- July 12, 2020
- Posted by: Andrew Easler
- Categories: Business Planning, Compliance, Tax & IRS
Businesses with global operations often pursue and maintain relationships by relying on their globally mobile employees to initiate and sustain relationships with their foreign customer bases. These practices may have developed over a number of years in line with the growth of the business and frequently without any consideration being given to the potential tax consequences of such assignments. Where such employees are regularly conducting business in other jurisdictions, there is a risk of the business creating a permanent establishment and therefore becoming liable for local taxes.
Permanent establishment is a concept defined by a country’s tax laws or by their international treaties. The Organisation for Economic Co-operation and Development (OECD) has published a model convention on income tax entitled “Model Tax Convention on Income and on Capital 2014” (Convention). The Convention defines permanent establishment as “a fixed place of business through which the business of the enterprise is wholly or partly carried on.” This definition is simply a model, and every income tax treaty has its own variation on this concept. This definition is simply a model, and every income tax treaty has its own variation on this concept. Under the 2014 treaty definition of permanent establishment, the threshold of activity of an enterprise in one jurisdiction that results in the creation of a permanent establishment in another jurisdiction is determined by two forms of presence. The first form of presence is the fixed place of business test. An enterprise has a permanent establishment in another territory if it has a fixed place of business there through which it carries on its business, subject to several specific activity exemptions. The second form of presence is the dependent agent test. Currently, a permanent establishment arises when an agent, acting on behalf of a foreign enterprise, habitually exercises authority to conclude contracts in the name of the enterprise, unless the agent is an independent agent (legally and economically independent from its principal) acting in the ordinary course of its business. Since the previous definition was limited to the formal conclusion of contracts, the OECD widened the scope of the definition to also include situations in which an agent habitually plays the principal role leading to the conclusion of contracts that are then routinely concluded without material modification by the enterprise.
To determine whether the presence of a representative abroad creates a permanent establishment in another country, the scope of activities undertaken by the representative for that business are essential. Not every activity carried out on behalf of the company will result in the creation of permanent establishment. Activities carried out by a potential dependent agent must be of regular and permanent character. The Convention provides that concluding contracts on behalf of the company does not include only the final stage of signing a contract, but also includes determining terms and conditions of a contract. Therefore, negotiating powers given by a company may be sufficient to recognize such a person as a dependent agent for tax purposes. An important issue is that the person acting on behalf of the foreign enterprise must maintain independence and autonomy. If the agent does not fall into the self-employed category, the agent does not bear the risk arising from contracts concluded, and if the employer is entitled to issue binding instructions and commands, the risk of the foreign establishment is largely reduced.
In Action 7 of the Base Erosion and Profit Shifting (BEPS) Project, the OECD attempts to tackle common tax avoidance strategies used to prevent the existence of a permanent establishment, including through agency or commissionaire arrangements instead of establishing related distributors. Action 7 also aims to prevent the misuse of specific exceptions to the permanent establishment definition, which relate to activities of a preparatory and supporting nature. A company’s supporting activities, such as preparatory work that does not generate revenue does not trigger permanent establishment status. The burden of proof is with the company to demonstrate that the activities are auxiliary and do not warrant a permanent establishment status.
What makes permanent establishment a risk?
The presence of a permanent establishment in the territory of a state is the “combination to the safe” in taxing the business profits of a foreign enterprise. The activities of an agent in a foreign country, can unintentionally trigger permanent establishment. When a business has permanent establishment in a country and some of its employees working there becomes taxable in that country. Without permanent establishment, some of its employees would not be taxed. The exponential rise in controversy over permanent establishment is the subject of frequent disputes between taxpayers and tax administrations.
Depending on the jurisdiction and the specific terms of the income tax treaty, in the event of noncompliance, companies and some of their employees may be subjected to additional taxation, and there is the possibility that employees could be stopped at the border and prohibited from entering the country, resulting in a lost opportunity or loss of business. In addition, companies may be subject to fines, penalties, and other legal action from a foreign government. This could be a costly result and may also negatively impact reputations and status with other business partners as well as customers.
Permanent establishment rules vary across jurisdictions and it would be necessary to obtain advice locally in order to ensure compliance. To prepare for new regulations, employers with a global footprint should review their existing structures or planned procedures. Particularly, enterprises should review the activities performed by their foreign agents determine whether their roles and responsibilities may lead to permanent establishment in a foreign jurisdiction.
Org. for Economic Co-operation and Dev., Article 5 Permanent Establishment in Model Tax Convention on Income an on Capital 2014 (full version) OECD Publishing, Paris (2014). The most recent version, as of the date of this article, was published on April 25, 2019 and is entitled “Model Tax Convention on Income and on Capital 2017”.  Id.  Id.  Id.  Org. for Economic Co-operation and Dev., Article 5 Permanent Establishment in Model Tax Convention on Income an on Capital 2014 (full version) OECD Publishing, Paris (2014).  Id.  Org. for Economic Co-operation and Dev., Additional Guidance on the Attribution of Profits to Permanent Establishments, BEPS Action 7 (2018).  Id.  Id. Org. for Economic Co-operation and Dev., Multilateral Convention To Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, (2016).  Org. for Economic Co-operation and Dev., Article 5 Permanent Establishment in Model Tax Convention on Income an on Capital 2014 (full version) OECD Publishing, Paris (2014). Id.