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Summary: If a business creates permanent establishment in a foreign country that generates local revenue, then the foreign country (or host country for that business) can impose local corporate taxes on that business.
Permanent Establishment
Permanent establishment (PE) is a tax concept in which a business with an ongoing and stable presence in a foreign country is liable for taxes imposed by that foreign jurisdiction. In other words, a PE is when a company creates a taxable presence outside of its home country. If a business creates PE in a foreign country that generates local revenue, then the foreign country (or host country for that business) can impose local corporate taxes on that business.
The Organisation for Economic Co-operation and Development (OECD) provides a tax treaty model for countries and plays a crucial role in defining permanent establishment through the Model Tax Convention on Income and on Capital. The OECD represents close to 40 countries globally.
Generally, the criteria for creating permanent establishment are:
- A business has been established in a foreign country
- The place of business is permanent or fixed
- The business is partly or wholly operated through that permanent or fixed establishment
If a business meets these criteria, then any revenue earned inside the host country qualifies for local taxation. Any imposed taxation is based on local tax statutes and the time the business has permanent establishment.
Permanent establishment is a critical tax concept that businesses operating globally must understand. However, like many tax concepts, PE is complex.
Keep reading to understand what qualifies as PE, what is exempted, and how to approach PE risk.
What are the 3 types of permanent establishment?
Three types of permanent establishment exist:
- Fixed place of business establishment
- Agency-based establishment
- Service-based establishment
Fixed place of business establishment
Under the OECD’s Model Convention with Respect to Taxes on Income and on Capital (the “OECD Model Convention”), a PE is “a fixed place of business through which the business of an enterprise is wholly or partly carried on.” This is the most common type of PE.
Let’s break this down.
- Fixed: An establishment is “fixed” within a foreign country to a certain degree of permanence and not transitory.
- Place: An establishment is located in a physical space where the business is partly or wholly conducted. The “place” can be in more than one location and does not need to be used exclusively by the business.
- Business: An establishment is used by a business to partly or wholly conduct its business. “Business” refers to any activities that generate revenue for the enterprise. If no commercial activities take place, a fixed place of business may not be established.
According to the OECD, a permanent establishment includes:
- A place of management
- A branch
- An office
- A factory
- A workshop
- A mine, an oil or gas well, a quarry, or any other place where natural resources are extracted
A building or construction site may be a permanent establishment if it lasts more than 12 months.
For example, buying a factory, such as one to manufacture goods, in another country can trigger PE. If this occurs, the business would be taxed in both countries: its home country and the foreign country in which it is doing business and generating revenue.
Agency-based establishment
Even without a fixed place of business, a company may trigger PE in another country if an agent in that country conducts business on behalf of the company. This occurs if:
- The agent is dependent: The agent must be legally and economically dependent on the company. This means the agent’s activities are directed or controlled by the company, and the agent does not operate independently.
- The agent has the authority to enter contracts on the company’s behalf: The agent must have the authority to negotiate and conclude contracts that are binding on the company. If the agent exercises this authority habitually, it can create a PE for the company in that country.
These types of agents are common in the fashion, pharmaceutical, and cybersecurity industries.
An agent is not dependent if it is both legally and economically independent of the business. For example, brokers and general commission agents who may be legally and economically independent of the business will generally not create PE for that business. Additionally, an infrequent execution of contracts in a foreign country does not rise to the level of creating PE.
For example, a Parisian-based sales manager frequently travels to Beijing to negotiate clothing manufacturing contracts, which may trigger PE in China.
Service-based establishment
Finally, a business’ employee may trigger PE by providing services in a foreign country for a period, such as six or twelve months, without having a fixed place of business in that country. Typically, the employee must be physically present in that foreign country when providing services.
For example, a managerial consultant may trigger PE if they currently reside and provide services in a foreign country, generating revenue from their services. Keep in mind that this triggers PE for the service provider, not the company receiving the services.
Virtual permanent establishment: the fourth type of permanent establishment?
As more companies rely on cross-border remote workers, a new permanent establishment category is emerging, as the lines of when and where we work continually blur. According to a 2023 study, five jurisdictions—Austria, Denmark, Slovenia, Sweden, and Switzerland—have issued local tax guidance on how to assess the fixed place of business requirement for cross-border remote working arrangements.
Additionally, five jurisdictions—Denmark, Finland, Poland, Netherlands, and Switzerland—have issued advanced tax rulings on cross-border remote workers. Although these rulings aren’t binding on third parties, they do provide insight into the changing tide of defining PE in a post-pandemic world.
Specifically, this study asked respondents to list the most common criteria when assessing PE existence as it applies to cross-border remote workers. Here are the most common responses:
While most OECD guidance revolves around “office-based operations” in foreign jurisdictions, revised guidance would be welcome for businesses worldwide in light of this new post-pandemic normal.
Are any establishments excluded from permanent establishment?
Some establishments are excluded from PE based on their activities. In other words, if a business would otherwise meet the permanent establishment definition, it may not establish PE if it is used solely for incidental, preparatory, or ancillary activities.
Here are some examples of these types of exempt services:
- The use of a storage facility for the storage, display, or delivery of goods
- The maintenance of goods owned by the business but held for processing by another business
- The maintenance of goods or merchandise owned by the business solely for storage, display, or delivery of those goods or merchandise
- Any other incidental, preparatory, or ancillary activity
What is permanent establishment risk?
Although there are many benefits to companies when they create PE, there are also risks that business owners must be aware of when globally expanding. Here are a few common examples:
- Corporate and employment-related tax penalties and fines (including failure to offer certain employee benefits or protect equal opportunity rights)
- Interest charges
- Regulatory issues
- Compliance problems
- Reputational damage
- Back payments
- Increased chances of tax or employment regulatory audits
- Immigration issues
- Inefficient tax planning
These risks may surface when a company doesn’t even know that it has created PE in another country. Understanding when PE is created is critical to a business’s global expansion, helping it avoid costly and time-consuming future mistakes.
What are some best practices when considering permanent establishment risk?
With so many PE criteria, most of which are based on facts and circumstances, preparing for PE can seem daunting. Here are some ways to manage, mitigate, or avoid any potential PE risk as you expand globally:
- Act early: Look into PE regulations before you start conducting business in a foreign country. Since the rules and regulations vary country by country, it’s imperative that you understand how your business may be taxed. Obtaining advice from legal and tax professionals familiar with PE in the country you’re considering can help you assess your risk while developing a solid business plan before expanding.
- Engage local partners, service providers, and professionals: Engaging with local partners, service providers, and professionals can give you insight into local laws and regulations and the country’s business culture.
- Use an employer of record (EOR) or professional employer organization (PEO): Use an EOR (or a global PEO serving as an EOR) to help you control the business operations and human resources (HR) functions, including payroll, benefits, and tax remittance. This can help to eliminate any risk of creating PE.
- Limit your global business: Limiting your global business to activities that don’t trigger PE—such as marketing—can also mitigate or eliminate any potential PE risk.
- Set up a headquarters in another country: If you plan to do business in another country and know that you’ll need to manage PE risk, then you might consider setting up a headquarters in the host country. This is a more time-consuming and costly step when expanding globally, but it can help you reap the rewards of a global presence without having to navigate the legal and tax implications in separate countries.
- Create a foreign subsidiary: Since foreign subsidiaries operate independently from the parent company (unlike branches), the subsidiary is legally and financially responsible for compliance, taxation, liabilities, and assets. This is another way to eliminate PE risk for the parent company.
- Be strategic with any global working arrangements: When sending employees to work in foreign countries, understand what may trigger PE, such as length of stay, types of job duties, location of work (including your remote employees), and ability to bind the company in contractual arrangements. Doing so can either mitigate or eliminate any PE risk you may otherwise face.
The complexity of an ever-changing global legal and tax landscape has made businesses wishing to expand globally vulnerable to PE risks. Understanding how to manage, mitigate, or eliminate PR risk is critical in today’s business environment.
Need help?
Looking for more ideas on how to manage, mitigate, or eliminate permanent establishment risk? Check out our services at Remote People.
FAQ
Permanent establishment is a tax concept where a business with an ongoing and stable presence in a foreign country is liable for taxes imposed by that foreign jurisdiction. Failing to understand if you’ve created PE can cause risks, such as tax liabilities and penalties, regulatory issues, and reputational damage.
Some common ways to manage, mitigate, or avoid PE risk include understanding the local tax laws in the country where you’d like to expand, utilizing an EOR or global PEO, creating a foreign subsidiary, and engaging local partners.
