishment, like employee frequency or negotiations in the homeland, etc. Sales agents are prevalent in industries like retail, fashion, pharmaceutical, etc.
Example: If the sales agents of one firm negotiate business deals in a foreign country, it requires them to stay longer there, thus, establishing a PE.
Project or construction permanent establishment
For construction sites, most agreements lay out a precise rulebook. The rulebook explains that any site for an installation project or construction/building site can signify a permanent establishment only if it goes beyond a certain timespan. To establish PE, the project/ construction activity may take place from six to twelve months. This period varies according to treaties.
Taxation on Permanent Establishment
There is no simple answer to the question, “what is a permanent establishment for tax purposes”. The presence of any business ventures on international land can trigger permanent establishment risks or corporate tax threats. However, most firms aren’t fully aware that their presence abroad poses a PE threat, thus, attracting unanticipated tax liabilities.
So how to know if your firm is eligible for PE risks?
You can start by learning about the tax laws and treaties of the host country with your homeland. The best way to overcome a PE threat is to partner with local entities which are aware of the domestic laws. They can help you mitigate PE risks and divert potential legal actions.
The second avenue you can adopt is to limit your business activities in a foreign country and opt for short business tours. You should also steer clear of lengthy employee assignments. This way, you will make sure that you are only engaged in short-term consulting, sales, marketing, etc., without owning a fixed place of business.
Permanent Establishment and Taxation for Foreign Companies
A permanent establishment is not the sole apparatus for taxing foreign entities in a host country. Due to large-scale tax avoidance of permanent establishments, many nations have brought a new concept of ‘digital services tax’. The guidelines of this tax scheme vary country-wise. Still, the core concept is that this scheme is applicable to digital service firms’ revenue earnings linked with users in different geographical locations.
For instance, from 1 April 2020, the UK government has levied a 2% digital service tax. This tax applies to all revenues earned from UK users via social media utilities, search engines, online marketplaces, etc. Similarly, Malaysia has also introduced digital service taxes from 1 January 2020 at a 6% rate, applicable to the revenues earned from Malaysian citizens by providing digital services.
Permanent Establishment Risk
Permanent establishment risk is the threat that a firm’s overseas presence has unintentionally led to creating a permanent establishment in a foreign country. It means the firm is liable to corporate taxes, VATs, and any other interest charges or penalties in the overseas country.
Apart from a heavy financial burden, PE can also cause:
- Associated liability for the employer
- Tax liabilities
- Tax registration liabilities
- Attracting audit attention
- Hampered reputation
- Improper tax planning
How to Avoid the Permanent Establishment Classification?
Unmanaged risks of a permanent establishment can pose dire consequences. Thus, entrepreneurs need to know which activities can lead to classifying their overseas operations as permanent establishments. Under Article 5(4) of the OECD Model Tax Convention, if a business entity is only utilized for ‘incidental, preparatory or ancillary’ activities, it is not considered a permanent establishment. Certain activities which exclude a business from being classified as a permanent establishment:
- Using a storage facility only for delivering commodities to the consumers.
- Maintaining a fixed business workplace only for occasions like purchasing goods and merchandise, collecting any vital information for the firm, etc.
- Maintaining a stock of goods owned by a firm but intended to be processed by another firm.
- Other activities are preparatory, ancillary, or incidental by nature.
Recently, a new rule – the ‘anti-fragmentation rule’ – has been introduced to these ‘exclusion rules’ as a result of the BEPS (Base Erosion and Profit Shifting) Action Plan. Previously, many enterprises have used the aforementioned ‘ancillary activities’ to segregate or fragment their operations into separate units, thus, claiming their businesses are only ancillary in nature.
The new rule clearly states that the exception does not apply to activities that appear to be auxiliary or preparatory in nature if scrutinized in isolation. Firms can only demand exclusions if the activities do not have any other complementary functions linked with intricate business operations, thereby qualifying as ancillary.
Can an Agency Help in Avoiding Permanent Establishment Risks?
Agents can help you circumvent PE risks to a certain extent. One might question, “ if the enterprise isn’t involved in any business activity in the host country, how can it trigger a PE appearance?”
However, Article 5(5) under BEPS states that involving a dependent agent can lead to PE in case they are habitually executing their authority in the firm’s name to sign contracts. BEPS Action 7 also states that a dependent agent refers to a person who merely signs contracts in the firm’s name and individuals exercising a ‘principal role’ in drafting the contracts.
Attributing Profit to a Permanent Establishment
Under the OECD model, article 7 mentions that business revenues can attract tax liabilities in the home country in case there aren’t any permanent establishments abroad. However, the profits earned by PE might be taxable in the host country. But how to determine the attribution of profits to permanent establishments that are taxable in the source country?
For attributing profits of PE in the host country, one must first prove that the entity exists only for relevant operations and is not eligible for any exclusions. Now the PE is treated as an ‘independent and separate enterprise’. Its expenses and revenues are analyzed by considering it as an independent entity entitled to the profits earned in the host country.
What is the Next Step After Permanent Establishment?
Once you are sure that your firm has established a permanent establishment in the host country, here’s what you should do:
- File your tax returns.
- Attribute your profits. Prepare the documents beforehand justifying why your firm’s profits are attributed in a way that doesn’t attract any legal penalties.
- Sort out which tax scheme types are applicable for your PE. Apart from corporate taxes, certain firms can also attract sales taxes or turnover taxes, withholding taxes, etc.
- Educate yourself about the non-tax compliance regulations. PE in a foreign land attracts tax obligations and other non-tax obligations like entitlements of employees, regulations related to anti-money laundering, financial reporting, etc.
Recent Developments in Permanent Establishment
OECD’s BEPS Action Plan organizes a review of the permanent establishment concept over time to ensure that the common tax evasion strategies aren’t used to circumvent the present definition of PE.
Many taxpayers have replaced subsidiaries with commissionaire dispositions, which traditionally played the role of distributors. According to OECD, periodic changes in the PE definition are necessary to prevent the exploitation of the specific exceptions to the PE definition available under Article 5(4).
If you’re worried about whether your company can trigger PE abroad, you can manage it by partnering with reputed PEO services. While employing a PEO service will not limit the occurrence of PE, it can help a firm prepare an authentic trail for employment and tax authorities to ensure all its activities are tax compliant.
Multiplier is a global PEO firm that can help you onboard global talent and conduct operations overseas without establishing a subsidiary. Our experts ensure everything is legally compliant with the country’s laws and international tax treaties.
Frequently Asked Questions
Q. Are subsidiaries considered permanent establishments?
No, not always. In situations where a subsidiary functions as the enterprise’s dependent agent, it is considered a permanent establishment.
Q. What is the taxation process of permanent establishments?
The tax scheme of permanent establishments varies according to the country. According to the treaties designed between the resident and source countries, permanent establishments are treated as separate, independent entities and taxed. This treaty makes sure that an enterprise doesn’t have to bear the burden of double taxation.
Q. Can engagement in remote work trigger risks of permanent establishment?
Yes, it certainly can. If the remote worker suits the ‘dependent worker’ status for a given jurisdiction, they can attract permanent establishment risk. If the remote worker operates from a fixed business location, there is also a risk of permanent establishment.