Permanent Establishment

Why is the Concept of a Permanent Establishment Important? 

Tax treaties typically provide that the business profits of a foreign business or taxpayer are taxable in the host state only to the extent that the enterprise/taxpayer has a permanent establishment in the host state to which the profits are attributable.

The concept of a permanent establishment is, in other words, a basic nexus/threshold rule for determining whether or not a country can generally tax the business profits of a non-resident taxpayer.  The permanent establishment concept also acts as a source rule to the extent that, as a general rule, the only business profits of a non-resident that may be taxed by a country are those that are attributable to a permanent establishment. In addition, the permanent establishment concept is used to determine whether the reduced rates of, or exemptions from, tax provided for dividends, interest, and royalties apply or whether those amounts are taxed as business profits.

What is a Permanent Establishment? 

In general, under a treaty, a permanent establishment is a fixed place of business through which the business of an enterprise is carried on in whole or in part. A permanent establishment generally includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, or other places of extraction of natural resources.

The basic definition of permanent establishment is supplemented by a rule that deems a non-resident to have a permanent establishment in a country if another person acts in that country as an agent of the non–resident and habitually exercises an authority to conclude contracts in the name of the non-resident. That rule, however, does not apply to independent agents acting in the ordinary course of their business.

Thus, if a person, other than an independent agent, is acting on behalf of an enterprise and has and habitually exercises the authority in a country to conclude contracts in the name of an enterprise of the other country, the enterprise generally will be deemed to have a permanent establishment in the first country in respect of any activities that person undertakes for the enterprise. Under the U.S. model and the OECD model, this rule does not apply where the contracting authority is limited to those activities described above, such as storage, display, or delivery of merchandise which are excluded from the definition of a permanent establishment.  A foreign enterprise will not be deemed to have a permanent establishment in the United States merely because it carries on business in the United States through a broker, general commission agent, or any other agent of an independent status, provided that such person is acting in the ordinary course of his business as an independent agent.

What about a subsidiary? 

It is generally accepted that the existence of a subsidiary company does not, in and of itself, constitute a permanent establishment of its parent company.

However, any space or premises belonging to the subsidiary that is at the disposal of the parent company and that constitutes a fixed place of business through which the parent carries on its own business may constitute a permanent establishment of the parent.

An example is that of an employee of a company who, for a long period of time, is allowed to use an office in the headquarters of another company (e.g., a newly acquired subsidiary) in order to ensure that the latter company complies with its obligations under contracts concluded with the former company. In that case, the employee is carrying on activities related to the business of the former company and the office that is at his disposal at the headquarters of the other company may constitute a permanent establishment of his employer, provided that the office is at his disposal for a sufficiently long period of time so as to constitute a “fixed place of business.

Must the Place of Business be Fixed?

A place of business must be a “fixed” one.  That is, there must be a link between the place of business and a specific geographical point. (Geographically Fixed).

In addition, a permanent establishment will generally only be deemed to exist the place of business has a certain degree of permanency, i.e., if it is not of a purely temporary nature. (Temporally Fixed)

A place of business may, however, constitute a permanent establishment even though it exists, in practice, only for a very short period of time. Permanent establishments normally have not been considered to exist where a business had been carried on in a country through a place of business that was maintained for less than six months (conversely, there are a number of cases where a permanent establishment has been considered to exist where the place of business was maintained for a period longer than six months).

Temporary interruptions of activities do not cause a permanent establishment to cease to exist.

A nonresident alien individual or a foreign corporation is not considered to have an office or other fixed place of business merely because such alien individual or foreign corporation uses another person’s office or other fixed places of business, whether or not the office or place of business of a related person, through which to transact a trade or business, if the trade or business activities of the alien individual or foreign corporation in that office or other fixed place of business are relatively sporadic or infrequent, taking into account the overall needs and conduct of the trade or business.

See Commentary on Article 5(1) of the OECD Model; CIR v. Consolidated Premium Iron Ores, Limited, 265 F.2d 320 (6th Cir. 1959); Treas. Reg. Section 1.864-7(b)(2).  

What are Recent Developments in the Concept of a Permanent Establishment? 

The OECD’s Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan) calls for a review of the PE definition to prevent the use of common tax avoidance strategies that are used to circumvent the existing PE definition.  Included among the targeted arrangements are arrangements through which taxpayers replace subsidiaries that traditionally acted as distributors by commissionaire arrangements.  The OECD believes that changes to the PE definition are necessary to prevent the exploitation of certain exceptions to the PE definition provided under Art. 5(4) of the OECD Model Tax Convention (2014), particularly in the digital economy.