Today is the era of growing business operations where new technologies and solutions are adapted to expand their business markets and global presence. The growth in the number of enterprises and the extensive integration of national economies has significantly increased in the past 60 years. The bilateral treaties between countries to support international trade and investment has led to the growth of tax treaty networks. The main aim of tax treaty networks is the prevention of double taxation which arises due to the overlapping tax jurisdiction of two or more countries. The issue of overlapping tax comes into the picture because of the imposition of tax on the basis of residence jurisdiction and source jurisdiction. For instance, an enterprise receives income from abroad and the source country taxes the same into account and the taxpayer receives its income in its residence jurisdiction, which may also impose a tax on the resident’s worldwide income. In such cases, if no relief is given by the residence country, the enterprise will be subjected to double taxation which will be against the economic concept of horizontal equity.

In order to overcome the issue of double taxation, the concept of Permanent Establishment (PE) was introduced. Taking a step back into the first treaty on double taxation, the provision provides that business profits made by a PE were to be taxed in the country where the PE is situated. Therefore, the main aim behind introducing the concept of PE was to prevent double taxation and to determine the taxing jurisdiction over a foreigner’s business activities.

The current convention which provides for the concept of PE is the OECD Model Tax Convention (OECD MTC). The OECD Model Tax Convention on income and capital introduced by the Organisation of Economic Co-operation and Development (hereinafter referred to as “OECD”) protects its members from being subjected to double taxation. The aim of the OECD Model is ‘to clarify, standardize and confirm the fiscal situation of taxpayers who are engaged in commercial, industrial, financial or any other activities in other countries through the application by all countries of common solutions to identical cases of double taxation’.[1] However, the concept of PE has evolved over time.


Article 5 of the OECD Model Tax Convention on Income and Capital defines a PE. It is defined as a “fixed place of business through which the business of an enterprise is wholly or partly carried on.[2] Thus, the two basic principles being:

a) The existence of a fixed establishment

b) Place of business

Nowadays, the OECD Convention concept has influenced most of the country’s domestic laws concerning the definition of PE. Although the definitions of PE may vary according to the country’s circumstances, the general principle is drawn from the OECD Model. Under the Income Tax Act, 1961 a PE includes a fixed place of business through which the business of the enterprise is wholly or partly carried on and does not include a liaison office.[3] The presence of a physical business is a key element in this concept. Thus, a PE is a compromise between two states: one favouring principle of residence and another favouring principle of the source. For instance, an international bank located in a host country will be a PE for tax treaty purposes because the branch is a fixed place of business and the business of the international bank is carried through the fixed place of business. Furthermore, with respect to treatises that are entered into by India with other countries, the provisions of the treatises or the domestic law, whichever is beneficial will be made applicable. But in most cases, the treatises are seen to be more beneficial than domestic law.


Determination of profits is the most important and complex aspect with respect to PE. The international principles governing the attribution of profits to Permanent Establishments are provided under Article 7 of the OECD MTC. Accordingly, the business profits of an enterprise may be taxed in the contracting state i.e. where the PE is situated to the extent the profits are attributable. The underlying principles that govern the attribution of profits are twofold:

a) Separate entity principle

b) Arm’s Length Principle

India’s domestic law does not provide any detailed guidelines or regulations on the issue of attribution of profits. If a non-resident has a business connection in India, that part of income which is reasonably attributable can only be said to be attributed. To be more specific, a foreign company is supposed to pay taxes on the income that is received or deemed to be received in India or that profit that is accrued or deemed to have been accrued through a ‘business connection.’


The concept of PE gained wide significance in the development of global trading. At the international level, jurisdiction to tax is based on two spheres. Firstly, residence taxation and source taxation. When large corporations enter into cross-border transactions, they are subject to double taxation both in the home country (where the corporation resides) and where the activities take place (source country). In order to overcome that situation, the two countries engage in a double taxation treaty to avoid the same. Thus, to determine the taxing rights of the corporation, the concept of PE is very vital in these scenarios. It primarily determines the taxing jurisdiction over business activities of the States who lay income on therefrom.

Earlier, the underlying principle of Article 7 was that unless the enterprise of one state sets up a PE in the contracting state, it is not to be regarded as participating in the economic life of the other state. Thus, making business profits not taxable. This, in turn, limits the rights of the contracting state to tax the business profits of the enterprise.

However, the allocation of business profits and the interpretation of Article 7 of the OECD Model has undergone a vast change post the publication of the Report on the Attribution of Profits to Permanent Establishment in 2008. The former Article 7 provided a method for allocating business profits of an international enterprise operating in the host country through a permanent establishment.[4] It was based on the arm’s length principle and recognized PE as a separate entity for the allocation of profits.[5] However, for certain purposes, it was recognized as a part of a larger single entity. The concurrent reliance on both separate entity and single entity led to a failure on the part of the OECD countries to reach in a consensus interpretation. This has resulted in double taxation or under–taxation. Also, the expenses incurred by the international enterprise for the PE were allowed a deduction for determining the profits of the PE.[6]

The 2008 commentary claims that the meaning of the terms used in Article 7 was ambiguous and its connection to other provisions was unclear.  It has been criticized that the former Article 7 has resulted in a failure to provide consensus interpretation among OECD countries. For example, the term ‘profits of an enterprise’ resulted in inconsistent interpretation. The two ways of interpreting the term are the ‘relevant business activity’ approach and the ‘functional separate entity’ approach. The former represents the single entity method and the latter, as the name itself suggests, the separate entity method. In both the methods the issue of interpreting is whether the profits can be attributed to the permanent establishment of the host country.

The above-mentioned issues led to the implementation of a new Article 7 which reflects the principles in the 2008 report. The new Article 7 was adopted in 2010 and a revised version of the 2008 report was published in 2010, ‘to ensure that that the conclusions of that report could be read harmoniously with the new wording and modified numbering.’[7] The main aim of the 2010 OECD Model is to prevent the past interpretation of former Article 7 being applied to the new provision. The new Article provides relief to enterprises from double taxation and the other parts of the provision provide a bigger picture on the attribution of profits of PE. Article 7(1) of the OECD Tax Model Convention provides that the profits an enterprise of the Contracting State shall be taxable only in that State, only if the enterprise carries on its business activities in the other contracting state through a PE situated therein. Under the new Article 7(2), a PE is considered to be a separate enterprise transacting with other parts of the enterprises on arms’ length terms. Under this amendment, a PE’s dealings were subject to the adapted transfer pricing guidelines.

However, certain challenges came through its way with the implementation of new Article 7. This amendment was only adopted only by a few countries and some countries rejected the new Article 7 as well as the 2008 report. The key challenge was its practical application among most of the OECD countries. The uncertainty that was arising from its practical nature would increase the disputes between the authorities and the international enterprises. Furthermore, they were to incur high compliance costs. It was also claimed that the tax authorities will be reluctant to provide significant resources that are necessary to audit taxpayers’ economic analysis.

It is necessary to consider that PEs are not a separate legal entity in law or business practice. They are part of an integrated international enterprise having common management and common profit aim. The new Article 7 is based on Arms’ length principle and the legal fiction of treating an enterprise as a separate legal entity is only for the purpose of Article 7 and not for any other treaty provisions.


The increase in international trade relations and globalization has revealed the shortcomings in bilateral treaties based on arms’ length principle. Prior to globalization, the permanent establishment has been operating as a separate legal entity and a single entity because of the poor international relations. However, in the current scenario, it would not be apt to consider a permanent establishment as a separate enterprise in its dealings with the head office as the International enterprises operating through branches have achieved high levels of integration through high-quality communication level.

Therefore, the 2010 Report is based on the arms’ length principle that treats a permanent establishment as a separate legal entity and applying the adapted transfer pricing guidelines. The implementation of the new Article 7 was to treat a PE as a separate legal entity only for the purposes of attribution of profits and not for all treaty purposes. However, the new Article 7 is likely to provide uncertainty to the taxpayers because of the conflict between its theoretical concept with the business practice. Also, it is likely to cause high compliance costs to the taxpayers and high administrative costs to the tax authorities in treating the PE as a separate entity in the matter of attribution of profits. But the key advantage to the implementation of the new Article is the provision of relief from double taxation to the taxpayers. Thus, satisfying the main object behind


[1] 2010 OECD Model, p.7, para. 2.

[2] Article 5 of the OECD Model Tax Convention on Income and Capital

[3] Section 92F of the Income Tax Act, 1961

[4] Former Article 7(1) of the 2008 OECD Model

[5] Former Article 7(2) of the 2008 OECD Model

[6] Former Article 7(5) of the 2008 OECD Model

[7] 2010 OECD Model, pp. 130-1, para 8.

Author Bio

Name: Anjali A
Qualification: Student- Others
Company: N/A
Location: Kochi, Kerala, IN
Member Since: 17 Apr 2018 | Total Posts: 1

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One Comment


    Good article. However, there is no reference of BEPS7 recent amendment. There are various new concept added in this amendment, without that PE concept will not be complete.

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