What are Your Risk Factors for Triggering Permanent Establishment?
Permanent establishment (PE) is a tax term that refers to a business which is classified by local tax authorities as having a permanent and ongoing setup and may have subsequent tax responsibility in that jurisdiction.
In this blog, we will touch on the different types of PE, the criteria that determines when PE is triggered, the risk factors associated with having a PE, and other considerations for organisations doing business in another country.
What is a permanent establishment?
The definition of PE from the Organisation for Economic Cooperation and Development (OECD) is widely considered as the global standard. It describes a permanent establishment as “a fixed place of business through which the business of an enterprise is wholly or partly carried on.”
With regards to businesses operating in the US, the above definition is the standard the Inland Revenue Service (IRS) holds for classifying a US permanent establishment, characterising it as “a fixed place of business in the United States through which the foreign enterprise carries on its business.”
If the foreign entity is regarded as having a PE, its subsequent net income connected with its business operation in the US will be taxed accordingly.
In short, having a PE means that profits are potentially taxable in more than one jurisdiction.
What are the types of permanent establishment?
The classification of permanent establishment is typically triggered by three different categories:
1) Physical Permanent Establishment
This means a fixed place of business. Arguably one of the more simplistic indicators when it comes to determining whether an organisation has triggered PE.
Examples of fixed places of business listed on the OECD Model Treaties include:
Place of management
Branch or office
Factory
Workshop
Mine, oil or gas well, or any other place of extraction of natural resources.
It is worth noting that for businesses in the construction industry, a building site or installation project constitutes a permanent establishment only if it lasts more than twelve months.
The rise in remote working does add another layer of complexity when it comes to designating PE. Although there are only limited circumstances that results in the private residence of an individual being considered a place of business, a remote worker based in another jurisdiction can trigger PE based on their role as a dependent agent.
Commentary from the OECD indicates that an employee’s home office is not regarded as triggering PE if it is not considered to be at the disposal of the employer:
“Where an enterprise has an exclusive legal right to use a particular location which is used only for carrying on that enterprise’s own business activities, that location is clearly at the disposal of the enterprise.”
2) Agency Permanent Establishment
As alluded to above, PE may be created in the instance of an employee working remotely in a different jurisdiction to their company. This set of circumstances is primarily judged as to whether the agent is undertaking any revenue-generating activity. Examples of this may include an individual who does any of the following:
Has the authority to sign contracts on the company’s behalf
Has an executive or senior management role
Provides core business services (e.g., an accountant at an accountancy firm)
Undertakes sales activities.
These factors create a high risk for triggering Agency PE.
In terms of creating an agency permanent establishment in the US, the IRS quotes the following.
“A foreign enterprise will also be considered to have a US permanent establishment as a result of activities undertaken on its behalf by a dependent agent who has and habitually exercises in the United States an authority to conclude relevant contracts that are binding on the foreign enterprise. A foreign enterprise will not, however, be deemed to have a permanent establishment in the United States merely because it carries on business in the United States through a broker, general commission agent, or any other agent of an independent status, provided that such person is acting in the ordinary course of his business as an independent agent.”
3) Service Permanent Establishment
Another set of circumstances in which a business may find itself creating a PE involves offering and providing services to an entity outside of its own home country, even without having a physical entity. It is worth noting that this triggers PE for the service provider and not the company they are providing the service to.
This may impact businesses that offer services such as payroll, IT support, or talent acquisition.
If this category is in the interest of your business, you may be interested in our discussion with a US tax specialist on how UK recruiters can navigate the US tax system.
It is important to remember that not every action taken overseas is regarded as a PE risk. An example of this is if the activity of the overseas agent is regarded as auxiliary or preparatory. It is always recommended to consult with a US tax expert to get a deep understanding of whether your specific situation contains any risk factors with regards to permanent establishment.
What activities are not risk factors for triggering PE?
In the US, the IRS will determine whether an enterprise is conducting taxable trade based on its level of business and revenue-generating activity.
“A foreign enterprise will not be deemed to have a US permanent establishment if its activities in the United States are limited to certain activities—generally those of a preparatory or auxiliary nature.”
One of the factors that determine whether business activity is preparatory or auxiliary by nature is whether there is a tax treaty between the US and the nation of the foreign enterprise. In the example of a UK organisation doing business in the US, a tax treaty does exist between the two nations.
In this instance, the IRS claims that PE would not be triggered under the following activity:
The use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise.
The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery.
The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise.
The maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise.
The maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character.
How do I know if my activity is triggering PE?
With PE being used as a measuring stick, it is the responsibility of the enterprise to know whether or not they are creating a taxable presence. This is why it is important to seek the advice of a tax expert who can discuss your potential risk factors and help you determine your liability.
Once it has been established that PE has been triggered, businesses should understand whether a relevant treaty exists with their home nation and if there are any applicable PE criteria in said treaty. It is possible that tax credits may be available in the home nation of the organisation to help avoid double taxation.
Can permanent establishment be avoided by using an employer of record?
In short, no.
When it is the most appropriate solution, an employer of record is a great way to start operating in a new location. Although an EOR can address challenges associated with income tax, employment law, and insurance, it does not completely eliminate PE risk, particularly if you engage a worker through an EOR that is conducting undisputable revenue-generating activity.
Whilst an EOR does not eradicate the risk of PE, it remains a useful solution to enter a new market without setting up a physical entity; an activity that creates a natural obligation to file taxes federally, at state and local levels.
PGC offers full employment compliance, comprehensive insurance, and top-tier worker benefits. As the longest-serving employer of record exclusive to the North American market, we are best placed to provide you with the best guidance and support to help you achieve your US market ambition, and remain compliant at the same time.
It pays to get it right!
Or in the case of PE, it costs to get it wrong!
Proactively managing your PE risk reduces the potential of unexpected tax payments including penalties and interest charges.
If you want to learn more about the issues around permanent establishment or other US tax topics, get in touch with one of our US expansion consultants!
Disclaimer: The information provided here does not, and is not intended to, constitute legal or accountancy advice. Instead, the information and content available are for general informational purposes only