"Permanent Establishment" Does Not Have To Be a Scary Term

by Mary Kay Woods, KPMG LLP, New York City
(KPMG LLP in the United States is a KPMG International member firm)

The words “permanent establishment” (PE) seem to strike fear into the hearts of many normally resilient people. Why is that? Perhaps it’s the fear of having the tax authorities of one country or another reassessing their company’s tax liability — and hitting their company with interest and penalties — due to an investigation that ultimately determined that they had a PE. Because a PE, once established, causes the business profits attributable to said PE to be subject to corporate-level tax in the country where the activity takes place which has broad and long-term implications. In addition, having a PE can also increase the tax filing burden. Some companies are unaware that the activities of even one individual employee performing a simple service or activity in another country can subject the home country legal entity to host country corporate-level taxation and may also expose the individual employee to host country taxation.

Companies need to carefully plan, monitor, and document the assignments and duties of individuals sent outside the home country, as well as determine which entity is actually employing the individual(s) being sent overseas. This article discusses the issues surrounding PE, and suggests what steps may be taken to mitigate the risks associated with establishing a PE.

Background Definitions

The following definitions provide some parameters for our discussion. The definitions concern the types of individuals who may be working in host locations — that is, dependent agents, independent agents, and payroll agents.

Dependent Agent (e.g., Secondee or Income from Employment): A person (other than an independent agent) who acts on behalf of the enterprise and habitually concludes contracts in the name of the enterprise in a foreign country; those activities can create a PE for the entity.

If a foreign subsidiary is a commissionaire (an agent acting in its own name), the presence of seconded (transferred) employees who conclude contracts in the name of the foreign subsidiary could create less risk of a PE than seconded employees who concluded contracts in the name of the U.S. parent corporation. Under most U.S. treaties, a dependent agent creates a PE only if it concludes contracts in the name of the foreign company.

Independent Agent: For example, a broker, commission agent, or other "independent" agent; if such individuals conduct activities in the ordinary course of business, a PE does not exist. The Treasury regulations provide that an office or fixed place of business of an independent agent shall not be treated as an office or a fixed place of business of the foreign company even if the agent has the authority to conclude contracts and regularly exercises that authority or has stock or merchandise belonging to the enterprise and orders are regularly fulfilled.¹

If, however, the independent agent performs activities solely for one principal, the facts and circumstances of the arrangement must be evaluated to determine if the agent is truly independent. Such an agent would likely be treated as economically dependent on the principal, and hence, true independence would be compromised and the activities of the agent would actually benefit the principal. Under such circumstances, the relationship would be more like a dependent relationship and therefore should be taxed as such. This is consistent with the OECD commentary on "agency" where an agent of independent status must be independent of the principal "both legally and economically."²

Once a PE has been determined, however, the income subject to taxation in the particular jurisdiction may be limited by treaty to the amount of income attributed to the PE.

Payroll Agent: Typically, a corporation (the home country corporation) that transfers its employees to work for another corporation (the host country corporation) and continues to pay these employees, in whole or in part, from the home country payroll. If the home country corporation continues to be the employer of these employees, they may create a PE of the home country corporation in the host country.

A PE of the home country corporation in the host country can probably be avoided if the home country corporation is acting merely as the payroll agent for the host country corporation. The compensation should be charged back to the host country corporation as compensation and not as part of a general management fee. This arrangement should be sufficient to avoid PE issues where the U.S. is the host country. It may also be sufficient in most host foreign countries, but the laws of the relevant country should be consulted before proceeding.

The home country and host country corporations should have a written agreement in which the host country corporation appoints the home country corporation as its payroll agent.

Although the use of a payroll agent potentially can be effective for avoiding a PE for corporate tax planning purposes, this approach will deny treaty relief to certain employees transferred on short-term assignment and thus subject such employees to individual taxation in the host country. Under the Dependent Personal Services articles of many treaties, a resident of the home country who works in the host country for less than 183 days during the taxable year or during any 12-month period generally, will not be subject to host country individual income taxation if he or she is "paid by or on behalf of" a home country or non-host country employer. The use of a payroll agent will prevent the employee from meeting the latter test. If the home country employer is acting as the payroll agent for the host country employer, the individual will be paid on behalf of the host country employer and thus not qualify for treaty relief.

How Are PEs Created?

A PE may be inadvertently created in a number of ways and the following factors especially can augment the possibility:

• Certain activities of employees who are dependent agents of a U.S. company in a foreign jurisdiction or by employees of a non-U.S. company in the U.S. (e.g., negotiating and concluding contracts on behalf of the home country entity)
• The duration of a project or an assignment, including repetitive back-to-back assignments, and short-term activities that produce high profits
• Location of the activity:
• –  the relative 'permanence' of a business location or fixed place of business through which the activities of an entity are wholly or partially carried on (e.g., place of management, branch, office, factory, workshop, etc.) bears on the attendant PE risk (a place of business may, however, constitute a PE even though it exists in practice only for a short period of time because the nature of the business is such that it will be carried on for that short period of time)
• –  certain "mobile" or temporary locations can also be considered PEs (e.g., hotels)
• –  the office or other fixed place of business can be on the premises of a foreign customer or of a foreign subsidiary and create a PE
• –  no rent needs to be paid for the use of space in order to be considered a PE
• The type and depth of involvement by the home country company in the business operations and day-to-day management of a "foreign" company.

The OECD Model Tax Convention, Article 5, indicates that no PE is created under the following circumstances:

• Locally incorporated subsidiaries are not PEs of the parent corporation (in general)
• Employees or dependent agents whose activities meet the definition of auxiliary/preparatory in nature (e.g., market analysis), and
• Independent agents exercising authority to conclude binding contracts.

In the U.S. Model Tax Treaty, the business profits article contains particularly expansive rules defining when services in the host country may create a PE and establishes "tests" that will cause some activities to be characterized as a PE that might otherwise not be.

• Services are provided by an individual who is present in the country 183 days or more in any 12-month period, and during that period 50 percent of the enterprise's gross business revenue is derived from the services performed in that country by that individual, or
• Services are provided in the country for 183 days or more in any 12-month period with respect to the same or connected projects for customers who are either residents of that country or who maintain a PE in that country.

A PE must exist in a country with which the U.S. has an income tax treaty in order for a U.S. company to be subject to foreign taxation on the business profits arising in the foreign country. A lower threshold of activity may subject the U.S. company to foreign taxation in countries with which the U.S. does not have an income tax treaty. It is important to realize that PE and its trigger events can be treaty-specific and/or country-specific, and many factors should be considered in the analysis.

Mitigating Creation of PEs

For obvious reasons, a host country employment arrangement significantly mitigates PE exposure by severing the home country employment link and thereby separating the host and home corporate entities. Nevertheless, it is possible that a tax authority may "pierce" a fabricated arrangement designed to obscure the nexus of employment to avoid PE exposure. In this respect, and by way of example, the U.S. authorities would apply a set of facts and circumstances tests to determine the authentic employer and thus establish a connection with the home corporate entity where the situation warranted.

A home country employment arrangement can be structured so that PE exposure would be mitigated. Broadly speaking, there are three factors to consider: (1) documentation, (2) duration, and (3) due diligence.

Documentation. Typically there are up to three documents generally in place regarding international assignments — assignment letter, secondment agreement, and the services agreement. The first item, the assignment letter, is an agreement between the employer and employee stipulating the terms and conditions as to what compensation the employee is to receive (how much, when, and how, according to what corporate policy, etc.), as well as some other particulars (vacation time, holiday observances, health/welfare plan participation, etc.).

The secondment agreement is basically a formalized employee loan arrangement between employers that stipulates that Employer A is loaning an employee to Employer B for a set duration. During the period of secondment, all services performed by the employee are for the benefit and enjoyment of Employer B. By executing such an arrangement, the risk of PE for Employer A is mitigated, but arguably not 100 percent. The agreement is typically between the employee, the sending organization, and the receiving organization.

The secondment agreement is different from the assignment letter in that it documents services to be performed, the reporting chain of command/authority, and the duration of the assignment (stipulating key employment/re-employment rights including to which country's laws the agreement is subject) which can substantiate the intended assignment structure and employer and the fact that the individual is "loaned" to the host location. It also supports the use of totalization agreements — in terms of meeting the "detached worker" rule and supporting the deductibility of compensation costs in the host location. Sometimes the assignment letter and the secondment agreement are combined in one document.

The final document is a clearly articulated policy governing inter-company chargebacks and cost sharing, known, understood, and practiced by International Human Resource (IHR) management, payroll, corporate accounting, and tax. These service agreements are a useful means to protect against PE risk in substance as well as form. Keeping in mind that cost absorption at home may be indicative of a PE in the host country, all the efforts exerted in strengthening the assignment letter and secondment agreement are undone if the service agreement is not in place and correctly drafted. Typically, this agreement is executed by the sending and receiving organizations and care should be taken to establish that it is consistent with the assignment letter and/or secondment agreement. From a company perspective, a well-conceived inter-company agreement, spelling out the commercial terms of seconded staff, is essential.

Duration. An employee whose secondment is perpetually extended can give rise to greater PE exposure because the authenticity of the secondment arrangement can be questioned — blurring the lines between an assignee and a local hire. A documented and enforced company "step-down" policy (or localization policy), transitioning an extended assignee to 'local hire' status, can mitigate associated PE risks.

Likewise, short-term business visitors and/or "extended business trip" employees can give rise to PE risks because the nature of their work is not infrequently for the benefit of the home country (e.g., in place temporarily to close a deal, structure a team, or execute a project plan which ultimately accrues benefit to the home country). It is possible to overstate this risk, but certain activities, such as those mentioned above, require close scrutiny to avoid or mitigate exposure. Unfortunately, short-term business visitors and extended business travelers are usually not tracked by IHR management or the tax department, and thereby pose a risk through the lack of accountability.

Another source of risk is the employee who is deployed to one country and then, while on assignment, sent temporarily to a third country. Since this second "assignment within an assignment" may not be tracked by a central IHR management group, controls such as documentation may be inadvertently overlooked.

Due Diligence. To identify and deter instances of PE, some companies institute controls employed at both the individual and corporate levels. For this reason (as well as for immigration and income tax planning and compliance) an employer may establish certain internal controls to mitigate, prevent, or limit incidents of potential issues. Examples of such controls can include:

• Required approvals documented before any payroll, expense reimbursement, and/or allowance payments are made
• Specific alerts (generally automated) sent to human resources and relevant suppliers (e.g., immigration and tax) for certain employees depending on the tracking of days (compulsory) or results of monitoring corporate travel booking services
• Review of services to be performed in the host location, logistics regarding the payment/reimbursement of costs, and related supporting documents by corporate tax
• Periodic reviews, by internal audit, of adherence to documented processes and controls, and/or
• Periodic reviews of accounts payable and/or expense reporting, especially related to non-home country payments (including to non-home country addresses) and non-home country travel.

Underscoring all the above is routine, frequent communication between line managers, tax, and IHR management.

Conclusion

Before sending employees overseas to perform services on behalf of the company, clarification should be sought concerning the potential attendant risks and obligations, financial, legal, and tax, in particular. Unwittingly, companies eager to expand into overseas markets may be creating a PE. Tax authorities are heightening their scrutiny of potential PE issues. Oftentimes, discovery of PE issues comes too late — from the company's perspective — which can result in a re-assessed tax liability, imposition of interest and penalties, not to mention damage to a company's reputation. Consultation with a professional adviser, as well as careful planning, monitoring, and documentation, can help abate the scary aspects of PE.

Footnotes:

1 See Treas. Reg. § 1.864-7(d)(2).

2 OECD Commentary (as amended through November 1, 1997) on Art. 5, 37.

3 As indicated in the OECD Commentary on article 5 (paragraphs 24 through 27), it is often difficult to distinguish activities that have a preparatory or auxiliary character and those that have not. The decisive factor is whether the activity of the fixed place of business in itself forms an essential and significant part of the activity of the enterprise as a whole. A fixed place of business whose general purpose is one which is identical to the general purposes of the whole enterprise, does not exercise a preparatory or auxiliary activity. Where, for example, the servicing of patents and know-how is the purpose of an enterprise, a fixed place of business of such enterprise exercising such an activity cannot qualify as preparatory or auxiliary.

If an enterprise maintains a fixed place of business for the delivery of spare parts to customers for machinery supplied to those customers where, in addition, it maintains or repairs such machinery, it will have a PE, as this goes beyond pure delivery.

We learn from the OECD Commentary that a fixed place business that renders services not only to its enterprise but also directly to other enterprises within the same company or to outside parties would not qualify for the preparatory or auxiliary exception. If, for example, an advertising agency maintained by an enterprise were also to engage in advertising for other enterprises, it would be regarded as a PE of the enterprise by which it is maintained.

A fixed place of business used for both excepted activities and non-excepted activities would be regarded as a single PE and taxable as regards both types of activities. This would be the case, for example, where a store maintained for the delivery of goods also engaged in sales.

The author would like to thank Lincoln Terzian, KPMG LLP, Boston, for his contributions to this article.

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.