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Permanent Establishment or Not?

Updated: Jan 27, 2022

15 June 2021

Trading internationally from a fixed place of business is already quite confusing and daunting. If you are trading abroad and are in a location where the business is wholly or partially conducted, you can inadvertently create a Permanent Establishment or PE. This white paper will explain when a PE is created and provide a high-level overview of the hidden traps that can trigger a PE existence.

The permanent establishment (PE) issue is challenging both for cross-border businesses and for states involved as it might cause relevant tax liabilities. As a general rule of taxation of cross-border activities the profits of a non-resident enterprise shall not be taxed in a foreign state unless the enterprise carries on business in that state through a PE situated therein.

Through different tax-motivated constructions businesses used to avoid PE existence whereas source states were usually interested in the opposite.The spread of those constructions and use of them in aggressive tax-planning schemes attracted attention of G20 countries which initiated Base erosion and profit shifting (BEPS)project further transformedin collaboration of more than 135 states. Action 7 of the BEPS deals specifically with PE issues.

One of the initiativesdeveloped by BEPS is an‘anti-fragmentation rule’ that was laterimplemented in the 2017 OECD ModelDouble Taxation Agreement (DTA). The purpose of the rule is to prevent businesses from usingstrategy of the ‘fragmentation of activities’to artificially avoid PE status.In BEPS terminology ‘fragmentation of activities’ means fragmenting a cohesive operating business intoseveral small operations to argue that each part is merely engaged in preparatoryor auxiliary activities and as such is covered by the exceptions of Art. 5(4) of the OECD Model DTA and do not trigger a PE.

According to this provision preparatory or auxiliary exemption shall not apply to a fixed place of business that is used or maintained by an enterprise if the same enterprise or a closely related enterprise carries on business activities at the same place or at another place in the same State and (a) that place or other place constitutes a PE for the enterprise under the provision of art.5, or (b) the overall activity resulting from the combination of the activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, is not of a preparatory or auxiliary character.

Let’s consider how the rule works on the following example:

Bags Ltd is a company resident of State R. Bags Ltd used to manufacture its products in State R but due to an increase in demand, Bags Ltd has decided to outsource the manufacturing to State B. For this reason, Shoes Ltd enters into a toll-manufacturing contract with Factory Inc, an unrelated company resident in State B.

To supervise that the quality standards are maintained, Mr. S, an employee of Bags Ltd, makes regular visits to the manufacturing premises of Factory Inc to conduct quality control. For this purpose, Factory Inc makes available to Mr. Sa small office, which he shares with other three employees of Factory Inc. After manufacturing, almost all of the goods are shipped back to State R, where they will be sold in the local market.

The presence of Mr.S at manufacturing premises of Factory Inc triggers a PE only if all the requirements specified in art. 5.1. are met and it is not covered by specific activity exemptions of art. 5.4. of the 2017 OECD Model DTA. Art. 5.1. establishes the following requirements that might trigger a PE– existence of a fixed place of business through which the business of an enterprise is wholly or partially carried on. A PE should not be deemed to exist if an activityof the fixed place of businessis of a preparatory or auxiliary character. The common examples of possible activities covered by this exemption are specified in art. 5.4 of the OECD Model DTA.

In the example the activity carried on by Mr. S does not require a significant proportion of the assets or employees of the enterprise and is carried on for the enterprise itself to support. As it does not constitute the essential and significant part of the activity of the enterprise as a whole it is likely that the activity is of auxiliary character. Therefore, the presence of Mr. S at manufacturing premises of Factory Inc and his activities there do not trigger PE existence.Let’s extend the example and consider the next factual circumstances:

Bags Ltd is looking to expand its market beyond State R and decides to keep a small portion of the goods in a rented warehouse in State В to be sold on B's market.

If there are nosales performed by employees Bags Ltd and it is not involved in online sales that implies delivery of goods to final customers then it is still possible to argue that the maintenance by Bags Ltd of stock of goods in State S does not trigger a PE.According to art.5.4(d) of OECD Model DTA exemption the term ‘permanent establishment’ shall be deemed not to include the maintenance of a fixed place of business solely for the purpose of merchandise provided that such activity is of preparatory or auxiliary character. However, further extension of Bags Ltd.’s business presence in State S may convert the place in a PE.

Let’s consider the following example:

Bags Ltd decided to sell products through a shop of its wholly owned subsidiary Shoes Ltd located in State S.When a customer buys an item, employees of Shoes Ltd go the warehouse where they take possession of the item before delivering it to the customer; the ownership of the item is only acquired by Shoes Ltd from Bags Ltd when the item leaves a warehouse.

Due to the strategy of ‘fragmentation of activities’ Shoes Ltd could avoid a PE in State S so its sales profits even if sourced in the state were not taxable there. It is usually beneficial for the entity if, for example, the tax rate in a residence state is much lower. However, the anti-fragmentation rule inserted in art.5 of 2017 OECD Model DTA tackles this scheme.

As (1) Bags Ltd and its wholly-owned subsidiary are closely related enterprises, (2) store of Shoes Ltd constitutes a PE of Shoes Ltd and (3) business activities carried on by Bags Ltd at its warehouse and by Shoes Ltd at its store constitutes complementary business functions that are part of a cohesive business operation (i.e., storing goods in one place for the purpose of delivering these goods as part of the obligations resulting from the sale of these goods through another place in the same State), the anti-fragmentation rule comes into play. It means that the preparatory and auxiliary exemption does not apply and the warehouse of Bags Ltd constitutes a PE for Bags Ltd in State S and triggers source taxation of business income attributed to this PE.

The presence of Mr. S at premises of Factory Ltd may also create a PE if it is recognized that his activities and activities carried on by Bags Ltd and (or) Shoes Ltd constitute complementary functions that are part of a cohesive business operation.

Let’s consider the outcome if instead of using Shoes Ltd’s store Bags Ltd decides to act in a different way:

For assistance with the sales, Bags Ltd decided to hire Mr. X, a sales agent. Mr. Xconcludes contracts with the customers in State В in his own name.In Mr. X's contract with Bags Ltd it is stated that Mr. X is not responsible for any defective products, and that he can return unsold goods at the end of the year without any penalties or further costs.

If we assume that there is no a transfer of ownership from Bags Ltd to Mr. X, i.e. he does not act as a distributor, his activities in State S meet the requirements for agent PE stated in art. 5.5 of OECD Model DTA: (1) heacts on behalf of Bags Ltd and (2) in doing so habitually concludes contracts and (3) these contracts are for the transfer of the ownership of property owned by that enterprise of that the enterprise has the right to use (commissionaire arrangement); (4) he is not covered by independent agent exception (art. 5.6 of the OECD Model DTA).

However, the anti-fragmentation rule applies only to ‘a place’ and (or) ‘places’. So,if there is no a fixed place through which an agent exercises business activityof Bags Ltd, his activities do not convert another ‘fixed place’ intoa PE of Bags Ltd. Same is true when Mr. X’s activities do not create a ‘dependent agent PE’ for Shoes Ltd.

Therefore, art. 5.4.1 still leaves a space to businesses to artificially avoid a PE in a foreign country. However, special attention to other provisions of DTA, e.g., principal purpose test (PPT), as they may be used by contracting states to deny the provision of a treaty benefit.

Lef Permanent Establishment or Not
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For further information on any of the points above, please, contact

Yuliya Shved at: or

Dr Clifford J Frank at:

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