Both the Tax Cuts and Jobs Act (TCJA) and base erosion and profit shifting (BEPS) has multinationals assessing the taxability of their global profits. The Organization for Economic Cooperation and Development (OECD) made it clear: Taxing jurisdictions will look to the potential expansion of permanent establishment (PE) rules under Action 7, “Preventing the artificial avoidance of permanent establishment status,” to bolster tax revenue in their countries. Additionally, new U.S. international tax rules under the TCJA are consistent with the OECD’s recommendations under BEPS (e.g., hybrid disallowance rules, anti-deferral of controlled foreign corporation income and the new interest expense limitation) and will require companies to evaluate the risks in doing business abroad. This article addresses some of the risks of doing business offshore and being classified as a permanent establishment.
US multinational corporations doing business in foreign countries (and foreign based multinational corporations doing business inside the US or foreign countries other than their own) are typically subject to the domestic tax laws of the countries where they engaged in business activities. However, if the corporation’s home country has entered into a tax treaty with the target country, the treaty will typically provide a higher threshold for taxation than the domestic tax laws applicable in the target country. That higher threshold is commonly referred to as a permanent establishment (PE). Following is a brief discussion of the rules that govern the determination of PE under generic treaty language.
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As mentioned above, where a corporation’s home country has entered into a tax treaty with a target country, the business operations of the home country corporation are protected from target country taxation as long as those activities do not create a PE in the target country. Typically, a tax treaty defines a PE using the following two general tests:
Note that the definition of a PE is typically similar under both the Organization for Economic Cooperation and Development (OECD) model treaty standard language and US model treaty standard language. However, a specific treaty should always be examined for exceptions or differences from standard language.
Under the first prong of the PE test outlined above, a corporation must operate in a target country through a fixed place of business to create a PE. A fixed place of business has been defined to include the following types of physical locations:
However, there are exceptions to these general types of locations that do not constitute a PE for treaty purposes. The exceptions are as follows:
Based upon the foregoing, a corporation has many options for doing business in a target country without triggering a PE for treaty purposes. The analysis is highly fact-specific for each case, and the treaty language may vary depending upon the two countries involved in the analysis.
A PE may also be created in a target country if a corporation operates in that country through a dependent agent. Typically, treaties will provide the following general language addressing the use of agents in a target country:
An enterprise of a contracting state shall not be deemed to have a permanent establishment in the other contracting state merely because it carries on business in that other contracting state through a broker, general commission agent, or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business. However, when the activities of such an agent are devoted wholly or almost wholly on behalf of that enterprise, he/she will not be considered an agent of an independent status within the meaning of this paragraph if it is shown that the transactions between the agent and the enterprise were not made under arm’s-length conditions.
Typically, the analysis to determine whether an agent is working as an independent agent can be determined by examining whether the agent is:
Further, when examining the agency relationship, it is helpful to also identify the category of the agent that has been hired by the home country corporation. For example, agents can be considered any one of the following:
Each type of agent must always be operating in the ordinary course of their business – and must meet the economic and legal independence tests to protect the home country corporation from being considered as operating a business through a permanent establishment in the target country. In all cases, consideration of the issues discussed above must be made when any client or potential client is expanding their operations into a foreign country.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.