What is permanent establishment (PE)?
Breaking down the definition of permanent establishment, in a transnational business context.
‘Permanent establishment’ (PE) affects businesses looking to expand overseas in any way. From opening a foreign branch, sending a sales agent abroad and transferring an employee to another country, to performing services outwith your ‘home’ jurisdiction – PE is an international tax concept which is important for any business owner to understand.
In this guide, we will deconstruct the legal jargon codifying PE to give you a clearer idea of what permanent establishment is, how it is enforced in different countries, and what the future of permanent establishment may look like.
The origins of ‘permanent establishment’ (PE)
In the early-modern era, as the many different states of the German Confederation were beginning to knit more closely together, a problem arose. Businesses trading between, or operating within two or more jurisdictions faced taxation on multiple fronts. The financial impact of this ‘double taxation’ was crippling, enough so as to discourage cross-border business.
To counter this issue, a series of late-19th century tax treaties were introduced in Prussia and Saxony, until, in 1909, the concept of ‘permanent establishment’ (Betriebsstätte) was enshrined in law. The German Empire’s ‘double taxation law’ stated that an enterprise could only be taxed by authorities of a jurisdiction in which it maintained a fixed place of business.
To this day, a ‘fixed place of business’ (FPOB) remains one of the key identifiers of permanent establishment.
However, the definition of PE has since evolved: first introduced to the wider world by the League of Nations in 1928, the concept was further defined by the OECD in the 1960s with its Model Tax Convention. Bolstered by the UN’s Model Tax Convention, the OECD today informs the majority of bilateral tax treaties and their definitions of permanent establishment. Thus, it is with the OECD we will seek to paint a clearer picture of what permanent establishment means.
What is permanent establishment?
A permanent establishment is a type of business presence in a ‘host’ country (i.e.: one foreign to the enterprise’s residence, or ‘home’ country) which incurs income, or value-added tax liability in the host jurisdiction.
PE is a means for tax authorities around the world to determine which foreign enterprises operating in their area fall under their jurisdiction – and should therefore be taxed – and which are exempt.
Definitions of PE differ depending on the specific tax laws and treaties governing each jurisdiction, though generally adhere to the three main ‘types’ of PE defined by the OECD, and a fourth described by the UN.
Fixed place of business (FPOB) PE
According to Article 5(1) of the OECD Model Convention, a permanent establishment is “a fixed place of business through which the business of an enterprise is wholly or partly carried on.” Let’s break this down.
- Fixed: The establishment of an enterprise is ‘fixed’ within a specific geographical boundary (e.g.: a country, province, state, autonomous region or territory) to a degree of permanence.
- Place: The establishment constitutes a physical space in which an enterprise’s business is partly or wholly conducted, and which is at the disposal of the enterprise. The space(s) do not need to be used exclusively by the enterprise, nor be in only one location, but they must belong in some way to the enterprise.
- Business: The establishment is used by an enterprise for the whole or part conduct of its business. Generally, ‘business’ refers to any work which generates revenue or commercial leads for the enterprise; if no commercial activity takes place in the establishment, it is possible that it will not be considered an FPOB.
Prima facie permanent establishments
The OECD outlines a short list of permanent establishments, which it designates prima facie status; meaning that the existence of any one of the following will typically be considered by tax authorities to be a PE:
- A branch
- A warehouse
- A factory
- A mine or other place where natural resource extraction takes place
- A place of management.
The burden of proof that any of these is not a permanent establishment (if indeed this is the case), rests solely on the foreign enterprise in question.
Excluded establishments, then and now
In contrast to the OECD’s prima facie PEs, many international tax treaties also define places which are excluded from their definition of a permanent establishment. These exceptions include:
- Facilities used solely for storage, delivery or display of goods and merchandise owned by the enterprise
- Premises used to maintain goods or merchandise for processing by another enterprise (AKA: ‘toll processing’)
- A fixed place of business used by the enterprise solely for collecting information, or for purchasing goods or merchandise
- Any other type of establishment utilised by the enterprise for “ancillary or preparatory activities”, or for a combination of the exceptional activities.
Recently, however, the rules governing these exceptions are beginning to change. In 2017, the OECD and its member states concluded negotiations regarding the Base Erosion and Profit Shifting (BEPS) project. The BEPS project resulted in amendments to the organisation’s Model Tax Convention, most notably Articles 7 and 15.
Article 7 sought to combat the number of enterprises using the “ancillary or preparatory activities” exemption as a tax loophole. The definition of ancillary activities has since been narrowed considerably.
Construction or project PE
A building or construction site can sometimes also be considered a permanent establishment, but typically only if it exists for more than a set length of time. In Article 5(3) of the OECD Model Convention, this length of time is one year, or twelve months.
Some enterprises in the past have attempted to circumvent PE by relocating an agent overseas, to conduct business in a foreign jurisdiction on their behalf. This can however be constituted as another form of PE. Provided the agent is dependent on your organisation (i.e., they are an employee, not an independent contractor), their professional presence in another country may be enough to trigger permanent establishment.
Article 7 of the BEPS Project (referenced above) redefined the activities by an agent deemed a permanent establishment. For the first time, the definition of agency PE was broadened to include the activities of any agent which regularly result in the creation of new contracts for their employer, even if they do not conclude those contracts themselves (as was the former definition).
Out with the OECD, the UN’s Model Tax Convention also defines something called ‘service PE’. This type of permanent establishment exists – according to some treaties – when a company in one country provides services in another for more than ‘x’ amount of time.
Some countries like Saudi Arabia, for example, continue to push for the definition of service PE to include “virtual service”: i.e., services rendered via the internet, yet without anything approaching an FPOB, construction site, or agency in the host country.
As we will shortly discuss, the limitations of bilateral tax treaties with regard to digital, versus physical, establishment are beginning to be addressed.
How is permanent establishment regulated internationally?
Generally speaking, most jurisdictions around the world base their tax treaties on the OECD definitions of PE, sometimes also incorporating the Model Convention of the UN. However, the specifics of these definitions can differ considerably from country to country, jurisdiction to jurisdiction.
To operate compliantly overseas, business leaders must understand the nuances of the tax treaties drawn between their home and host country, or countries. A sensible approach to global compliance involves acquiring third-party risk assessments and advice on your company’s operations in a given region.
Risk management: What to do if you suspect you have, or will have, a permanent establishment overseas
Establishing a PE in a foreign country is by no means a bad thing. In fact, it may well be vital to the success of your international business expansion, depending upon the nature and intention of your operations.
Regardless, there are risks associated with permanent establishment which you will want to avoid. Seeking the expert guidance of an Employer of Record should be your first port of call when assessing the PE risks of any overseas venture.
The future of PE
As the nature of business rapidly evolves, and enterprises both big and small find themselves investing more time and resources into their online presence, the definition of PE requires reworking. Already there are some countries around the world seeking to incorporate the digital space into permanent establishment law.
We have already touched on Saudi Arabia’s desire for the UN and OECD to include ‘virtual service PE’ in their Model Conventions, but in the United Kingdom, this has already happened.
The UK’s digital services tax applies a 2% tax to revenues made by ‘digital services companies’ which profit partly from its UK user base (though, interestingly, US tech giants like Amazon, Meta and Google have been granted impunity by the UK government). Effectively this means that social media enterprises, online marketplaces and search engines with users in the UK will be considered to have a service-type permanent establishment there, and thus are taxed accordingly.
To keep up-to-date with the changing laws and treaties regulating PE around the world, and better understand how to manage risks associated with your plans for international expansion, engage the services of an experienced Employer of Record today.
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