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Tax Law Notes Legal Issues, Governance, and the IMF
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Tax Law Note: Definition of Permanent Establishment Legal Department Last Updated: December 02, 2004 Introduction The term "permanent establishment" of a nonresident is a key concept in the typical double tax treaty, and in the OECD and United Nations model tax treaties.1 Under the OECD and UN models, and commonly under treaties in force, a country may tax the business income generated by a nonresident's permanent establishment.2 In other words, a nonresident's business income derived in a country through the activities of the nonresident's permanent establishment is considered sourced in that country, and therefore subject to the tax jurisdiction of the country. Typically, this income is taxed on a net basis, i.e. after allowance of deductions. Some countries also impose withholding taxes on specific kinds of business income earned by nonresidents without a permanent establishment in the country. These withholding taxes might be precluded by treaties. This note, however, is limited to the question of how permanent establishment may be defined. It provides an introduction to the basics. Those wishing to go further might start with the various commentaries to the OECD and UN models and OECD documents that have considered details of the definition, as well as other literature cited below. It is useful to think of the definition of permanent establishment as part of the rules for determining the source of income.3 Although it is easy to conclude that a dividend paid by a company resident in Country X has its source in Country X, it is more difficult to identify the source of income of a multinational business. This task becomes especially difficult for Country X if the multinational does not structure its Country X operations as a resident company or partnership, but instead simply carries on sales or other activity in Country X without a recognized structure there. If the nonresident multinational's only contact with Country X is that goods are shipped to a destination in that country, then there is little justification for Country X to assert taxing jurisdiction over the nonresident for income tax purposes. But if the nonresident establishes a base of operations in Country X, then it is appropriate for Country X to assert the right to tax the nonresident on its income from the Country X activities. It would be common international practice for Country X to tax the multinational on income generated by the activities of its "permanent establishment" in Country X. Assertion of tax jurisdiction over the local-source income of a nonresident is the common international practice in taxation of multinational business, and it may be helpful to follow this practice so the taxing country's tax law meshes well with that of its international trading partners. The definition of "permanent establishment" is relevant both for a country's domestic law and for its treaties. As a matter of domestic law, the definition is needed to demarcate the cases where the country asserts its taxing jurisdiction over the business income of nonresidents. In the latter case, the definition of "permanent establishment" is a matter for discussion and negotiation between two countries in reaching agreement on a bilateral tax treaty, which by its terms will govern the way the nationals of one are treated when "nonresident" in the other.4 The United Nations model tax treaty, which is more generous to developing countries than the OECD model, has a relatively broad definition of "permanent establishment." A country wishing to have a strong negotiating position in its international tax treaties could include in its income tax a rule taxing residents on their worldwide income and nonresidents on their local-source income; and specify that nonresidents are taxable on the business income generated by a nonresident's "permanent establishment" in the country, broadly defining this concept. Country Practice The definition of "permanent establishment" in domestic laws often draws on the general structure of the UN or OECD model. Minor adjustments to take into account the enacting country's particular circumstances are common.5 For example, tax rules are to some extent shaped by practical considerations of tax administration. A country may be willing to give up the right to tax some income because it is simpler not to tax the income. Fashioning a Solution In general, a "permanent establishment" exists when a nonresident's Country X business activities are substantial enough for Country X to assert that the income generated by those activities is local-source income. To determine jurisdiction to tax business income, tax treaties start with the permanent establishment concept, which refers to a relatively enduring presence in a country whether by way of location (e.g., an office) or personnel. The definition article of "permanent establishment" in the UN and OECD models is quite lengthy. It can be simplified in domestic law by removing some of the qualifications that limit the concept. If the OECD model is used as the starting-place, then extensions of the concept found in the UN Model may be added, because the UN model was designed to increase the taxing reach of developing countries and to provide negotiating room in the tax treaty process. The illustrative definition of permanent establishment follows these general principles of drafting. Special rules on oil and mineral extraction activities may also be appropriate for some countries.6
The term "permanent establishment" specifically includes a place where a nonresident carries on business through an agent other than an "independent agent acting in the ordinary course of business." Whether an agent is "independent" of the person represented depends on the extent of the agent's obligations as regards the person represented.10 For example, an agent will not be regarded as being of independent status if the agent's commercial activities for the person represented are subject to detailed instructions or to comprehensive control by the person represented. The "agent of independent status" exclusion is commonly used in the definition of "permanent establishment" in double tax treaties and the illustrative definition follows this practice. The definition also specifically includes a place where a nonresident has a building site or construction, installation, or assembly project in the country. These activities are expressly included to avoid any argument, particularly where the activities are of a temporary nature,11 that they are not "permanent." In typical international practice, they are sufficiently connected with Country X to justify the assertion of tax jurisdiction over the income they generate. The term "construction, assembly, or installation project" is intended to be broad. It would include, for example, the construction of buildings, roads, bridges, dams, the laying of pipe-lines, and excavating or dredging. A nonresident is regarded as being engaged in a construction, assembly, or installation project if engaged in supervisory activities in relation to such a project. A nonresident multinational that carries on the entirety of its business in Country X through a Country X subsidiary would not be affected by inclusion in the law of the term "permanent establishment," because the subsidiary is a Country X resident and is separately taxable under the tax law provisions governing income taxation of residents. Further Reference Ault, Hugh, et al., Comparative Income Taxation 298-02, 452-55 (1997) (U.S., Canada, Australia, U.K., Sweden, Netherlands, Japan, France, Germany) Vann, Richard International Aspects of Income Tax, in Tax Law Design and Drafting 718 (1998). J.J. Burgers The Taxation of Permanent Establishments, International Bureau of Fiscal Documentation, (1993) The series of Tax Law Notes has been prepared by the IMF staff as a resource for use by government officials and members of the public. The notes have not been considered by the IMF Executive Board and, hence, should not be reported or described as representing the views of the IMF or IMF policy. 1Article 5. 2The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment." OECD Model Tax Convention, art.7. 3For example, while Canada uses the concept of permanent establishment in its treaties, it taxes nonresidents not on the basis of whether a non-resident has a permanent establishment in Canada, but whether the non-resident is considered as carrying on a business in Canada. Similarly in the U.S. the relevant concept for domestic law is whether income is effectively connected with a business carried on in the U.S. See I.R.C. §§ 863, 864. These concepts are, however, quite close to that of permanent establishment. I. Sapona, 2 The Taxation of Permanent Establishments, Canada- 45, (IBFD, 1993 & Supp. May 1996). In France, the term "permanent establishment" as used in treaties is merely defined as a fixed place of business through which a non-resident of France engages in industrial or commercial activity. The term "permanent establishment" as such does not exist under French domestic legislation, which uses instead the term autonomous establishment or refers to the principle of territoriality. PJ Douvier, 2 The Taxation of Permanent Establishments, France- 25-26, (IBFD, 1993). 4For definition of residence, see Richard Vann, International Aspects of Income Tax, in Tax Law Design and Drafting 718, 729-34 (1998). 5In Spain, contrary to the OECD Model, article 12 of the Non-residents Income Tax Law includes in the definition of permanent establishment agricultural, forestry, or livestock undertakings. These latter fall under the concept of income from immovable property under the article 6 of the OECD Model. S. Raventos Calvo, 1 The Taxation of Permanent Establishments, Spain- 23, (IBFD, 1993 & Supp.April 1999). 6Under the treaty between Greece and Hungary, a person who carries out activities in connection with the exploration or exploitation of the seabed and its subsoil and their natural resources situated in a contracting state has a permanent establishment if the activities last more than 30 days in the aggregate in any 12- month period. Moreover, in Mexico, this requirement of fixedness is not expressed. Thus, the Mexican Income Tax Law definition of permanent establishment uses merely the term "place of business": "A place of business in which part or the entirety of an entrepreuneurial activity is developed is deemed a permanent establishment for purposes hereof". M.E. Tron , 2 The Taxation of Permanent Establishments, Mexico- 54, (IBFD, 1993 & Supp.March 1998). 7Vann, supra note 4, at 737-38. 8Contrary to most countries' practice, Norwegian courts have, as a matter of principle, accepted portable equipment as a place of business (The Norwegian Supreme Court in Alaska, Rt.1984, at 99; the lower court in Creole, Utv.1981,at 285). See Arvid Aage Skaar, Commentary on article 5 of the OECD Model Treaty: The concept of Permanent Establishment The Taxation of Permanent Establishments, 13 (IBFD, 1993 & Suppl.February 1994). 9In Poland, contrary to the OECD Model, there is included in the list a place of exploration of natural resources. Thus, Poland's treaty with Indonesia, as well as those with India, Sri Lanka, the United Kingdom and Malaysia, provides that, apart from the extraction of natural resources, a place of exploration of natural resources and a drilling rig and ship used for exploration of natural resources also constitutes a permanent establishment. A. Ostaszewska, 2 The Taxation of Permanent Establishments, Poland- 24, (IBFD, 1993 & Supp.October 1998). 10In the treaty between Poland and Indonesia, an agent whose activities are devoted solely or at least 60% on behalf of the enterprise or its associated enterprises is not considered an independent agent. In the treaty between Poland and Malta, an agent acting wholly or almost wholly on behalf of the enterprise is not considered an independent agent if the transactions between the agent and the enterprise were not at arm's length. A. Ostaszewska, 2 The Taxation of Permanent Establishments, Poland- 28, (IBFD, 1993 & Supp.October 1998). 11In Hungary, construction sites and related activities constitute a permanent establishment after 3 months in non-treaty situation, as opposed to the 12-month period recommended by the OECD model convention. Whilst under the treaty with India, construction projects constitute a permanent establishment without any time limitation if the fees for the project or supervisory activities exceed 10% of the sales price of the machinery or equipment. In Netherlands, article 5 of the Nederlands Standaard Verdrag leaves the term open for agreement with treaty partners. See G. Erdös, 1 The Taxation of Permanent Establishments, Hungary- 40-42, (IBFD, 1993 & Supp.April 1999).
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