So, the permanent establishment threshold is coming to an end?

I – Introduction

It is fair to say that the permanent establishment (PE) has been at the forefront of international taxation for decades. This fact allows us to state that, undoubtedly, the matter of whether or not a PE is triggered in a source jurisdiction is still one of the most problematic and important issues for tax practitioners, tax authorities, and tax scholars alike, both from a tax treaty and domestic perspective.

Accordingly, the PE has historically been used in the tax model drafted by the OECD. Likewise, it has been added to most domestic tax rules and, if compared with the regulations in article 5 of the OECD’s tax convention (OECDTC), local tax legislations tend to copy it, often with few if any changes.

This observation permits us to mention that the rules governing the triggering of a PE could in some sense be deemed a “universal language” for tax lawyers, as the requirements surrounding the existence of the concept of “fixed place of business” has been largely replicated throughout the world’s domestic tax systems.

The reasoning that explains the importance of the PE relies on the fact that it is a key element in the distributive tax rules envisaged in the OECDTC. In that sense, the PE is a threshold for allocating the taxation rights of the source state over business profits.

Nowadays, we consider that the old rule of the PE is under very significant pressure due to several factors, such as the arrival of the digital economy (DE) (e.g., e-commerce, cloud computing), new ways to conduct business that can be carried out remotely, and services that can be rendered through digital means without any physical presence whatsoever.

This article lays down some general and preliminary thoughts about whether the international agreement concerning the PE rule should be revamped and, hence, replaced by a new nexus that considers factors other than those of tangible presence and, indeed, the new nexus and profit allocation rules proposed by pillar 1 of BEPS 2.0 and the proposed article 12(b) of the United Nation’s tax model (UNTC).

II – Origins of an anachronistic threshold but yet a paramount tax treaty concept

The birth of the PE takes us back to a different era under the frame of the second industrial revolution as the roots of the PE are related to the Betriebsstätte, meaning literally “physical business establishment”.

Afterward, the concept was used to allocate taxation rights over business revenue between German municipalities concerning local taxes. Later, PE made the jump to international taxation when it was included in the first tax treaty, signed by Prussia and the Austro-Hungarian Empire in 1899, keeping its German signature and roots by requiring physical presence.

Many authors have observed that, during the 1920s, a major milestone in international taxation was reached in what is known as the “1920 compromise”. This compromise entailed taxation of passive income in the residence state, whereas active income was taxed in the source state.

Under the governance of the League of Nations (LON), the PE threshold was added to the first model of 1927. Moreover, the LON’s first tax treaty models differentiated between personal and impersonal taxes in that personal taxes were only taxable in the residence state while impersonal taxes (related to business undertakings) were owed in the source jurisdiction if a PE was triggered therein.

This bedrock principle (PE) was followed by the London draft (1946) and, since then, by the OECD, starting with its 1963 draft, as working party No. 7 decided to continue with the physical PE as a way of allocating taxation rights over business profits.

To determine the taxable base, following a report prepared in 1933 by Mitchel B. Carroll, the LON decided to apply the long-standing “arm’s length” principle, thereby triggering, in our consideration, the most difficult issue surrounding the PE.

As can be seen, the historical review crystallizes Kingston’s appreciations,[1] as he described the PE as being “perhaps most rooted of all to the physical world”. Thus, one can conclude that the PE underpins a tangible presence of some sort in the source state with permanence therein and is tantamount to a physical requirement.

Moreover, the long existence of the PE without any changes explains its importance and conveys that it was a consensus that made all the parties happy at that time. In light of the above, Adams declared that the PE rule was “the most important field of agreement”.[2] Quoting Skaar,[3] the PE can be dubbed as the highly transcendental agreement made by the international taxation community. Likewise, let us not forget that the PE is related to rules that have remained relevant since its origin and that it has proven remarkably durable.[4]

Based on this background, however, it is clear that the PE was created for another time and for very different types of business – physical ones – and, hence, is not quite suitable today, despite having been a significant and long-standing achievement of International Tax Law.

III – Strain generated by the DE

BEPS 2.0 put forward that one of the main difficulties triggered by the DE from a direct taxation standpoint is a nexus problem as these particular businesses do not depend or rely on any physical presence. Conversely, the Internet is an intangible world that requires only users with remote access to the Web.

We consider, however, that the latter conclusion is also applicable to other types of services (e.g., professional, legal, technical) that, due to advancements in technology, can now be rendered remotely. Therefore, it is crystal clear that the PE as we know it is not suitable, tax-wise, for today’s new ways of conducting business that rely mainly on digital means. Hence, the principles of the “1920 compromise” are weak and, accordingly, in need of modification, as it is possible to be engaged in significant economic activity and have strong business bonds with a market jurisdiction without having any physical presence there.

Moreover, the OECD’s pillar 1 opens a path to a revamp of the tax rules for profits arising from automated digital services (DS). In general terms, such changes would consist of a new taxation right to the market jurisdiction under amount A and the abandonment of the “arm’s length” principle, which would be replaced by a formula. We think that such an initiative, as it addresses mainly the DS would leave many significant matters aside, and the problem would not have a solution but instead would only get worse as technological developments continue and hence it is foreseeable that the PE would again have to be revised.

IV – Alternative to the PE

Recently, the UN has proposed the addition of a new paragraph to article 12 of the UNTC to allow the source state to tax DS without the need for physical presence. Nonetheless, although the purview of the latter rule covers only “DS”, it could be designed in such a way that it could include any types of professional and business activities.

Considering this, our approach is to redraft article 7 of the OECDTC in a manner like that of the proposal recently disclosed by the UN to provide new taxation rights to the source state regarding revenue arising from the rendering of DS and any type of professional or commercial services without requiring physical presence. In this case, a sourcing rule could be put in place stating that the income is deemed to arise in a Contracting State when the payer is a resident of that State.

Naturally, article 5 of the OECDTC should be deleted accordingly as well as paragraph 4 of articles 10 and 11, paragraph 3 of article 12, section c) of paragraph 2 of article 15 and the reference to the PE in paragraph 5 of article 11. On the other hand, paragraph 2 of article 13 should be redrafted to allow taxing rights to the source state over any gain arising from the alienation of movable property located therein through a branch or directly by the foreign enterprise.

This proposal could work under two alternatives. The first is a withholding tax that would be made by the source-state debtor on the gross amount of the consideration, while the rate would be blank as the contracting state should set the rate (which could range between 5% to 10%, although special rates could be set for different services). The second alternative would be a taxation system over a net basis, i.e., taxpayers would be allowed to subtract related costs and expenses as incurred that could be allocated to the revenue, in which case the tax would be settled by applying the income tax rate applicable in the source. A simplified system should be put in place so that nonresidents could file tax returns to avert a needless administrative burden.

Lastly, regarding the alienation of tangible goods, we consider that article 7 should be designed to allow the source state to tax any such gain, if the goods are located within its jurisdiction at the moment of their alienation, even if alienated through an agent located therein.

V – Conclusions

We consider that the long-lasting PE should be revamped; hence, article 7 of the OECD’s tax model should be redrafted considering the arrival of the DE. Our proposal is to abandon the requirement of a physical presence and provide the source state with new taxation rights over any professional, administrative, and/or DS rendered from the residence state to taxpayers in the source state considering two alternatives: gross taxation based on a withholding tax or net taxation.

[1] Kingson Charles I. Taxing the Future, Tax Law Review, vol. 56, 1996, p. 643.
[2] Graetz, J. Michael; O’Hear M., Michael. The “Original Intent” of U.S. International Taxation, Duke Law Journal, vol. 46, 1997.
[3] Skaar, Arvid A. Permanent Establishment: Erosion of a Tax Treaty Principle, Boston: Kluwer Law, 1991.
[4] Graetz, J. Michael; O’Hear M., Michael. Ob Cit.

Disclaimer. Readers are informed that the views, thoughts, and opinions expressed in the text belong solely to the author, and not necessarily to the author's employer, organization, committee or other group the author might be associated with, nor to the Executive Secretariat of CIAT. The author is also responsible for the precision and accuracy of data and sources.

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