The PE concept and its implications for multinational companies

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The concept of a permanent establishment (PE) under Article 5 in the OECD Model is primarily important because the business profits of an enterprise of a Contracting State are only taxable in the other Contracting State if the enterprise carries on business through a permanent establishment situated therein. The concept marks the dividing line for business between merely trading with a country and trading in that country. 

There are two types of a PE contemplated by Article 5. The first type of a permanent establishment is referred as an “associated permanent establishment” which is part of the same enterprise and under common ownership and control like an office and branch. The second type of a permanent establishment is referred as an “unassociated permanent establishment”. This type of permanent establishment involves an agent who is legally separate from the enterprise, but is nevertheless dependent on the enterprise to the point of forming a permanent establishment.

The basic concept in Article 5(1) contains the key requirements of the first type of a permanent establishment in that there must be a “fixed place of business through which the business of an enterprise is wholly or partly carried on”. To meet the requirements, three conditions need to be satisfied. The first condition is that there must be a place of business where personnel exist. In addition, the premises must be the place through which the business is carried out, not the business itself. The business of the enterprise is carried on by the personnel at the premises in most cases, but automated equipment may constitute a permanent establishment in certain circumstances. 

The OECD Committee on Fiscal Affairs adopted changes to the Commentary to the effect that human intervention is not a requirement for the existence of a permanent establishment. In the Pipeline Case, a Dutch oil transport company transported oil to Germany through an underground pipeline. The Dutch company owned the pipeline but had no personnel or place of business in Germany. In this case, the court concluded that the operation of the oil pipeline in Germany did result in a permanent establishment in Germany for the Dutch corporation, whose business is the transport of oil, conducts its business which is the most important part of the Dutch corporation’s business. 

A permanent establishment begins to exist as soon as the enterprise commences to carry on its business through a fixed place of business. The permanent establishment ceases to exist with the disposal of the fixed place of business or with the cessation of any activity through it, that is when all acts and measures connected with the former activities of the permanent establishment are terminated. The third condition is that the place of business must be at the disposal of the enterprise.

There is a distinction between the civil law concept of agency and the common law concept. Under the civil law concept of indirect representation, brokers and general commission agents do not bind their principals, and so they never need to be excluded from Article 5(5). At common law, an agent for an undisclosed principal might bind his principal even if he does not “conclude contracts in the name of his principal”. The agent need not enter into contracts literally in the name of the principal, as long as the agent concludes contracts which are binding on the enterprise

In the Zimmer Case, Zimmer SAS, a French commissionaire, sold products in France under a civil law commercial arrangement in its own name, but on the account of, and at the risk of, its UK parent (Zimmer Limited). With regard to the French customers, Zimmer Limited was an undisclosed principal. Before the commissionaire agreement was signed, Zimmer SAS had only been a French distributor of the products sold by Zimmer Limited. The Supreme Administrative Court held that contracts concluded by a commissionaire, even though they are concluded for the account of its principal, do not bind the latter directly vis-à-vis the counterparties of the commissionaire. Zimmer is, therefore, a case in which a PE was not recognized due to the formal civil law peculiarities of the case.

In Dell Products (NUF) v. Tax East 31, Dell Products Ltd (Dell Products) was a company incorporated in the Netherlands but resident in Ireland. It was the sales unit for Dell products in Europe, and purchased products from Dell Products (Europe) BV, which had manufacturing facilities in Ireland. In Norway it sold through Dell AS, which acted as a commissionaire. For the tax years 2003 to 2006, Dell Products submitted returns showing zero liability in Norway. However, the Norwegian Revenue authorities took the view that the company had a permanent establishment in Norway through the commissionaire, and attributed to that permanent establishment 60% of the net profit from sales in Norway. The Supreme Court of Norway held that Dell Products did not have a permanent establishment in Norway. A dependent agent permanent establishment only exists if the agent has, and habitually exercises, authority to conclude contracts binding on its principal. The essence of a commissionaire specifically under Norwegian law is that there is no agreement binding on the principal. Hence there was no permanent establishment within the express words of the convention. The UK common law concepts of agency does not include the commercial relationship of commissionaire, as such exists under the laws of France, Norway, and other civil law jurisdictions.

While insurance companies are not expressly dealt with in Article 5, states may wish to provide expressly that the collection of premiums or the insurance of risks through an agent may represent a permanent establishment since such companies may transact substantial amounts of business through independent agents. The UN Model, as well as some non-UN double tax treaties contains a paragraph in Article 5 which specifically provides that the collecting of premiums by an insurance agent will give rise to a permanent establishment in the state in which the premiums are collected. Absent a specific provision, the issue turns upon whether insurance agents are dependent or independent.

In Taisei Fire & Marine Insurance v. CIT, four Japanese insurance companies were the principal customers of Fortress Re, a US reinsurance manager owed by US resident individuals. Fortress Re had authority to conclude contracts binding on its clients, it was accepted that it was not a broker or general commission agent, and it was accepted that it was acting in the ordinary course of business. The only issue was whether it was an agent of independent status. The Tax Court held that Fortress Re was legally independent as it had complete discretion over the detail of its work and was subject to no external control. It was also financially independent. Therefore, the Fortress Re that acted on behalf of four Japanese insurance companies did not cause the companies to have permanent establishments in the United States.

The other situation where an associated company may give rise to a permanent establishment is where premises owned by one affiliate are placed at the disposal of a foreign affiliate. Assume that, within a multinational group, the affiliate in State A makes an office regularly available to the CEO of the affiliate in State B. If that office is at the disposal of the State B affiliate, then it will have a permanent establishment just as if it had premises at its disposal in a building owned by any other person. For a multinational group, it is particularly important, therefore, that one affiliate does not place premises at the disposal of another in this way.

In the Philip Morris Germany GmbH Case, a German company that was a member of the Philip Morris Group (Philip Morris GmbH) received royalties from the Italian Tobacco Administration for the license to produce and supply cigarettes and tobacco products with the Philip Morris Trademark. An Italian company belonging to the same Philip Morris group (Intertaba Spa) supervised the execution of the contract by the Italian Tobacco Administration and performed agency and promotional activities in relation to sales of Philip Morris products in “duty-free” areas. The main business purpose of Intertaba Spa was to manufacture and distribute cigarette filters both in Italy and abroad. The tax authorities assessed the Philip Morris Group, claiming that the royalties derived by Philip Morris GmbH were subject to tax in Italy at the ordinary rates, as they were attributable to a disguised permanent establishment that the group maintained in Italy.

The Supreme Court set forth the following principles to be taken into account in deciding the case:

 An Italian company may constitute a multiple permanent establishment of foreign companies belonging to the same group and pursuing a common strategy

 The supervision or control of the performance of a contract between a resident entity and a non-resident entity cannot be considered, in principle, to be an auxiliary activity within the meaning of Article 5(4) in the OECD Model and the corresponding article of the Italy–Germany tax treaty

 The participation of representatives or employees of a resident company in a phase of the conclusion of a contract between a foreign company and another resident entity may fall within the concept of authority to conclude contracts in the name of the foreign company

 The fact that the non-resident company entrusted the resident company with the management of some of its business operation makes the latter a permanent establishment of the former.

Therefore, the Supreme Court held that the German company had a permanent establishment in Italy.

Many multinational groups have sought to limit their exposure to foreign taxes by making changes to their supply chains. For instance, whereas before, the foreign subsidiary might have carried out manufacturing for the group, buying in materials, using its own intellectual property and employing its own sales force, the subsidiary could be converted to a ‘contract manufacturer’. Typically, the intellectual property used in the manufacturing process and the materials processed would belong not to the manufacturing subsidiary but to a group company in a low tax jurisdiction. The manufacturing subsidiary would then be paid only for its manufacturing activities, usually on a cost plus basis, which would result in a drop in taxable profits. The group has thus switched internal profits from a high tax jurisdiction to a low tax one.

The permanent establishment for services

There is a significant problem with characterizing income from services. Many countries, principally developing countries, charge a withholding tax on the gross amount of payments made to a non-resident in respect of services. The distinction between royalties and technical service fees is important because royalty payments may be subject to withholding tax on the gross amount in many treaties. The UN Model also still permits withholding tax on royalties. In order for a payment to be classified as a royalty, the intellectual property in question must exist prior to the making available of the design or to the imparting of the know-how. 

If a payment is in respect of the development or amendment of a model, plan, secret formula or process or for work which will result in the gaining of information concerning industrial, commercial or scientific experience, then there will be difficulties in asserting that such a payment constitutes royalties. Furthermore, the distinction between a contract for use of know-how and a contract for the provision of services often rests on who carries out the work. In a contract for know-how, the client himself usually carries out the work, using secret information imparted to him by the know-how provider. In a services contract, it is the service provider who carries out the work for the client.

In Berkholz v Finanzamt Hamburg-Mitte-Altstadt, the company owner Berkholz with the headquarters in Germany, provided the service of installing and operating gaming machines on board two ferries running between Germany and Denmark. The machines were maintained regularly by employees of the German company but without a permanent staff on the ferryboats. The taxpayer claimed exemption in respect of the supply of services to meet direct needs of sea-going vessels. The German authorities denied exemption and sought to levy tax on the whole of the receipts in Germany. However, the taxpayer contended that even if exemption was not available, the whole receipts were not taxable in Germany, as part of the services was provided in Denmark. On the taxpayer's appeal, it was held that the ship was not a 'fixed establishment', since no permanent staff were employed on the ship and the operation of gaming machines was done on an intermittent/irregular basis. The place of supply was the place of business establishment of the taxpayer which was in Germany. Hence, the services were wholly liable to service tax in Germany.