Nothing is certain in this world, except death and taxes – and even taxes are subject to change. The ever-expanding definition of a permanent establishment ("P.E.") and ever diminishing exceptions to a P.E. under the O.E.C.D.'s B.E.P.S. Project has made one thing clear – the restrictions local jurisdictions put on activities by foreign taxpayers to trigger taxation are tightening. The dwindling preparatory and auxiliary activities exception is a prime example.

Under U.S. domestic law, a foreign enterprise is subject to taxation in the U.S. if its activities constitute a U.S. trade or business ("U.S.T.B.") and the income is effectively connected with the U.S.T.B.1 However, if the foreign enterprise is resident in a country that has an income tax treaty with the U.S., an exception may apply. If the activities of the foreign enterprise, as defined in the applicable income tax treaty, do not rise to a certain level, the foreign enterprise will not be taxable in the U.S. More specifically, as long as the foreign enterprise is not deemed to create a P.E. in the U.S., it will not be subject to U.S. taxation on income related to its U.S.T.B.

This article discusses the meaning of a P.E. in general and a particular exception to the creation of a P.E. that is invariably found in the tax treaties signed by the U.S. As will be shown, the "safe harbor" activities that have so far been treated as de minimis, and thus not sufficient to create a P.E., are dwindling.

PERMANENT ESTABLISHMENT DEFINED

In broad terms, the profits of an enterprise of one country are taxable only in that country (i.e., the home country or country of residence) unless it carries on a business in the U.S. through a P.E.2 Therefore, the definition of a P.E. is crucial for identifying which country has a primary right to taxation.

In most cases, U.S. income tax treaties define a P.E. to include a fixed place of business in the U.S. through which the foreign enterprise carries on its business either wholly or partly. This includes, inter alia, the following examples:

  • A place of management
  • A branch
  • An office
  • A factory
  • A workshop

However, a foreign enterprise will not be deemed to have a U.S. P.E. if its activities in the U.S. are limited to certain activities that are of a preparatory or auxiliary nature. For example, the U.S.-U.K. Income Tax Treaty provides that a P.E. will not include the following preparatory and auxiliary activities:3

  • The use of facilities solely for the purpose of storage, display, or delivery of goods or merchandise belonging to the enterprise
  • The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display, or delivery
  • The maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise
  • The maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise
  • The maintenance of a fixed pace of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character
  • The maintenance of a fixed place of business solely for any combination of these activities noted, provided that the overall activity of the fixed place of business resulting from the combination is of a preparatory or auxiliary character

Thus, any fixed place of business in the U.S. – like a branch, factory, or warehouse – that carries out exclusively the above mentioned preparatory or auxiliary activities in the U.S. is not a P.E. of the foreign enterprise. For example, an office solely for the purpose of advertising, supplying information or scientific research, or servicing a patent or a know-how contract is not a P.E. if such activities have a preparatory or auxiliary character.

It should be noted that the nature of the activity itself, and not the type of fixed place of business that carries out the activity, must be examined to determine whether the activity is preparatory or auxiliary in nature. Thus, the activity may be carried out by a wholly-owned subsidiary of a foreign enterprise with multiple offices in the U.S., but it may still not be regarded as a fixed place of business if it is merely conducting preparatory or auxiliary activities. Further, a person acting on behalf of an enterprise and concluding contracts in the U.S. that relate to the preparatory or auxiliary activities does not create a P.E. of the foreign enterprise in the U.S.4

Footnotes

1 Code §864(c)(1)(A). Special rules apply to certain passive U.S. source income derived by foreign persons. The latter is typically subject to U.S. withholding tax unless it is reduced (up to zero) under an applicable income tax treaty.

2 U.S. Department of the Treasury, U.S. Model Income Tax Convention, (Feb. 17, 2016), art. 7.

3 U.S. Department of the Treasury, U.S.-U.K. Income Tax Treaty, (Jul. 24, 2001), art. 5(4).

4 Id.

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