Francisco A. Laguna & Jimmy Wang
An emerging issue of cross border investments or foreign direct investment is the double taxation created by the competition between developed and developing countries regarding how profits should be allocated (and taxed) between the source country and the country of residence. One of the factors that creates this problem is the existence of a permanent establishment (PE). A PE will give the country where the PE is found the right to tax a portion of business profits resulting from the foreign investment. Developed and developing countries generally have different views as to what constitutes a PE. Although it is a legal issue, it is also a highly political one since it involves countries’ revenue collection. This also causes the deviation of legal standards between developed and developing countries. In general, developing countries have lower PE thresholds in order to collect more tax from foreign investments, and developed countries vice versa. This post will explore the PE concept from the developing countries’ perspective.
A PE is a “fixed place of business” through which the business of an enterprise is wholly or partly run. A multinational enterprise (MNE) of a developed country that engages in a trade or business through fixed places within the territory of a developing country would give the developing country the right to tax a portion of the income generated from the business operations. The threshold question here is what constitutes a PE that would allow the taxing authority of the developing country to tax a portion of income allocable to that PE. Developing countries usually follow the United Nations Model Tax Convention to define the PE threshold; and developed countries follow the OECD Model Tax Convention. Under the UN Model Tax Convention, the following types of PE are created, which encompass a broad category of industries.
- Building Sites
Article 5 (3)(a) provides that the term PE encompasses: A building site, a construction, assembly or installation project or supervisory activities in connection therewith, but only if such site, project or activities last more than six months.
In contrast, for a building site to be considered a PE under the OECD standard, a longer period of operation is required (1 year). However, under the UN standard, a period exceeding 6 months is enough to create a PE. MNEs engaging in construction or instruction projects should always be aware of the term of the projects because it might create a sufficient economic footprint in another country to allow taxation.
- Service Providers
Article 5 (3)(b) provides that PE also encompasses: The furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continue (for the same or a connected project) within a Contracting State for a period or periods aggregating more than 183 days in any 12-month period commencing or ending in the fiscal year concerned.
Article 5 (3)(b) of the UN Convention addresses a special provision for service PEs, which is not included in the OECD PE provisions. This type of service PEs can be found in two of the BRIC countries: China; and India. Without a mirroring provision, presumably, the OECD will treat services in the same way it determines whether a PE exists, i.e., whether the services provided constitute a PE depends on whether it delivers them through fixed place or by a dependent agent.
MNEs in the services sector need to be mindful of this type of PE. Service PEs can be found if services are provided by employees or through related third parties and last more than 6 months. If there is more than one service project in the other country, MNEs should consider whether these projects are related because the duration of the connected projects, one following the other, could add up to, and exceed, the 6-month threshold period.
- Delivery Agents
The UN Convention creates a type of dependent agent PE that is not included in the OECD version. Article 5 (5)(b) provides that: Notwithstanding the provisions of paragraphs 1 and 2, where a person — other than an agent of an independent status to whom paragraph 7 applies — is acting in a Contracting State on behalf of an enterprise of the other Contracting State, that enterprise shall be deemed to have a permanent establishment in the first-mentioned Contracting State in respect of any activities which that person undertakes for the enterprise, if such a person: (b) Has no such authority, but habitually maintains in the first-mentioned State a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the enterprise.
Developed countries that follow the OECD Model only recognize one type of Agent PE — the Dependent Agent. A dependent agent is someone who has the right to enter into contracts that bind the principal. The UN Model provides for two types of Agent PEs: the Delivery Agent; and the Dependent Agent. MNEs that have a distribution branch or engage third-party distributors in developing countries might face potential PE risks in this regard.
In conclusion, the developing countries that follow the UN Model Tax Convention preserve greater source country taxation rights by creating and developing different types of PEs. It is a matter of what constitutes a sufficient economic nexus to the host country so as to justify taxation by the host country. Determining what dictates the right minimum economic footprint for taxation is an area where law and policy interact. For MNEs, it is important to understand this difference and the reason behind when considering investing in foreign countries with complicated PE provisions.
Contact TransLegal with your questions concerning permanent establishments in developing countries.