Thought leadership from our experts

Permanent establishment: a tax concept that every business executive should appreciate

, EY, Hong Kong

The concept of permanent establishment (PE) is arguably one of the most important issues in treaty-based international tax law. Indeed, it is largely this concept that decides how much tax a company selling goods or services from Country A to Country B is charged – by both countries, in the end.

It is perhaps the most dynamic issue, too.

The first statement is confirmed by the fact that virtually every single one of the thousands of present-day bilateral tax treaties –the very bedrock of the cross-border tax architecture – use PE as the main tool via which to establish taxing right for the source jurisdiction over a foreign entity's unincorporated business activities.

The second statement is validated by the fact that PE – or, more accurately, changes to the PE concept – sits at the very heart of government and Organisation for Economic Co-operation and Development (OECD) focus alike, forming the central crux of the Base Erosion and Profit Shifting or "BEPS" project1, often referred to as the largest set of changes experienced since tax treaties themselves were developed.

Today, the focus on PE (and its family member, nexus) is equally (if not more) strong as it was in the 2015 BEPS work2. This is due to the advent of the BEPS 2.0 program of work3 – originally conceived as a way to mop up hitherto unfinished parts of the original BEPS project that were designed to address the tax challenges brought about by the existence of the digital economy, but quickly moving past that ring-fenced descriptor, affecting virtually every single company doing business internationally.

Looking forward, this unfinished work is at the center of the global tax debate today and, should consensus be found on an increasingly complex project, will impact cross-border taxation for years to come. These are not small changes. They are fundamental. Who should have the rights to tax companies? And on what basis?

It is for that reason alone that business leaders outside the tax department should ensure they have a robust understanding of PE, its history and its role in a debate that may define the next hundred years of taxation.

PE 101

In the simplest terms, having a PE means having a taxable presence outside your company's state of residence. That may seem like a simple enough concept, but fast forward from the advent of tax treaties4 and 100 years into a future of globalization, communications and what some have described as technological "scale without mass"5 and tax authorities have expanded the concept way beyond the "bricks and mortar" definition. Tax authorities now identify PEs caused by overseas contractors, short-term business travelers, warehouse space, digital activity and many more activities.

The existence of PE will typically give rise to several tax effects. The most important and obvious effect, both from legal and practical viewpoints, is that the PE principle under tax treaties is decisive in determining a non-resident enterprise's tax obligation due to business activities with economic allegiance6 to more than one country – through a branch office, representative, project office or even the simple signing of a contract. But while PE might seem like a relatively straight-forward concept to manage, the opposite is in fact true.

While a charge to tax might not be entirely expected by a business, it is unlikely to cause a business to exit a market or change its business model. But while a failure to disclose a PE is often the first investigation a foreign tax authority will undertake, such an investigation has been compared to layering back an onion – uncovering layers of multi-year and multi-geography consequences (which arise through successive amended returns) and, ultimately, making one's eyes water as a result.

As is the case with many tax issues, the penalties (both civil and criminal) that may be applied as a result of the failure to disclose a PE vary wildly. While Thailand may only charge a 1.5% monthly surcharge on tax shortfall, Italy is a completely different ball game – imprisonment is possible, along with a penalty of the unpaid tax7. Additionally, an increasing number of countries are making their criminal tax laws extra-territorial and/or simultaneously targeted at non-tax-department executives within a company; in 29 of the 42 (69%) countries responding to an EY criminal sanctions survey in 2019, such laws could apply to a company or their legal representative acting or existing in another country. These are not reasons to not do business in a market – but they do highlight the need to ensure that appropriate tax corporate governance is in place, and that ever-shifting local regulations are continually assessed and managed.

BEPS 1.0

While it would be wrong to sweep nearly a century of technical developments under the rug, it is also fair to say that it was not until after the global financial crisis of 2008-9 that policy-maker's attentions really turned to look more closely at PE.

What arguably began as a crackdown on tax havens quickly evolved into a broad debate regarding how and where multinational enterprises report their income and pay their taxes. In the 2013-2015 design phase of the BEPS project, many countries expressed concern that cross-border tax systems had not kept pace with how companies do business in a globalized, digitally-driven economy. The international community does not easily reach consensus on issues that affect sovereign purse strings, yet in response to G20 requests, and with the input of its member countries, the OECD developed and issued its 15-part BEPS recommendations, Action 7 of which addressed PE8. These recommendations, described by the OECD's Secretary-General, the "most fundamental change to the international tax rules since the 1920's" effectively tightened many of what policy-makers saw as the most open-to-abuse elements of PE rules, used by companies, they say, to avoid having a taxable presence in a jurisdiction.

Action 7 proposed several changes to the definition of permanent establishment in the OECD Model Tax Convention9 (the template upon which the majority of countries base their PE and other tax rules) to counter such avoidance. These include:

  • Changes to ensure that where the activities that an intermediary exercises in a jurisdiction are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, that enterprise will be considered to have a taxable presence in that jurisdiction unless the intermediary is performing these activities in the course of an independent business.
  • Changes to restrict the application of a number of exceptions to the definition of permanent establishment to activities that are preparatory or auxiliary nature and will ensure that it is not possible to take advantage of these exceptions by the fragmentation of a cohesive operating business into several small operations; and
  • Changes to address situations where the exception applicable to construction sites is circumvented through the splitting-up contracts between closely related enterprises.

BEPS Action 7 was implemented by a large number of jurisdictions in the years after the recommendations were made.

BEPS 2.0

While the BEPS recommendations were clearly significant, they did not quite finish the job as the OECD intended. This is especially the case as it relates to Action 110 of the BEPS recommendations, those designed to tackle the Tax challenges arising from the digital economy. Here, the work was explicitly carried forward into 2020, on the basis that more time was needed – especially when the task at hand is to carve up the revenues earned by large tech-heavy multinational companies, many of whom are the champions of the countries in which they are headquartered.

These companies can foster, it is argued, a mismatch between where profits are currently taxed and where and how certain digital activities create value. As was noted in an EY publication in early 201811:

"To be clear, notwithstanding the fact that taxing digitalized activity was first addressed within the OECD's BEPS project, the current debate is not about tax avoidance or the existence of stateless income. It is, rather, about the division of tax rights among countries who consider that their citizens contribute to the profits made by some digitally focused companies, even if they do so via unconventional means."

Many policymakers believe that the value creation mismatch is the result of a combination of several factors. First, they say that businesses can today supply digital services where they are not physically established, for which the European Commission coined the phrase "scale without mass." Second, they posit that digital business models tend to have a heavy reliance on intellectual property assets, and are therefore more mobile. And third (and perhaps the biggest challenge in the debate) the Commission believes that a higher level of value than currently assessed comes from users' participation in the digital activities that some platforms enable – commonly described as "user value creation".

Through 2019, though, it became clear that the so-called BEPS 2.0 program (as it quickly became known) was not just about taxing digitally-native companies who were selling into other countries without being physically present there. Instead, it was clear, it had (and has) the potential to impact virtually every company that carries on cross-border business today. Indeed, EY's early-2019 comment letter to the OECD12 illustrates this:

"..while the digitalization of the economy is a factor that fuels this project, the project has implications that go well beyond digital business models and potentially affect virtually all cross-border activity. We would encourage the OECD to limit the use of digital references in describing this project. It should be clear to country policymakers and stakeholders that this project is more sweeping than a digital label might suggest."

Final thoughts

The objective of this short article was not to delve into the deepest coverage of BEPS 1.0 or 2.0. Instead, it is to highlight that the very concepts of nexus and PE are likely to see change in the years ahead, and that that change can affect businesses at both institutional and personal levels.

I noted earlier in this article that PE is pervasive. In fact, even COVID-19 has a significant PE element to it – personnel working in a foreign country may have become stranded there, a company's supply chain may need to be reworked in order to locate scarce materials and many companies may be running up against risks from rules such as India's Place of Effective Management13, when managers use virtual connectivity to run operations from afar. Put simply, businesses need to be vigilant about every aspect of their value chain to mitigate any unforeseen tax and other risks caused by PEs.

Tax rates aside, ask the leader of the tax department of any large company which one technical topic is the most important to track and address, and it is likely that PE will be the answer. As such and given its close interaction with the strategic plans of any business pursuing overseas growth, PE should be a topic that any company executive should feel that they understand.

The author wishes to extend special thanks to the EY Global Tax Policy team for their supports to this article.

The above are the views of the author and do not represent the views of the EY organization.


1. Source: https://www.oecd.org/tax/beps/

2. Source: https://www.oecd.org/tax/beps/beps-actions/

3. Source: https://www.oecd.org/tax/beps/statement-by-the-oecd-g20-inclusive-framework-on-beps-january-2020.pdf

4. International Financial Conference, Brussels 1920, League of Nations

5. Source: https://www.oecd.org/tax/beps/beps-actions/action7/

6. Source: The Doctrine of Economic Allegiance, Report on Double Taxation: Document E.F.S.73 F.19; April 5, 1923

7. https://taxnews.ey.com/news/2019-2063-italy-considers-significant-amendments-to-tax-criminal-penalties?uAlertID=Sd%2FG8rua1oj6%2Fl58EZ2AiA%3D%3D

8. Source: https://www.oecd.org/tax/beps/beps-actions/action7/

9. Source: http://www.oecd.org/ctp/model-tax-convention-on-income-and-on-capital-full-version-9a5b369e-en.htm

10. Source: https://www.oecd.org/tax/beps/beps-actions/action1/

11. Source: https://www.ey.com/Publication/vwLUAssets/EY-new-digital-tax-policies-what-when-where-how-and-by-whom/%24FILE/EY-new-digital-tax-policies-what-when-where-how-and-by-whom.pdf

12. Source: https://www.ey.com/Publication/vwLUAssets/ey-oecd-centre-for-tax-policy-and-administration/$File/ey-oecd-centre-for-tax-policy-and-administration.pdf

13. Source: https://taxinsights.ey.com/archive/archive-news/india-issues-guidance-on-place-of-effective-management.aspx