How permanent establishment abroad is changing

In recent years, a number of multinational companies - including some Italian groups - have ended up in the spotlight because of their decisions to move their head offices abroad, a move that would mask an attempt to minimize their fiscal contribution in their home countries. This is one of the many facets of the ever-more common phenomenon called “profit shifting”: the revenues generated by a company in a given country are taxed in a different country where the tax system is more advantageous. When companies move their profits abroad they cause an “erosion of the taxable base” in their home countries, where they maintain business operations but avoid paying their fair share in taxes.

In an effort to counteract these distortions, in 2013 the Organisation for Economic Co-operation and Development (OECD) and the G20 launched a 15-points Action Plan (the so-called BEPS Project). The Plan aims to promote the adoption of consensus-based international tax rules and to facilitate the establishment of bilateral agreements between countries. To follow up on the Action Plan a series of reports was issues, and then in 2016 a multilateral convention (known as the Multilateral Instrument, MLI), as of today signed by 94 countries and ratified by 47 (Italy was among the first signatories but has not yet ratified the MLI). Finally, in 2017 the OECD released a new version of its Model Tax Convention on Income and on Capital, along with a commentary. The purpose of this template is to simplify the process for countries to enter into bilateral tax agreements.

In light of today’s economic context, in which production, capital and profits are increasingly mobile, the underlying aim of the BEPS Project is to help better clarify which specific economic activities have generated a certain item of income. This then serves as the basis for establishing exactly where these activities have been performed, and consequently which country’s taxation they should be subject to.

From this perspective, the criterion of a company having a “permanent establishment” (PE) in a given country becomes a central question. The concept of PE is linked to the presence of a fixed place of business (a facility or in some cases machinery) and/or commercial activity carried out on a regular basis by agents working for the non-resident enterprise. The most recent Model Tax Convention aims to encourage bilateral agreements between countries centering on this principle: if a company actually has a permanent establishment in a country where it does not reside, the profits attributable to that PE can be taxed by the host country.

Yet the interpretation of the “permanent establishment” criterion is not unequivocal; indeed, in recent years the courts in numerous countries have handed down a variety of sentences in this regard. Therefore, by analyzing the applicable case-law, we can come to better understand the directions in which the concept is evolving, the way in which this may be interpreted in international case-law and the relative implications for business activity.

From an analysis of international case-law relative to the concept of PE, two particularly interesting questions emerge which are the subject of in-depth investigation here. The first involves the anti-fragmentation rule and how preparatory or auxiliary activities conducted in a foreign country are considered in light of this provision. The second relates to agency PE, that is, the presence of an “agent” representing a company in a foreign country.

Based on the principle of preparatory/auxiliary activities, if in a third country a company conducts activities which exclusively serve a preparatory or auxiliary function in relation to the company’s core business, said activities are not taxable in that country. Traditionally, the law tended to consider the auxiliary nature of an activity in strictly formal terms; for example, owning a warehouse in a third county was normally considered merely a preparatory activity, and as such not taxable.

This approach was superseded in part by the new Model Tax Convention, which introduced the anti-fragmentation rule with the intent to prevent the activities of multinational concerns from being presented as split into myriad activities and operations classed as auxiliary and hence not taxable. With the anti-fragmentation rule, the criterion of “functional interdependence” emerged. Using this measure, all activities conducted in a third county would be evaluated with respect to the production process and the general business model of the company to determine what role each activity actually plays. This new approach was validated in several recent judgments which deemed not only owning a warehouse but also collecting and managing information as activities that cannot be split up; hence said activities must be taxed in the country in question.

A functional approach is being applied more and more often when weighing the question of agency PE. This criterion applies to companies which may not have physical premises in a given country, but are nonetheless represented by agents who serve their interests. Until 2017, in order to qualify as PE, the presence of an agent in a third country was necessarily associated with the authority exercised by that agent to conclude contracts on behalf of the company that person represented. Such an approach prompted many companies to engage a commissionaire or intermediary that would act under their direct control, but conclude contracts (for example for the sale of goods or the provision of services) in his or her own name, rather than on behalf of the company.

With the new functional approach, a situation is considered agency PE even where there is an agent who, although acting in that person’s own name, habitually carries out negotiations and concludes contracts pertaining to the transfer of goods and/or services attributable to a company based in a foreign country; hence this agent is in fact a dependent of that company. However, there is no permanent establishment if this agent is truly independent, in other words, autonomously performing activities as the representative of foreign companies in a given country, while these companies have no direct or binding control over said activities. Clearly, only a detailed, in-depth analysis of the work and the business model of agents would make it possible to determine whether or not they work independently of the companies which they represent.

The most recent international legislation and case-law reveal an evolution in the approach to taxation of business activities conducted in foreign countries. Specifically, the concept of “permanent establishment” is more and more often being viewed through a functional lens rather than a formal one, in other words, by analyzing the activities performed abroad and the actual function they serve the within the overall business model of the company.

As a result, companies with foreign operations must pay closer attention to the methods with which they maintain their foreign presence, even if only at the level of commercial agency.