What is a Permanent Establishment?
A permanent establishment is a fixed place of business where an enterprise (a company) conducts its business activities. This place can be a building, office, factory, workshop, mine, oil/gas well, quarry, agricultural land, or similar locations.
Broadly speaking, permanent establishment is often referred to as a PE or a branch. It is defined as the presence of a business or individual in a specific location within a country where they conduct business activities.
Requirements for a Permanent Establishment
For a location to be considered a permanent establishment, it must meet two key criteria: geographic permanence and temporal permanence. It’s essential to note that “permanence” does not necessarily mean “forever” and varies based on the nature of the business.
Geographic permanence implies that a business operates within a specific area or a clearly defined commercial place of business. A practical example of this is a stall set up at different spots within a market at various times.
Temporal permanence requires a business to operate at a specific place for a significant period. As a general guideline, if a business operates continuously in a location for at least 6 months, it is considered temporally permanent.
There are specific circumstances in which the 6 month rule for temporal permanence may not apply. In extraordinary cases, such as situations where an entity is required to stay in a location for more than 6 months due to events like the COVID 19 pandemic, the tax officials may consider this presence as temporary. The determination is based on the specific facts and degree of permanence in each case.
Inclusions in the Definition of Permanent Establishment
Business Through an Agent
The definition of “permanent establishment” includes a situation where a person conducts business through an agent. However, it’s important to note that unless the person is otherwise conducting business in that place independently, the location where business activities occur through an agent is not considered a permanent establishment.
Use of Substantial Equipment or Machinery
A place where a person has, is using, or is installing substantial equipment or substantial machinery is also considered a permanent establishment if it lasts for more than 12 months.
Engagement in a Construction Project
If a person is involved in a construction project in a specific location, that place can be categorized as a permanent establishment. However, it must last for over 12 months.
Selling Goods from Another Person
When a person is engaged in selling goods that are manufactured, assembled, processed, packed, or distributed by another person for the first mentioned person or at their request, and there’s participation in the management, control, or capital of either one or both of these persons, then the place where these goods are manufactured, assembled, processed, packed, or distributed is also regarded as a permanent establishment.
This clause essentially includes situations where there is a close business relationship or significant involvement in the operations of the entities involved.
There are exceptions where certain activities can be treated as a permanent establishment even if they don’t meet the usual criteria. These activities include:
- Supervisory or consultancy activities for construction or installation projects lasting more than 12 months.
- Activities related to the exploration or exploitation of natural resources in another country for more than 90 days in a 12 month period.
- Operating substantial equipment in another country (excluding natural resource activities) for more than 183 days in a 12 month period.
Duration of Activities
The time duration for these activities is calculated by adding up the periods during which an enterprise and its associated enterprises (companies linked by management, control, or capital) carry out activities in a specific country.
If two or more associated enterprises are doing activities at the same time, it’s counted only once.
What are Associated Enterprises?
Enterprises are considered associated with each other if:
- One enterprise directly or indirectly influences the management, control, or capital of the other.
- The same individuals or groups of individuals directly or indirectly influence the management, control, or capital of both enterprises.
Thus, understanding the concept of “permanent establishment” is crucial in international tax agreements to determine where a company is subject to taxation.
Exemptions from Permanent Establishment
Certain business activities should not be considered as creating a “permanent establishment.” These activities are exceptions and include:
- Use of Facilities: When a company uses facilities for storing, displaying, or delivering its goods or products.
- Maintaining a Stock of Goods: If a business keeps a supply of goods for the sole purposes of storage, display, or delivery.
- Processing Goods for Another Business: When a company processes goods on behalf of another company.
- Maintaining a Fixed Place of Business: This exemption applies when a business maintains a physical location (like an office) for specific purposes, such as purchasing goods, collecting information, or conducting activities that are considered preparatory or auxiliary in nature.
These exemptions are designed to ensure that activities that are merely supportive or preliminary in nature don’t lead to the classification of a permanent establishment.
Other exclusions include:
- Commission Agents or Brokers: Locations where a person’s business dealings are conducted through a legitimate commission agent or broker who is acting in the regular course of their business and receiving the standard commission rate for such transactions are not considered permanent establishments.
- Agents with Limited Authority: Places where a person conducts business through an agent who either lacks or does not frequently exercise the general authority to negotiate and conclude contracts on the person’s behalf or whose authority is limited to fulfilling orders from a stock of goods in the country but is not consistently exercising that authority. However, this exclusion does not apply if the person otherwise conducts business in that location.
- Places for Purchasing Goods: Places of business solely maintained by a person for the purpose of purchasing goods or merchandise are not regarded as permanent establishments.
These exclusions align with similar provisions found in Australia’s double tax agreements.
The double tax agreements typically stipulate that an enterprise of one country will not be considered to have a permanent establishment in the other country solely because it conducts business through an agent with independent status, like a broker or general commission agent, operating in the regular course of their business.
Modifications by MLI (Multilateral Convention)
There are certain changes made by the Multilateral Convention (MLI) to the rules regarding permanent establishments.
The changes reaffirm the exempt status of certain activities mentioned above. This means these activities remain exempt regardless of whether they are considered preparatory or auxiliary.
The MLI also allows companies to maintain a fixed place of business for activities that aren’t explicitly listed in the exempt activities but are still of a preparatory or auxiliary character.
In other words, it broadens the scope of activities that can be exempted from creating a permanent establishment.
Activities of Closely Related Enterprises
There are situations where two or more enterprises are closely related. The rules about permanent establishments do not apply to a fixed place of business that is used or maintained by an enterprise, if that enterprise or a closely related enterprise conducts business activities at the same location or another location within the same Contracting State.
However, there is a condition. This exemption does not hold if the overall activities carried out by these enterprises at those places are not of a preparatory or auxiliary nature. Instead, the business activities must complement each other and form part of a unified, cohesive business operation.
In simple terms, if closely related enterprises engage in complementary business activities at the same or different locations within a Contracting State, these activities may not create a permanent establishment as long as they are connected and part of a cohesive business operation.
Activities of Agents
In the context of creating a permanent establishment, there are certain activities of agents that must be considered.
There are two types of agents:
- independent agents
- non independent agents
For non independent agents, if a person substantially negotiates contracts or manufactures goods on behalf of an enterprise, this could lead to the enterprise being deemed to have a permanent establishment in the Contracting State where these activities occur.
However, there’s an exception: if these activities fall under the exempt activities described earlier, they won’t create a permanent establishment.
On the other hand, independent agents, like brokers or commission agents, do not create a permanent establishment for the enterprise they represent simply by conducting their normal business activities in the ordinary course.
Control Between Companies
This refers to situations where one company has significant influence or authority over another company. This control could be through direct ownership, indirect influence, or other means. It means one company effectively directs the operations, decisions, or policies of another company.
Business Activities Across Borders
It’s common for companies to have relationships with others in different countries, either through control, ownership, or joint ventures.
They might have businesses that span international boundaries, which is known as carrying on business activities in each other’s countries.
Non Permanent Establishment
Australian laws emphasize that merely having control over another company or conducting business activities in each other’s countries does not, by itself, lead to the establishment of a permanent presence (permanent establishment) for either of the companies in the other country.
In simpler terms, just because one company is in control of another, or they conduct business across international borders, it doesn’t automatically mean that either of these companies will have a permanent establishment in the other country.
The existence of a permanent establishment depends on the specific activities they conduct in that foreign country, as defined by the rules we discussed earlier.
Application Beyond the Contracting States
The principles discussed in the previous paragraphs are not limited to the Contracting States. These principles revolve around what activities constitute a permanent establishment in international tax agreements.
These principles apply not only to determine whether a permanent establishment exists within the Contracting States (the countries involved in the tax agreement) but also for the purpose of deciding whether there are permanent establishments in other states (countries that are not part of the original agreement).
Additionally, these principles are used to assess the status of enterprises that do not belong to either of the Contracting States.
In other words, these principles are not confined to a specific group of companies but have broader applicability when it comes to determining when and where an enterprise has a permanent establishment for tax purposes.
Record Keeping Obligations for Entities with Australian Permanent Establishments
According to Australian tax legislation, there are record keeping obligations for entities that have Australian permanent establishments.
Entities that have a specific status in terms of their investment activities. These entities are known as “inward investors,” and they can be of different types, such as general investors, financial investors, or entities regulated under Australian Deposit Taking Institution (ADI) rules.
Importantly, these entities need to carry on their business operations through one or more Australian permanent establishments during a given income year.
The entity’s obligation to maintain records for Australian permanent establishments is contingent on the total revenues generated by those establishments during the year.
If the revenues attributable to these Australian permanent establishments amount to at least $2,000,000, the record keeping requirements come into effect.
Record Keeping Options
Entities have a choice between two approaches for maintaining records related to their Australian permanent establishments.
Australian Accounting Standards
If an entity selects this option, it must keep financial records as per Australian accounting standards. This includes a statement of financial position and a statement of financial performance, both prepared in accordance with these standards, along with accompanying notes.
Overseas and International Accounting Standards
If the entity chooses this option, it should maintain statements, in any format, that correspond to the financial statements described in Option 1. However, these statements must align with overseas or international accounting standards.
These overseas standards can be those established in specific countries like the UK, the US, Canada, New Zealand, Japan, France, and Germany, or international accounting standards issued by the International Accounting Standards Board.
Hence, in the context of permanent establishments, it is important to maintain accurate financial records for entities that operate in Australia through permanent establishments. This compliance is vital for tax and regulatory purposes, particularly for entities with significant operations in Australia through permanent establishments.
Requirements for Records
Entities must prepare these records before the deadline for filing their income tax return for the relevant income year. This ensures that the financial information is in order and can be properly reported for tax purposes.
An important aspect of record keeping is treating the Australian permanent establishments as if they were a separate entity, often referred to as a “notional entity.” This means that the entity must account for various financial elements attributed to these establishments.
- Assets and Liabilities: The assets and liabilities, including debt capital, related to the Australian permanent establishments must be recorded as if they belong to the notional entity.
- Revenues and Expenses: Similarly, the revenues and expenses associated with the Australian permanent establishments should be accounted for as if they were the revenues and expenses of the notional entity.
To maintain consistency, accounting standards are adapted to refer to “income years” rather than “financial years.” This modification ensures that the terminology used in financial reporting aligns with the specific reporting period for tax purposes.
Exclusion of Australian Permanent Establishments Not Covered by Double Tax Treaty
Under this provision, an entity is not obligated to comply with the record keeping requirements for a specific income year related to an Australian permanent establishment under certain conditions:
- Residency Status: Throughout that income year, the entity should be considered a resident of a foreign country as per a double tax agreement, regardless of whether it’s also an Australian resident or a resident of another foreign country.
- Permanent Establishment Criteria: The Australian permanent establishment must not meet the specific criteria of a “permanent establishment” as defined in the double tax agreement during the period when the entity conducted its business activities through that establishment.
Conditions for R&D Activities Conducted by Permanent Establishments for Corporate Entities
Australian tax laws outline specific conditions that govern Research and Development (R&D) activities conducted by a permanent establishment in Australia for the broader corporate entity. These conditions are as follows:
Solely Conducted in Australia
R&D activities must be conducted exclusively within the geographical boundaries of Australia. In other words, all R&D work must take place within the country.
Supporting R&D Activities and Core R&D Activities
If an R&D activity is classified as a “supporting R&D activity,” it must meet the following criteria:
- The supporting R&D activity should be conducted solely within Australia.
- The corresponding “core R&D activity” should also be an Australian operation and eligible for registration under section 27A of the Industry Research and Development Act 1986.
Alternatively, it should be eligible for registration if conducted within the same income year.
Evidence of R&D Activity Purpose
Written evidence must exist, demonstrating that the R&D activities are carried out for the benefit of the entire corporate entity and not solely for the advantage of the permanent establishment.
Thus, tax laws in Australia lay out essential conditions for R&D activities conducted by permanent establishments within Australia for the overarching corporate entity. Compliance with these conditions ensures that the R&D activities meet the legal and regulatory requirements set forth in the tax or regulatory code.
Reducing Capital Gain/Loss for Business Assets in Australian Permanent Establishments
When you use a business asset in an Australian permanent establishment and that asset qualifies as “taxable Australian property,” this concept comes into play.
The concept provides a way to fairly calculate the reduction in capital gain or loss when an asset was not used for the intended business purpose throughout the entire period leading up to a tax event.
The reduction is proportional to the amount of time the asset wasn’t used as intended for business activities within an Australian Permanent establishment.
Arm’s Length Profits for Permanent Establishments
Tax laws in Australia want to make sure that the PE’s profits accurately reflect what it would earn if it were a standalone company, not just a part of a larger one.
To do this, they allocate the actual expenses and income of the entire company between the PE and the rest of the company.
- Separate Entity Assumption: They make assumptions about the PE as if it were an entirely separate company. This includes assuming that the PE has its own functions, uses its own assets, and takes its own risks.
- Arm’s Length Conditions: The authorities also ensure that the terms and conditions governing the relationship between the PE and the larger company are fair and resemble what you’d expect in a regular business deal with unrelated companies.
- Including All Relevant Financial Aspects: When looking at the expenses of the entire company and the income it generates, they consider not only the regular costs and profits but also include things like losses, outgoings, and any income that should be considered as part of the overall income.
Thus, this helps make sure that the tax calculation for the PE is fair. It treats the PE as a separate business entity and ensures that it’s taxed appropriately, just as it would be if it were operating independently.
This is important in international business settings where a single company may have multiple establishments in different countries. The goal is to prevent any unfair tax advantages or disadvantages for the PE based on its relationship with the larger company.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.