Chapter Forty

Permanent Establishment Parameters

Host Countries might be able to force multinational taxpayers to pay tax on their extended operations if the tax authorities are able to establish that these extended operations constitute a permanent establishment (PE) within their own territory. Developing and developed countries have long been asserting jurisdiction based on such PE claims. What is new to this tax regime are new methodologies—courtesy of the Organisation of Economic Co-operation and Development (OECD)—that enable tax administrations to assert a PE based on the extended operations of the multinational operations.

British-developed countries—including Australia, Canada, Hong Kong, India, Singapore, and the United States—apply long-existing common law determinations to the scope of PE activities. The host tax authority can ascertain whether its operations in a host country constitute a PE by applying common law principles. Into those established norms, the OECD formulated alternative approaches in July 2010 under which the host tax authority can ascertain whether operations in a host country constitute a PE.

We suspect that the tax authorities might view the OECD PE approach as adding to the government’s present tax arsenal, not replacing the existing common law approaches to assert PE status. We suspect that the OECD’s promulgation of PE principles will thus add to the tax exposure of the multinational enterprise (MNE).

OECD’S PERMANENT ESTABLISHMENT PROVISIONS

The PE issue is inherently complex in the OECD tax convention context. The model tax convention involves an interplay between Article 7 (Business Profits) and Article 5 (Permanent Establishment). The OECD made extensive changes to Article 7(2) in 2010, specifying that the profits that are attributable to the contracting state “are the profits it might expect to make, in particular in its dealings with other parts of the enterprise, as if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions. The contracting state would take into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.”1 Practitioners refer to Article 7(2) as the transfer pricing rule. United Nations (UN)-based treaties have PE provisions. UN officials have specified their intent for the UN to follow the OECD in making the PE provisions.

CONSEQUENCES OF PERMANENT ESTABLISHMENT STATUS

As a general matter, if a country enters into a tax treaty with another country, such a treaty provides that the host country entering into the tax treaty can tax the income that is attributable to a PE located in that host state.2 Such tax treaty precludes the tax authority in that country from imposing income taxation on an enterprise unless the activities of the enterprise reach the requisite threshold, that of constituting a PE. The creation of a PE provision, then, is a dual-edged sword:

• The PE provision protects the revenue in the countries in which the enterprise does business, but:
• The PE provision protects the enterprise from tax claims that the overreaching tax authority in host countries can bring.

As a general matter, a tax treaty, through its PE provision, imposes a higher threshold for tax liability than the threshold nexus standard that would otherwise apply in the nontreaty context. Consider the U.S. approach. The nontreaty nexus standard is the presence of business activities in the United States that might rise to the level of a trade or business undertaken in the United States. Such a level of business might not constitute a PE under treaty principles.3 In contrast, the treaty PE principles would impose taxation on the enterprise’s activities in the host country only if the activities reach a defined higher threshold.

The unintended creation of a PE is a continuing and growing concern for businesses having overseas operations. The operative word is “unintended.” An enterprise often can obtain tax benefits from having a PE if the enterprise deliberately undertakes PE status. For example, the presence of a PE in that host country might enable the enterprise to obtain a foreign tax credit against taxes the enterprise would otherwise pay in its home location.

CONSEQUENCES OF A PERMANENT ESTABLISHMENT TO BUSINESS

The presence of a PE can be especially troublesome to the tax authority in which the PE is located and to the PE itself. Quite simply, the enterprise might not have known it is a PE in the host country and might not have registered with the tax authorities. The tax enterprise might not have met the tax authority’s statute of limitations requirements because the statute of limitations period begins only from the time the enterprise first had PE status in that jurisdiction, even though the enterprise was unaware of its status.

The tax administration is likely to compel documents from the enterprise when the enterprise’s activities create a PE within its jurisdiction. The tax administration might request these documents beginning from the enterprise’s initial PE status in that jurisdiction. The enterprise, not being previously aware of the document requirements, might have failed to retain the requested documents prepared in prior years. The enterprise runs the risk of having to pay a myriad of penalties and taxes to that jurisdiction.

In addition, the enterprise, now being subject to documentation requirements, might also be subject to transfer pricing considerations. The tax administration might successfully seek PE status in the same manner as a subsidiary of the parent company for transfer pricing purposes. For example, the commentary 20–21 pertaining to Model Tax Convention on Income and Capital Article 7(2) discusses functional and factual analysis.

Double taxation is likely, especially when the tax authority in the host country requires the PE to pay tax retroactively for prior years. The enterprise might have paid tax to its place of incorporation and to its place of activity. The tax treaty between the enterprise’s country of incorporation and its PE’s physical location might provide remedies against double taxation, but these remedies would often fail to apply because of differing statute of limitations issues.

TRANSFER PRICING AND PERMANENT ESTABLISHMENT

The PE assertion brings with it the taxability of that enterprise in that host jurisdiction together with the ensuing transfer pricing considerations. The two concepts, transfer pricing and PE, are closely related, as both concepts address the determination of the income related to the entity in question. Tax authorities in a myriad of states are developing sophisticated tax collection strategies. One such collection strategy of critical importance is the penchant of the tax authorities to investigate potential PE activities.

PE became the predicate for transfer pricing. If the tax authority can ascertain the presence of these PE activities, the next focus on the part of that tax authority is to develop a transfer pricing adjustment in its favor. As a result, multinational taxpayers are increasingly facing the risk of extensive double taxation, in part because of PE claims based on an aggressive tax collector’s claims.

Governments are beginning to develop transfer pricing adjustments based on the presence of PE activities. A government under the OECD approach treats the PE and the foreign enterprise as being related parties. The government’s “long arm” extends outward, often reaching beyond the geographical confines of the country itself. This long arm often reaches the activities taking place abroad as well as the activities of foreign-based enterprises.

The presence of PE activities and transfer pricing adjustments between the PE and other facets of the enterprise creates double taxation. In addition, significant areas of double taxation exist between jurisdictions because of the differences in source rules. Further, significant areas of double taxation exist because of aggressive tax enforcement. Significant areas of double taxation exist when one government follows the UN tax treaty model and the counterparty applies the OECD model tax treaty.

OVERALL TAX CONSIDERATIONS

The taxpayer is well served by establishing a “worldview” of the tax liabilities it might face. The multinational taxpayer is well advised to undertake the process of aggregating its total effective tax costs on a worldwide basis. As a starting point, the multinational taxpayer then should determine the tax base and the tax rate in each jurisdiction. The multinational taxpayer should then determine the aggregate tax base and the cumulative effective tax rate.

Double taxation is becoming an increasing threat. The multinational taxpayer is likely to find that its aggregate tax base, determined on a worldwide basis, is more than 100% of the company’s aggregate income. The multinational taxpayer is likely to find that its aggregate income subject to tax is substantially more than 100% of its aggregate tax base. As a result, and very importantly, the multinational taxpayer is well advised to address the conflicting tax systems simultaneously from a PE–transfer pricing prospective.

POTENTIAL FOR THE IMPOSITION OF TWO LEVELS OF TAXATION

The country in which the subsidiary is located might be able to tax the subsidiary because of the subsidiary’s activities in the country. This same host country can impose an additional level of tax on the parent company headquartered elsewhere. The country in which the subsidiary is located can look toward the activities of the parent company and then examine the relationship of parent company toward the subsidiary. The host country may determine that the MNE’s extended operations contribute more income to the MNE than the MNE admits. The host country sees itself as being entitled to receive more tax receipts. In essence, the country in which the subsidiary is located might be able to tax the parent company based on that parent company–subsidiary relationship. The home country can seek to tax the enterprise on its worldwide income while the host country can seek to tax its PE income.

OECD APPROACH TO DETERMINE PERMANENT ESTABLISHMENT

The OECD approach applies five specific standards to determine whether an enterprise constitutes a PE:

HONG KONG APPLIES THE OECD PERMANENT ESTABLISHMENT PROVISIONS

The government of Hong Kong has established provisions that are designed to attribute profits and expenses to the Hong Kong PE if the nonresident enterprise has a PE in Hong Kong. We have selected Hong Kong because it issued its transfer pricing provisions in December 2009, relatively contemporaneous with the OECD Article 7(2) formalization, and because the Hong Kong provisions address functional analysis and PE in the anti–tax haven context.

The Hong Kong transfer pricing guidelines provide eight steps to the PE process. The Hong Kong transfer pricing guidelines, in demonstrating this eight-step process, provide guidance as to its interpretation of the OECD PE provisions. The taxpayer is to:

HOW HONG KONG APPLIES THE PERMANENT ESTABLISHMENT PROVISIONS

The Hong Kong transfer pricing guidelines apply the “functionally separate entity” to determine taxability of the PE. Using the “functionally separate entity” approach, the Commissioner will treat a PE as being a separate enterprise as if this enterprise is operating at arm’s length. Such an enterprise must treat PEs in Hong Kong and elsewhere as reflecting its profits and expenses. The separate entity approach operates to produce the same outcome as would transactions between two enterprises at arm’s length.

The Hong Kong Commissioner can assess the profits of the PE of a nonresident enterprise. The PE might earn income from more than one source. The Commissioner, in assessing the profits of the PE of a nonresident enterprise, can examine the separate sources of profit that the nonresident enterprise has derived from Hong Kong and determine what a resident (PE) enterprise’s profitability should be.

The Hong Kong Special Economic Zone does not mandate that the MNE book the PE profit in the jurisdiction. Nevertheless, such a PE might have to attribute the profit to the PE of the nonresident enterprise carrying on a business on Hong Kong. The PE is to reflect these PE amounts if the enterprise undertakes “economically significant activities or responsibilities” in Hong Kong.

The profit might be generated from “economically significant activities or responsibilities” outside Hong Kong. In that event, the profit will not be attributed to the PE of the nonresident enterprise in Hong Kong. The presence of “economically significant activities or responsibilities” outside Hong Kong occurs when there is another PE outside Hong Kong, or when the head office undertakes the “economically significant activities or responsibilities.”

The Commissioner can attribute profits to the PE in Hong Kong under Article 7(2). The Commissioner, in making such attribution of profits, is also to consider these functions:

• The significant “people functions” of the PE
• The key entrepreneurial risk-taking functions of the PE (i.e., those functions that are relevant to the assumption or acceptance or management of risks)

COMMON LAW PERMANENT ESTABLISHMENT CRITERIA

The five OECD PE criteria are designed to integrate the PE objectives with the transfer pricing objectives. The preceding objective criteria address the presence or absence of objective facts (i.e., facts the tax authorities would know or should have known before applying the Article 7(2) transfer pricing approach). The subjective criteria might be, for example, the customers’ view of the relationship between the parties, including the name of the enterprise.

However, the enterprise should undertake five fact-based common law inquiries to activities of the enterprise to ascertain the presence of a PE:

Next we examine the five facets of the PE inquiry.

DIRECT ACTIVITIES

The direct business activities by the parent company in the host country can indicate the presence of a PE in the host country. As such, a taxpayer is well advised to ascertain whether the direct business activities that the parent company undertakes create a PE in the host country. It is important to note that the taxpayer’s activities as a shareholder are a separate inquiry from the subsidiary’s operations in the host country and a separate inquiry from its own direct activities in the host country.

The presence of a subsidiary in the host country is not necessary for the host country to find PE status. The subsidiary’s activities in the host country will be taxed in that country and the subsidiary by its very nature is a PE. The extended enterprise must run the gamut of PE assertions and the transfer pricing provisions in light of Article 7(2).

An enterprise can grow its international operations without initially focusing on its ensuing tax responsibilities. These operations can occur because of the company’s overseas growth. Tax executives at a multinational business might not be aware of the PE activities that enterprise is undertaking, as non-tax people might be making its business decisions. These risks are exacerbated because of the confluence of two factors: the growth of overseas business operations and the penchant of tax preparers to prepare tax returns based on “same as last year” standard rather than reviewing the underlying facts, including the year by year changes in these facts.

Consider the next example in which Company X fails to notify the tax authorities in Country B of its business activities taking place in Country B.

• Company X began its operations in Country A, having no international operations in year 1.
• In year 2, Company X sets up a border office within Country A, trying to reach its potential customers transiting from Country B.
• In year 3, Company X sets up an occasional trading post in Country B to take advantage of seasonal and weekend traffic during the holidays.
• In year 4, Company X leases retail space and begins to sell its wares in Country B.
• In year 5, Company X advertises its goods in Country B and engages in contracts with suppliers and customers in Country B.
• In year 6, Company X manufactures its products in Country B.
• In year 7, the Country B tax authorities first assert taxability over the Company X operations and seek all Company X data from the current and prior years.

Company X is close to being considered a PE in Country B in year 3. Company X is a PE in Country B beginning in year 4.

AGENCY RELATIONSHIPS

The presence of an agency relationship can create a PE. The extended enterprise often can be an agent of the MNE in some situations, but the MNE might be an agent of an extended enterprise in other situations. A taxpayer is well advised to ascertain whether the indirect relationship between the MNE and its extended enterprise constitutes an agency relationship. That agency relationship might bind the parent company to the company for PE purposes. For example, the extended agency can serve as the company’s agent by negotiating, binding, entering into, or concluding contracts on behalf of the MNE. The taxpayer is well advised to examine the powers that the agency undertakes.

The delineation in terms of agency is between a dependent agency and an independent agency. As a general matter, having a dependent agency in a jurisdiction causes that dependent agency to constitute a PE in that jurisdiction. In contrast, having an independent agency in a jurisdiction does not constitute a PE in that jurisdiction.

The law of agency, not the tax rules, takes precedence in determining the nature of the agency relationship. One such agency law, for example, is the power to conclude contracts. Thus, the power to conclude contracts determines the power and extent of an agency relationship and is often a prerequisite to creating a PE. The taxpayer can assert that a party that does not have the power to conclude contracts on behalf of the principal does not have the requisite PE for the principal. See, for example, the decision of the Supreme Court of India in Morgan Stanley (2007).

The presence of control within the agency context determines the nature of the relationship for tax purposes. If the agent deals with multiple parties, the tax law postulates that the agent that has more than one principal is an independent agent and that no one principal controls the agent. As a result, such an agency relationship does not constitute PE status. In contrast, the tax law presupposes that an agent having one principal is dependent on that one principal, and the principal controls that dependent agent and creates a PE. See, for example, KnoWerX Education (India) Limited, opinion by the Authority for Advance Rulings (2008).

An issue has arisen as to whether having multiple principals constitutes a PE over the agent. An agreement in concert among these principals can constitute common control over the agent. In contrast, a cross-insurance or reinvoicing arrangement does not constitute sufficient common control to create a PE.4 Four independent property and casualty companies set up a reinsurance arrangement with Fortress Re Inc. The Tax Court held that the four insurers did not have comprehensive control over Fortress Re as a dependent agent so as to create a PE.

SHAREHOLDER ACTIVITIES IN SUBSIDIARIES’ LOCATIONS

An enterprise can conduct shareholder activities in subsidiaries’ locations without these activities itself constituting a PE. An enterprise that engages in activities beyond the stewardship role might find itself in a PE situation. Chapter 7.9 in the OECD guidelines delineates shareholder activities from the broader-based stewardship activities. Such stewardship nonshareholder activities include detailed planning services for particular operations, emergency management, or technical advice (troubleshooting), or, in some cases, assistance in day-to-day management.

The next activities constitute shareholder activities:

• Activities that relate to the juridical structure of the parent company itself. Such activities include the cost:
  • Of meeting the parent company’s shareholders
  • Of issuing of shares in the parent company
  • Connected with the supervisory board
  • Relating to reporting requirements of the parent company, including the cost of preparing consolidated reports
  • Of raising funds for the acquisition of the participations

The taxpayer is well advised to ascertain whether the parent company’s activities as to the subsidiary go beyond the shareholder relationship. Shareholder activities themselves are exempt for PE characterization. The parent company’s activities can transcend the shareholder relationship as the subsidiary can create a PE on the part of the parent company.

PRESENCE OF PERSONNEL SHIFTS AMONG ENTITIES

The taxpayer is well advised to ascertain whether the parent company’s personnel being shifted to the host country creates a PE on the part of the parent company. The parent company might have furnished personnel, might continue to provide payroll for subsidiary, or might take specific responsibility for the work of its employees at the foreign enterprise’s location. As a result, the host country might view all activities taking place in that country as creating a PE.

ENTIRETY OF THE OPERATIONS

The entirety of the operations in the country of operations may create PE status. The tax collector might ascertain another basis of taxation apart from the four operational categories mentioned earlier.

DECLINING BUSINESSES

A multinational business might quite validly face a risk of a tax authority’s overregulation of the PE claims. This overregulation is especially apparent as to a declining business. A declining business might be caught in the PE web even though the business is declining year by year.

Consider this scenario: Company X manufactures televisions in Country A, combining the TV tube with other components and a console. In addition to the company’s manufacturing operations in Country A, Company X enters into a long-term contract with a manufacturer of consoles in Country B to assemble the televisions in Country B, using Company X’s components and technology and locally produced consoles. Assume that the tax authority in Country B determines that Company X’s activities in Country B create a PE because the technology is ongoing and requires cross-border personnel.

After decades of sustained sales, Company X’s business is now supplanted by flat-screen TVs. Company X’s business is declining rapidly in both Country A and Country B. Company X no longer provides technology to its Company B operations. Nevertheless, the tax authorities in Country B might continue to view Company X’s operations in Country B as a PE despite the change in facts. The issue then might become whether Company X, now facing losses in Country B, can obtain net operating loss benefits in Country B or in Country A.

“PREPARATORY TO” AND “AUXILIARY FROM” EXEMPTIONS

Income tax treaties exempt activities that are preparatory to or are auxiliary from PE status. See Article 5.4f of the OECD Treaty. The issue of whether these activities are preparatory or auxiliary can be disputed. Whether activities are preparatory or auxiliary depends on the nature of the activities being conducted, the presence of revenue from the operations, and the duration of the activities being sought for the exemption.

TIME SPENT

The taxpayer should be careful that the term “permanent establishment” does not directly relate to the permanency of the enterprise. Time spent does become relevant in the construction context. Treaties differ in ascertaining time thresholds, and six months is commonplace to determine PE. An issue arises, though, whether the time period must be consecutive to reach this threshold, and whether the activities in two separate years are combined to reach the threshold amount. PE issues, especially timing, can be different for major players who have negotiation power with the host government to not be considered a PE regardless of how much presence is required to complete a task. See, for example, the Airport Authority of India’s dispute before the Authority for Advance Rulings pertaining to Raytheon payments.

WILL THE OECD APPROACH PREVAIL?

The OECD approach to PE status does make sense in that the taxpayer and the tax authorities are often well positioned to assess the profits the enterprise is to make in accordance to Article 7(2) as if the enterprise were separate and independent, engaged in the same or similar activities under the same or similar conditions. This transfer pricing approach assumes that the taxpayer and the tax authorities can commit substantial expertise and effort to the transfer pricing approach and its application to the PE process.

When the taxpayer or the tax collector is unwilling or unable to apply these assumptions as to effort and expertise, perhaps because of the potentially limited tax revenues involved, we suggest that the taxpayer and tax authorities first address these more ascertainable business facets:

• The presence of direct business activities
• The presence of agency relationships
• The presence of more-than-stewardship activities
• The presence of personnel shifts from the parent company to the subsidiary
• The entirety of operations

Only time will tell whether the tax administrations will accept the OECD PE approach, reject the OECD PE approach entirely, or expand their tax arsenals.

NOTES

1. See Model Tax Convention on Income and on Capital, OECD July 22, 2010; M. Kent and R. Feinschreiber, “Permanent Establishment Parameters,” Derecho Fiscal Internacional, 2011, p. 159.

2. See OECD Model Tax Convention, Articles 7 and 5.

3. See de Amodio v. Commissioner, U. S. Tax Court, 1960.

4. See Taisei Fire & Marine Insurance v. Commissioner, U.S. Tax Court 1995.