What is A permanent establishment
Activities carried on by a company in abroad may give rise to a permanent establishment in another country. The assessment of whether a company has a permanent establishment abroad and obligations related to it are one of the key elements of international business taxation.
The definition of a permanent establishment is not exact and it is often difficult to understand for those, who are less familiar with international tax questions. A permanent establishment is not an independent legal entity but a part of a company which, however, is treated for tax purposes as an independent enterprise. It is important to note, that a permanent establishment may be created unintentionally. The Tax authority in another country may consider, that a company has a permanent establishment in the country even if the company has not intentionally established permanent business in the country in question. The aspects related to permanent establishment have central role in the field of international tax law in dividing the taxation right between the countries.
Internal legislation of a country and importance of tax treaties
In international situations, a country’s right to tax on certain income depends essentially on whether or not a tax treaty applies. If a tax treaty will not apply, countries tax certain income entirely on the basis of their internal legislation. This usually means, that a country generally has right to tax persons and companies, which are tax resident in the country on their worldwide income. In contrast, a country usually has right to tax non-residents only on income, which is generated from the country in question. For example, Finland may tax any income that a foreign company receives from Finland to the extent allowed by our domestic law. Thus, according to the Finnish national law, the business income of a foreign company in Finland may be taxed in Finland, even if the company don’t have permanent establishment in Finland.
Although countries independently determine their income tax law, principles and treaties related to international tax law, such as income tax treaties, must be taken into account. Provisions of the tax treaties divide the taxation right between the countries. According to the general rule, only the country of residence has the right to tax business income, unless the company carries on business in another country from a permanent establishment there. Respectively, if the company carries on business in another country from a permanent establishment, this country may tax all the income of the permanent establishment. So, any other types of income are also taxed as part of the income of the permanent establishment in the country, where the permanent establishment is located. In contrast, according to the tax treaties, if the company does not have a permanent establishment in the country, from which it receives business income, the country does not have the right to tax the business income. Countries generally have right to tax other types of income derived from that country (dividends, royalties, interest) only if the right to tax is expressly permitted by the tax treaty.
A permanent establishment according to the tax treaties
For tax treaty purposes, a permanent establishment is a fixed place of business, through which the company conducts some or all of its operations. However, preparatory and auxiliary activities do not give rise to a permanent establishment. In order to be considered a permanent establishment, the place of business must have a fixed geographical location and the business operation should not be temporary in duration. As an exception, however, a dependent agent may give rise to a permanent establishment even if there is no separate fixed location. it is generally required, that the activity has to be continued for at least six months before the company may be considered to have a permanent establishment. In the case of the aforementioned dependent agent, the agent will normally be required to enter into significant contracts on behalf of the company or to have a lead role in the conclusion of binding contracts I order to give rise to a permanent establishment.
The concept of a permanent establishment is based on the main principle, that a country must have a right to tax the business carried on within the country’s territory. The purpose is, that non-residents are in the same position than tax residents related to taxation.
It is good to note that a permanent establishment constitutes a taxation right for a country in respect of all income of a permanent establishment. In case there is no permanent establishment, the taxation right of a country is limited to income derived from that country to the extent permitted by the tax treaty’s provisions. In addition, it should be noted, that the country of residence of a company will also tax foreign income received by the company, unless the tax treaty exceptionally requires the application of an exemption method or the income is tax exempt according to the internal legislation of the country of residence. When the country of residence tax the foreign income, it is obliged to eliminate the double taxation according to the respective tax treaty provisions.
Important to note:
If a company has a permanent establishment abroad, the company is almost always liable to pay tax in the country, in which the permanent establishment is located. Due to tax liability, the income of a permanent establishment must be distinguished from the other income of the company and, accordingly, the taxable income of the permanent establishment must be determined and correctly calculated in accordance with the laws and regulations of the country, in which the permanent establishment is located. These obligations can surprise and turn out to be quite challenging to manage, if the company is not prepared in advance.
In addition to the tax liability of the permanent establishment, the company will in most cases be subject to different registration obligations in the country, in which the permanent establishment is located. For example, a company may need to register with a local employer register, VAT register, and prepayment register. Through these registrations, the company may be required to pay advance taxes, VAT and various payroll contributions. In addition, in most cases, the company must prepare accounting and financial statements (or at least income statement and balance sheet) in accordance with local law, and file tax returns and various other periodic returns. In addition, employees of the company may be liable to pay tax in the country, in which the permanent establishment is located, if the employees are considered to work related to the activities of the permanent establishment.
It will be highly recommended, that a company, which considers to expand the business abroad, contacts specialists in the country in question in order to find out the potential tax and other obligations, which its activities in another country might create. If a company wishes to avoid to having a permanent establishment abroad, it is good to find out in advance, whether there are alternative ways to reach the same result. Naturally, it is much easier, safer and cheaper to expand the business abroad when there aren’t any unnecessary negative surprises expected.