|An aspect of fiscal policy|
A permanent establishment (PE) is a fixed place of business which generally gives rise to income or value-added tax liability in a particular jurisdiction. The term is defined in many income tax treaties and in most European Union Value Added Tax systems. The tax systems in some civil-law countries impose income taxes and value-added taxes only where an enterprise maintains a PE in the country concerned. Definitions of PEs under tax law or tax treaties may contain specific inclusions or exclusions.
The concept of permanent establishment emerged in the German Empire after 1845, culminating with the German Double Taxation Act of 1909. Initially the objective was to prevent double taxation between Prussian municipalities and this was extended to the entire German federation. In 1889, the first bilateral tax treaty, including the concept of permanent establishment, was concluded between the Austro-Hungarian Empire and Prussia, marking the first time the concept was used in international tax law. After years of preparatory works, in 1928, the League of Nations developed a model to tackle cross-border double taxation and to counter tax evasion. Since then, an extensive network of bilateral tax treaty was gradually established, particularly through the influence of the OECD Model Tax Convention, where this concept persisted.
Types of permanent establishments
- A fixed place of business permanent establishment (article 5(1));
- A construction or project permanent establishment, which is a special subset of the fixed place of business permanent establishment, with different requirements (article 5(3)); and
- An agency permanent establishment, through the actions of a dependent agent (article 5(5-6)).
The UN Model Tax Convention, which gives greater consideration to developing countries, adds what is known by service permanent establishment in article 5(3)b. Some countries, such as Saudi Arabia, have been trying to extend the concept of service PE into a virtual service PE.
Under the Base Erosion and Profit Shifting project being developed by the OECD and endorsed by the G20, a new nexus based on significant digital presence is being considered under Action 1, aimed at Addressing the Tax Challenges of the Digital Economy.
Fixed place of business
The starting point for determination if a permanent establishment exists is generally a fixed place of business. The definition of permanent establishment in article 5 of the OECD Model Income Tax Treaty is followed in most income tax treaties.
The commentary indicates that a fixed place of business has three components:
- Fixed refers to a link between the place of business and a specific geographic point, as well as a degree of permanence with respect to the taxpayer. An "office hotel" may constitute a fixed place for a business for an enterprise that regularly uses different offices within the space. By contrast, where there is no commercial coherence, the fact that activities may be conducted within a limited geographic area should not result in that area being considered a fixed place of business.
- A place of business. This refers to some facilities used by an enterprise for carrying out its business. The premises must be at the disposal of the enterprise. The mere presence of the enterprise at that place does not necessarily mean that it is a place of business of the enterprise. The facilities need not be the exclusive location, and they need not be used exclusively by that enterprise or for that business. However, the facilities must be those of the taxpayer, not another unrelated person. Thus, regular use of a customer's premises does not generally constitute a place of business.
- Business of the enterprise must be carried on wholly or partly at the fixed place.
The requirements of what constitutes a 'permanent establishment' within the scope of a particular treaty depend on what interpretation a particular country places on that term, in context of the text of that treaty. As per Article 3 of the Vienna Convention on the Law of Treaties, no one is entitled to claim rights under a particular treaty unless otherwise authorised by the contracting state. Therefore, if a particular contracting state places a different meaning on the term 'permanent establishment' than what the taxpayer seeks to place, the taxpayer would be left with virtually no remedy within that state, other than to seek a mutual agreement to that dispute with the other contracting state to that treaty.
Indicative list of permanent establishments
The OECD Model Tax Convention includes a short indicative list of prima facie permanent establishments. These, however, are not automatically permanent establishments as the requirements set out, namely, for fixed place of business permanent establishment must be met. The list is as follows:
- A branch
- A warehouse (but see excluded places below)
- A factory
- A mine or place of extraction of natural resources
- A place of management
Specifically excluded places
Many treaties explicitly exclude from the definition of PE places where certain activities are conducted. Generally, these exclusions do not apply if non-excluded activities are conducted at the fixed place of business. Among the excluded activities are:
- Ancillary or preparatory activities
- The use of a storage facility solely for delivery of goods to customers
- The maintenance of a stock of goods owned by the enterprise solely for purposes of processing by another enterprise (sometimes referred to as toll processing)
- Purchasing or information gathering activities
Other specific provisions
Construction or Project PE
Many treaties provide specific rules with respect to construction sites. Under those treaties, a building site or construction or installation project constitutes a PE only if it lasts more than a specified length of time. The amount of time varies by treaty.
In addition, the activities of a dependent agent may give rise to a PE for the principal. Dependent agents may include employees or others under the control of the principal. A company is generally not considered an agent solely by reason of ownership of the agent company by the principal. However, activities of an independent agent generally are not attributed to the principal.
BEPS Action 7 and 15
In October 2015, the OECD released the final reports on the Base Erosion and Profit Shifting (BEPS) project. Action 7 was targeted at Preventing the Artificial Avoidance of Permanent Establishment Status and proposes a large number of changes that are set to be included in the next version of the OECD Model Tax Convention. The OECD expects many of these changes to be applied to currently existing tax treaties through the work based on Action 15 on Developing a Multilateral Instrument to Modify Bilateral Tax Treaties. A large number of countries are involved in the negotiations that are expected to be concluded by the end of 2016.
The final report on Action 7 proposes substantial changes to the definition of Agency PE and stricter requirements to the exclusions provision:
"These changes will ensure that where the activities that an intermediary exercises in a country are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, that enterprise will be considered to have a taxable presence in that country unless the intermediary is performing these activities in the course of an independent business.
The changes will also restrict the application of a number of exceptions to the definition of permanent establishment to activities that are preparatory or auxiliary nature and will ensure that it is not possible to take advantage of these exceptions by the fragmentation of a cohesive operating business into several small operations; they will also address situations where the exception applicable to construction sites is circumvented through the splitting-up contracts between closely related enterprises."
- For example, Germany taxes non-German companies only on income from a PE.
- Kobetsky, Michael. History of tax treaties and the permanent establishment concept. pp. 106–151. doi:10.1017/cbo9780511977855.005.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version 2014. doi:10.1787/mtc_cond-2014-en.
- "UN Model Tax Convention (2011)" (PDF).
- "Saudi Arabian tax authorities introduce Virtual Service PE concept". www.ey.com. Retrieved 2016-03-15.
- "About Base Erosion and Profit Shifting (BEPS) - OECD". www.oecd.org. Retrieved 2016-03-15.
- OECD. OECD/G20 Base Erosion and Profit Shifting Project, Addressing the Tax Challenges of the Digital Economy, Action 1 - 2015 Final Report. doi:10.1787/9789264241046-en.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version 2014. Article 5 and Commentary. doi:10.1787/mtc_cond-2014-en.
- See, e.g., the U.S./UK treaty Article 5, which is virtually identical to the OECD Model Article 5. The Nigeria/South Africa treaty Article 5, is nearly identical to the OECD Model Article 5, with the addition of a provision clarifying that a fixed place of business used as a sales outlet is a PE, notwithstanding exclusions elsewhere in the article.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version 2014. Commentary 5-6 to Article 5. doi:10.1787/mtc_cond-2014-en.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version 2014. Commentary 4 to Article 5. doi:10.1787/mtc_cond-2014-en.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version 2014. Commentary 7 to Article 5. doi:10.1787/mtc_cond-2014-en.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version 2014. Commentary 12 to Article 5. doi:10.1787/mtc_cond-2014-en.
This paragraph contains a list, by no means exhaustive, of examples, each of which can be regarded, prima facie, as constituting a permanent establishment. As these examples are to be seen against the background of the general definition given in paragraph 1, it is assumed that the Contracting States interpret the terms listed, “a place of management”, “a branch”, “an office”, etc. in such a way that such places of business constitute permanent establishments only if they meet the requirements of paragraph 1.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version, Model Tax Convention on Income and on Capital: Condensed Version 2014. Article 4 and Commentary thereon. doi:10.1787/mtc_cond-2014-en.
- For example, the Canada/Belgium treaty sets this limit as 12 months, as does the OECD Model. By contrast, the US/India treaty treats such a site, project or activities continuing for more than 120 days in any twelve-month period as a PE.
- See Agency (law) for a discussion of the essential characteristics of agent and principal.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version 2014. Paragraph 5 of Article 5 and Commentary 31 to Article 5. doi:10.1787/mtc_cond-2014-en.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version 2014. Paragraph 7 of Article 5 and Commentary 40-41 to Article 5. doi:10.1787/mtc_cond-2014-en.
- OECD. Model Tax Convention on Income and on Capital: Condensed Version 2014. Paragraph 6 to Article 5 and Commentary 36-39. doi:10.1787/mtc_cond-2014-en.
- See, e.g., the United Nations Model Tax Convention Article 5 paragraph 3(b).
- See, e.g., the US/India treaty, supra., Article 5 paragraph 2(l).
- OECD. OECD/G20 Base Erosion and Profit Shifting Project, Developing a Multilateral Instrument to Modify Bilateral Tax Treaties, Action 15 - 2015 Final Report. doi:10.1787/9789264241688-en.
- "Multilateral instrument for BEPS tax treaty measures: the Ad hoc Group - OECD". www.oecd.org. Retrieved 2016-03-15.
- "Preventing the Artificial Avoidance of Permanent Establishment Status, Action 7 - 2015 Final Report - en - OECD". www.oecd.org. Retrieved 2016-03-15.