US-AU DTA: Article 5 – Permanent Establishment
In the unprecedented COVID-19 environment the temporary displacement of employees has given rise to many concerns from employers that it may unintentionally be creating ‘permanent establishment’ issues for them in foreign jurisdictions. This is especially relevant where employees are working through the pandemic in a different country to where they ordinarily work.
Due to COVID-19, it is common for employees of US employers to be temporarily working in Australia when they would ordinarily work in the US and vice versa.
Tax authorities around the world are also targeting in particular ‘artificial PE avoidance’ by multinationals on foreign-sourced income.
This blog will highlight some of the key permanent establishment issues facing US and Australian taxpayers with an emphasis on Article 5 of the US/Australia DTA.
The fundamental rationale behind the PE concept is to allow, within certain limits, the taxation of non-resident enterprises in respect of their activities in the source jurisdiction.
Understanding the rules relating to permanent establishments (PEs) has two steps to it.
- The first step is to understand when a PE exists, and
- The second step is to look at how profits are attributed to that PE.
Broadly speaking, an overseas resident has a substantive presence in a state if he meets the
threshold of having a PE. At the same time, if that person is carrying on business through the PE then tax may be due in the state in which the PE is established as well as in the state of residence.
Therefore, on its own, without a business activity through it, a PE may not of itself
give rise to a tax liability.
In its simplest form a PE exists where a company is resident in one country (referred to as the head office) but also has a business conducted from a fixed base in another country (the branch). The income attributable to the other fixed base usually attracts a tax liability in the second country.
In its more complex form of deemed PE, it is a tax “fiction” enabling tax authorities to impose corporate taxes on the deemed branch. A third type of PE is again a tax “fiction” where there is a deemed branch providing services.
INTERPRETING ARTICLE 5 OF THE DTA – PERMANENT ESTABLISHMENT
Under the US/Australia PE provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country.
Article 7 of the US/Aus DTA (which will be discussed in detail in the following weeks) states that profits are taxable only in the Contracting State where the enterprise is situated “unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein,” in which case the other Contracting State may tax the business profits “but only so much of them as [are] attributable to the permanent establishment.”
TYPES OF PERMANENT ESTABLISHMENTS
There are a few common types of permanent establishment to be aware of based on traditional approaches, although these are being modified as more business is conducted virtually over digital mediums.
Fixed Place of Business Permanent Establishment
The historical and easiest test of ‘permanent establishment’ is having a fixed place of business and can include:
- A branch
- An office
- A factory
- A workshop
- A mine, or gas/oil well
Employees that work as sales agents and have the authority to conclude contracts in the name of an enterprise may also be sufficient to create PE. The determining requirement is that the authority must be exercised habitually, rather than once or twice. Also, the majority of the negotiation, drafting and signing of contracts must have occurred in the host country.
Service Permanent Establishment
The areas of service PE are expanding in scope and can include situations such as providing technical or managerial services in the country.
PRACTICAL EXAMPLES OF PERMANENT ESTABLISHMENT
Building and Construction Projects
Since building and construction projects are not “permanent” for the company, the test for PE becomes more time-based. The time period applicable to the US/Aus DTA is a site which exists for at least 9 months may trigger PE.
Services and Consulting Projects
The analysis for services PE will revolve around the non-physical elements of permanent establishment, since there may be no office or branch in the country.
TYPES OF AGENCY PERMANENT ESTABLISHMENT
If a company uses sales agents inside a country, this type of activity may trigger permanent establishment if the agents are concluding contracts on behalf of the company. This qualifies for the ‘revenue creation’ element of PE, and those contracts would be subject to corporate tax if the activity is habitual and ongoing.
Digital Sales and e-Commerce
An emerging area of PE is that of revenue created through the digital economy. This is extremely prevalent, especially with online platforms being used to sell goods or services worldwide.
WHAT IS THE TAX RISK RELATED TO CREATING A PE?
When embarking on global expansion, one of the core considerations is corporate taxation on foreign sourced revenue. While a company will typically be taxed on profits in its home country, there may be additional taxes owed in other countries of business activity. This could affect the net profitability of entering a new country and should be part of an overall planning analysis.
HOW WILL A PE BE TAXED?
If sufficient presence is created in a foreign country, but a multinational, this could make it liable for local corporate taxes or value-added tax (VAT). This law basically reflects the rights of countries to tax businesses that are generating revenue through local operations, even if they maintain their principal headquarters in the home country.
The reason this becomes important for planning purposes is that a company could be subject to ‘double taxation’ on profits, since the home country could tax those amounts as well.
The IRS will impose corporate tax on foreign companies that meet the PE criteria. To avoid any penalties or back payments, a company should file IRS Form 8833 as a proactive claim on any treaty benefits with the US.
To assist in managing PE issues from a US and Australian income tax perspective, taxpayers should ensure they action the following:
- Carefully monitor and keep track of the geographical working location of employees during the COVID-19 pandemic;
- Understand what constitutes a PE and a deemed PE;
- Seek tax advice if due to COVID-19 you have employees temporarily exercising their employment in another country;
- Seek tax advice if your business tax model has changed due to COVID-19 and could potentially place you at risk of creating a PE; and
- monitor and carefully consider official guidance in respect of “permanent establishment” issues (ie. from the ATO, IRS, OECD and other relevant foreign authorities);
The global pandemic has changed the way businesses conduct business. It has also created opportunities for new businesses to conduct business exclusively on online platforms, without physically being present in the country the services are provided or goods are sold.