Managing Permanent Establishment Risk Efficiently
20 September 2016
Posted by: Author: Charles Makola
Author: Charles Makola (EY)
A brief overview of the written and unwritten rules governing Permanent Establishment and advice on how to navigate PE risk.
Permanent Establishment ("PE”) risk management is one of the critical inputs for operating models to remain sustainable and effective in a foreign market. Once an enterprise establishes a PE in a foreign country, a portion of its business is segregated and effectively treated as part of the economic citizenry of that foreign country. This comes with significant fiscal obligations that may eliminate the tax savings costs normally associated with integrated operating models. The creation of PE in a country would usually require registration for tax, fiscal record keeping, tax filling, an expectation to pay income taxes in that country and other commercial administrative responsibilities.
The risk of creating a PE is particularly acute in many African countries as revenue authorities are pressured to make up for shortfalls in budget revenues and in several instances, practically make up for the gaps in domestic tax legislations. While there is a greater desire for foreign investment to stimulate growth, there is a general scepticism about operating models that elude the creation of a PE and thus local tax liability. In some instances, there is tightening of domestic anti-avoidance and taxable presence legislation. When the OECD Base Erosion & Profit Shifting (BEPS) Action 7 final recommendations are adopted, this will lower the thresholds for creating a PE and further increase the PE risk.
Conceptually, the PE concept requires that there must be an identifiable business carried on in a country before it can levy tax on business income derived by a foreign enterprise within its shores. At a granular level, a PE exist if (i) there is a fixed place, (ii) the place is at the disposal of an enterprise, and (iii) substantial (i.e. not preparatory or auxiliary) business activities are carried on in that space. This includes branches, offices, workshops, construction sites, or other business spaces. A PE will also be created if there is a dependent agent who acts on behalf of the business and habitually concludes contracts in the name of a business in a particular country.
Although there are variations on the meaning of a PE in different African countries, there are common features. There is generally no definition in domestic legislation. Where there is a specific definition, it largely follows the OECD Model Convention and Commentary. There is also no stipulated time threshold before a PE is created. The practical OECD guidance of six months is used, subject to a lower threshold in various treaties. However, sometimes even a short presence may be treated as a PE.
Technically, the uncertainties and issues associated with the PE concept are archaic and abstract. For example, what does it mean that a fixed place must be at the disposal of an enterprise? Does a main contractor that subcontracts all aspects of the contract create a PE? What is the required time threshold before a person creates a PE? What does it mean that an agent must conclude contracts in the name of the enterprise? Does a country adopt a static or ambulatory approach to interpreting changes to the PE definition? How to attribute profits to a PE once it is created?
The degree to which an enterprise may face PE issues vary, mainly depending on the business model adopted. As a rule of thumb, increased visibility may increase the likelihood of tax audit, where the existence of a PE may be asserted. The profitability gap between a host and a home country may also trigger audits if the enterprise enjoys favourable tax treatment in its home country.
Management and professional services, construction, assembly, installation and related supervisory activities are of specific concern for most African countries. Other activities with a high PE risk probability include: procurement offices (procuring goods for resale), flash title limited risk distributors and other agency sales arrangements, toll manufacturing (with absolute or restricted access to stock), warehousing (access to stock), etc. Although activities such as purchasing representatives, contract manufacturing, local procurement and full risk local distributors, etc. traditionally pose a low PE risk, if more than one of these fragmented activities take place in-country, they may be aggregated to create a PE in that country. This would particularly be the case where these activities are seen as complementary and forming part of a cohesive business operation.
Disruptive operating models and the digital economy introduces a unique set of concerns given the minimal human intervention in-country (e.g. co-locations in a high frequency trading environment and the digital delivery of goods and services).
As an input, PE risk management has thus become broader than assignment policies to monitor business travellers or secondment arrangements. Standard operating procedures with dos and don’ts are equally critical. Various other layers of the model may also be impacted, such as key performance indicators (KPIs) and performance management, legal entity structure, reporting lines, and in-country stakeholder relationships.
Embedded in the PE risk management process are the internal controls and procedures to be rolled out throughout the group. Efficient processes will have built-in PE triggers for various countries, allow for the continued sustainability checks of the operating model and have sound documentation requirements for tax accountability and defence.
This article first appeared on the September/October 2016 edition on Tax Talk.