Doing Business Internationally and the Concept of Permanent Establishment
A question which often is raised by companies doing business internationally is, “When is the activity subject to tax in the local country?”. There are many factors to consider when answering the question, but the place to start is having an understanding of what generally creates a permanent establishment (“PE”).
Whenever a business activity that generates business profits is conducted either directly in or contributes to a company’s overall revenue, and such activity is cross border in nature, the concept of PE should be considered. PE is a foundational concept of international taxation. The concept of PE can be determined under local country laws or where a treaty exists between the United States and the country in which the business activity occurs, an Income Tax Treaty.
The impact of engaging in a business activity in a foreign country through a PE is the full taxation by that country of the source of business profits attributable to the PE.
The United States currently has a treaty network of 57 treaties covering 65 countries. The basis of all these treaties is the U.S. Model Treaty (“Treaty”). The Treaty defines a PE as a “fixed place of business through which the business is wholly or partly carried on”. The Treaty further clarifies the following activities as creating a PE:
- a place of management;
- a branch;
- an office;
- a workshop; and
- a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources.
The Treaty also provides a special provision for construction projects by clarifying that a building site or construction or installation project, or an installation or drilling rig or ship used for the exploration of natural resources, constitutes a PE only if it lasts, or the exploration activity continues for more than twelve months.
The Treaty likewise defines those activities which do not rise to the level of a PE in a treaty country. These activities include:
- the use of facilities solely for the purpose of storage, display or deliver of goods or merchandise belonging to an enterprise;
- the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
- the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
- the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;
- the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;
- the maintenance of a fixed place of business solely for any combination of the activities previously noted provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.
Another element that may create a PE is the activity of dependent agents. This is likewise addressed in the Treaty. A PE is deemed to exist where a person is acting on behalf of an enterprise and has and habitually exercises in a Contracting State an authority to conclude contracts that are binding on the enterprise. Thus the mere presence of a dependent agent with the authority to enter into binding contracts can be imputed to the principal as a PE. It should be noted that activities of a dependent agent that is limited to various “auxiliary” activities may not create a PE for the principal. Activities such as habitually entering into binding contracts for the display of goods, purchase of goods, advertising, or various combinations or these activities will not create a PE for the principal.
Where a PE can be imputed to a dependent agent, such is not generally the case with an independent agent. A principal does not have a PE in a country if the business is carried on through a broker, general commission agent, or any other agent of an independent status, providing that the individuals are acting in the ordinary course of their businesses as independent agents. Generally, the independent agent may have the authority to conclude contracts on behalf of a principal without creating a PE. Caution however should be exercised, where an “independent” agent works for only one major principal. This may be interpreted as lacking the quality of independence which is necessary to avoid the creation of a PE.
It is important to have a clear understanding of what business activity will be conducted in a country, how such activity will be conducted, how long such activity will be undertaken, by whom, and what powers to bind the principal will be granted. Where a treaty exists between the U.S. and the country where the activity is to be undertaken, such specific treaty should be reviewed to determine whether a PE exists and to determine if the activity can be reconfigured to avoid the creation of the PE. Where no treaty exists, it is important to confer with local legal and tax advisors to make such a determination and plan accordingly.