Tax & Legal How to deal with the new PE definition?

1. How does a PE Analysis work after BEPS Action 7?

Tax treaties generally provide that the business profits of a foreign enterprise are taxable in a country only to the extent that the enterprise has a permanent establishment (“PE”) in that country to which the profits are attributable. Such a PE is formed when certain criteria listed under the tax treaties are met.

BEPS Action 7 was developed by the Organization for Economic Cooperation and Development (“OECD”) and G-20 to review the existing PE definition contained in the tax treaties because of unintended use of certain tax avoidance strategies commonly employed to circumvent the current PE definition.

However, in an attempt to close the loopholes of the existing PE definition, Action 7, inadvertently, also lowers the threshold for the classification of the local business activities of a foreign enterprise as a PE of such enterprise.

2. Did you know that the “zero-sum” game is over?

The “zero-sum approach” or the “single taxpayer approach”, as discussed by the OECD in its 2010 report on ‘Attribution of Profits to Permanent Establishments’ suggests that after an arm’s length remuneration has been provided to a dependent agent (as per the arm’s length principle enshrined in transfer pricing), no further remuneration needs to be awarded to the dependent agent PE.

However, after BEPS Action 7, these concepts do not appear to hold true anymore. Governments around the world are adopting diverse interpretations of Article 7 to attribute additional profit to the local operations of foreign enterprises. This is seen in, among others, two particular ways:


The new language proposed by BEPS Action 7 states that a PE is formed by the actions of the local agent if the agent is seen to habitually play the principal role, leading to conclusion of contracts between the end customer and the foreign enterprise. This change is aimed to target situations (that were not addressed by the existing definition) where the local agent has been given full authority to negotiate with customers but where the contract at the end (which remains a mere formality at this point) is signed by the foreign enterprise.

However,  the  explanation  provided  under  BEPS  Action  7  allows  for  a  much  wider  interpretation  to be  adopted.  For  example,  the  tax  authorities  in  the  jurisdiction  of  the  agent  could  treat  the  inter- action  of  the  local  sales  agent  with  the  end  customer  as  essential  in  generating  income  for  the foreign enterprise, thereby labelling its activities as “playing the principal role” leading to formation of a PE.


A  number  of  countries  following  the  UN  Model  Double  Taxation  Avoidance  Agreement  follow  the principle  of  focus  on  ‘source  state  taxation’  when  it  comes  to  attributing  profits to  a  PE  of  a  foreign enterprise. This means that when a foreign enterprise is said to have a PE in another country, a major portion of income that the foreign enterprise earns from carrying on activities (of similar kind as carried on by the PE) in that other country, whether or not through that PE is exposed to taxation as income of the PE. Such  intention  of  allocation  of  additional  profits  to  the  PE  also  appears  to  come  out  of  the  wording of the final report on BEPS Action 7, which suggests that formation of a PE could be a stepping stone to attribution  of  (additional)  income  earned  by  the  foreign  enterprise  in  the  country  of  the  PE  to  the  PE.

3. When does the MLI with the new PE  definition kick in?

The multilateral instrument (“MLI”) seeks to implement a global standard for double tax avoidance treaties between countries signing and ratifying the MLI. However, the MLI proposes an elective approach for this purpose i.e. countries signing the MLI can make reservations on the application of certain articles contained in the MLI to their treaties covered by the MLI.

Thus, if a country makes a reservation on the definition of the PE in a covered tax agreement in the MLI, the old definition will continue to apply in respect of the treaties of that country. Only if two countries simultaneously accept (and ratify in their domestic law) the new definition of PE, it will become applicable to these countries.

4. TPA’s approach for PE self-assessment – process steps

The following chart presents, on one side, an illustration of the steps involved in conducting a PE analysis based on the new BEPS Action 7, and on the other side, the process steps to be taken for such analysis. Please note that the following decision tree only refers to the definition of a dependent agent PE. Similar decision trees are also available to assess the formation of physical PE and project PE.

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