Permanent Establishments in the Middle East: Potential Taxation for an Office that Doesn't Exist?

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Mohamed  Serokh Schervin Pouyan Jochem Rossel James Pollard

Mohamed Serokh, Schervin Pouyan, Jochem Rossel and James Pollard PwC Middle East

Mohamed Serokh, Schervin Pouyan, Jochem Rossel and James Pollard are Partners with PwC Middle East, based in the UAE

PE regulations in the Middle East can be complex: companies operating in the region need to be increasingly aware of PE risk in their business models and review their practices accordingly.

A common tax issue for groups with activities outside of their home jurisdiction is that these activities, be it specifically in-country or not, can potentially trigger foreign tax liabilities through what is known as a permanent establishment (“PE”) in that foreign country. Generally, whether the group have a physical office in that foreign country, occasionally send their employees to meet potential clients or have a representative in that country, the concept of a PE can be triggered.

The existence of a PE in a foreign country can result in unexpected additional tax costs and foreign compliance obligations. The failure to comply with these requirements in a timely manner could result in additional taxation, interest, penalties, reputational damage and other costs and sanctions.

Whilst the general concept of PE may be considered similar, the definitions and practical views of tax authorities naturally differ from country to country, especially in the Middle East, where most countries have broad and often vague PE definitions in their tax laws. In certain scenarios can this lead to a risk that a PE is deemed to exist even where there is no actual activity or fixed establishment in the relevant country? Let's discuss…

The Concept of a PE

A PE is an important principle of international tax law used by taxing authorities to assert taxing rights on the activities of a foreign entity deemed to be doing business in their country.

Indeed, the practical purpose of the PE concept is to determine whether a nonresident company has established sufficient presence in a foreign country so as to warrant the direct taxation of income relevant to those activities. Otherwise, a tax authority in a country may only have the ability to tax certain payments made to the nonresident via withholding tax mechanisms.

The starting point for considering a PE position is whether there is a definition in a foreign country's domestic tax laws. Where there is a relevant double tax treaty (“DTT”) in place between the “home” country and the foreign country, the DTT would have its own definition and thresholds for what would constitute a PE under that DTT. The practical interpretation of this, and the actual practice of tax authorities, still of course allows for ambiguities to arise.

DTTs entered into by most countries in the developed world as well as in the Middle East generally follow the existing PE definition in Article 5 of a document produced by the Organisation for Economic Cooperation and Development (the “OECD”), called the Model Tax Convention (“MTC”).

The existing PE definition under Article 5 in the OECD MTC Commentary identifies three common types of PEs as illustrated/summarized in Figure 1.

Figure 1
More Recent International Developments and Context

As a practical matter, the existing OECD PE definitions have not been changed since 1977. Clearly, businesses and the commercial breakdown of geographical boundaries (without even adding e-commerce) have moved on significantly since then. One result has been widespread controversy and debate on various PE threshold issues, despite earlier attempts by the OECD to make multiple changes to the OECD MTC Commentary.

In order to manage risk, businesses have needed to take measures to address the ambiguities of domestic legislation, the MTC and, where relevant, DTTs. This has arguably resulted in strategies to avoid PEs, which in recent times has led to much scrutiny of the very broad concept of businesses paying their “fair share” of tax globally.

Largely in reaction to this, as a means of guiding global tax authorities and businesses to prevent the now well-known phrase tax base erosion and profit shifting (aka “BEPS”) through businesses, for example, circumventing the existing PE definition, a package of proposed measures (15 actions) was published by the OECD in 2015.

One of the key actions under the BEPS package is Action 7 (Preventing the Artificial Avoidance of Permanent Establishment Status), which calls for PE definitions to be reviewed and updated in order to prevent the artificial avoidance of PEs in the context of the current business environment, the rapid evolution of the global economy and the emergence of new business models.

BEPS Action 7 is one of the most important work streams within the overall BEPS project and we believe this has intensified the focus on PE issues in the Middle East (and globally), particularly with the proposed lowering of the PE thresholds as a consequence of the new guidance.

The main targets of BEPS Action 7 are summarized in Figure 2.

Figure 2

Important points to highlight are that BEPS Action 7 has lowered the dependent agent threshold by introducing a new dependent agent test. The revised test is met, and a dependent agent PE is established, where the agent “habitually concludes contracts or habitually plays a principal role leading to the conclusion of contracts that are routinely concluded without material modification.” This is a potential landscape changer for many businesses where historically such arrangements have been relatively common but under existing PE definitions such in-country activities have not triggered a dependent agent PE. It will be important for businesses operating in such a manner to review such positions going forward.

Another target of the work on Action 7 is the artificial avoidance of PE status through the fragmentation of activities and the specific activity exemptions to a fixed place of business PE definition in Article 5(4) of the OECD MTC.

The BEPS Action 7 recommendations on PE thresholds were finalized in October 2015 and further work on the attribution of profits to PEs (the second key element once a PE has been established) has continued into 2017 and this topic remains live.

A Middle East Perspective

Changes to the PE threshold proposed by the BEPS initiative should of course require subsequent local law (and potentially DTT) changes.

Whilst not all Middle East countries are OECD members, several Middle East countries have already signed or formally expressed their intention to sign the OECD's Multilateral Instrument (“MLI”), which is a mechanism the OECD have developed for implementing swift and multilateral changes to DTTs. This does mean that we can expect a number of the BEPS proposals, including BEPS Action 7, to be formally captured by DTTs in the Middle East soon.

Further, the BEPS project is expected to lead to an increased focus by Middle East tax authorities on identifying and taxing PEs. Where DTTs are not relevant, there is a mix of sophistication around the extent of domestic PE definitions; some being closely aligned to the OECD Article 5 definition, with others being very broad. Whilst the DTT network across the Middle East has increased dramatically over recent years, there are still many gaps, and the practical experience and application of DTTs remains inconsistent. This creates uncertainty in this regard for businesses operating in the Middle East.

In practice, PE provisions are often interpreted very widely by the local tax authorities and the circumstances that have given rise to a PE have, in certain situations, been quite minimal. In the KSA, for example, the tax authorities adopt a virtual PE concept, where no physical presence in the KSA is required for establishing a PE where there is the provision of long-term (i.e., more than 183 days in any 12-month period) services to customers in the KSA. This is generally only being applied in circumstances where DTT benefits are sought by the taxpayer; however, it is a worrying development.

The potential exposure to virtual PEs has further increased through the use of technology and the growth of electronic commerce activities within multinational organizations. The link between digitalization and PE risk was initially mainly related to server PEs but has more recently moved into the context of cloud computing, which allows for the hardware (servers) to be further away from the customer (i.e., not in the same jurisdiction). In this context, tax authorities globally are considering whether to qualify an online store or website as a PE even though no servers are situated in that country and no activity was performed through human means or assets located in that country. This is an area to monitor closely.

Practical Examples

We have set out some recent practical cases to illustrate some of the potential issues (of course case by case situations need to be looked at based on relevant facts).

Figure 3

Figure 3: In this case, employees of GCC Company provided technical support services to customers on a “fly-in fly-out basis” in GCC Country 2. On average, GCC Company employees spent no more than two weeks in GCC Country 2 in a given calendar year.

As the relevant tax law did not specify a minimum duration for an activity to create a PE, the relevant tax authorities in GCC Country 2 recognized a PE in the above case.

Further, the relevant tax law also contained a “force of attraction” rule, according to which any income derived by the nonresident from the sale of products or rendering of services in that country which are similar to those sold or rendered through the nonresident's PE in GCC Country 2, will also be attributed to the PE and taxed accordingly. This resulted in significantly more income being required to be reported in the PE's tax return.

Figure 4

Figure 4: In this case, products were sold by GCC Company to customers in GCC Country 2. In addition, employees based in GCC Country 1 provided remote after-sales technical support services to customers in GCC Country 2.

The relevant tax authorities taxed all income arising from the customer contracts, even though no physical activities were performed in-country, on the basis that the income was locally sourced income.

Figure 5: In this case, a GCC-based company entered into an agency agreement with an independent agent in another Middle East country, who negotiated contracts with customers on behalf of GCC Company. While the agent was providing agency services to several principal companies, the agent dedicated most of its time during the year to contracts concluded by GCC Company.

On that basis, the relevant tax authorities in the Middle East country recognized a PE of the GCC Company and taxed the income accordingly.

Potential Risk Factors

As indicated in these simplified case studies, there are various scenarios that can drive a PE risk, and the level of this risk will of course vary with the type and extent of the activities carried out by companies operating in the Middle East. Based on our practical experience, companies engaged in the following activities or facing the following fact patterns should consider their PE risks in the Middle East region if they have:

  •  short-term business visits;
  •  employees permanently based in a jurisdiction other than that of their employer;
  •  employees or project teams temporarily based in a jurisdiction other than that of their employer;
  •  cross-border secondment arrangements;
  •  travelling sales and/or marketing staff or investment teams;
  •  consultants/agents in foreign territories involved in any level of negotiation, sales and/or marketing; and;
  •  inventory in a foreign country.

Indeed, there are also other more complex scenarios, and even where risks have been considered on a historical basis, or where prior transfer pricing arrangements have been put in place, recent PE developments do mean that most groups in the Middle East region should be reassessing this position.

Allocation of Profits to a PE and Transfer Pricing

Once it is determined that a PE exists under the domestic legislation or a DTT (if applicable), an important question arises as to how much of any profits, assuming there are profits, should be allocated to the PE and on what basis.

Most countries in the Middle East that have PE rules in their domestic legislation determine the profits to be allocated to a fixed place of business PE on an actual profit basis (i.e., based on books and records to be maintained locally). However, deemed profit allocations do also exist in some countries, or in certain scenarios. In the case of no physical presence, we have also seen Middle East countries generally attribute the entire profits resulting from the performance of contracts with local customers to the local PE.

However, Middle East countries have also started adopting the OECD concept of treating a PE as an independent and separate entity for the allocation of profits to a PE, in DTT scenarios as well as under domestic rules.

Article 7 of the OECD MTC sets out guidance around the attribution of profits to a PE and recommends that profits attributable to a PE are those that the PE would have derived if it were a separate and independent entity engaged in the same or similar activities under the same or similar conditions.

Indeed, Qatar, for example, has adopted the Authorized OECD Approach (“AOA”), which is a broad methodology (and globally accepted) for the attribution of profit. The AOA sets out that the profits to be attributed to a PE are the profits that the PE would have earned at arm's length, in particular in its dealings with other parts of the enterprise, taking into account the functions performed, assets used and risks assumed by the enterprise through the PE and through the other parts of the enterprise.

The AOA is based on a two-step analysis. The first step includes hypothesizing the PE as a separate and independent enterprise. Figure 6 summarizes the typical analysis to be performed under step 1 of the AOA.

Figure 6

As illustrated in Figure 6, the analysis starts with step (A), where the relevant assets and risks are identified. As part of step (B), the significant people functions (“SPF”s) relevant to the attribution of economic ownership of assets and the assumption of risks, are determined. Under step (C), assets and risks are allocated to the PE on the basis of the determined SPFs. As part of step (D), capital is attributed to the PE based on the assets and risks attributed to the PE. As a final step (E), dealings are recognized and the nature of the dealings is determined.

As part of the second step, the recognized dealings are priced on an arm's length basis. The transfer pricing analysis to be performed is thus based on the local transfer pricing rules of the respective jurisdiction.

Qatar, for instance, makes specific reference to the OECD Transfer Pricing Guidelines for the determination of comparability between the recognized dealings and uncontrolled transactions and the selection and application of the most appropriate transfer pricing method.

As outlined above, the AOA fundamentally changes the assessment of PE profits and essentially aligns the PE profit allocation with that of a subsidiary. We anticipate that the limited experience of Middle East tax authorities with the AOA, and the remaining areas of uncertainty in the approach, will increase disputes on the profit attribution to PEs. This will likely increase the importance of clear and concise transfer pricing documentation for PEs, and proactive defense mechanisms such as Advanced Pricing Agreements (“APA”s) for PE profit attribution may become more common.

Going Forward

So, can an office that doesn't exist be taxed in the Middle East? This is indeed a risk and potentially just the beginning of the story!

We believe that multinational companies operating in the Middle East (both locally based, or based outside the region) are likely to experience increased PE risk and challenge from tax authorities in the region, mainly due to the recent international developments as discussed above, but also combined with the rather ambiguous PE application adopted by certain tax authorities.

Undeclared PEs could of course result in unexpected tax assessments (as well as penalties and interest) over multiple historic years. Once a PE is deemed to exist by the tax authorities, an appropriate level of profits must be attributed to the activities that are performed in the jurisdiction.

Given this backdrop, we are seeing an increasing number of companies in the Middle East region looking at these issues, assessing their risk and developing further guidelines as a result in order to mitigate or address such issues appropriately.

Mohamed Serokh is a Tax and Transfer Pricing Partner, Schervin Pouyan is a Transfer Pricing Manager, Jochem Rossel and James Pollard are Tax Partners with PwC Middle East, based in the UAE. Their comments are intended to provide a perspective only, and are the views of the authors in their individual capacity. The comments made above are the authors' own and are not a formal view of PwC. The authors may be contacted at:;; and

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