Multinational enterprises (MNEs) operate across multiple jurisdictions, often triggering tax and transfer pricing implications when their activities create a permanent establishment (PE) in a foreign country.
The concept of a PE is fundamental in international taxation, as it determines whether a country has the right to tax the profits of a foreign enterprise. At the same time, transfer pricing rules ensure that transactions between associated enterprises (including PEs and their head offices) are conducted at arm’s length.
The interaction between PEs and transfer pricing is a complex issue involving profit attribution, functional analysis, and compliance with international best practice and domestic tax laws.
This article explores the PE concept, covering its definition, types, exemptions, key controversies, profit attribution issues and the challenges faced by enterprises and tax authorities.
The definition and legal framework
The PE concept is fundamental in international taxation as it determines whether an enterprise has a taxable presence in a foreign jurisdiction i.e., whether an enterprise is liable to corporate income tax in its host country.
The Organisation for Economic Cooperation and Development (OECD) Model Tax Convention (MTC), Article 5 defines a PE as a fixed place of business through which the activities of an enterprise are wholly or partly carried out. Similarly, the United Nations MTC and domestic tax laws contain similar provisions, with some variations.
Types of permanent establishments
The PEs are categorised into the following:
Fixed place PE: A traditional PE arises when an enterprise has a physical presence in a foreign country for conducting business operations such as an office, branch, factory, or mine that is physically present in the foreign country.
Construction PE: A PE can also arise when an enterprise carries out construction or installation projects in a foreign jurisdiction beyond a specified duration (e.g. 12 months for OECD Model, or 6 months for UN Model).
Agency PE: Rises when a dependent agent habitually concludes contracts on behalf of a foreign enterprise. This also includes agents who play a principal role in contract negotiations, even if they do not formally conclude the contracts.
Service PE: The UN MTC includes a service PE provision, where a foreign enterprise renders services in a country for an extended period (e.g.,183 days in a 12-month period).
Digital PE: With the growth of the digital economy, some countries have introduced a digital PE or significant economic presence concept where enterprises may have a taxable presence in a country without physical presence.
Key PE exemptions
The existence of a PE generally subjects the enterprise to local taxation. However, various PE exemptions exist to prevent unintended tax liabilities for enterprises engaged in minimal or preparatory activities. The main categories of exemptions include:
Preparatory or auxiliary activities: A foreign enterprise does not create a PE if it engages in activities that are preparatory (initial setup) or auxiliary (supportive) to its core business such as storage, display, and delivery of goods in a warehouse or facility; purchase of goods; information collection activities; public relations and research, etc.
Independent agents: A foreign enterprise does not create a PE if it operates through an independent agent acting in the ordinary course of its business. However, if the agent exclusively or almost exclusively works for one MNE, it may be a dependent agent PE.
Construction and time-based exemptions: A construction site does not create a PE unless it lasts for more than 12 months (OECD Model) or six months (UN Model). Splitting contracts artificially to remain below the threshold is often challenged as abusive tax planning.
Controversial issues in PE determination
Several contentious issues arise in the interpretation and application of PE rules.
Anti-fragmentation rules: Some MNEs split functions across multiple subsidiaries to ensure each enterprise qualifies for the preparatory or auxiliary activities exemption. Anti-fragmentation rules have been introduced to prevent such abuse by requiring that all business activities in a jurisdiction be viewed together.
Splitting of contracts: Some MNEs split long-term contracts into shorter ones under different legal entities to avoid the creation of construction PEs. Beps Action 7 prevents this by aggregating contracts between associated enterprises.
Independent vs. dependent agents: The distinction between dependent agents (PE) and independent agents (no PE) has been controversial, particularly for commissionaire arrangements.
E-commerce and digital PE: Traditional PE rules struggle to address digital businesses (e.g., Google, Facebook, Amazon), which operate in countries without a physical presence. Many jurisdictions have introduced digital services taxes (DSTs) in response.
Profit attribution to PEs
Once a PE is established, it is treated as a separate and independent entity for tax purposes. The main methods of PE profit attribution are as follows:
The authorised OECD approach: Aims to align profit attribution with the arm’s length principle by treating the PE as if it were a functionally separate and independent enterprise.
Force of attraction principle: Under this principle, a PE is not treated as a separate entity but is taxed on all income derived from the source country, even if the transactions were not directly conducted through the PE.
Challenges in applying transfer pricing to PEs
PEs lack legal personality. As such, disputes often arise over their classification, the allocation of income and expenses, and attribution of profits.
Conclusion
The PE concept remains one of the most contentious issues in international taxation and transfer pricing. The Beps Action 7 measures, along with the rise of digital taxation, have fundamentally reshaped PE rules. Furthermore, ongoing international tax reforms (pillar one and two) may further impact how PEs are taxed in the future.
As tax authorities continue tightening PE rules, MNEs must carefully assess their operations to determine whether a PE exists and adopt robust compliance strategies to mitigate tax risks while ensuring global tax efficiency.
The next article in this series will focus on business restructuring, exploring tax and transfer pricing implications when MNEs reorganise their operations.
*Vilipo Muchani Munthali is managing consultant at Swift Resources, an international tax and transfer pricing consulting firm that specialises in developing, implementing, and defending transfer pricing policies for both local groups and multinational enterprises across a wide range of industries. Feedback: vilipo@swiftmalawi.com
