The Relevance of the Permanent Establishment Concept

Introduction to Art. 15

Article 15 of the OECD MC – one of the most important due to its scope in cross-border activities becomes unclear. Thee is a number of legal terms without it legal definition in the OECD MC. According to that subject to the provisions of articles 16, 18 and 19, salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State. Notwithstanding the provisions of para. 1, remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other contracting State shall be taxable only in the first-mentioned State, if: the recipient is present in the other State for a period or periods not exceeding in the aggregate 183 days in any twelve month period commencing or ending in the fiscal year concerned and the remuneration is paid by, or on behalf of, an employer who is not a resident of the other State, and the remuneration is not borne by a permanent establishment which the employer has in the other State.

Article 15 of the OECD Model Convention applies solely to individuals. This however is not clear and has no direct meaning from its wording. As such an Article is so important for thousands of taxpayers engaged in cross border activities, this is extremely important to have its provisions clear enough. This is however not a case, as lack of clarity and legal certainty is so high. This may be a result of number of the terms used in the Article which are not defined in the Model. In the Article 15, salaries, wages and other similar remuneration derived by a resident are taxable as described in this article, however „resident“ in the meaning of Article 3 para 2 lit a OECD MC is an individual, a legal person or its association. Direct reference to a such definition might mean that „resident“ defined in Art. 15 is also somebody else than an individual. However the scope of Art. 15 refers only to individuals as an individual is the only who can exercise in the state [1]

The general scope of the Article 15 reflects taxation of remuneration in respect of employment. Furthermore this provision may only be applicable in case the special provisions can not be applicable. As a result, Article 15 plays the role of „lex generali“ to other provisions related to salaries, similar to the role of Art. 21 which refers to other income. [2]

Art. 15 enters the rule, that employment income should be taxed in the country, where the employee is a resident. This definition shall be understand in the light of Art. 4 para 1 OECD MC, what means that the resident of a country is a person who is liable to tax in the State by reason of his domicile, residence or any other criterion. However there is one very important exemption – in the case work is performed in the state, which is not country of residence of the employee, his remuneration may be subject to tax in this country. With this regard it is generally accepted that the location where the employee physically performs his work has to be examined first. [3] Such an approach has however some variations and exemptions which are described in the para.2 and para. 2 as the regulation resulting from Article 15 para 1 – relatively clear in the aspect of allocation, could however cause serious complications related to withholding of the tax in place where the work is performed. The obligation of taxation in the country where the work is performed could be extremely difficult in the case of short term jobs or even business trips. Administrative costs of such operations could be unproportionally high in comparison to its fiscal effects.

Content and aims of Article 15 (2) c

Under Art. 15(2) c of OECD MC, the 183-day rule does not apply if remuneration is borne by a PE in the state which the employment is exercised. Such an exemption causes also a number of doubts and questions. First relates to „borne by“. According to OECD Commentary, there is no obligation to relate such a remuneration to costs of running business by the PE. As OECD Mc to Art. 7(2) says „the phrase „borne by“ must be interpreted in the light of the underlying purpose of subparagraph c) of the Article, which is to ensure that the exception provided for in paragraph 2 does not apply to remuneration that is deductible, having regard to the principles of Article 7, in computing the profits of a permanent establishment situated in the State in which the employment is exercised. In this regard, it must be noted that the fact that the employer has, or has not, actually deducted the remuneration in computing the profits attributable to the permanent establishment is not necessarily conclusive since the proper test is whether the remuneration would be allowed as a deduction for tax purposes“. Such a position – shared by many practitioners, is however not always interpreted in the case law of a number of countries. The rule that the remuneration must not have been borne by a permanent establishment or a fixed base which the employer has in the state of employment is as a such designed to prevent any impairment of the state of employment’s rights to impose tax. [4] However the main goal of this provision is to compensate for tax revenue lost through the deduction of operating expense in the state of employment. It seems, therefore, that the remuneration is to be taxed in the State of employment even when the permanent establishment bears its costs but the employer is resident in a third state. The condition laid down in Art. 15 (2) (c) can be taken to have been satisfied – the remuneration thus be taxable only in the State of residence, if the enterprise actually maintains in the state of employment a permanent establishment that bears the remuneration, but where the PE’s profits are not tax in the latter state. The reason is that in such a case, the deduction of the remuneration as business expense does not adversely affect the state of the permanent establishment. [5]

Permanent establishment as an employer

A permanent establishment may be defined as a fixed place of business through which activities of an organization are wholly or partially carried on.  The term permanent establishment includes a place of management, a branch, an office, a factory, a workshop, and a mine, oil or gas well, quarry or other place of extraction of natural resources residing in a foreign jurisdiction.

A permanent establishment exists where an enterprise has a fixed place of business located in a foreign jurisdiction. The enterprise must carry on business in the Contracting State through a fixed place.  The term fixed implies a certain degree of permanence as opposed to temporary.

The concept of a permanent establishment is not limited to a fixed place of business, it may extend to include an agent who is legally separate from an enterprise but sufficiently connected and dependent upon the enterprise so that a permanent establishment is implied to exist, through the actions of that agent.  This concept is found in paragraph 5 and 6 of the Article 5. Thus, there are two types of permanent establishments; a fixed place of business (associated enterprise) and a dependent agent (unassociated enterprise).

The permanent establishment concept is important because it distinguishes between enterprises that are trading with a country and those trading within a country.  This is an important distinction since enterprises trading within a country are subject to taxation on the income and assets derived from its physical presence through a permanent establishment.  This insures that business activities will not be taxed by a State unless there is a significant economic relationship between the permanent establishment and the State.

As indicated in the OECD Commentaries, a general principle to be observed in determining whether a permanent establishment exists is that the place of business must be “fixed” in the sense that a particular building or physical location is used by the enterprise for the conduct of its business, and that it must be foreseeable that the enterprises use of this building or other physical location will be more than temporary.

When determining the existence of a permanent establishment, in it necessary to first determine if there is a fixed place of business as put forth in the rules. These rules are put forth below in Article 5.  If the conclusion is; there is a fixed place of business then, paragraphs 5 and 6 which provide for agency relationships is of no consequence; they are inapplicable.

In the light of the above described general rules, it is important to underline that a permanent establishment may constitute on retro-active basis. This means that not from the moment, when it is possible to find a business as permanent, but from the very beginning. Since the place of business must be fixed, it also follows that a permanent establishment can be deemed to exist only if the place of business was not set up for temporary use. [6] As a result, such a mechanism may cause uncertainty of the employee – i.e. at the moment of payment of his remuneration it is not clear where such a salary should be taxed. This may occur for example when an employee starts to work in construction side at its beginning. If such works will exceed 12 months, his remuneration must be taxed in the country of performance of the work also for the period when has no obligation to be taxed there. This is due to the fact that until that moment he should be taxed in the country of his residence.

Another very important issue is a definition of “employer”. In the Commentary to MC the possibility of reference to the definition of the domestic law was rejected. In this understanding an employer is each entity which has rights to the results of the job performed by the employee. This entity is defined as a real employer. [7] Such an issue is extremely important in the case of international hiring out of labor.

The relevance of the PE concept in the context of employment

Permanent establishment is neither a tax entity nor legal person – what results in a problematic assessment if the remuneration is paid by the permanent establishment. PE can pay the remuneration which is not related to its business activity, but with the activity of different PEss. This is also possible that the remuneration is paid by the taxpayer directly, from the bank account in different country. According to commentary to MC OECD, the remuneration which is taken into account as a tax deductible cost shall be taxed in this country where the work is performed. It should not be taken into account if the taxpayer deducted such a remuneration but only had right to do so. [8]

This is also important that a definition of Permanent Establishment may be different in different double tax treaties. This causes additional problems, especially regarding construction PEs, while an employee is a resident of state A, working for the employer of state B, but the work is performed in country C. The question which may arise is on the basis of which double tax treaty ( A and C or B and C or A and B) the taxation right should be determined and especially if the PE exists or not. Such a problem is not solved by countries in the only one way. As an example, Dannish authorities solved that issue on the basis of the treaty between country B and C, i.e. country of the employer’s residence and country of performance of the job. [9]

Must be underlined that the main assumption of this provision was to tax the income in the country where such an income s allowed as a tax deductible cost.

Salaries, wages and remunerations and reason for the payment.

The terms “salaries, wages and other similar remuneration” and employment are not defined in the OECD MC. Under Art. 3(2) of OECD Model, unless the context requires a different interpretation, terms that are not further defined in the tax treaty are given the meaning that they have according to the domestic law of the contracting state applying the treaty. In this respect, the general principles contained in the Vienna Convention on the law of treaties of 23 May 1969, will have to be considered. The application of these interpretation principles in two different countries, each given a different interpretation to the term “salaries, wages and other similar remuneration”, can lead to double non taxation. Such a problem arise with exceptional payments such as severance pay, compensation for non-competition clauses or sick payments. This may be extremely difficult to properly tax that kind of payments especially when borne by the Permanent Establishment. Te right of taxation under Art. 15 of the OECD Model is allocated to the state in which the employment is exercised. In such a case it is hard to assume when the work is exercised while severance payment does not relate to “performed work”. According to the Netherlands Supreme Court, the fact that the verb “to be” is used in the present tense in this article is not important. [10] This court also believes that in practice an examination will still have to be made whether there is enough of a link between the work performed earlier and the severance payment.

Another problem of this nature relates to a non-competition clause. In the decision of Brussels Court of Appeal of 14 November 1997 [11] held that the compensation for a non-competition clause had to be interpreted on the basis of Belgian domestic law, in the absence of a definition of the terms “salaries, wages and other similar remuneration” in the treaty itself. The Court then had to determine in which state the personal activity, as source of the income, had been exercised. According to the Court, this activity had to be considered to be exercised in the state of residence. It is also worth of being underlined that in this case the non-competition clause had a general application and was not limited to a specific country or countries.

A similar problem arises with payments paid to employees on standby. An employee may receive a normal remuneration without having to perform any professional work. In such a case the employee is paid to stand by for the performance of activities in another country. For example in German case law the country where the activities are considered to be preformed is the one where the employee actually stays while waiting to perform work. [12]

The above analysis leads to the conclusion that variation in Art. 15 switching the taxation right of the remuneration to the country where PE exists only strengths possible risk.

Remuneration for dependent personal services

There is no definition of the term “dependent personal services” in the OECD MC. Paragraph 3 names only some activities as examples which usually fall under the term, It can be however assumed that the OECD MC are based on common understanding of the type of activities to be covered by the term “dependent personal services”. The term is accordingly to be derived on the one hand by distinguishing it from other types of income and on the other hand by referring to a common international understanding. Dependent services may be presumed if an employee makes his capacity for work available to an employer and, in performing such activities, the employee is obliged to follow the instructions of the employer. It is therefore forbidden for the country to exclude arbitrarily from the scope of “dependent personal services” an activity falling under this understanding. Indicative of “dependent services” is thus the integration of the dependent activity into the enterprise of the employer so that the employee is under the direction of the employer and must follow his instructions. [13] A good example for the role of the criterion of “integration” is in a decision of the Dannish Landsskatteret [14] . In this case, the advisory activity of a German resident marketing expert performed for a Danish company was deemed to be a dependent service as he was a memner of the board of directors and received a monthly salary. However following his departure from the company, he was compensated for his advisory activities only for the amount of days he actually worked. He was then considered “independently” employed.

The term “dependent services” also encompasses the activities of the directors and managers of the company liable for corporate taxation as long as they do not fall under the special rule of Art. 16. Because of their nature, problems arise with respect to determining the place where their work is exercised and by whom (PE or the company) they are paid.

Inter-company charges as a sufficient condition of the provision

The rule that the remuneration must not have been borne by a permanent establishment or a fixed base which the employer has in the country of employment is also designed to prevent any impairment of the country of employment’s rights to impose tax. Remuneration for dependent personal services is considered to be borne by a permanent establishment or fixed base if it can be claimed as a deduction for business expenses when calculating the profits to be attributed to the establishment or base. [15] If the permanent establishment in fact bears the cost of remuneration is decisive, not whether it should have done so or whether the cost could have been attributed to it. This is conditional on the personnel in question also being attributable, in functional respects, to the permanent establishment or fixed base and, on the payments constituting, for the permanent establishment or fixed base, remuneration for dependent personal services. If, in hands of the permanent establishment, they are allowed to be given consideration merely as an inter-company charge for supplies, services or executive expenses, the restriction laid down in Art. 15 (2) c) does not apply. [16]

Inter-company charges between head office and permanent establishment are not always sufficient to satisfy the condition of remuneration having been “borne” within the meaning of OECD MC. An indication that the foreign permanent establishment “bears” the remuneration might be that it itself settles accounts directly with the employee sent abroad. It can do so either by paying the remuneration itself or by arranging for another enterprise to advance the money. It makes no difference what is the accounting method used for its presentation. Whether the remuneration was initially paid by the domestic employer and subsequently charged to the foreign subsidiary is irrelevant. Monthly accounting is not necessary. The remuneration paid to an employee may also be attributed to a dissolved permanent establishment [17] .

This inter-company relation may also increase a level of uncertainty. In such cases it would be advisable to consider the goal of that provision, which is to compensate for tax revenue lost through the deduction of operating expenses in the state of employment.

International hiring-out of labor

The use of such expression in the field of tax treaties dates back to 1985, when the OECD issued a report addressing the treaty problems of arrangements of hiring out labor. Basically those arrangements consist on a local employer wishing to use short-term foreign labor and avoid taxation of employment income in his state by recruiting the labor force through an intermediary (lessor) established abroad. The relationship is characterized by the fact that, although there is a contract of employment between the lessor and the employee and a special contract between the lessor and the lessee (local employer), no contract exists between the employee and the lessee.

In terms of tax, a problem started to arise in cases of international hiring-out of labor. Since the right of the state of the temporary employment to tax employment income was limited by the provisions and conditions of Art. 15, the tax administrations were not happy to notice that non-resident labor was easily entering their boundaries and as easily avoiding source country taxation.

As a possible contribution to solving problems of abuse, the 1985 OECD report suggested interpreting the notion of employer through a factual analysis for treaty purposes of the employment relationship. In fact, as part of the 1992 update to the OECD Model, the Commentary was amended to clarify situations covered by the exception Art. 15(2). In particular, the concept of material employer in hiring-our of labor situations and the formal criteria for a substance over form approach were inserted in paragraph 8 of the OECD Commentary.

Nevertheless, experience demonstrated that applying the criteria mentioned in paragraph 8 of the OECD Commentary only to abusive cases was a difficult task and that its practical application could easily target bona fide companies and employees. Recognizing the difficulty in certain cases of establishing which enterprise is the employer, the OECD initiated a revision of the Commentary to address this particular problems.

Under the general rule of paragraph 1 of the Art. 15, the residence country of the employee has the exclusive right to tax the income from employment, unless the employment is exercised in the other treaty country (i.e. country of activity). In the latter case, paragraph 2 allows the country of activity to tax the remuneration if the employee is present in the country of activity for a less than 183 days, the remuneration is paid by a resident employer or it is borne by a permanent establishment situated in the country of activity.

The purpose of the new Commentary is thereby to resolve interpretation issues concerning the concept of “employer” for purposes of paragraph 2 of Art. 15. The conflicts increasingly arise because some countries disregard the formal employment relationship in order to assess whether the income derived by short-term assignees is also taxable in the country of activity. In fact, over the last years, a body of case law and rulings from countries such as Australia, Netherlands and Belgium have proven the tendency towards a more economical employer approach.

In determining the employer, the draft attaches importance to the nature of the services rendered, in order to determine whether the services rendered by the individual constitute an integral part of the business of the enterprise to which these services are provided. In cases where the nature of the services rendered point to an employment relationship different than the one of the formal employer, the draft suggests objective criteria to determine the employer, namely:

− who has the authority to instruct the individual regarding the manner in which the work has to be performed;

− who controls and has responsibility for the place at which the work is performed;

− the remuneration of the individual is directly charged by the formal employer to the enterprise to which the services are provided;

− who puts the tools and materials necessary for the work at the individual’s disposal;

− who determines the number and qualifications of the individuals performing the work.

As a consequence, instead of being regarded as non-resident employee of a non-resident employer rendering services on a temporary basis, individuals may, if certain objective criteria are met, be deemed to be the employees of the service recipient in the other country (i.e. source country), and therefore, taxable in the source country where they are performing their services.

Conclusions – is that allocation rule relevant to modern tax system?

Application of Art. 15 OECD MC very often leads to numerous number of unsolved interpretation problems. Art. 15 (2) c definitely is the one which increases the level of uncertainty for employee and leads even to double taxation of the same revenues. In such a case the interpretation problem is not only related to the meaning of particular provisions of Art. 15, but also to the meaning of „permanent establishment“ and/or problems related to relevance of the remuneration for that PE. It would be advisable for OECD Fiscal Committee and/or respective tax authorities to take into consideration a simplification of that provisions. This is extremely important due to the fact, that taxpayers in such a case are individuals. A huge increase of cross border movement of labor forces results in the increase of number of cases related to double taxation of their income. Furthermore very often it is technically difficult and expensive to fulfill all local requirements related to taxes due . The above analysis leads to the conclusion that salaries paid by permanent establishment should be taxable in the state of residence of the taxpayer. On the other hand, PE should not be able to deduct its costs as a tax deductible costs of PE. This construction could simplify tax calculations of individuals employed by PEs and allows countries where the work is performed to benefit from a such by the increase of taxable base of PE as a such not by charging individuals with this taxes. Furthermore, from the perspective of fiscal administrations it is always much more easy to tax and control if such a taxation is complied with all the regulation than to tax employees who even can not be able to pay such taxes in a proper way.