[Opinion] Analysis of the Concept of Permanent Establishment

CA Sombir Singh – [2023] 151 taxmann.com 39 (Article)

1. Introduction

The business profits of an enterprise of other Contracting State can be taxed if it carries a business through a permanent establishment; therefore, whether a foreign company carrying on business operations in another (source) country constitutes a Permanent Establishment (PE) in that country. It is an intriguing question for the tax authorities as well as for the taxpayers for a long time, because a taxpayer is generally taxed on its world-wide income in the country of its residence. It can also be taxed in another country if it has recognised source of income there.

Primarily, the taxability of business profits an enterprise in any country depends upon two distinct factors, viz.,

(a) whether it is doing business with that country e.g. where an enterprise does business with a country by exporting goods/services from a place outside India. Or

(b) whether it is doing business in that country e.g. where an enterprise carries on business in a country through establishing an office/branch or through an agent.

Business in a country may constitutes a PE and PE would give rise to taxable income attributable to PE. Business with a country would not give to rise to any tax liability under DTAA, although business connection could be established. But as per section 90(2), the assessee can take benefit of the provisions of DTAA. Hence the term PE marks a dividing line for carrying on business with that country and doing business in that country and the concept of ‘permanent establishment’ assumes significance as Article 7 of DTAA mandates that the business profits of non-resident shall not be taxable in the source state unless the non-resident has PE in that state.

The concept of “permanent establishment” is also relevance for other articles of the convention such as Article 14 (Independent Personal Services)- the term “Fixed base” is understood to have a meaning akin to “permanent establishment”, Article 10 (Dividends), Article 11 (Interest) and Article 12 ( Royalties) for reduced rates of withholding tax on payments to the residents of the other Contracting State, it is necessary that such income is not effectively connected to a permanent establishment or fixed base of the recipient. Further, the concept is also relevant for Article 13 (Capital gains), Article 21 (Other income), Article 22 (Capital), Article 24 (Non-discrimination). Therefore, the purpose of this article to give overview about the concept of ‘permanent establishment’.

2. Permanent Establishment

The taxation of business income on the basis of source rule requires in the country of source some business presence. Such presence is known as permanent establishment. Thus, the historical origin of the concept of PE is a compromise between the countries that favoured the principle of residence and the countries that favoured the principle of source. The basic rule of the PE is that it represents physical business presence. Article 5 of the UN Model defines the expression PE exhaustively; hence, Article 5 of the UN Model is briefly stated as follows:

Paragraph 1 sets out a general definition, as a fixed place through which business of an enterprise is wholly or partly carried on. It is sometimes referred to as the basic rule or Fixed Place PE.

Paragraph 2 gives an inclusive definition, defining the type or nature of place which prima facie create a PE e.g. An office, workshop, place of management.

Paragraph 3 prescribes threshold of 6 months. It is a further extension of the inclusive definition which is made subject to a qualification based on period of continuance. This does not extend the scope of the definition in the earlier paragraphs. These are known as Construction/Installation or Service PE.

Paragraph 4 outlines a number of exclusions of fixed place of business from the PE concept, which are in the nature of preparatory or auxiliary activities as such activities do not contribute directly to the profits.

Paragraph 5 stipulates that a dependent agent of an enterprise shall constitute PE if he habitually exercises an authority to conclude contracts on behalf of the enterprise. This is known as Dependent Agency PE.

Paragraph 6 contain a special rule for agents of insurance companies

Paragraph 7 provides that an independent agent acting in the ordinary course of business shall not constitute PE, provided the agent satisfied certain prescribed condition.

Paragraph 8 provides that a controlled company by itself does not constitute a permanent establishment.

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