How to avoid triggering a permanent establishment where you already have a legal entity

3 July 2024
Tax authorities in any country may deem that a company has triggered a permanent establishment under local rules if the company has engaged in certain activities. These typically include maintaining a local fixed place of business, hiring a local dependent agent to act on the company’s behalf or providing local services.

Most finance, tax and other leaders at multinational organisations understand the concept of permanent establishment — or PE — and know that it’s important to abide by local PE rules. Triggering a permanent establishment essentially means that an organisation has established a local corporate tax presence, and in many cases the organisation may then set up a local legal entity — such as a subsidiary — through which it can file and, in some cases, remit corporate taxes.

Some stakeholders at multinational organisations may assume that establishing a legal entity in a particular jurisdiction eliminates permanent establishment risks in that jurisdiction. Unfortunately, a multinational that has established a legal entity in another country may still run the risk of triggering a permanent establishment and being liable for corporate taxes it didn’t anticipate. This article summarises a recent case between Indian tax authorities and a US-based company to illustrate this little-known PE risk.

Case background and court decision

Caterpillar Group, a US-based company, established a wholly owned Indian subsidiary in 1996 known as Progress Rail Locomotive Inc. Progress Rail maintains a factory in India, which was initially based in Noida and later moved to Hubli. Progress Rail also provides support services to Caterpillar on an intra-group cost-plus recharge basis.

Indian tax authorities deemed that Progress Rail India triggered a permanent establishment in India based on the company having substantial involvement in the core business activities of Caterpillar. Progress Rail and Caterpillar contended that activities carried out by Progress Rail India that were associated with Caterpillar’s India-based activities were preparatory and auxiliary in nature and not aligned with Progress Rail’s core activities. They further argued that Caterpillar’s transactions with Progress Rail were conducted at arm’s length and based on objective transfer pricing studies.

On 28 May 2024, India’s High Court ruled in favour of Progress Rail India and Caterpillar, determining that their activities did not constitute a PE under the US-India tax treaty. The Court’s decision considered the following key factors when making its determination.

  • Fixed place of business. As a general point, maintaining a fixed place through which the business of a company is carried on in a country is one of the two primary ways an organisation can trigger a PE under Article 5 of the OECD’s Model Tax Convention. Progress Rail was not considered to have a fixed-place permanent establishment under India’s rules since Caterpillar’s activities were considered to be preparatory and auxiliary in nature. In addition, no evidence was found to show that Progress Rail’s premises were under the control of or at the disposal of Caterpillar for the use of its business activities.
  • Dependent agent. Engaging someone in a country to regularly conclude contracts on behalf of a company is the other primary means of triggering a permanent establishment according to the OECD’s model convention. India’s High Court found no evidence that Progress Rail had the habitual authority to conclude contracts or to secure orders on behalf of Caterpillar. As a result, the Court concluded that a dependent agent PE did not exist.
  • Services. Providing services across borders — which is increasingly common in our digital global economy — can also trigger a PE under most regulations, including India’s. The Court determined that Caterpillar employees did not render any services to Progress Rail, and therefore a service PE did not exist.
Lessons for multinationals

The High Court ruled in favour of Progress Rail and Caterpillar, but it’s important to keep in mind that the decision was based on the individual facts of the specific case, not on the premise that a non-resident company cannot trigger a PE due to the corporate group also having a local subsidiary. That is, if the facts of the Progress Rail case had been different — for example, if the Indian subsidiary had regularly concluded contracts in India on behalf of Caterpillar or the activities carried out by Progress Rail were more closely attributable to or associated with the business activities of Caterpillar — then the Court would almost certainly have ruled that a PE had been triggered.

The case illustrates that tax authorities in virtually any country may scrutinise a local subsidiary’s activities that are related to the subsidiary’s non-resident parent company to determine if a PE has been triggered. Again, the mere presence of a subsidiary does not eliminate the risk of a PE being triggered. So, a subsidiary of a non-resident company should be prepared to answer questions from tax authorities as to whether its activities in relation to the parent company could trigger a PE related to a fixed place, dependent agent and/or the provision of services. Keep in mind as well that the corporate group could have additional permanent establishment risks in the country where it has the subsidiary.

It’s also worth remembering that each country has its own permanent establishment rules, tax treaties and enforcement practices. As a result, permanent establishment risks vary by country and of course by an organisation’s activities in a given country. Most multinational organisations protect themselves by engaging third-party global tax experts to perform regular analyses of their activities in light of their countries of operation and all relevant permanent establishment risks.

For a detailed look at permanent establishment, and how you can protect your organisation, download our Permanent establishment playbook.