Understanding Permanent Establishment in Tax
Globalization has led to the question of trade and investment suffering from double taxation. Policy discussions are ongoing, discussing the harmful impact of aggressive tax planning and have led to discussions of double taxation agreement, the cornerstone being permanent establishment.
Double taxation has led to companies engaging in tax avoidance schemes, often complex in nature, to avoid paying taxes in a resident state and in a state where profits are received.
Double taxation agreements (DTAs), often entered into as a political tool or gesture, can also harm a country’s revenues. Agreements with the United States can cost billions in losses annually. The Netherlands may have lost as much as €770 million in 2011 alone due to agreements with developing countries.
Tech giants, such as Facebook, Google and Apple, also funneled money through international headquarters to avoid a “physical establishment” in countries that have higher tax rates.
The issue, which led to Apple and Google owing $600 million to Italy, has led to the European Union planning to revise their rules on Permanent Establishments.
What is a Permanent Establishment?
Businesses that operate outside of their resident country, or country in which they are a resident, are required, in many countries, to still pay taxes in their resident country. Even when the operations are based in another country, the resident company wants to receive taxes from the income made.
DTAs are such that source countries and resident countries have taxing rights.
Permanent establishment (PE), as pertains to DTAs, helps put in place a threshold for the taxing source. For example, let’s assume the following:
- State A is the resident country
- State B is the source company (non-resident)
A company earns revenue from State B, and State A and B have a DTA in place. Under the DTA, there may be a threshold for how much a company is taxed by State B and State A.
Thresholds for taxation will be dependent on the DTA that’s in place.
What a PE does is a few things:
- Limits taxing at the source State
- Sets minimum limits on the nature of the activity
Let's assume that a PE is formed, when in accordance to the DTA, if a company has been operating in State B for a period of 6 – 12 months.
A company, signing a new contract, may have to operate in the non-resident state for a period of eight months. This means that the DTA would consider the operations to be a permanent establishment, meeting the threshold in the agreement.
The non-resident country will want an allotment of taxes as a result.
But the company doesn’t want to pay these taxes. Complex avoidance strategies may be put in place, and now, the company has formed three different entities. All of the three entities will work on the project for no more than three months at a time in an effort to avoid further taxation.
The state where the operations took place may not realize that the contract has been split in such a way that it’s designed to reduce or avoid the PE definition.
Under the example above, and it happens frequently, the company will pay less taxes while still operating in a non-resident state.
When a DTA is formed, it’s important that the definition of a permanent establishment is clear and concise. Both states must understand and consider the implications that the PE definition will have on the agreement.
Source States are often the beneficiary of a wider agreement, wherein a wider range of situations for a permanent establishment exist. The Source States may not benefit from a narrower permanent establishment definition because it will often reduce the State’s right to tax the company.
There are reasons why a state may agree to narrower agreements aside from a lack of understanding.
For example, perhaps the state is willing to concede with less taxation rights on the basis that Foreign Direct Investment will increase, covering the potential loss in revenue.
Conventions and Permanent Establishments
There are model conventions in DTAs resulting in an agreement, despite differences in wording, offering similar provisions. OECD, UN and United States proposals on conventions have led to this similar wording being adopted in DTAs.
States have a right to follow these recommendations fully, or the state can choose to make changes as needed.
Initial Definitions of a Personal Establishment
Under the models, and they are different, the personal establishment is determined under the “place of business test.” The requirements often fall under:
- Existence of a place of business
- The place of business must have a degree of permanence, but that permanence doesn’t need an attachment to the soil
- Operations are through a fixed place of business
Following these criteria, you’ll also find sections that include examples of what a PE may consist of and the minimum period of time that is required for a permanent establishment to be triggered.
It's important to mention that “operations are through a fixed place of business” means that the company employs workers in the State. These workers may not be independent of the company.
Exclusions in activities will also be listed in a third section, and this means activities that may provide little or no income.
UN, OECD and US models, while having significant similarities, vary greatly primarily due to the minimum time that constitutes a PE. For example, under the OECD model, it would require a company to operate in a state for 12 months to be considered a PE.
UN models establish a PE after just a six-month period.
Resident and non-resident states will be greatly impacted, depending on the model adopted, because it may mean a significant drop in tax revenue. OECD models are also lacking information on what happens if a company operates in a non-resident country past the PE definition.
UN models, in this case, are more thorough and may provide a better framework for a DTA to follow.
Each model also has its own definition of “auxiliary” activities. The benefit of each model must be considered so that the DTA is as thorough as possible. There are also differences between the UN and OECD models as pertains to:
- Consultancy business provisions for the duration test
- Specific anti-abuse clauses
- Preparatory or auxiliary activities
The result is that DTAs become a complex agreement wherein multiple editions may be signed that cover different policies appropriately. Contracting States may decide that it’s best to adopt several DTAs to provide better overall provisions and tax benefits.
Duration tests are often the most important part of a PE, and contracting states may decide to update their agreements or use different agreements with different contracting states.
Extractive Industry Impacts and Permanent Establishment
Defining a permanent establishment is key to enforcing a DTA, but it may be difficult to define a PE because there are different triggers. As we’ve learned, there are different means in which a PE can be established based on the adopted model convention.
Questions exist in business industries where fragmented work may count towards PE establishment.
Multiple parties may operate in extractive industries, and these parties may be commonly owned. Fragmented activities may exist in one common project, but there’s the question of whether or not these fragmented activities should be lumped together.
When lumped together, this may create a PE, which may or may not be beneficial.
Contract splits, which are often utilized as a means of avoidance, also occur in extractive industry operations. Should these activities be grouped together, too?
There's also the consideration of investor-State contracts.
Joint operating agreements may exist within these contracts which will trigger different PEs, and subcontractors may also trigger a PE despite only being called in for short-term work. It's a complex web of legalities that can lead to more questions than answers for businesses.
Tax administrators will need to monitor work closely in order to correctly develop a timeline of work and ensure that the definition of a PE is properly established.
Companies have also been known to call in several companies to split the work among. These companies may be subsidiaries, and the companies may shift profits around in such a way that they avoid PE and are able to maximize profits.
Avoiding taxes at source benefits companies, but it also lowers revenue in the source countries where operations took place.
Extractive services are such that different stages are likely to trigger permanent establishment. States often require companies in this field to establish a presence in the region.
Subcontractor Issues and Concerns
Subcontractors are a vital part of the workforce, and it’s not uncommon, despite the industry, for subcontractors to be called into a project. These professionals will often only work for a short-term period, and the skills that they offer are highly specialized.
Electricians, for example, may be subcontracted to work on a defense building.
These individuals operate on their own terms, so they may or may not trigger a PE. Companies, in an effort to avoid triggering a PE, will subcontract in such a way or structure operations to avoid threshold establishment.
Subcontracting companies, which may be closely related, may also be called in for profit shifting, or to shift profits from a company that has met the PE threshold to a company that does not meet the threshold.
Since the two companies are closely related, and they may even have the same owners, this provides a direct benefit in terms of revenue.
Resident states will often negotiate longer PE thresholds, and this will generate higher tax revenue for the resident state. Larger entities with higher operations may request longer PE thresholds because the state that they’re coming to an agreement with is smaller in size and less beneficial of a partner.
The Republic of China, known for its large economy, has an 18-month threshold with their agreement with the Government of Ukraine. Ukraine loses out on revenue as a result of the poorly agreed upon DTA.
Loopholes exist that allow companies to shift profits, and this is what Google and Apple did when they setup their bases in Ireland. The companies knew that Ireland had lower taxes than Italy, for example, so it made economic sense to shift profits.
The penalties paid were small in comparison to the profit made, and it is likely, although not certain, that the two tech giants knew the potential fines or penalties would be far lower than the savings potential.
It's a risk-reward basis for these companies, and the BEPS project, from the OECD, aims at helping governments find solutions to the growing profit shifting problem.
Base erosion profit sharing is a major issue facing many of these models, and it’s an issue that will continue to exist, although the area does have room for improvement. OECD’s Multilateral Convention is a promising solution that will allow the adoption of specific clauses by States that will prevent the avoidance of PE.
Anti-fragmentation rules are especially important and are the focus of many solutions because of the widespread use of fragmentation to avoid thresholds.