Permanent establishment risk review – what could it mean for you?

The permanent establishment (PE) threshold test is contained in many territories' domestic tax laws and double tax treaties. It determines whether a business has sufficient activity in another territory to create a taxable presence in that other territory from a corporate tax perspective.

While multinational groups may have found that PE issues were not a key area of focus for many tax authorities in the past, this position is now changing following the introduction of OECD Action 7, which changed the definition of permanent establishment in the OECD Model Tax Convention with the aim of addressing the perceived artificial avoidance of PEs by multinational corporations. In addition to this, the ever increasing mobility, and displacement of workers during the global pandemic has led to further focus on this area by tax authorities.

Why it’s important to act now

There is a heightened interest in PE rules driven by a more rapid pace of change, greater complexity of global business models and an increase in worker mobility. These factors alongside the ever increasing requirement to keep and submit digital records are expected to lead to tax authorities across the globe focussing resources on mounting more effective PE challenges. Where a PE is created, this can have a knock on effect from an employment tax and individual income tax perspective as additional requirements at an employer and employee level can be triggered.

The risk of inadvertently creating a PE is therefore a key risk area for multinational corporations and the effective control of PE risk, including a PE risk review, can form an essential part of a multinational corporation’s wider tax control framework.

What are the indicators of PE risk?

Under the current OECD treaty definition of PE, the threshold of activity of an enterprise in one territory that results in the creation of a PE in another territory is determined by two forms of presence:

1. Fixed place of business test
   An enterprise has a PE in another territory if it has a fixed place of business there through which it carries on its business, subject to a number of specific activity exemptions.
2. Dependent agent test
   An enterprise has a PE in another territory where a person (other than an independent agent) is acting on its behalf, and habitually exercises an authority to conclude contracts in its name, in that other territory.

In addition to the above, some double tax treaties include the concept of a services PE, which can be created where an enterprise in one territory performs services in another, through one or more individuals over a defined period of time. In practice, this type of PE is less common, but should still be considered for the purpose of managing PE risk.

Note however that not all treaties follow the OECD model, as such it is important to consider each scenario on a case by case basis.

Under the OECD model, where a PE is created and there is an attribution of employment costs to the PE relating to treaty non resident individuals undertaking work in that location, the conditions to exempt an individual’s employment income from tax in that location are often not met. Additionally, for many countries, the presence of a PE is the domestic law threshold required for wage tax withholding to be operated.

Benefits

Proactively managing PE risk can:

• Provide comfort on a potentially high-profile area of challenge.
• Reduce the risk of unexpected tax payments by minimising the likelihood of errors, including penalties and interest charges.
• Help you identify opportunities for tax efficiencies and/or improvements to the internal control framework.
• Enable you to make appropriate disclosures to tax authorities showing that reasonable care has been taken to manage PE issues, thereby reducing the risk of challenge and subsequent penalties.
• Provide greater certainty to the business on their employment tax obligations and to employees regarding the jurisdiction(s) in which they will pay individual income tax and allow time for appropriate mitigations to be put in place.
  

Risks

A PE risk that is not correctly managed can result in:

• Reputational damage.
• Unfunded corporate tax liabilities.
• Potential indirect tax cost in a territory if appropriate VAT registrations have not been made.
• Increased audits from tax authorities requiring management time and incurring cost.
• Penalties and interest charges.
• The need to restate financial accounts.
• Employer reporting obligations, including payroll and social security.
• Immigration considerations for employees.
• Regulatory issues (for certain industries).
• Remedial action being required from an individual income tax and social security perspective, potentially impacting the personal positions of employees.
  

Practical steps you can take now

Ensuring you are able to maximise value in a cost-effective manner according to factors such as territory and/or business line complexity, known issues and the perceived level of risk is important.

When carrying out a review this could look at current and historic positions but could also focus on governance and controls to highlight potential PE risks for the business going forward. We can help you to ensure your specific needs across the relevant markets and territories are met through the following.

• Full scope reviews
  Interviews and discussions with relevant individuals, alongside desktop reviews, are used to drill down into the operational practice of documented policies and procedures. They are also used to assess and challenge the methodology of each business unit, and the approach to governance of operational risk against current tax standards applied by the business.
• Desktop review
  Where the level of PE risk is considered to be low, a full scope review may not be the most cost effective option. Sufficient coverage could instead be provided through a rules-based desktop review of the policies, procedures and processes applied in each territory and business line. This information can then be benchmarked against central governance requirements and those of the local territory.
• Focussed scope
  For areas where the level of PE risk is perceived to be moderate, the focussed scope review replaces detailed interviews with the use of standard questionnaires/surveys of key personnel, alongside a desktop review of the policies and procedures applied by the business to manage PE risk.

An alternative focussed scope option is to adopt the full scope approach, but limit the detailed analysis of risks identified to a smaller, pre-agreed set of risks.

In any of the above options our scope can be extended to consider the employment tax and social security regime of each applicable country, either as part of the review or as a subsequent phase in order to provide comments on the wider tax considerations for employers, the possible impact on employees and potential strategies for mitigating these impacts.

If you would like to discuss the PE risk your business might be facing, please contact the authors of this article directly, or your usual PwC contact.