The Treaty Definition of a Permanent Establishment


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The definition of the term “Permanent Establishment” is fairly uniform among all income tax treaties and will typically be found where there is either a Physical or Imputed Permanent Establishment. In the U.S., for example, failure to file an income tax return with a treaty disclosure will result in a loss of deductions if it is later determined that there was a PE, so it's important to determine upfront whether you have a PE.[1] In the U.S., a sole proprietor Nonresident should always file a “protective return” with schedules of income zeroed-out asserting no Permanent Establishment on IRS Form 8833 in order to preserve deductions and credits and run the Statute of Limitations.[2] But enough about the U.S., let's focus on Permanent Establishments worldwide.

Physical Permanent Establishment

A Physical Permanent Establishment is a fixed place of business (e.g., factory, office, tent in a marketplace, gas well, mine, etc.) that is at a foreign person’s constant disposal (e.g., owned, leased, sharing, or illegally squatting) through which business is carried on (e.g., for at least 6 months) and determined under treaty principles without regard to domestic law.[3] A Physical Permanent Establishment can even include a temporary construction site, installation project, or drilling rig for the exploration of natural resources that last more than twelve months.

Business Income Shifting Strategy

A permanent establishment can be intentionally created to shift income to another country. For example, under some treaties, “director’s fees” are apportioned based on the area of performance. But if the individual creates a permanent establishment in one country and not in the other, the “director’s fees” would be recharacterized as “business income” that is attributable solely to a permanent establishment in one of the countries.

These and other strategies, however, should only be employed and implemented under the guidance and instruction of our firm. If you do it incorrectly, it could be disastrous for your company.

Treaty Shopping

Coupled with planning under an income tax treaty’s Limitation on Benefits (“LOB”) Article or by focusing on country’s whose income tax treaty with the forum country completely lacks an LOB Article, such as Greece, Hungary, Pakistan, Philippines, Poland, or Romania, it is possible to effectively treaty shop for the best result. However, international tax professionals should take careful note to add a substantial amount of economic substance and non-tax purpose to each step in these arrangements to avoid a counter-attack from tax authorities for lack of economic substance and the step-transaction doctrine, respectively.[4]

Imputed Permanent Establishment

When a nonresident conducts business through a partnership, another’s PE, a dependent agent, or even a not-truly-independent agent, then there are several concerns that the nonresident must consider to avoid having a Permanent Establishment in the forum country imputed to them.

At One’s Disposal

If there is a Permanent Establishment “at the constant disposal” of a nonresident, then it’s attributed to that nonresident. Ask yourself: does the foreign person use the premises as they please? If so, then the foreign person will have that Permanent Establishment imputed to him. If not, continue analyzing either in the non-subsidiary or subsidiary context.

Case Sample: Computer Servers

If a corporation engaged in e-commerce through a website that processes orders and also owns or leases the use of servers that host the website, which remain unmoved at a certain location for a sufficient period of time so as to become “fixed,” then the place where the server is located is a PE.[5] However, where there is merely a hosting arrangement for a website with an ISP, then the ISP’s computer servers cannot constitute a Permanent Establishment since the ISP would be considered an independent agent acting in the ordinary course of its own business of hosting websites.[6]

The U.K. does not believe a server should constitute a Permanent Establishment since the U.K. has few server companies and would lose a substantial amount of revenue to other nations. On the other hand, India believes that even a mere hosting arrangement should constitute a Permanent Establishment since their country hosts many websites and would thus benefit from having the host declared a Permanent Establishment of every e-commerce website. Some countries are biased in favor of their own national interests.

Dependent Agency and Subsidiary Analysis

Generally, a dependent agent is any person, regardless of whether or not the person is an employee or subsidiary, that is not an independent agent.[7] For a domestic subsidiary’s Permanent Establishment to be attributed to a foreign parent, the foreign parent must either have the Permanent Establishment at its disposal, as mentioned above, or have the discretionary authority to conclude contracts in the name of the principal and must be shown to habitually exercise said discretion. Mere authority alone is insufficient.

If the subsidiary has the authority to conclude contracts in parent’s name and often use that power, there will be a finding of a PE; however, if the subsidiary acts in its own name, there will be no PE.

As long as a subsidiary does not allow its Permanent Establishment to be available to the foreign parent (e.g., restricting access to employees of SubCo only and specifically excluding employees of parent and sister companies) and acts in its own name, the subsidiary’s Permanent Establishment will not be attributed to the foreign parent.

Independent Agency Analysis

Is the agent dependent or independent? The analysis turns on the discretion of the agent’s authority; whether the principal has interest ownership in the agent, and whether the relationship is permanent or terminable. In other words, is the agent legally and economically independent?[8] An exclusive consignment agent or commissionaire qualifies as an independent agent even if this would constitute taxable presence under domestic law of the forum country. Treaty law supersedes domestic law.

Legal Independence

Is the authority to bind discretionary or non-discretionary? If the agent has discretionary authority to conduct business on behalf of the principal, there is a strong showing of legal independence. If the person does business in their own name, there is a presumption of discretion.

If there is no interest ownership in the agent-corporation or an employment arrangement with the agent individual, there can be no de facto comprehensive control.

Economic Independence

If either party is able to terminate their contractual relationship, there is no exclusivity; hence, there is economic independence. Entrepreneurial risk is irrelevant; therefore, guarantee of business based on principal is irrelevant.

Effect of a Partnership

A Partnership’s Permanent Establishment is deemed to be at every partner’s constant disposal. Therefore, avoid operating through a partnership.

The automatic imputing of a PE via a partnership is based on two theories:

Agency Theory

The first is that the general active partners are treated as the agents of the passive limited partners.[9]

If the limited partners have no binding authority or control, then the active partners are independent agents at best.

Interest Theory

The second, and more compelling, theory is that the partnership agreement gives all partners, including passive limited partners, a legal interest in all assets, including the offices, which creates the permanent establishment for the foreign partner despite the passive nature of the investment.[10]

If the Partnership Agreement (or even an after-the-fact signed and contractually binding Memorandum of Clarification) creates a new limited profits-only interest that specifically says that the limited partner has no legal interest in any company assets, there is a very strong argument that no Permanent Establishment can be imputed to foreign partners.

If your company needs a customized Partnership Agreement in order to comply with this standard, contact our firm today to schedule a free consultation.

Exception for Auxiliary Activities

Under the OECD Model Income Tax Treaty, Article 5(4), a Permanent Establishment specifically does not include the following activities:

Marketing Branch. Fixed places of business solely for the purpose of advertising and marketing company goods or services.[11] Even an independent advertising agency maintained by an enterprise solely engaged in advertising its own company and not others is covered.[12] The use of facilities for the passive marketing, such as a display stand at a trade show or mall, would be included as well. An art gallery that does not take orders would also be protected against Permanent Establishment status.

Storage Facility. The use of facilities for the maintenance of a stock of goods or merchandise in a contracting state for storage.

Processing/Delivery Facility. The use of facilities for the maintenance of a stock of goods or merchandise in a contracting state for delivery (packing and labeling facility).

Warranty Repairs.[13] The use of facilities for warranty-based repairs does not constitute a Permanent Establishment.

Quality Inspections.[14] The use of facilities for quality inspections does not constitute a Permanent Establishment.

Purchasing Activities. The maintenance of a fixed place of business for the purpose of purchasing raw materials or purchasing goods for resale.

Collecting Client Information. The maintenance of a fixed place of business for the purpose of collecting client information.

Providing a Communications Link. Maintaining a telephone line between suppliers and customers.[15] In other words, having a local phone number is not enough. Logic would apply this to a virtual office. What about providing a computer through which a client can order?

Mirror Server. Relaying information through a mirror server for security and efficiency purposes.[16]

Data Acquisition. Gathering market data for the enterprise and supplying that information.[17]

Scientific Research. Fixed places of business solely for science research.[18]

Servicing Patent or Know-How Contract. Fixed places of business solely for servicing patent or know-how contract.[19]

Non-Commercial Info-Only Website. If the website merely advertises and does not process orders, not even a server constitutes a PE.[20]

Preparatory or Auxiliary Activities. The maintenance of a fixed place of business solely for any other activity of a preparatory or auxiliary character.[21]


Contact Our Firm

Contact our firm today to schedule a free consultation so we can discuss how your company can fully utilize the exceptions for auxiliary activities to maximize your company’s operations without giving rise to local tax implications.

[1] IRC §§ 874(a), 882(c); Treas. Reg. § 1.882-4; Swallows Holding, Ltd. v. C.I.R., 515 F.3d 162 (3d Cir. 2008).

[2] Treas. Reg. 1.874-1(b)(6).

[3] See Inez de Amodio v. C.I.R., 34 T.C. 894 (1960) aff’d, 299 F2d 623 (3d Cir. 1962).

[4] See Del Commercial Properties, Inc. v. C.I.R., 251 F.3d 210 (D.C. Cir. 2001).

[5] See, e.g., Piedras Negras Broad. Co. v. C.I.R., 43 B.T.A. 297 (1941) aff’d, 127 F.2d 260 (5th Cir. 1942).

[6] OECD 2010 Commentary, Art. 5, ¶¶ 42.1 - 42.10.

[7] OECD 2014 Commentary, Art. 5 ¶ 32.

[8] Taisei Fire & Marine Ins. v. C.I.R., 104 T.C. 535 (1995).

[9] Donroy, Ltd. v. U.S., 301 F.2d 200, 208 (9th Cir. 1962).

[10] Donroy, Ltd. v. U.S., 301 F.2d 200, 207 (9th Cir. 1962); Unger v. C.I.R., 936 F.2d 1316, 1318 (D.C. Cir. 1991).

[11] OECD 2014 Commentary, Art. 5, ¶ 23, 42.7.

[12] OECD 2014 Commentary, Art. 5, ¶ 28.

[13] OECD 2010 Commentary, Art. 5, ¶¶ 21-27.

[14] OECD 2010 Commentary, Art. 5, ¶¶ 21-27.

[15] OECD 2014 Commentary, Art. 5, ¶ 42.7.

[16] OECD 2014 Commentary, Art. 5, ¶ 42.7.

[17] OECD 2014 Commentary, Art. 5, ¶¶ 23, 42.7.

[18] OECD 2014 Commentary, Art. 5, ¶ 23.

[19] OECD 2014 Commentary, Art. 5, ¶ 23.

[20] OECD 2014 Commentary, Art. 5, ¶ 42.9.

[21] OECD 2010 Commentary, Art. 5, ¶¶ 21-27.

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