A company rarely wishes to create a permanent establishment within a foreign country, particularly without planning for it. While each country can define a permanent establishment as it sees fit, Article 5 of the OECD Model Convention is an authoritative source on this topic:
A permanent establishment is a fixed place of business through which the business of an enterprise or wholly or partly carried on…
The concept of permanent establishment is quite possibly one of the most discussed concepts in all of the international taxes, and this is largely because the definition can be very subjective. While it is not the purpose of this article to begin a theoretical discussion on the topic, a permanent establishment can usually be classified into two types:
- A physical PE
- An agency PE
Physical Permanent Establishment
The more straightforward of the two classifications is the physical PE. In general, a physical PE will result when a foreign company has a branch or other fixed office in the contracting country. It is important to note that even when using an independent agent in the local country if the premises are at the constant disposal of the employees of the foreign company, it can still constitute a physical PE.
Agency Permanent Establishment
The second classification, agency PE, considers the distinction between dependent and independent agents and is based on the activity rather than the location. A dependent agent (e.g. employee) that can conclude contracts in the name of the foreign company and habitually exercises this authority is likely to bind the foreign company to an agency PE.
In turn, an independent agent that is both legally and economically independent of the foreign company and acts within the ordinary course of business would not be considered as creating a PE for the foreign company.
(Editors Note: this is good news for recruitment agencies and consulting companies who have contractors working on a client site and payrolled by a local management company).
Since a permanent establishment is rarely the objective of a company working in a foreign country for a temporary project, it is particularly important to understand how to avoid this burdensome classification.
A foreign company may maintain a fixed place of business provided that the business is used “solely for engaging in an activity of a preparatory or auxiliary character.”
Although this seems to be a generous grant of latitude by the OECD, be careful. Each case would need to be reviewed on its own merits. Any activity that is furthering the goal of the parent company is unlikely to be considered an auxiliary but rather central to the business.
Avoiding Permanent Establishment
Under most conventions, it is important to note that a company that engages in business activity in a foreign company through independent local agents will most likely not be deemed to create a permanent establishment and taxable income in that country.
About the author: Christian Wunderley, LL.M. is an international tax consultant and Managing Partner of the U.S tax firm, CD Tax Associates. He has several years of experience working in both financial services and international tax, including firms such as PricewaterhouseCoopers, BDO, and Citigroup. His specializations include withholding tax, particularly for non-U.S. businesses and investors that want to invest in the United States.