Introduction:
In the realm of international taxation, the concept of Permanent Establishment (PE) plays a pivotal role. It is primarily defined in Article 5 of tax treaties and is of utmost importance for those engaged in international transactions and expanding their global business presence. This article delves into the world of Permanent Establishment, unraveling its definition, structure, and key components that are integral to understanding its implications.
What is Permanent Establishment?
The concept of Permanent Establishment (PE) is defined in Article 5 of the tax treaties and this term holds significant importance for one who is engaged in the international transactions and seeking to expand their global business presence.
It is important to understand the PE as article 7 mandates the existence of a PE as a pre-requisite for the purpose of taxation of business profit in that particular jurisdiction.
Structure of Article 5 of the UN Model convention
5(1): Basic rule for constitution of a PE
5(2): Inclusions to constitute a PE (Example; Office, branch etc.)
5(3): PE in relation to construction or installation projects etc.
5(4): List of exclusions (Example; storage or display of goods/ merchandise)
5(5): Agency PE
5(6): Special rule for insurance agents
5(7): Non-applicability of para 5 and para 6
5(8): Rule of controlling entity that is resident in the contracting state
The above-mentioned para is the structure of UN Model convention which is for the treaty entered between a Developed and Developing Country
Article 5(1): Basic rule for constitution of a PE
“For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.”
As per the above paragraph, we understand that for constitution of a PE, the following conditions must be satisfied cumulatively:
- There is a place of business
- Place of business is “fixed”
- Existence of an “enterprise” which is carrying on a business
- Business is wholly or partly carried on through this enterprise
The UN convention doesn’t define the term ‘business’ and hence, we refer the Income-tax Act, 1961 (Act) in this regard. Section 2(13) of the Act defines business as including any trade, commerce or manufacture. We can further use the case laws and judgements as what constitutes a business is something which depends on facts and circumstances.
Since the term business is not defined in the UN convention, the ‘place of business’ is also not defined. The term ‘place’ can be used widely and it covers a large geographical area and not limited to any thing since the same is not defined under the convention. There are some examples which can be used as a ‘place of business’ as seen practically:
- Office space
- Residential premises, if used for carrying out a business activity
- A depot for storing the imported goods
- A motor racing circuit*
The place of business may be owned and rented, there is no mandate of place of business to be owned only.
While we move further, lets understand the meaning of ‘fixed’ in relation to the place of business.
The term ‘Fixed’ it may be interpreted as the place of business is to be located at a ‘specific place’ or ‘distinct place’ within source state. It involves identifying a ‘definite place’ as the place from which a business is carried on.
Furthermore, it is essential to note that Article 5(1) does not make any reference to any minimum period for which a PE should be in existence in the Source state and it is Article 5(3) that suggests that the duration of PE which may be 6 months or 183 days etc. However, it is important to acknowledge that this standard may not universally apply to all situations.
The duration may be depending upon the business nature and the circumstances. One such example can be taken is for SC judgement on Formula One World Championship Ltd (2017) wherein it has been held that even a 3-day event can constitute a PE.
Article 5(2): Inclusions to constitute a PE
The term ‘Permanent Establishment’ includes especially:
– A place of management
– A branch
– An office
– A factory
– A workshop
– A mine, an oil or gas well, a quarry or any other place of extraction of natural resources
The above-mentioned are the inclusions and it contains the list of places which, prima facie constitutes a PE
Article 5(3): PE in relation to construction or installation projects etc. (Construction or Service PE)
The term “permanent establishment” also encompasses:
(a) 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
(b) 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 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.
The Sub para (a) refers to Construction PE wherein the duration of such site, project or activities in order to constitute a PE should last for more than six months.
However, sub para (b) refers to Service PE wherein the duration of the services in order to constitute a PE should be six months within any 12-month period
Let’s further discuss about the expression ‘site’ and ‘project’ from a duration perspective. These terms are not synonyms and a ‘project’ may be carried on at more than one ‘site’ or ‘location’ and the activities performed at each spot or site are part of a single project and such ‘project’ may be regarded as a PE if, as a whole, it lasts for more than six months in the source state.
While computing the duration it is pertinent to note that there may be some interruptions of operations and work on account of several reasons which can impact the duration of a particular project. Hence, the seasonal or temporary interruptions (Example; bad weather, labour issues) may be included in determining the duration of a site.
Article 5(4): List of exclusions
Article 5(4) of UN Model reads as follows:
Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include:
(a) The use of facilities solely for the purpose of storage or display of goods or merchandise belonging to the enterprise
(b) The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage or display
(c) The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise
(d) The maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise
(e) The maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity
(f) The maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs (a) to (e), provided that such activity or, in the case of subparagraph (f), the overall activity of the fixed place of business, is of a preparatory or auxiliary character.
Let’s understand the above article hereunder:
Article 5(4)(a): Unlike OECD Model, this article does not include the word “delivery” and restricts para (a) to “storage or display’. Consequently, the warehouse in the source state used for delivery of goods may constitute a PE.
Article 5(4)(b): It relates to the stock of goods pr merchandise and provides that such stock shall not be treated as a PE if it maintained solely for the purpose of storage or display for the enterprise.
Article 5(4)(c): It provides that a PE is not constituted when a stock of goods or merchandise belonging to a foreign enterprise is maintained solely for processing by another enterprise in the source state.
Article 5(4)(d) & (e): If there exists a fixed place in the source state which is solely for the purpose of purchasing goods or merchandise or of collecting information/ solely for the purpose of any other activity for the enterprise that it does not constitutes a PE.
Article 5(4)(f): It provides the exception of a PE if the activity is ‘preparatory or auxiliary’ in nature. The term ‘preparatory’ or ‘auxiliary’ is not defined under the article and it has to be examined on case-to-case basis.
‘Preparatory’ is something that prepares or serves to prepare for the core activity. ‘Auxiliary’ is something that is ancillary or subsidiary in nature and involves helping, assisting or supporting the main activity
Article 5(5): Agency PE
Article 5(5) of the UN model reads as:
“Notwithstanding the provisions of paragraphs 1 and 2 but subject to the provisions of paragraph 7, where a person is acting in a Contracting State on behalf of an enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise, if such a person:
(a) habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are
(i) in the name of the enterprise, or
(ii) for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or
(iii) for the provision of services by that enterprise, unless the activities of such person are limited to those mentioned in paragraph 4 which, if exercised through a fixed place of business (other than a fixed place of business to which paragraph 4.1 would apply), would not make this fixed place of business a permanent establishment under the provisions of that paragraph; or
(b) the person does not habitually conclude contracts nor plays the principal role leading to the conclusion of such contracts, but habitually maintains in that State a stock of goods or merchandise from which that person regularly delivers goods or merchandise on behalf of the enterprise”
Who is an Agent?
An agent is one who works for another in accordance with his authority while dealing with third parties for his principal. In order to determine the existence of a principal-agency relationship it is important to understand the substance rather than its form.
Further, a dependent agent could be an entity, individuals or companies, employees of a foreign enterprise or non-employees.
Habitually: An agent must be habitually exercise an authority to conclude contracts. ‘Habitually’ refers to a systematic course and would mean ‘repeatedly’ and not in isolated cases.
A person can be said to have the authority to conclude the contracts if he has sufficient authority to bid the enterprise in the source state and to decide the final terms of the contract.
Article 5(6): Special rule for Insurance enterprise
“Notwithstanding the preceding provisions of this Article but subject to the provisions of paragraph 7, an insurance enterprise of a Contracting State shall, except in regard to re-insurance, be deemed to have a permanent establishment in the other Contracting State if it collects premiums in the territory of that other State or insures risks situated therein through a person”
It means that PE may be constituted in the source state if the agent through whom premiums are collected and risk insured, is present in the source state where risk is located. (It does not apply to reinsurance)
Article 5(7): Non-applicability of para 5 and para 6
“Paragraphs 5 and 6 shall not apply where the person acting in a Contracting State on behalf of an enterprise of the other Contracting State carries on business in the first-mentioned State as an independent agent and acts for the enterprise in the ordinary course of that business. Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, that person shall not be considered to be an independent agent within the meaning of this paragraph with respect to any such enterprise”
This para is an exception to para 5 and 6 and should be read with respective paragraphs for better understanding of the particular treaty.
The expression “independence” means not subject to the authority or control of any person. The agent will be independent if he has overall control over an autonomous business conducted by him and bears the risk of his business.
Wholly or almost wholly: The word ‘wholly’ means entirely and ‘almost wholly’ means almost entirely, very near to wholly.
Hence, in order to determine the dependency, it is relevant that the agent’s activities are for a single principal and not the principal’s activities are carried on by a sole agent.
Article 5(8): Rule of controlling entity that is resident in the contracting state
“The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other”
This article is a clarificatory in nature and clarifies that the company of a residence state is not deemed to have a PE in the source state merely because it controls, or is controlled by, a company that is a resident of a source state.
Conclusion:
In the world of international taxation, the concept of Permanent Establishment is a cornerstone for determining a business’s taxable presence in a foreign jurisdiction. This article has shed light on the essence of Permanent Establishment, elucidating its definition, structure, and various components as delineated in Article 5 of the UN Model Convention. Understanding PE is indispensable for businesses engaged in international transactions and expansion, as it directly impacts their taxation and compliance obligations in different countries. Remember, interpretations may vary across treaties and jurisdictions, making it essential to seek professional advice for specific situations.
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Disclaimer: The above article is only for an understanding purpose and should not be interpreted as an opinion of the author.
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