Permanent Establishment

When a company does business in another country through a fixed place there, it can create a permanent establishment (PE). The host country may then tax the profits of that PE, even though it is not a separate legal entity.

What counts as a PE

Most tax treaties follow Article 5 of the OECD Model Tax Convention. A PE is a fixed place of business through which the business of an enterprise is wholly or partly carried on: a branch, an office, a factory, a workshop, a mine. A building site or installation project becomes a PE once it lasts longer than twelve months (six months in the UN Model, which many developing countries prefer).

A company can also have a PE without any premises, through a dependent agent: a person who habitually concludes contracts on its behalf, or habitually plays the principal role leading to such contracts. Since the 2017 update (BEPS Action 7), this test is wider than before.

Activities that are only preparatory or auxiliary, such as storage or purchasing, do not create a PE. Splitting activities over several places to stay below that threshold no longer works (anti-fragmentation rule).

What happens next

The host country taxes the profits attributable to the PE (Article 7). The home country, which taxes the company's worldwide profit, gives relief: either by exempting the PE profit (Article 23A) or by crediting the tax paid abroad (Article 23B). Without a treaty, domestic law alone decides, and double taxation becomes a real risk.

How much profit belongs to the PE

Under the Authorised OECD Approach, the PE is treated as if it were a separate, independent enterprise. You map its functions, assets and risks, and then price its dealings with the head office using the transfer pricing methods (see CUP, cost plus and TNMM). Older treaties may still use the pre-2010 wording of Article 7, which leaves more room for different outcomes.

Costa Rica

Costa Rica defines a PE in its own income tax law (Ley 7092, art. 2). In 2023 the Legislative Assembly approved a bill (expediente 23.581) that removes the word "essential" from that definition, so any fixed place where the business is carried on, wholly or partly, can qualify. Costa Rica has only a small treaty network, so for many foreign companies the domestic definition is the one that applies.

Typical risk points

Staff who sign or negotiate contracts locally, employees working from home abroad, warehouses, long-running projects, and servers.

Photo: Dan Freeman on Unsplash