What is a Permanent Establishment - Corporate Tax

Permanent Establishment


The term permanent establishment (PE) is a concept which exists for tax purposes only and should not be confused with an entity’s place of business, tax residency, place of effective management or a branch.

A PE can only be created in a country other than that in which an entity is established and there can only be one PE per country. The practical meaning of a PE is then that it creates a taxable presence for a company outside the company’s country of establishment.

The significance of a PE being deemed to exist is that the profits attributable to this PE are subject to domestic corporate taxation. This would include profits generated by a non-resident company from sales made or services rendered to customers based in a third country if they were generated through the activities of a the PE.

As a general rule, a PE must be registered with the local tax administration and separate (tax) accounting and tax filing must be arranged.

To give a simple example, a Dutch company could never have a PE in the Netherlands (because it is already operational there), but if its activities check all the boxes for creating a PE in Germany for example, then you have a Dutch company with an additional taxable presence in Germany.

Ultimately, the existence (or not) of a PE should be determined according to:

1) The relevant domestic corporate tax legislation. Each country has a slightly different approach to PE’s and the specific domestic definition should always be checked.


2) Consult the tax treaty (double taxation agreement or “DTA”) between an entity’s country of establishment and the PE state. As the text of individual DTA’s can vary, the relevant article of the appropriate treaty should always be consulted when making a PE determination. Tax treaties often limit the existence of a PE compared to rules in domestic law. Interpretation of a treaty will be assisted by the commentary to the OECD Model Tax Convention on Income and on Capital.

AND, where adopted

3) The Multilateral Instrument (MLI).

Permanent Establishment under the OECD Model Tax Convention

The text of Article 5 of the OECD Model Tax Convention on Income and on Capital (the OECD Model Convention) addresses the issue of PE. This text and the text of Article 5 of many DTA’s will be the same. Given that the same text applies, it is reasonable when interpreting the provisions of a treaty to refer for aid to the commentary provided to the OECD Model Convention.

The formal definition of a “classical PE” provided by the OECD Model Tax Convention under Article 5(1) says:

“a permanent establishment means a fixed place of business through which the business of an enterprise is wholly or partly carried on”

Each element of this definition is crucial for a PE to exist:

1. There must be a place of business or facility;

2. The place of business must be “fixed” i.e. must be a distinct place with a degree of permanence;

3. The business of the enterprise must be undertaken through this fixed place of business.

Most countries have modeled their domestic definition of a PE in line with the OECD Model Tax Convention and it is followed by a majority of effective tax treaties.

Under Article 5(5) of the convention, even if an entity is deemed not to have a fixed place of business, a PE may nevertheless arise if the entity is found to conduct business within the country through an agent that is not independent, referred to as a dependent agent. Such a “dependent agent” or “agency PE” is described as “a person acting on behalf of an enterprise who has, and habitually exercises an authority to conclude contracts in the name of the enterprise in the other state“. As per international practise, such a dependent agent PE arises if a domestic person has and habitually exercises the authority to conclude contracts in the name of the entity. As opposed to a “classical PE”, it does not require a specific fixed location in order to be triggered but instead relates to the nature of the agent’s activities.

In summary, under general tax treaties the term “permanent establishment” includes the following:

Asset-Typed Classical PE An entity in the contracting state has a fixed place of business (e.g. a branch, office, factory, warehouse) in the other contracting state

Activity-Typed PE

An entity in the contracting state has a building site or construction or assembly project or services activities which exist for a specified period in the other contracting state

Agent-Typed PE

An entity in the contracting state has a dependent agent to conclude contract, keep stock of goods or secure orders in the other contracting state on its behalf

Risks Associated with a Permanent Establishment

In line with the above mentioned definitions, the risks associated with a PE arising can essentially be placed within two broad categories. Practical steps should be taken to monitor these activities.

1) PE risks associated with a fixed place of business:

Article 5 of the Model Convention provides examples of a PE under this definition, which include a place of management, a branch office, a factory or workshop.

The potential for the following factors to give rise to a fixed place of business PE should be considered:

· The processing by domestic Tollers of raw materials and semi-finished products owned by the entity within that country;

· The warehousing of raw materials and finished goods owned by the entity within that country, at domestic Toller’s premises and at other warehouse locations;

· The activities of the entity’s management, and the extent to which the entity maintains an ‘office’ or other ‘place of management’ domestically.

Note: Exclusions:

Examples of what do not constitute a PE include the use of facilities solely for the purpose of storage, display or delivery, purchasing goods or merchandise, or for collecting information and solely for the purpose of advertising, for the supply of information, for scientific research or for similar activities which have a preparatory or auxiliary character. See paragraph 3 for details.

2) PE risks associated with dependent agency:

A key area to consider in determining if a PE exists under the “agency PE” definition is sales. As a general rule, where no sales are concluded in the other state by independent agents of the enterprise, there is no taxable presence for it in the other state. However, if the enterprise employs salespersons travelling to, or based in, the other state, it is necessary to examine where the sales contracts are concluded. If the sale is agreed in the other state by the salesperson and they do this on a regular basis, there is a taxable presence there; if not, then there is no taxable presence. In practice, good documentation i.e. contracts, minutes of meetings etc., is essential in proving where decisions are made.

The potential for the following factors to give rise to a dependent agent PE should be considered:

· The domestic distribution of finished goods purchased from the entity by a domestic Distributor;

· The procurement services provided to the entity, local Tollers and the domestic Distributor by the Procurement Company domestic personnel;

· The shared services provided to the entity, local Tollers, the domestic Distributor, and the Procurement Company by the domestic Service Company; and

· The logistics services provided to the entity by domestic Distributor personnel.

BEPS Action 7 - Preventing the Artificial Avoidance of Permanent Establishment Status

In October 2015, the OECD released its final report on Base Erosion Profit Shifting (BEPS) Action 7, “Preventing the Artificial Avoidance of Permanent Establishment Status”. BEPS Action 7 calls for:

“the development of changes to the definition of Permanent Establishment to prevent the artificial avoidance of PE status in relation to BEPS, including through the use of commissionaire arrangements and the specific activity exemptions”

The Multilateral Instrument

The OECD’s multilateral instrument (MLI) provides a mechanism to allow countries to transpose recommendations from its BEPS initiative into existing DTA’s while providing for options in certain areas. The MLI enables countries to simultaneously update multiple tax treaties to ensure they comply with BEPS recommendations, without the need for multiple bilateral negotiations. For a MLI to take effect it is necessary that the counter-party treaty jurisdiction has also ratified the MLI.

Article 12 of the MLI sought to introduce a new test for when an agent could trigger a PE. Specifically, a PE would be created where an individual is acting in another jurisdiction on behalf of an enterprise and in doing so, habitually concludes or habitually plays the principal role in concluding contracts that are routinely concluded without significant modification by the enterprise.

Note: A number of DTA partners have not adopted this new tie-breaker clause (e.g. Italy, Luxembourg and Malta). The ‘place of effective management’ standard will continue to apply in those cases.

The “PPT Test”

The BEPS project recommended that measures be taken to further enhance the anti-treaty shopping measures in DTAs and this is being implemented across the OECD members now via the MLI.

Article 7 of the MLI, on Prevention of Treaty Abuse, allows for an option to introduce what is called a Principal Purposes Test (‘PPT’) and/or a Simplified Limitation of Benefits rule.

All 68 OECD jurisdictions have opted to introduce the PPT into their DTAs.

The test of the article states:

“Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.”

To summarise the key points of the PPT Test:

• Must be reasonable to conclude that one of the principal purposes of an arrangement or transaction was to obtain the benefits of the tax treaty.

• The treaty benefit does not have to be the sole purpose to fall foul of the PPT.

• It also states that a purpose will not be a principal purpose when it is reasonable to conclude that obtaining the tax treaty benefit was not a principal consideration and would not have justified entering into any transaction or arrangement that has resulted in that benefit.

Attribution of Profits to PE’s

BEPS Action 7 also mandated additional guidance the development of on how the existing rules on attribution of profits to PEs under Article 7 would apply to PEs resulting from the changes recommended in the Report.

The additional guidance resulting from this mandate sets out high-level general principles for the attribution of profits to permanent establishments arising under Article 5(5), in accordance with applicable treaty provisions, and includes examples of a commissionaire structure for the sale of goods, an online advertising sales structure, and a procurement structure. It also includes additional guidance related to permanent establishments created as a result of the changes to Article 5(4), and provides an example on the attribution of profits to permanent establishments arising from the anti-fragmentation rule included in Article 5(4.1).

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