CONCEPT OF PERMANENT ESTABLISHMENT

 

A RESERCH BY MANISH AGARWAL

 

·         What is Permanent Establishment meaning for a tax professional.

     

With the globalization of world economies, the concept of Permanent  Establishment (PE) has gained significant magnitude both in India and worldwide  due to its direct impact on the tax revenue generated by a Country. The PE  concept is a measuring tool to determine the right of a country to tax the  profits of an enterprise which is resident of another country and is generally used in parlance of cross border business and taxability of the income  generated.

 

 PE may be defined as a fixed place of business through which activities of an

organization are wholly or partially carried on. This fixed place of business

should be the place of business of foreign entity itself (at the disposal of  such foreign entity) and not the local entity. Thus the maintenance of fixed  place of business only for preparatory and auxiliary activities has been  specifically excluded from the definition of PE.  

 

·         Significance

One of the paramount objectives of a tax treaty is to resolve the claims of competing jurisdictions where an enterprise is resident in one country and carries out business activities in another. Most often, domestic laws of countries prescribe the threshold for taxing business profits of a foreign enterprise carrying on business within their taxable territory. For instance in India, we have the concept of a 'business connection', which is discussed below, and is analogous to the concept of a PE. In the UK, the threshold is described as the point when a foreign enterprise trades within the UK, as opposed to merely trading with the UK. The PE concept is therefore a major contribution to international tax law and is a significant feature of bilateral tax treaties in force throughout the world. Where a tax treaty is in operation, the crucial question is whether a foreign enterprise is carrying on business through a PE in the country where the profits are earned. If the enterprise does not have a PE then it can be taxed only in the country where it is a resident. However, where the enterprise operates through a PE, the profits attributable to it, may be taxed by the country where the PE is located, leaving the country of residence to give relief from double taxation. Thus it may be possible for an enterprise with overseas trading operations to avoid foreign taxes by carefully structuring its operations to come below the PE threshold. Where a PE is in existence, the country where it is located may also tax its capital gains, dividends, interest and royalties that are effectively connected to such PE.

 

·         Types of PE

 

Even though the basic concept of PE revolves around the fixed place of business,  it may also extend to include an agent who is legally separate from an  enterprise and also rendering of services in India by a foreign entity. The

Double Taxation Avoidance Agreements entered into by India recognizes the

following main types of PE for a foreign enterprise in India:

 

°         Fixed Place PE

 

°         Agency PE

 

°         Service PE

 

 

 In order to determine the type of permanent establishment, the transaction has to be classified within any of the below mentioned requisites:

 

 

·         Tests of PE

 

Even if the transaction can be classified in one of the above requisites,  certain peculiar transactions can still not be classified to constitute a PE.  For the purpose of removal of such ambiguities, in addition to the requisites  stated above, certain qualifying tests have been defined to ascertain the  correct type of PE with reasonable finality:

 

Some Important Concepts in Permanent Establishment

 

Since the law governing the concept of PE has not been clearly defined, in order to have a precise understanding of taxation of a foreign entity operating in  India, some important concepts used are:

 

 Business Connection

 

 Income tax act has defined the term Business connection, thereby clarifying and  restricting the scope of varied interpretation. Business connection is a long  recognized mode of determining tax liability of non resident. A business

connection involves a relation between a business carried on by a non-resident, which yields profits or gains and some activity in India that contributes to the earning of these profits or gains. A business connection may arise between  a non-resident and a resident if both of them carry on business and if the  non-resident earns income through such a connection.

 

The term business connection is of colossal significance in the concept of PE.

If there is no business connection between a non resident entity and a resident  entity, the resident entity may not be a PE of the non-resident entity, and the  resident entity would have to be assessed to income-tax as a separate entity. In such a case, the non-resident entity will not be liable to tax in India.  

 

Business connection is an expression of wide and indefinite import and is

different from the expression business as defined under the Act .Hence the term  was being interpreted differently by different authorities under different

circumstances and had been the subject matter of judicial interpretations by

various authorities.

 

Some of the illustrative examples of business connection based on decided case  laws are:

 °        Maintaining a branch office in India for the purchase or sale of goods

or transacting other business.

 °        Appointing an agent in India for the systematic and regular purchaseof

raw materials or other commodities, or for sale of the non residents goods, or for other business purposes.

 °        Erecting a factory in India where the raw material  purchased locally

is worked into a form suitable for export abroad

 °        Forming a local subsidiary company to sell the products of the non

          resident parent company

 °        Having financial association between a resident and a non-resident

          company.

 

 

Attribution of profits

 

The PE criterion is commonly used in international double taxation conventions to determine the taxability of an income in the country from which it  originates.  As per various double taxation conventions, the profits of an enterprise of a Contracting state shall be taxable only in that state unless the

enterprise carries on business in the other Contracting State through a PE.

 

Currently, the international tax principles for attributing profits to a PE are  provided in the OECD Model tax treaty; however a number of bilateral tax  treaties adopt features of UN Model Convention. The models have been briefly  discussed in the paragraphs below:

OECD Model

 

This model provides that only so much of the profits of an enterprise as are

attributable to a PE in a country may be taxed in that country. It also secures

taxing rights of a host country so that profits of a non-resident enterprise

that are not attributable to the permanent establishment cannot be subject to

tax. Working Hypothesis is developed as a preferred approach for the attribution  of profits by the OECD. It has examined the feasibility of treating a PE as a  hypothetical distinct and separate enterprise and has reviewed ways in which  transfer pricing principles could be applied in order to attribute profits to a  PE in accordance with the arm's length principle.

UN Model Convention

 

UN Model generally follows the similar principles, however, the major difference  between the two models is that the UN Model extends source country taxing rights beyond the strict attribution of profit to a PE and grants a host country the  right to tax profits attributable to sales made by the non-resident enterprise in the countrys territory of goods or merchandise of the same or similar kind as those sold through that PE.

Analysis of Article 5 of DTAA.

ACIT Test.

 

 Situation of different contracts.

 

 

In 1989 the revenue authorities of Belgium, the Netherlands and Germany issued an interpretation of tax treaty provisions. This interpretation had the following rules.

 

1.    the length of time separate construction sites last does not have to be added up for computing whether a PE is formed;

2.    work performed for separate principals may normally be treated as a separate project, unless it forms one unit with another project or series of projects, from an economic point of view;

3.    different projects performed for one principal by virtue of one contract are treated as 'one' unless the different projects are not performed in any relationship to each other;

4.     projects performed for one principal by virtue of several contracts are also to be treated as 'one' if the construction, although performed at different sites, is only part of a more global project and there is no appreciable interruption of the activity between the sites."

 

 

Agency Test.

 

Paragraph 5 states that a non-independent agent who has an authority to conclude contracts on behalf of an enterprise, and who habitually exercises that authority, will constitute a PE of the enterprise. However, if the enterprise carries on business through an independent agent such as a broker or general commission agent, paragraph 6 provides that such person will not constitute a PE of the enterprise. The official commentary on the OECD Model furthers states that a person will only have independent status if it is independent both legally and economically, and it acts in its ordinary course of business when acting on behalf of the enterprise33. If an agent acts almost exclusively for one enterprise it may be difficult for him to show that he is independent, and in some Indian treaties (for example the one with UK) it is expressly provided that in such a case the agent will be deemed not to have an independent status. Paragraph 7 recognizes that an overseas subsidiary company is a separate legal entity from its parent and as such cannot automatically be regarded as a PE. However, if the subsidiary functions as a non-independent     agent/entity on behalf of its parent, it will constitute a PE.

 

Activities Test.

 

Paragraph 4 of the OECD Model is of great significance as it sets out those activities, which even if carried on through a fixed place of business will not constitute a PE. Thus, if  the operations are structured properly to fall within these exclusions, it could very well fall within the exceptions and avail of the benefits thereto. Perhaps the logic behind providing these exceptions was so as to exclude services that are really very remote from the actual realisation of profits. The exclusions given by sub-clause (e) offer significant opportunities where there is a double tax treaty, for enterprises wishing to maintain a presence overseas without actually incurring any foreign tax liability. The principle advantage of a representative office is that it is relatively simple and cheap to establish compared to say forming a subsidiary. Further most often the expenses of the representative offices will be deductible for tax purposes in the hands of the parent enterprise. Once established, a  representative office would be entitled to (subject of course to the regulations prevailing in the country where it is established) have a telephone, maintain a bank account, etc.

 

A mere sales solicitation office is sufficient, whether intended for one's own goods or services or those of an unrelated supplier for the constitution of a PE.

 

Mailing address.

 

The question arises as to whether the existence of a mailing address of the enterprise in a foreign country would lead to the existence of a PE. In a case decided by the US court it was held that a Canadian company which only had a mailing address in the US, but had no office, telephone listing or bank account there, could not said as to having a PE in the US.

 

Trade fairs.

 

Merely selling merchandise at the end of a trade fair or convention would not result in a PE in the state in which the trade fair is held36. The trade fair or convention clause would indicate that sales and delivery to customers from stock on any regular basis should produce the PE characterisation for the place of business, even if operated for relatively short periods of time37. The above ruling involving the solicitation by one entity of orders for the goods and services of another, suggest that PE status may be avoided by careful legal structuring. Consider for example, the creation by a foreign enterprise of a representative office in the source country. That office has as its purpose the creation of customer goodwill and product awareness through representative office brochures, advertising, participation in trade fairs, and customer visits (in which direct solicitation is avoided). Suppose further that the representative personnel share office space in the source country with personnel of an unrelated source –country corporation who attend to(and to whom are referred) all source country customer orders, bookings and the transmission to and acceptance by the foreign enterprise at a foreign location. If such separation of functions is required by agreement and adhered to in practice, the foreign enterprise has no PE in the source country

 

·         Conclusion

 

 Even though the concept of PE has been defined extensively in various literatures, still there are a number of issues which remain unanswered. The distinct nature of each transaction makes interpretation of the law and case law  precedents worth noting. This not only helps in formulation of the law and

providing clarification for various judicial proceedings but also gives rise to introduction of various concepts to make the interpretation of the law simpler.

Subsidiary PE and Installation/ Construction PE, though do not fall under any

specific classifications but are still treated as PE as a result of the  interpretation of such decided case laws.