August 2010 (102) – Permanent Establishment


I hope all our readers are enjoying an exceptional summer with family interests taking over from work. And perhaps the last thing you want to receive is a newsletter analysing technical issues which do not necessarily need to be thought about when the sun is shining. But maybe it is useful to take a half hour respite in the shade and allow this month’s topic to permeate your relaxed brain so that you can avoid nasty tax surprises leaping out at you when the weather turns.

Indeed, the question that I am being asked consistently by clients is whether they have a taxable presence in another country as a result of their business activities. It makes no sense to find out years later that the local tax authority has decided to raise an assessment based on such a taxable presence which could totally negate the benefits of any corporate structure created. Even worse is the potential double taxation which could arise, and which could be avoided with a better understanding of what constitutes a taxable presence in another country.

I did write about the concept of permanent establishments in our December 2009 newsletter but make no apology for repeating much of that material within this comprehensive article which our new colleague, Dmitry Zapol, has written. Dmitry, who has joined IFS as from the beginning of this month, is a Russian lawyer who spent several years working at Barshevsky & Partners in Moscow before coming to the UK to embark on an international tax planning course. It was while he was a student of mine at the Institute of Advanced Legal Studies MA course on International Taxation that I became aware of his competency in understanding the commercial, legal and tax issues of client requirements, and I look forward to introducing him to you at future meetings.

In the meantime, in addition to the issues raised in the December newsletter, Dmitry has included relevant legislative and juridical information provided by contributing authors to our new book (with the same title), the 2010 edition of “International Tax Systems and Planning Techniques” or ITSAPT. This is being published by Sweet & Maxwell in September 2010 and will be available (at a discounted price) at our Conference at the Landmark Hotel in London on 28th October.

Dmitry has used the case study of ITSAPT as the basis for this month’s article. As I have explained in other emails, the ITSAPT Conference analyses the development of the Polycon Group into a worldwide conglomerate, exploring the tax issues arising at each stage of the group’s development. Clearly, the permanent establishment concept is just one of the issues which will be relevant during the planning of the growth of Polycon into a multinational group, and the contributing authors to ITSAPT will be discussing at the ITSAPT Conference how these various issues are interpreted by the tax administrations of their particular country. 
I hope that you enjoy reading this, and would welcome any comments that you have (click here). Also, in the event that you would like further information about the Conference, please click here.


In life two things are certain: death and taxes. The optometrist-turned-entrepreneur Mr Stephen Holmes was having none of the former: he exercised regularly, ate well and practiced yoga in the back yard of his family home in the Northern European Republic, or NER as it was commonly called. As to the latter, Mr Holmes had a nagging feeling that the taxman would ring more than once and in more than one country where Mr Holmes’s Polycon Lens Company Ltd (or simply Polycon) was putting down its roots.

We are reminding you that Mr Holmes is the protagonist of the case study that lies in the beginning of International Tax Systems and Planning Techniques (ITSAPT) – the leading international tax reference book which Roy started over 27 years ago and which completed its 59th loose leaf version in April this year. It has now been re-written, brought up to date as at the end of June 2010 and will be available in a bound version and on-line as from September 2010. Roy would like to thank our colleagues in over 30 jurisdictions for their invaluable contributions to this new book.

The story of the case study follows Mr Holmes, who uses his training as an optometrist to make a break-through in acrylic lenses manufacturing. Mr Holmes establishes the first Polycon company abroad in the Central European Republic (CER) to manufacture haute couture spectacles, soon broadening his product range with military telescopic lenses and then supplying both kinds of product to customers worldwide. Polycon goes through the increasingly complex stages of business development. A small start-up soon has an established board of directors, subsidiaries, representative offices, agents, storage facilities and distributors, all in different jurisdictions worldwide.

Mr Holmes is advised by Maurice Brightman – an international tax advisor, who some may know from Roy’s earlier book The Principles of International Tax Planning. While Mr Holmes instigates the company’s development, Mr Brightman plans for the tax-efficient international development strategy. Mr Brightman knows when there is a permanent establishment and what it entails, advises what kind of business entity to choose for a particular purpose or cautions against high gearing to avoid the effect of thin capitalisation provisions. With Mr Brightman’s help Polycon soon turns into a listed diverse international conglomerate that boasts its own in-house finance company, e-commerce subsidiary, real estate investment group and an off-shore private equity fund.

Each stage of Polycon’s development in various fictional jurisdictions is interspersed with references to different countries’ chapters of ITSAPT to demonstrate the variety of the relevant international tax planning issues. The book thus serves a double purpose of being an encyclopædia of practical taxation in 31 different jurisdictions and providing model answers to common tax planning issues that an international minded entrepreneur may encounter.

Let us return to Mr Holmes who wants to venture beyond Polycon’s birthplace in the CER and expand the company globally, but who is wary that entering foreign markets will cause Polycon to incur heavy foreign tax liabilities. Mr Holmes asked Maurice Brightman to explain to him in uncomplicated terms whether and on which basis will a foreign state claim the right to tax a non-resident company running a business in its territory.

Mr Brightman began his foray in international tax law by explaining that states levy taxes on the basis either of residence or source of income. Thus domestic companies, which are incorporated and registered there, may be taxed on the basis of residence, whilst foreign companies may also be taxed if the source of their income is in that state. Such foreign companies may conduct their business in the relevant territory through a registered branch, and the profits allocated to that branch will therefore be subject to domestic tax.

Such a simple explanation was clear to Mr Holmes. “But surely, I do not HAVE to register Polycon’s branch abroad,” he ventured, “can’t I just sign a contract with a buyer abroad and ship him the goods or rent a foreign warehouse quietly and sell the lenses from there?” “My dear Holmes,” – Mr Brightman replied, “unfortunately things are not as elementary here as we would like them to be.” This time Maurice explained to Mr Holmes the concept of the permanent establishment of a foreign company abroad (usually shortened to “PE”). The PE is that margin that separates a foreign corporation merely appearing as a blip on the domestic market’s trading activity radar from the same corporation establishing itself permanently on the foreign soil and whose profits, attributable to that place of business, are taxed under local laws.

Mr Holmes was surprised to learn that such seemingly subjective concept could be defined by rules, which existed in the laws of practically all jurisdictions; these though could be superseded by the definition given in any relevant double tax treaty entered between the state of the parent company and that where the PE was deemed to exist. Where, however, the definition of the PE under domestic law is more favourable to the taxpayer, it can normally be used in lieu of the double tax treaty definition.

The basic definition of the term ‘PE’ is a fixed place of business through which the business of an enterprise is wholly or partly carried on. This contains the three basic conditions: the existence of a “place of business,” such as premises or sometimes machinery or equipment; the place of business must be “fixed,” that is, it must be established at a distinct place with a certain degree of permanence; and the business of the enterprise must be carried on through this place of business by its personnel.

Pre-empting Mr Holmes’s questions, Maurice moved on to consider some examples.

Were Polycon to deliver a few shipments of lenses to the foreign buyer, it would only have a temporary place of business in his jurisdiction (such as its delivery lorries in the cargo unloading area.) Generally it is considered that anywhere which has a duration of less than six months could not be considered a fixed place of business.

Let us now suppose that Polycon decides to penetrate a foreign market. It sends an employee abroad who finds office space, brings products samples, organises viewings and establishes client relationships, although yet conducts no sales. In legal terms such activities would most likely be considered to be “preparatory and auxiliary,” and Polycon would still have no PE abroad; it would have no reporting or tax liabilities.

Polycon would have a PE abroad were it to rent an office abroad for, say, 12 months and to start selling goods to local customers. The most important point though is whether Polycon has a right to use premises, even if they are indeed fixed and exist for more than six months. Thus the company must either own, rent or otherwise have premises available for its use as a result of a legal right. So if Polycon had signed up with a foreign landlord to occupy an office for 12 months, even if it is only actually selling there for one or two months, Polycon would have the legal right to use fixed premises at a specific location for a certain duration, and this is where its business is carried on. Ergo, a PE (taxable presence) would exist. Alternatively, Polycon could use the garage of Mr Holmes’s foreign uncle under an oral agreement; or a Polycon salesman could arrange sales over the phone from the foreign club of which Mr Holmes is a member – the result would still be the same.

Carrying on of the business of the enterprise through the fixed place of business usually means that persons dependent on the enterprise (personnel) conduct its business in the state where the PE is situated. Polycon’s personnel may include both paid employees and dependent agents, i.e. companies or individuals who are not employed by Polycon but are under a contractual arrangement with and receive instructions from Polycon. This should be contrasted with the situation where Polycon retains an independent firm or a broker (i.e. an independent agent) that specialises in sales of lenses and caters to the needs or several manufacturers. On the condition that such entity is independent from Polycon both legally and economically and Polycon cannot control its activities, as well as if it acts in the course of its ordinary business capacity, there will be no PE.

Neither will there be a PE where Polycon incorporates a foreign subsidiary – the latter will be taxed independently and will distribute dividends subject to withholding tax. Should, however, Mr Holmes, as the shareholder of Polycon, decide to excessively interfere with how the subsidiary’s CEO or the board conduct their business in the country of the subsidiary’s incorporation, the local tax authorities may come to the conclusion that a PE of Polycon itself exists.

Although it is usual for the business to be carried on mainly by natural persons, a human being need not necessarily perform the activities. Were Polycon to install an automatic spectacles dispenser abroad, it would thus constitute a PE from the moment of commencement of sales. Mr Holmes was also very keen on the idea of selling his products over the Internet. He envisaged sales through an online retailer, such as Amazon and eBay, as well as creating Polycon’s own website in the local language. Maurice explained that e-commerce is a complex topic in the international tax planning world and is subject to constant change. Currently, however, selling spectacles lenses through the above e-tailers or through a dedicated corporate website does not normally constitute a PE in the absence of the location that can constitute a “fixed place of business available to Polycon.” This should be contrasted with acquiring a foreign server, locking it up in a room to which Polycon has regular access, and using it to host the foreign website. On the condition that the server is fixed (i.e. literally bolted to the floor, as opposed to being a laptop) and Polycon has access to the room it is located in, the server may constitute the place where the business is carried out, resulting in the existence of a PE. The usual way to circumvent this would be to lease server-space from a specialised foreign company (ISP).

“These provisions,” – concluded Maurice, “constitute the basis for the concept of the PE in the field of international tax planning and are typically used by states across the world as the starting point in drafting of their domestic laws or negotiating double tax treaties.” Maurice then proposed to look at how the idea of the PE may differ across jurisdictions, taking a dog-eared and heavily underlined copy of ITSAPT from the mahogany bookshelf.

Mr Brightman began by pointing out that PEs, in addition to direct primary taxation, often suffer the same secondary withholding tax (as for example the branch level tax levied by France or Spain), which can create double taxation issues if assessments are raised much later when a foreign tax jurisdiction becomes aware of the existence of a PE. It may be, for example, that Polycon is time barred from claiming any relevant credits that would otherwise be available. He then proceeded flicking through the book’s pages, reading from the bookmarked passages.

Mr Holmes learnt that, for instance, France, in addition to using the concept of the “fixed place of business,” explained above, deems a PE to exist where the foreign company has derived income from a complete cycle of commercial operations that has been performed in France, and which is disconnected from the other operations of the foreign company (a so-called cycle commercial complet).

Quite unusually, Canadian legislation starts with a fairly expansive definition of “permanent establishment”. Absent the normal starting point of a fixed place of business, the definition expands the term to include “where the person carries on business through an employee or agent, established in a particular place, who has general authority to contract for the person or who has a stock of merchandise owned by the person from which the employee or agent regularly fills orders, the person shall be deemed to have a permanent establishment at that place” but does provide “the fact that the person has business dealings through a commission agent, broker or other independent agent or maintains an office solely for the purchase of merchandise shall not of itself be held to mean that the person has a permanent establishment.”

Another interesting feature of the Canadian legal framework results from case law. An American taxpayer convinced a Canadian court that he did not have a fixed base in the premises of his client because the taxpayer’s access to those premises was restricted and he did not identify or use the premises as his own – even though he attended there most of the year. Canada responded by renegotiating that section of the Canada-U.S. Tax Treaty to capture such activity as a Permanent Establishment starting in 2010 if carried on for more than 183 days in any twelve month period, and if either more than 50 percent of the gross active business revenues of the enterprise consists of income derived from the services performed in that other State by that individual, or the services were to the same customers.

Australia follows the general provisions of residence and source, the latter being determined both by general law principles worked out over the years by the courts and by specific statutory provisions. Thus income derived from carrying on a business (which includes a gain made on the disposal of an asset made in the ordinary course of the business or as part of a profit-making scheme) will be subject to tax in Australia where that income is Australian sourced. The concept of ‘source’ is not defined in the Tax Act, but given under case law. The judgement of Issacs J in Nathan v F.C. of T (1918) 25 CLR 183 is commonly cited for this purpose: “The legislature using the word ‘source’ meant not a legal concept, but something which a practical man would regard as a real source of income. Legal concepts must, of course, enter into the question when we have to consider to whom a given source belongs. But the ascertainment of the actual source of the given income is a practical hard matter of fact, the Act on examination so treats it.”

States may have different attitudes to interpretation and application of the basic conditions outlined earlier. Thus, as for most countries, Luxembourg stipulates that a non-independent agent of an enterprise which has authority to conclude contracts on behalf of and to commit the enterprise contractually, may create a permanent establishment of such enterprise in Luxembourg, based on that agent’s specific factual situation. However, it is not necessary for the agent to be a Luxembourg resident for his activities in Luxembourg to create a permanent establishment of an enterprise in Luxembourg.

A sales agent or commission agent that has other customers and does not act exclusively for one enterprise may be regarded as an independent agent. The authority to conclude contracts is understood as being the ability of the agent to represent the enterprise in such a manner that the enterprise is legally bound by such authority. Being able to bind the enterprise and complete a transaction is relevant, but mere signatory powers are normally not sufficient to create a permanent establishment. Compare this with the approach adopted in the UK. In determining whether one person is an agent for another, HMRC will examine the three “Rs”—risks, responsibilities and rewards. In deciding whether a branch/agency exists or not, the presentation of the facts, explanation and interpretation of those factors will have an influence on the opinion of the tax inspector.

There are also different approaches to the establishment of the existence of a PE in e-commerce situations. In Italy domestic law takes a stance opposed to the one discussed above in that it excludes the possibility that a “server” used for the purpose of selling goods and services may constitute per se a PE. However, the suitability of such equipment and its use for the commercialisation of goods and services belonging to the foreign enterprise might constitute evidence of the existence of a PE in Italy. The UK concurs with the Italian position. It takes the view that a server, either alone or together with web sites, could not as such constitute a PE of a business that is conducting e-commerce through a web site on the server. Surprisingly, this is regardless of whether the server is owned, rented or otherwise at the disposal of the business.

Maurice kept talking. He explained to his friend such (what Mr Holmes thought to be) arcane ideas, as establishment of the PE through a mine or an oil well, both in and outside the country’s territorial waters; the difference between states in the length of the construction period following which a contractor acquires a PE; the significance of the PE for VAT purposes and varied attitudes of jurisdictions to tax avoidance schemes using the PE concept. It was a long day but Mr Holmes learnt a lot. He thought that the most valuable lesson was the realisation that prior to entering a foreign market, the business owner should consider its expected level of involvement and the scope of its future activities. This should be weighed against the tax consequences arising from a PE that may be established as a result of such market penetration. Last, but not least, the treaty network and domestic laws of the target jurisdiction must be analysed. And finally, one should let professionals be good at what they are doing and leave tax planning to Maurice Brightman with his trusted ITSAPT!