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International Tax Risks: PermanentEstablishment

February 28, 2011 | No. 2011-10

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KPMGsTaxNewsFlashpublications containing technical discussions of tax

developments in the United States and around the world are released every day to tax

directors and other tax professionals. This summary is intended for executives who need

to be informed about tax developmentsbut without the technical details.

This edition follows up on last weeks discussion of corporate governance of tax risk with afocus on international tax risks. SeeTaxNewsFlash-Weekly Tax Summary for Corporate

Executives 2011-09.

Broadly speaking, tax risk is a possible change in tax liability resulting from uncertainty as to

the taxpayers facts or the application of the tax law to the taxpayers facts at the time a tax

liability is quantified and reported. Exposure to tax, and therefore tax risk, is embedded in

every aspect of a companys businessincluding international operations.

The most significant sources of international tax risks arise from:

Determination of arms length transfer prices in cross border transactionsCompilation and adjustment of non-U.S. financial data for U.S. tax purposes

Cross-border corporate acquisitions, dispositions, and reorganizations

Carrying on business outside a legal entitys country of residence (permanent establishment

or PE risk)

This article discusses permanent establishment tax risks. In this article, it is assumed that the

business is carried on in a treaty country because if the business is in a non-treaty country,

then permanent establishment is not relevant and the taxing threshold is lower.

Background

The traditional objectives of tax treaties have been the avoidance of international double

taxation and the prevention of tax evasion. The objective of avoiding double taxation

generally is accomplished under income tax treaties through the agreement of each

country to limit, in specified situations, its right to tax income arising within its jurisdiction

by residents of the other country and either to exempt from tax, or provide a credit for

income taxes paid on, income arising in the other country. A resident of one country

carrying on business in the other country generally will be subject to income tax in that

country if it has (1) a permanent establishment in that country and (2) income

attributable to the permanent establishment.

Permanent Establishment Tax Risks

What is a permanent establishment?

Income tax treaties of developed countries typically include standard language defining the

term permanent establishment that is based on the OECD Model Income Tax Convention. An

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enterprise of one country generally will have a permanent establishment in the other country if

it has either a fixed place of business (e.g., a place of management, a branch, office, factory,

etc.) in the other country or it has a dependent agent in the other country that has the authority

to conclude contracts binding the enterprise and the agent habitually exercises that authority.

Although the definition is standardized, it is quite general and countries vary as to how theyapply it to various fact patterns. For example, how long must an office exist before it creates a

permanent establishment? Does performing services for a customer in its offices create a

permanent establishment? Does an independent contractor create a permanent

establishment?

What is the permanent establishment tax risk?

It is the risk that an enterprise will be subject to tax in another country as a result of conducting

some activities in that country. This gives rise to an obligation to file a tax return and pay taxes

in that country. It also raises the possibility that that the residence country will refuse to credit

the resulting foreign income tax (or to exempt that income from domestic tax) if it believes apermanent establishment does not exist.

What steps need to be considered to limit the permanent establishment tax risk?

Ways in which a chief financial officer might limit permanent establishment uncertainty could

include:

Involving the tax department in the opening and closing, expanding or contracting, or other

modification of foreign offices and operations

Reviewing international travel and relocation of domestic and foreign personnel (including

numbers of employees, duration of temporary assignments, and other aspects of expatriateassignments)

Evaluating intercompany and third-party contracts to determine that third parties do not

have authority to enter into contracts in the name of the company

Reviewing intercompany product or service flows

Requiring periodic reports by foreign operations to determine that foreign tax filing

obligations are satisfied

Oversight by internal audit

KPMG Observation

Tax and financial executives in multinational companies need to be aware ofinternational tax risks, including permanent establishment, transfer pricing, and other

risks, and be prepared to take steps to manage the risks both defensively and proactivel