Permanent Establishment | Article 5| OECD Model Tax Convention – Post 2


Continuing from the previous post, here we deal with Paragraph 2 to 4.1 of Article 5 of the OECD Model Tax Treaty.

Paragraph 2 of Article 5: General Forms of Permanent Establishment

Paragraph 2 states the following are the Permanent Establishment: a place of management, an office, a branch, a factory, a workshop, a mine, an oil well or, any other area of extraction of natural resources.

We need not dwell much into terms of office, branch, factory, and workshop, as they are defined well under the prevailing laws.

What forms a place of management?

A place of management is not necessarily an office. It is where the managerial decisions of the entity take place, for example, a board meeting. In a few countries law, there is no bifurcation made between the office or a place of management; in such cases, we can ignore the distinction.

What forms part of Permanent Establishment when Natural resources are involved?

Subparagraph f of Paragraph 2 of Article 5, states that a mine, an oil or gas well, a quarry or any other place of extraction of natural resources would form part of term Permanent Establishment. The phrase ‘any other place of extraction’ is considered broadly. For instance, it includes all places of extraction of hydrocarbons, offshore, or onshore.

The Subparagraph does not speak about the exploration of natural resources. Therefore whenever there is a business income derived from the exploration of natural resources, be it onshore or offshore, Paragraph 1 of Article 5 is to be referred.

Paragraph 3 – Creation of Permanent Establishment in case of building construction

Paragraph 3 of Article 5 provides expressly that a building or construction site or installation project constitutes a Permanent Establishment only if it lasts for more than 12 months. If the condition mentioned above is not satisfied, then a Permanent Establishment does not exist irrespective of the fact that installation, office or a workshop explained under Paragraph 2 of Article 5, lives in the said site and is exclusively associated with the site.

The building construction takes 11 months, but the site office manages multiple projects from the same premise?

If the office manages various construction sites from the office, but none of the construction activity exceeds the time limit provided under Paragraph 3 of Article 5, then the office would be evaluated independently based upon the other paragraphs contained under Article 5.

Explain the phrase ‘building site or construction or installation project’.

The phrase ‘building site or construction site or installation project’ is to be interpreted in the broad term. It will include the construction of roads, bridges, canals, renovation, maintenance, or redecoration.

How to compute the 12-month test for Article Paragraph 3 of Article 5?

The 12-month test is computed for each site or project.  A site should be considered as a single unit, even if several contractors are working on it, provided it becomes coherent whole commercially or geographically. The computation of the period commences from the date the site contractor begins his work, including preparatory work. Seasonal or temporary interruptions are also included in the period.   If the person attempts to abuse the 12 months provision by unlawfully splitting the transaction among the sister concerns, then Anti Abuse provisions can be invoked.

How does 12-month test work for Fiscally transparent entities?

In the fiscally transparent entities, the twelve-month test applies at the level of partnership firm, concerning the specific partners share. Each partner is tested for Permanent Establishment, based upon the number of months the construction was active and the clause provided in the applicable treaty. Then the partner’s share of partnership income is taxed regardless of the time spent by him.


May, a resident of State A, and June, a resident of State B, are partners. They are undertaking a construction project in State C. State A and State C have adopted the OECD model tax convention with eight months, as mentioned in Paragraph 3 of Article 5. State B and State C have adopted the OECD Model tax convention without any changes. The partnership firm has completed the project in 10 months, and the Firm is considered as a fiscally transparent entity in all the three states. How will the source country i.e. State C will tax the transaction?

The Firm will be considered as Permanent Establishment in State C as per the DTAA between State A and State C for May’s share of profits of the Firm. State C has the right to tax May’s portion of profits of the Firm. For June’s Share, the Firm does not have Permanent Establishment in State C, as per the DTAA between State B and State C.

United Nations Model Tax Convention views:

UN Model tax convention has provided a differing view concerning Paragraph 3 of Article 5. It consists of 2 subparagraphs:

Subparagraph a of Paragraph 3 of Article 5 has included the assembly function and supervisory activities to a building site, construction, assembly, or installation project. It has reduced the term of twelve months to six months.

Subparagraph b of Paragraph 3 of Article 5, includes the services provided by employees or personnel of an enterprise in another contracting state, if the service provided exceeds 183 days in any 12 months commencing or ending at the fiscal year concerned.

Paragraph 4 – Exclusions from definition of Permanent Establishment

What are excluded from the general definition of Permanent Establishment?

The exception carved out in Paragraph 4 is for non-taxation of the activities undertaken in a State by an entity registered in another state, which is of purely auxiliary or preparatory in nature.

What qualifies as a preparatory or auxiliary activity for Paragraph 4 of Article 5?

Preparatory: An activity that has a preparatory character and carried on in contemplation of the actual work to be done by the enterprise. Since the preparatory work precedes the actual work, the activity is done for the short period (varies with the nature of the enterprise).

Auxiliary: Auxiliary activity is done to support the essential or core business of an enterprise. It does not employ significant resources of an enterprise.

The exemption provided under paragraph 4 of Article 5 will not stand if the fixed base maintained by the enterprise in another state is used for providing services mentioned under Subparagraph a) to e) for another entity.

Illustration: State A and State B have adopted the OECD model tax convention. ABC Inc of State A has an office in State B for providing the advertisement services for ABC Inc. Advertisement is presumed to be an auxiliary service in the present case. The office is also providing advertisement services to other entities/companies of State B. In such a case, Paragraph 4 of Article 5 will not provide relief, and the office would be considered as a Permanent Establishment.

What are the scenarios provided in Paragraph 4 of Article 5?

Paragraph 4 of Article 5 states that the general definition provided for the Permanent Establishment would not be applicable in the following scenarios if the fixed based of the entity in another state is formed for undertaking activity in the form of auxiliary or preparatory character.

Paragraph 4.  a) usage of facilities in another state solely for the purpose of storage, display or delivery of goods or merchandise of the enterprise

The applicability of this Subparagraph has to be analyzed based on facts and circumstances of each case to identify the preparatory or auxiliary nature. The word delivery does not stand for the sale of goods, but only delivery, which will include a free sample.

Illustration 1: ANC Inc, a US-based pharmaceutical entity, has set up a showroom in the UK. Presume, UK And USA have adopted the OECD Model tax treaty. Displaying of the medicines, storage, and delivering the samples to the local doctors/hospital for their feedback will not make the showroom a Permanent Establishment in the UK.

Whereas in the given case, if the entity were selling the medicine/drugs to the doctors or hospitals, then Permanent Establishment would exist, as selling the medicine/drugs is the core function of the enterprise.

United Nations Model Convention Views: United Nations Model Convention, does not support the view of adding the delivery clause in the Subparagraph a. of paragraph 4. According to them, when delivery takes place, the fixed base will become Permanent Establishment.

Paragraph 4. b) the maintenance of the stock of enterprise for storage, display, or delivery.

It deals with maintenance of the stock of the enterprise in another country, be it for storage, display, or delivery. It is not applicable if another enterprise has maintained the inventory as a dealer or distributor.

United Nations Model Tax Convention Views: United Nations Model Convention, views when delivery takes place, the fixed base will become Permanent Establishment. Hence it does not support OECD view on Subparagraph b) of paragraph 4.

Paragraph 4. c) the maintenance of the stock of the enterprise by another enterprise for processing.

It covers the situation where the stock of an enterprise is with another enterprise for processing on its behalf.

Illustration: Linka Inc of State A, is a leading online fashion website. Designers work and create clothes and pack them in State A, but send it to labeling at State B for cost-effectiveness. The entity in State B, will mark the package with calligraphic design and send it back to Linka Inc. State A and State B have adopted the OECD model tax convention; does Linka Inc have a Permanent Establishment in State B?

No, the entity in State B provides auxiliary services to Linka Inc.

Paragraph 4. d) maintenance of a place of business for purchasing goods,  merchandise, or for collecting information.

When a fixed place of business is formed explicitly for purchasing functions or collection of information, then it will not be treated as a Permanent Establishment.

Illustration: Gia Re is a reinsurance company based in France. It is planning to enter into German Insurance Market, so it has set up an office in Berlin, for collecting information and statistics about the country. Also, it undertakes the lobby functions for entering into the market. This office procures stationaries for their daily use. Assuming Germany and France have adopted the OECD Model Tax Convention, will the office in Berlin, be a Permanent Establishment for Gia Re.

No. The office in Berlin will not be a Permanent Establishment as the functions undertaken by the office is preparatory. If Gia Re had commenced advertising and collecting premiums from the companies in Germany, then it would not attract subparagraph d of Article 4.

Paragraph 4. e) the maintenance of a fixed place of business solely to carry on, for the enterprise, any other activity.

The generic phrase ‘ any other activity’ is placed to cover any function or activity which the other subparagraphs do not cover.

Paragraph 4. f) the maintenance of a fixed place of business solely for any combination of activities mentioned in a) to e)

This Subparagraph places the flexibility on the acceptability of the activity for exclusions under Paragraph 4 even if it takes multiple or combination of activities mentioned under Subparagraph a) to e).

Paragraph 4.1– Anti-abuse condition for Paragraph 4

This paragraph prevents the fragmentation of business operations by closely held entities.

The exception under Paragraph 4 of Article will not be applicable when the following conditions are satisfied:

  • The enterprise and its closely related entities undertake business activity in another country (be the same place or multiple locations in the country); and
  • The functions of these entities form a complementary role leading to cohesive business operation.
  • The place will create a Permanent Establishment for the enterprise or the closely related enterprise as per the provision of Article 5 [as per Paragraph 4.1 a) ] or
  • The overall activity of the closely related enterprises in the country is not of a preparatory or auxiliary. [as per Paragraph 4.1 b) ]

Illustration: State A and State B have adopted the OECD Model Tax Convention. ABCD Inc and LQ Inc are residents of State A  and are closely related entities. ABCD Inc procures machinery from other manufactures and stores them at a warehouse in State B. LQ Inc’s hires professionals in State B to verify the machinery and to make necessary changes as per the client’s requirement. LQ Inc specializes in Brand Marketing, and providing professionals to ABCD Inc is an auxiliary function for the business. Is there a Permanent Establishment in State B?

Yes, the Permanent Establishment Exists.

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