What Is an OECD Permanent Establishment?

The concept of a Permanent Establishment (PE) is a principle in international taxation that determines a country’s right to tax a foreign company’s profits. The Organisation for Economic Co-operation and Development (OECD) Model Tax Convention provides a foundational definition of PE that is widely used in bilateral tax treaties between countries. These treaties aim to prevent double taxation, which is the levying of tax by two or more jurisdictions on the same income.

At its core, a PE represents a taxable presence in a foreign jurisdiction. If a company’s activities in another country are substantial enough to create a PE, that source country acquires the right to tax the income generated from those specific activities. This prevents foreign enterprises from generating significant revenue within a country without contributing to its tax base.

The Core Concept of a Fixed Place of Business PE

The most common way a permanent establishment is created is through a “fixed place of business.” This is defined as a fixed location through which the business of an enterprise is wholly or partly carried on. To meet this definition, three conditions must be satisfied: the existence of a “place of business,” that this place is “fixed,” and that the enterprise’s business is conducted “through” that place.

A “place of business” refers to any physical facility or location at the disposal of the foreign enterprise. Examples include a branch, a factory, a workshop, a mine, a place of management, or an office. The enterprise must have effective power to use the location for its business activities, meaning it doesn’t necessarily have to own or lease the property, but it must have it at its disposal.

The second condition is that the place of business must be “fixed.” This implies a connection to a specific geographical point and a degree of permanence, meaning it cannot be purely temporary or transitory. The assessment of permanence is not based on a single, rigid timeline but on the nature of the business. A business that is inherently short-term might still create a PE if the location is used for the entire duration of that business activity.

Finally, the enterprise’s business must be carried on through this fixed place. This means the core, income-generating activities of the business are conducted from that location, not merely ancillary or support functions. For instance, a sales office where employees actively solicit and conclude contracts would likely meet this test, as the activities are an integral part of the enterprise’s primary operations.

Other Forms of Permanent Establishment

Beyond a physical office, a permanent establishment can be formed in other ways that demonstrate a significant economic presence. One of the most important alternative triggers is through the actions of an agent. An “Agency PE” can be created even if the foreign enterprise has no fixed place of business in the country. This occurs when a dependent agent acts on behalf of the enterprise and habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise.

This dependent agent does not have to be an employee; it can be an individual or another company. This rule prevents companies from avoiding a taxable presence by simply using a local representative to conduct core business functions instead of establishing a formal branch. For example, if a local sales agent regularly negotiates and secures sales agreements for a foreign company, tax authorities may deem that a PE has been created.

In contrast, using an “independent agent” does not create a PE. An independent agent is a person or entity, such as a broker or general commission agent, who acts in the ordinary course of their own business. The distinction hinges on the legal and economic independence of the agent from the foreign enterprise they represent.

A specific rule also applies to construction-related activities. A building site, or a construction or installation project, constitutes a PE, but only if it lasts for a certain period. The OECD Model Tax Convention specifies that such a project creates a PE only if it exists for more than twelve months. This rule recognizes that a long-term project represents a significant economic commitment to a country, justifying a taxable presence.

Activities Exempt from Creating a Permanent Establishment

The OECD Model Tax Convention explicitly lists certain activities that are exempt from creating a permanent establishment, even if they are carried out through a fixed place of business. These exceptions cover functions that are considered “preparatory or auxiliary” in character. The logic is that these activities are supportive of the main business and do not, on their own, represent the core income-generating function of the enterprise in that country.

Specific exemptions include:

• Using facilities solely for the purpose of storage, display, or delivery of the enterprise’s goods or merchandise.
• Maintaining a stock of goods for these same purposes, or for processing by another enterprise.
• Maintaining a fixed place of business solely for the purpose of purchasing goods or merchandise, or for collecting information for the enterprise.
• Maintaining a fixed place of business for any other activity that has a preparatory or auxiliary character relative to the enterprise’s overall operations.

To counter abuse of these exemptions, the OECD’s Base Erosion and Profit Shifting (BEPS) project introduced an anti-fragmentation rule. This rule is designed to prevent companies from artificially breaking up a cohesive business operation into several smaller activities to claim each one is merely preparatory or auxiliary. Under this rule, the exemptions will not apply if the combined activities of an enterprise and its closely related entities in a country go beyond a preparatory or auxiliary nature.

Tax Consequences of a Permanent Establishment

Once it is determined that an enterprise has a permanent establishment in a foreign country, specific tax consequences follow. The primary result is that the source country—the country where the PE is located—gains the right to tax the profits of the foreign enterprise. This taxing right is not unlimited, as the country cannot tax the enterprise’s total worldwide profits.

Instead, the host country may only tax the profits that are “attributable” to the permanent establishment. This principle ensures that profits are taxed where the economic activities that generate them occur. The amount of profit to be taxed is determined by treating the PE as if it were a separate and independent entity.

This is known as the “functionally separate entity” principle. Under this approach, the PE is hypothetically treated as a distinct enterprise dealing with its own head office at arm’s length. This method helps in allocating the appropriate amount of profit to the PE based on the functions it performs, the assets it uses, and the risks it assumes.

The taxation levied on the permanent establishment must not be less favorable than the taxation applied to domestic enterprises carrying on the same activities. This non-discrimination principle ensures a level playing field between foreign and local businesses.