Global mobility and increased cross-border operations carried by multinational enterprises have exposed attention to undefined business activities in terms of international taxation over the past decade. Thus, local tax authorities had chosen to have more aggressive positions as a result of corporations’ large number of disputes which was occurred with competent bodies. Since having sufficient activity in another country through permanent establishment[1] may constitute a taxable presence in that another country, therefore, such operations are significant to be considered by multinational enterprises in order to not encounter an unexpected tax liabilities, potential indirect costs, penalties and interest charges. The risk of unintentionally constituting a permanent establishment is a grey area, and the risk management regarding the subject matter can form an essential part of multinational enterprises’ corporate and tax maintenance.
Identifying the existence of a permanent establishment is essential for the taxing rights of the jurisdictions. If a permanent establishment exists through which the non-resident enterprise carries on business, then the jurisdiction where the permanent establishment is located may tax the profits of the enterprise that are attributable to the permanent establishment using the source principle[2].
The Organisation for Economic Co-operation and Development (“OECD”) is an international organisation that works on establishing model international norms and applications to a range of economic challenges including tax matters. A set of provisions under the OECD Model Tax Convention on Income and Capital (“OECD Convention”), which was published by the OECD in order to provide a means of settling on a uniform basis the most common problems that arise in the field of international taxation, have been determined regarding concept of the permanent establishment. In this direction, Article 5 of the OECD Convention outlines the definition of the permanent establishment and Article 7 answers the question of when an enterprise carries on business in another country through a permanent establishment situated therein, what, if any, are the profits that the other jurisdiction may tax.
Although the OECD is not an organisation which is entitled to impose any legally binding international standard; models and guidances introduced by the OECD are commonly adopted in double tax treaties between states in many aspects. Apart from the fact that the criteria and determinations decided by states in relevant double tax treaties may vary, there are common indicators for the term of permanent establishment and such indicators will be examined below given the provisions of the OECD Convention set forth.
An enterprise shall be deemed to have a permanent establishment in another state provided that it has a fixed place of business through which the business of the enterprise is wholly or partly carried on according to Article 5(1) of the Convention. This definition, therefore, contains the following conditions:
Furthermore, as stipulated under Article 5(2), permanent establishments include especially: (i) A place of management; (ii) A branch; (iii) An office; (iv) A factory; (v) A workshop; and (vi) A mine, an oil or gas well, a quary or any other place of extraction of natural resources.
Important to note that it is not necessary for the non-resident enterprise to legally own or lease the foreign premises, such as examples given under Article 5(2). While no formal legal right to use a particular place is required for that place to constitute a permanent establishment, the mere presence of an enterprise at a particular location does not necessarily mean that the location herein is at the disposal of that enterprise. Whether a location may be considered to be at the disposal of an enterprise in such a way that it may constitute a “place of business through which the business of the [that] enterprise is wholly or partly carried on” will depend on that enterprise having the effective power to use that location as well as the extent of the presence of the enterprise at that location and the activities that it performs there[4].
A first example provided by the OECD for that situation is that of a salesperson who regularly visits a major customer to take orders and meets the purchasing director in her office to do so. In that case, the customer’s premises are not at the disposal of the enterprise for which the salesperson is working and therefore do not constitute a place of business through which the business of that enterprise is carried on (depending on the circumstances, however, Article 5(5) could apply to deem a permanent establishment to exist as explained below under section (b)). A second example is that of an employee of a company who, for a long period of time, is allowed to use an office in the headquarters of another company (i.e., a newly acquired subsidiary) in order to ensure that the latter company complies with its obligations under contracts concluded with the former company. In that case, the employee is carrying on activities related to the business of the former company and the office that is at her disposal at the headquarters of the other company will constitute a permanent establishment of her employer, provided that the office is at her disposal for a sufficiently long period of time so as to constitute a fixed place of business and that the activities that are performed there go beyond the activities referred to in Article 5(4). A third example is that of a road transportation enterprise which would use a delivery dock at a customer’s warehouse every day for a number of years for the purpose of delivering goods purchased by that customer. In that case, the presence of the road transportation enterprise at the delivery dock would be so limited that that enterprise could not consider that place as being at its disposal so as to constitute a permanent establishment of that enterprise. A fourth example is that of a painter who, for two years, spends three days a week in the large office building of its main client. In that case, the presence of the painter in that office building where she is performing the most important functions of her business (i.e., painting) constitute a permanent establishment of that painter.
During the COVID-19 pandemic, remote working has become widespread and many employees has been working under home-office conditions. Even though part of the business of an enterprise may be carried on at a location such as an individual’s home office, that should not lead to the automatic conclusion that that location is at the disposal of that enterprise simply because that location is used by an individual (i.e., an employee) who works for the enterprise. Whether or not a home-office constitutes a location at the disposal of the enterprise will depend on the facts and circumstances of each case. In many cases, the carrying on of business activities at the home of an individual will be so intermittent or incidental that the home will not be considered to be a location at the disposal of the enterprise. Where, however, a home-office is used on a continuous basis for carrying on business activities for an enterprise and it is clear from the facts and circumstances that the enterprise has required the individual to use that location to carry on the enterprise’s business (i.e., by not providing an office to an employee in circumstances where the nature of the employment clearly requires an office), the home-office may be considered to be at the disposal of the enterprise[5].
OECD has published “Updated Guidance on Tax Treaties and the Impact of the COVID-19 Pandemic” on 21.01.2021. It is stated under this updated guidance that some businesses may be concerned that employees dislocated to jurisdictions other than the one in which they regularly work, and working from their homes during the COVID-19 pandemic, could create a permanent establishment in those jurisdictions, triggering for those businesses new filing requirements and tax obligations[6]. OECD is of the opinion that the exceptional and temporary change of the location where employees exercise their employment because of the COVID-19 pandemic, such as working from home, should not create new permanent establishments for the employer. Similarly, the temporary conclusion of contracts in the home of employees or agents because of the COVID-19 pandemic should not create permanent establishments for the businesses. But jurisdictions may consider “stopping the clock” for determining whether the permanent establishment threshold has been satisfied during certain periods where operations are suspended as a public health measure to prevent the spread of the COVID-19 virus.
A number of tax authorities have issued guidance on whether changes in work practices prompted by the COVID-19 pandemic can result in the creation of a permanent establishment. The Australian Tax Office, the Canada Revenue Agency, the German Federal Ministry of Finance, Greece’s Independent Authority for Public Revenue, Ireland’s Revenue, New Zealand’s Inland Revenue, the UK’s HM Revenue & Customs and the US Internal Revenue Service are the ones that have issued such guidance, and other tax authorities of states have been expected to take relevant actions in order to clarify the said situation to a certain extent[7].
Even though an enterprise may not have a fixed place of business in another country within the meaning of abovementioned matters, the enterprise will be deemed to have a permanent establishment in another country (i) where a person is acting on behalf of the enterprise, and (ii) habitually exercises an authority to conclude contracts in the name of the enterprise. Such persons may be either individuals or companies and need not to be residents of, nor have a place of business in, another country in which they act for the enterprise.
Exercising an authority to conclude contracts in the name of the enterprise is one of the key conditions for establishing a permanent establishment in another country; on the other side, there could be some cases for the enterprise being deemed to have a permanent establishment even though the relevant person does not conclude contracts in the name of the enterprise. For such cases, the OECD commentary provides the example below:
“A person who is authorized to negotiate all elements and details of a contract in a way binding on the enterprise can be said to exercise this authority “in that State”, even if the contract is signed by another person in the State in which the enterprise is situated or if the first person has not formally been given a power of representation. The mere fact, however, that a person has attended or even participated in negotiations in a State between an enterprise and a client will not be sufficient, by itself, to conclude that the person has exercised in that State an authority to conclude contracts in the name of the enterprise. The fact that a person has attended or even participated in such negotiations could, however, be a relevant factor in determining the exact functions performed by that person on behalf of the enterprise.”[8]
Status of independency of the person is important, and carrying on business through an independent agent will not be deemed as a permanent establishment. Therefore, criteria of independence can be demonstrated by a combination of the following factors: (i) An agent bearing a commercial degree of entrepreneurial risk; (ii) An agent being both legally and commercially independent of the enterprise; (iii) An agent not being required to comply with detailed instructions from the enterprise; (iv) An agent not being subject to comprehensive control by the enterprise; (v) An agent having skill and knowledge on which the enterprise relies; and (vi) An agent working for a number of different clients[9]. Such factors will be important in determining whether the agent is dependent or not.
To set an example, operations such as a sales representative regularly concluding contracts on behalf of the company, or a person servicing a contract that results in revenue to the enterprise will increase the risk of having a permanent establishment in another country.
As COVID-19 is the case for “fixed place of business” criteria as explained above, it is also crucial for agent activities in terms of determining permanent establishments. The OECD has stated under its updated guidance that the agent’s activity in a jurisdiction should not be regarded as “habitual” if they have exceptionally begun working at home in that jurisdiction as a public health measure imposed or recommended by at least one of the governments of the jurisdictions involved to prevent the spread of the COVID-19 virus and, therefore, would not constitute a dependent agent permanent establishment provided that the person does not continue those activities after the public health measures cease to apply[10]. Further, if the employee continues to work from home for a non-resident employer after the COVID-19 pandemic, on a habitual basis and continues to conclude contracts on behalf of the enterprise, it would be more likely that the employee would be considered to habitually conclude contracts on behalf of the enterprise.
Activities Having Preparatory or Auxiliary Character
According to Article 5(4) of the OECD Convention, if the activity carried on has preparatory or auxiliary character, and does not create an essential part of the business as a whole, the enterprise shall not be deemed as having a permanent establishment.
The list of activities which could have preparatory or auxiliary character mentioned in Article 5(4) include:
Activities of an enterprise can be divided into “core activities” and those that are merely “preparatory or auxiliary”. Within this scope, the OECD proposes the following considerations in order to settle with the subject matter in question: (i) It is necessary to decide which activities constitute an essential and significant parts of the activity of the enterprise as a whole; (ii) Preparatory activities will often be relatively short term; (iii) Auxiliary activities are those that support the core activities. Carrying them out does not usually require a significant proportion of the assets or employees of the enterprise.
It should be noted that the nature of the activity itself, and not the type of fixed place of business that carries on the activity, must be examined to determine whether the activity is preparatory or auxiliary. According to OECD Commentary on Article 5, an example is provided in the following case:
“Where, for example, an enterprise of State R maintains in State S a very large warehouse in which a significant number of employees work for the main purpose of storing and delivering goods owned by the enterprise that the enterprise sells online to customers in State S, paragraph 4 will not apply to that warehouse since the storage and delivery activities that are performed through that warehouse, which represents an important asset and requires a number of employees, constitute an essential part of the enterprise’s sale/distribution business and do not have, therefore, a preparatory or auxiliary character.”[11]
As seen from example above, although the characteristic of the relevant activities may match with the sample preparatory or auxiliary operations defined in Article 5(4), all the existing facts must be analyzed as a whole.
Some activities carried on in another country could be considered as having preparatory or auxiliary character by the enterprises, however, in practice, proving the required factors against the tax authorities in order to benefit from abovementioned exceptions can be problematic.
Building Sites, Construction or Installation Projects
In addition to preparatory or auxiliary activities defined in Article 5(4), a building site or construction or installation project does not constitute a permanent establishment if it lasts less than twelve months pursuant to Article 5(3). The term “building site or construction or installation project” includes not only the construction of buildings but also the construction of roads, bridges or canals, the renovation (involving more than mere maintenance or redecoration) of buildings, roads, bridges or canals, the laying of pipe-lines and excavating and dredging. Additionally, the term “installation project” is not restricted to an installation related to a construction project; it also includes the installation of new equipment, such as a complex machine, in an existing building or outdoors.
Profits of an enterprise of a state shall be taxable only in that state unless the enterprise carries on business in the other state through a permanent establishment situated therein according to Article 7 of the Convention. In this context, if an enterprise of a contracting state has not a permanent establishment situated in the other state, business profits of that enterprise may not be taxed by that other state. The profits that are attributable in each state to the permanent establishment referred under the Article 7 are the profit it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.
The right to tax of the state where the permanent establishment is situated does not extend to profits that the enterprise may derive from that state but that are not attributable to the permanent establishment. This is a question on which there have historically been differences of view, a few countries having some time ago pursued a principle of general “force of attraction”[12] according to which income such as other business profits, dividends, interests and royalties arising from sources in their territory was fully taxable by them if the beneficiary had a permanent establishment therein even though such income was clearly not attributable to that permanent establishment[13]. The method of force of attraction has now been rejected in international tax treaty practice. The principle that is now generally accepted in double tax treaties is based on the view that in taxing the profits that a foreign enterprise derives from a particular state, the tax authorities of that state should look at the separate sources of profit that the enterprise derives from their country.
There are considerable number of companies each of which is engaged in a wide diversity of activities and is carrying on business extensively in many countries. A company may set up a permanent establishment in another state through which it carries on manufacturing activities whilst a different part of the same company sells different goods in that other state through independent agents. That company may have perfectly valid commercial reasons for doing so, for instance, in terms of commercial convenience. If the state in which the permanent establishment is situated wished to go so far as to try to determine, and tax, the profit element of each of the transactions carried on through independent agents, with a view to aggregating that profit with the profits of the permanent establishment, that approach would interfere seriously to ordinary commercial activities.
The attribution of profits to a permanent establishment under Article 7(2) will follow from the calculation of the profits (for losses) from all its activities, including transactions with independent enterprises, transactions with associated enterprises and dealings with other parts of the enterprise. According to an example given by the OECD, experience has shown that building site or a construction or installation projects can give rise to special problems in attributing profits to them under Article 7[14]. These problems arise chiefly where goods are provided, or services performed, by the other parts of the enterprise or a related party in connection with the building site or construction or installation project. Whilst these problems can arise with any permanent establishment, they are particularly acute for building sites and construction or installation projects. In these circumstances, it is necessary to pay close attention to the general principle that profits are attributable to a permanent establishment only with respect to activities carried on by the enterprise through that permanent establishment. For instance, where such goods are supplied by the other parts of the enterprise, the profits arising from that supply do not result from the activities carried on through the permanent establishment and are not attributable to it.
In the event that the cross-border operations carried on by enterprise are not correctly managed and the existing permanent establishments are not determined, it can lead various risks including but not limited to:
When an enterprise is seeking to enter a new market in another country, operations which will be carried on should be monitored in order to identify the potential tax liabilities. One of the most important guidelines for enterprises to look at in first place is a double tax treaty entered into between relevant countries where operations take place. If there is a double tax treaty between relevant countries, provisions for the definition of permanent establishment and its exceptions should be analyzed subsequently. In the absence of such double tax treaty, then local tax laws may define the permanent establishment matters. In conclusion, the risk management regarding the subject matter is vital part of multinational enterprises’ corporate and tax maintenance, thus unintentional permanent establishments should be determined by examining the international operations in order to prevent the various risks which the enterprises may encounter in terms of tax liabilities.
Att. Burak Yöney
Ozay Law Firm
[1] The term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on. The main use of the concept of a permanent establishment is to determine the right of a contracting state to tax the profits of an enterprise of the other contracting state.
[2] Angharad Miller & Lynne Oats, Principles of International Taxation, Bloomsbury Professional, 5th Edition, 2016, p.179
[3] According the statement of OECD, it is sometimes difficult to determine whether this is the case. Whilst the practices followed by member countries have not been consistent in so far as time requirements are concerned, experience has shown that permanent establishments normally have not been considered to exist in situations where a business had been carried on in a country through a place of business that was maintained for less than six months. One exception has been where the activities were of a recurrent nature; in such cases, each period of time during which the place is used needs to be considered in combination with the number during which that place is used (which may extend over number of years).
[4] OECD Commentary on Model Tax Convention on Income and Capital, Condensed Version 2017, p.117
[5] OECD Commentaries on the Articles of the Model Tax Convention, 2017, p.120
[6] Updated Guidance on Tax Treaties and the Impact of the COVID-19 Pandemic, 2021, paragraph 9
[7] For Australia, see: https://www.ato.gov.au/business/international-tax-for-business/working-out-your-residency/
For Canada, see: https://www.canada.ca/en/revenue-agency/campaigns/covid-19-update/guidance-international-income-tax-issues.html
For Greece, see: https://aade.gr/sites/default/files/2020-07/E2113_2020.pdf
For Ireland, see: https://www.revenue.ie/en/corporate/communications/covid19/compliance-with-certain-reporting-and-filing-obligations.aspx
For New Zealand, see: https://www.ird.govt.nz/covid-19/international/tax-residency
For United Kingdom, see: https://www.gov.uk/hmrc-internal-manuals/international-manual/intm261010
For United States, see: https://www.irs.gov/newsroom/faqs-for-nonresident-alien-individuals-and-foreign-businesses-with-employees-or-agents-impacted-by-covid-19-emergency-travel-disruptions
[8] OECD Commentaries on the Articles of the Model Tax Convention, 2010, p.106
[9] Andy Lymer & Lynne Oats, Taxation: Policy and Practice, Fiscal Publications, 21th Edition, 2014, p.273
[10] Updated Guidance on Tax Treaties and the Impact of the COVID-19 Pandemic, 2021, paragraph 24
[11] OECD Additional Guidance on the Attribution of Profits to Permanent Establishments, BEPS Action 7, 2018, p.9
[12] When an enterprise sets up a permanent establishment in another state, that state can tax all profits that the enterprise derives there, whether or not the transactions are routed and performed through the permanent establishment.
[13] OECD Commentary on Model Tax Convention on Income and Capital, Condensed Version 2017, p.176
[14] OECD Commentary on Model Tax Convention on Income and Capital, Condensed Version 2017, p.184