Subsidiary or Permanent Establishment: A Strategy Guide

When setting up shop in a new jurisdiction, be it through a conscious effort or more or less mindlessly, the question always pops up: should we incorporate a subsidiary or just proceed as a branch [aka: a ‘Permanent Establishment’]?

To put that into perspective: it happens often enough that a company never really made a conscious decision to set up a Permanent Establishment rather than a Subsidiary; business simply grew and as it did, suddenly a foreign presence became substantial enough to trigger taxation. And the company may have realized this themselves first and addressed the related obligations proactively, or they were less fortunate and a foreign tax Authority took note first and slapped them with tax assessments and potential non-filing penalties.

There’s much more value in your tax budget if you can use it for strategic planning rather than fending off dragons and fighting fires, which is why we like to be involved sooner rather than later in expansion plans. And as tax advisors, the ‘Sub or PE’-fork in the road is always a design item in the corporate plan. In this blog post, we walk through some basic principles of foreign taxable presense, the similarities and differences between subsidiaries and permanent establishments, certain practicalities and our rules of thumb.👍

The Wheeler & Co. Case: Specialized Wheels entering the Dutch Market.

When you embark on a business venture abroad, us tax folk first look at whether you hit ‘taxable presence’ marks. To complicate matters, these marks may be different between types of taxes [like Corporate Income Tax or Wage Tax or VAT] and between countries [i.e.: some countries have lower thresholds than others]. But they have in common that from a certain ‘robustness’ on, the venture abroad is no longer just a tax free probe but a taxable foundation. Let’s zoom in.

Imagine that our case revolves around Wheeler & Co., a startup business from Brighton, England, that makes incredibly smooth wheels for rollerskates – out of recycled plastics no less. At one point, Wheeler & Co. sees an oppoprtunity in the vibrant Dutch rollerskating community after having attended a breakout session at an international skater convention and wants to get involved.

The company recruits Sophie, a Dutch resident of The Hague with a history in sales and an avid skater, to head the expansion and pursue market share in the Netherlands. Convinced that this won’t take long, Wheeler, Co. rents some space in a local storage and ships inventory to it, so that Sophie can display the Wheeler Ware and deliver quickly. Skaters are an impatient bunch, after all.

Wheeler & Co. calls the Archipel offices; as they want to get off to a clean start, they want to ensure that they observe their obligations and capture their benefits. And so they ask:

Do we have to file and pay Dutch Wage Taxes?

Where Wheeler & Co. is Sophie’s employer and Sophie generally does het work in the Netherlands [which would align with the ambition of making it big on the Dutch market], Wheeler Co. would indeed have Dutch Wage Tax olbigations.

Based on Article 6 of the Dutch Wage Tax Act, a ‘Withholding Agent’ for wage tax purposes is any body with employees that are in scope of Dutch wage tax. And based on Article 2 of the Dutch Wage Tax Act, such an ‘Employee’ is any Dutch resident person that has entered into an employment arrangement with a Withholding Agent and works in Dutch territories.

Quickly jumping over many technicalities and details, this broadly means that ‘foreign’ companies must do Dutch wage tax compliance and withholding if they [1] employ a Permanent Representative, [2] employ Employees through a Permanent Establishment for Corporate Income Tax purposes, and/or [3] have Dutch Employees and register as a Withholding Agent.

So: chances are that Wheeler & Co. has Wage Tax obligations in the Netherlands, for instance because they have a Permanent Establishment or Permanent Representative in the Netherlands. And even if they don’t have to engage in Dutch wage tax withholding and compliance, they may want to, in order to gain access to certain beneficial regimes, and in order to nip in the bud any Wage Tax withholding discussions [including backpay assessments] further down the road:

Do we have to file and pay Value Added Taxes?

When considering VAT, the first step is to determine if the company or person qualifies as a VAT-entrepreneur. According to Article 7, sub 1, of the Dutch VAT Act and Article 9, sub 1, of the EU VAT-Directive, a VAT-entrepreneur is anyone who independently carries out economic activities, aiming for sustainable income. Occasional activities, therefore, do not qualify [just imagine; anyone selling their old rollerblades on Craigs List would have to register for VAT!].

Sophie, employed by Wheels & Co. in the Netherlands, plans to sell goods within the EU in a business capacity. This makes Wheels & Co. a VAT-entrepreneur and establishes a ‘Fixed Establishment’ in the Netherlands. This establishment must have permanence and suitable resources to operate.

Note that the ‘Fixed Establishment’ concept for VAT purposes differs from the ‘Permanent Establishment’ for corporate tax. Meeting its thresholds, which are linked less to ‘brick an mortar’ and more to permanence of business, triggers the obligation of a VAT registration, a VAT Identification Number, and periodic VAT returns. The VAT also status affects the ‘place of supply’ and the use of the reverse charge mechanism.

So: upon registration as a VAT Entrepreneur in line with their obligations, Wheels & Co. receive a VAT number. Then, importing the goods from the UK into the EU incurs a 21% import VAT, payable upon entry. This VAT can be deducted in the periodic VAT returns as ‘input VAT’, though it may still be unfavorable to cashflow as the VAT needs to be paid in advance at the border. Obtaining an Article 23-license would allow Wheels & Co. to defer the import VAT until the goods [the wheels!] hit circulation [are sold]:

After clearing customs, Wheels & Co. can sell goods within the EU, charging VAT based on customer type and location.

Do we have to file and pay Corporate Income Taxes?

This depends on whether Wheeler Co.‘s presence in the Netherlands surpasses the threshold of a Permanent Establishment or whether Sophie’s setup makes her a Permanent Representative. What does this mean? Put briefly, the concept of a Permanent Establishment came to be as a measure to determine whether a foreign company’s presence is substantial enough to tax. In non-tax-talk, a Permanent Establishment is often refered to as a foreign ‘branch’; not separately incorporated, but physically palpable presence in another country.

As per the OECD-Commentary to Article 5 [“Permanent Estabblishment”] of the OECD Model Treaty: “The main use of the concept of a permanent establishment is to determine the right of a Contracting State to tax the profits of an enterprise of the other Contracting State. Under Article 7 a Contracting State cannot tax the profits of an enterprise of the other Contracting State unless it carries on its business through a permanent establishment situated therein.”

Under Dutch tax law, as per Article 3 of Duth Corporate Income Tax Act, the ‘Permanent Establishment’ [PE] threshold [including the Permanent Representative] which triggers Dutch domestic taxing points, is generally linked to the PE-definitions stated in an applicable treaty. This means that for Wheeler Co., we have to look at the Double Tax Treaty [DTT] as concluded between the United Kingdom and the Netherlands.

Put briefly, as per said Treaty’s Article 5, a Permanent Establishment refers to a ‘fixed place of business’ where an enterprise conducts its operations, either wholly or partially. This includes places like management offices, branches, factories, workshops, and sites for extracting natural resources. However, certain activities, such as storage, display, or delivery of goods, and other preparatory or auxiliary activities, do not constitute a permanent establishment, as this threshold would be too low, making admin life too difficult. Agents who ‘habitually conclude contracts on behalf of an enterprise’ [‘Permanent Representatives’] can also create a PE, unless their activities are limited to those excluded under the treaty [i.e.: auxiliary activities].

Now in Wheeler & Co,’s case, it may be up for debate whether the PE-thresholds are met. Why? Much will depend on the terms of Sophie’s contract – can she conclude or ‘materially prepare’ contracts on Wheeler & Co.‘s behalf? If so, there is an increased chance that Sophie is a ‘Permanent Representative’ which is a brick-and-mortar-light form of a PE. The nature of the storage space plays a role as well; simply maintaining some stock in the Netherlands should not create taxable presence, but when this square footage ‘evolves’ into, for instance, a showroom, a fitting room and an office for Sophie, things get PE-isher…

What’s the consequence? If Wheeler & Co has a PE in the Netherlands for Corporate Income Tax purposes, it’s Arm’s Length profits need to be determined, and Wheeler & Co will need to file [and pay] Corporate Income Tax returns in the Netherlands to pay up on the portion of its worldwide profits allocable to Sophie’s efforts.

So what do we conclude?

In the wake of its spectacular Dutch market entry, Wheeler & Co. will also need to establish some Dutch tax compliance:

Note that the applying tax Treaties and Directives should make sure that whatever is taxed here is not taxed elsewhere. This means that the whole ‘Permanent Establishment’ -or more accurately: taxable presence- thing is mainly a matter of allocation: where is tax due. And when a company, like Wheeler & Co, spans multiple countries, so do its tax obligations. So what is there to talk about? Plenty!

What exactly is a ‘Permanent Establishment’ aka a Branch?

When we take a ‘generic case’ and look at the OECD Model Treaty, which is the go-to ‘template’ for individual bilateral Tax treaties, Article 5 gives the basic building block of a mutual PE-definition:

So put very briefly: a Permanent Establishment is when you do business in another country where that business is not a business trip, errand run or just an online sale, but hassome permanence and physical presence. I always like to use the example of grocery stores. Imagine that a UK Grocerer opens a super market in the Netherlands. It would seem logical that the profit allocable to said super market should be taxable in the Netherlands, even if the UK Grocerer has not incorporated a separate Dutch legal entity for it – making the Dutch super market a direct part of the UK Grocerer’s balance sheet. *That* is the concept of a PE. And in order to not make life too difficult, super thin presence doesn’t quite count yet [imagine you’d have to file corporate income tax in every country where your stockpile may linger for a little bit on the way to it’s final destination].

But of course, there are anti-abuse rules. For instance, if you’d fragment several of the above caveated activities within a single jurisdiction over a series of different outside subsidiaries with the intention of avoiding amalgamated PE-status, Article 5 paragraph 4.1 of the OECD-Model Treaty steps in, mixes these activities and identifies a PE still. For example:

And what is Permanent Representative?

The ‘Permanent Representative’ principle establishes that an enterprise is also considered to have a PE if ‘a person acting on its behalf habitually concludes contracts or plays a principal role leading to the conclusion of contracts without material modification by the enterprise’. These contracts can be in the name of the enterprise, for the transfer of ownership or the right to use property owned by the enterprise, or for the provision of services by the enterprise. Unless their activities are limited to those that would not constitute a PE if conducted through a fixed place of business.

Note that the principle *does not* apply if the person acts as an ‘independent agent’ carrying on business in the ordinary course, unless the agent acts exclusively or almost exclusively on behalf of closely related enterprises [in which case they are not considered ‘independent’ agents]. This principle ensures that enterprises cannot avoid tax obligations by using intermediaries to conduct significant business activities in a Contracting State.

What does this mean? If Sophie could conclude meaningcul contracts on Wheeler & Co.‘s behalf, or if she could all but conclude them [a popular old-fashioned way of circumventing this principle was to require a final signature from HQ], the profits allocable to her involvement would be taxable in the Netherlands even if Wheeler & Co. wouldn’t separately rent her an office space. But if she were a ‘hired gun’ who sourced deals, for Wheeler & Co. but for other companies too, Wheeler & Co. wouldn’t have to file a tax return for their Dutch deals [instead: Sophie would send them an invoice, and file her taxes here anyway].

And what is a Subsidiary?

A subsidiary is a legal entity owned by another legal entity, for instance: a Dutch incorporated BV [Limited Liability Company] the shares in which are owned by a UK Limited. This separate entity would have its own Assets & Debts, and it would hold its own risks and liabilities. This means that as long as the legal entity is properly maintained [e.g.: annual accounts are filed, contracting flows are observed], it be separately liable for its own dealings, meaning that its Shareholder is not accountable for resulting liabilities past any capital amount it has invested.

So… what’s the difference?

Briefly put: a Subsidiary is a separate company, albeit one that is controlled by another company – the parent company. Usually, the parent company will own more than 50% of the subsidiary’s stock [often even 100%], giving it control over the subsidiary’s operations and decisions. Nonetheles, subsidiaries are separate legal entities from their parent companies, meaning they have their own management, finances, and liabilities.

A Permanent Establishment on the other hand, is not a separate company but a foreign part of the ‘main entity’. This concept is crucial for tax purposes, as it determines the tax obligations of a company in the foreign country. From a legal perspective, however, the PE is not a separate company meaning that the main entity is actually the signatory to any contracts that are allocable to the PE.

To put that into perspective:

Getting Technical: About Withholding Taxes

Many ‘Sub-or-PE’-considerations will not be tax items, but some will be and a common one lies in ‘withholding taxes’. These are regulations that ‘skim’ a percentage off cross-border payments, usually on financial flows. Commmon withholding taxes pertain to dividends, interests and royalties [call them ‘passive income streams’ for the receiving entity]. Put visually:

If Wheeler & Co. were to incorporate a Dutch subsidiary, the Dutch entity would pay corporate income tax on its profits taking into account the Arm’s Length Principle [i.e.: dealings with its parent and the rest of the group should be priced at independent levels when determining the associated costs en incomes]. After it pays the Dutch Corporate Income Tax of 19.0% – 25.8%, the remaining €1.00M of net profits are distributed ‘up the chain’ to the 100% parent in the UK.

In principle, the Netherlands has a 15% Dividend Withholding Tax as per the Dutch Withholding Tax Act. However, there is 100% domestic exemption for -put briefly- dividend payments to >5% shareholders that are ultimate beneficiary receivers resident of a treaty state, provided the setup is not abusive. In addition, the Tax Treaty between the Netherlands and the UK which limits the withholding percentage on such payments to 10% [making that the maximum exposure rather than the full domestic rate, which is relevant should national law ever change].

In Wheeler & Co.’s case, we conclude that no withholding tax will be due on the dividend payment that the Dutch subsidiary makes to its UK parent, meaning it receives the full after-tax profit.

Note that for intra-EU expansions, a series of Directives [such as the Parent-Subdidiary Directive and the Interest and Royalty Directive] mandate cross-border payments without any withholding taxes between >10% related entities, in order to integrate the ‘single market’. For more background:

If the Dutch presence were to have been set-up as a Permanent Establishment [i.e.: Wheeler & Co. did not incorporate a Dutch legal entity for its taxable presence], there would not be a cross-border payment. Instead, Wheeler & Co. Ltd, the UK ‘main entity’, would file a Dutch Corporate Income Tax Return and report its Arm’s Length taxable profits and pay corporate income accordingly, equally at the 19.0% – 25.8% rate.

The conclusion here is that the ultimate tax filing and paying outcomes, as well as the net returns for the UK ownership structure are identical. However, from a legal perspective, the subsidiary route offers limited liability for said structure, at the expense of a marginally more demanding legal & accounting framework [maintaining two entities as opposed to one].

Note that if the situation were the other way around and Wheeler & Co. would have been a Dutch company opening shop in the UK, Dutch tax law would apply a 100% Participation Exemption for the dividends received from the UK subsidiary, and a 100% PE Profits Exemption for the profits allocated to and taxed in the UK. From an ownership perspective, the pickup taxes would therefore be identical as well.

Getting Technical: Transfer Pricing Aspects

When analyzing the allocable profitsand Arm’s Length Pricing, we would need to apply Transfer Pricing principles; the rules and methods for pricing transactions within and between enterprises under common ownership or control. Transfer Pricing principles exists to ensure that transactions between related parties are conducted at arm’s length, meaning the prices charged are comparable to those charged between independent parties in the open market. This helps prevent profit shifting to low-tax jurisdictions and ensures fair tax distribution among countries.

There are five OECD-recognized Transfer Pricing methods:

1. Comparable Uncontrolled Price (CUP) Method: Compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction.
2. Resale Price Method (RPM): Determines the transfer price by subtracting an appropriate gross margin from the resale price to an independent party.
3. Cost Plus Method: Adds an appropriate markup to the costs incurred by the supplier of goods or services in a controlled transaction.
4. Transactional Net Margin Method (TNMM): Examines the net profit margin relative to an appropriate base (e.g., costs, sales) that a taxpayer realizes from a controlled transaction.
5. Profit Split Method: Divides the combined profits from controlled transactions in a way that reflects the value of each party’s contribution.

These methods help ensure that intercompany transactions are priced fairly and in line with market conditions. We discuss them in further detail in these two posts:

As a Permanent Establishment does not need to maintain its own statutory accounts [after all, it is just a ‘part’ of the Main Entity], the bookkeeping may seem easier at first glance. However, for tax purposes, some sort of ‘pretend accounts’ like a balance sheet and a profit and loss statement may need to be construed as the OECD’s TP Guidelines -under reference to the Report on the Attribution of Profits to Permanent Establishments– intend for there not te be profit tax related reasons to incorporate and opt for a subsidiary, or not and just go straight in. That’s why for the Arm’s Length Profit Allocation to a PE, the Guidelines prescribe the Functionally Separate Entity approach:

“The authorised OECD approach is 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, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise. […]

The interpretation of Article 7(2) under the authorised OECD approach is that a two-step analysis
is required. First, a functional and factual analysis, conducted in accordance with the guidance found in the Guidelines, must be performed in order to hypothesise appropriately the PE and the remainder of the
enterprise (or a segment or segments thereof) as if they were associated enterprises, each undertaking
functions, owning and/or using assets, assuming risks, and entering into dealings with each other and
transactions with other related and unrelated enterprises.

Under the first step, the functional and factual analysis must identify the economically significant activities and responsibilities undertaken by the PE. This analysis should, to the extent relevant, consider the PE‘s activities and responsibilities in the context of the activities and responsibilities undertaken by the enterprise as a whole, particularly those parts of the enterprise that engage in dealings with the PE.

Under the second step, the remuneration of any dealings between the hypothesised enterprises is determined by applying by analogy the Article 9 transfer pricing tools (as articulated in the Guidelines for separate enterprises) by reference to the functions performed, assets used and risk assumed by the hypothesised enterprises. The result of these two steps will be to allow the calculation of the profits (or losses) of the PE from all its activities, including transactions with other unrelated enterprises, transactions with related enterprises (with direct application of the Guidelines) and
dealings with other parts of the enterprise (under step 2 of the authorised OECD approach).

The hypothesis by which a PE is treated as a functionally separate and independent enterprise is a
mere fiction necessary for purposes of determining the business profits of this part of the enterprise under
Article 7. The authorised OECD approach should not be viewed as implying that the PE must be treated as a separate enterprise entering into dealings with the rest of the enterprise of which it is a part for purposes of any other provisions of the Convention.”

As a result, the profit determination for a PE is marginally different from that of a subsidiary, and may require a separate functional allocation of profits, costs, assets and liabilities. The cross-border ROI-payments are governed by Article 7 of the OECD-Model Treaty [Business Profits] as opposed to Articles 10 [Dividends], 11 [Interests] and 12 [Royalties]. Something to keep in mind!

So what do we Conclude?

As predominantly Law School folks, we would generally say that incorporating a Subsidiary is generally the superior conscious step over sprouting a Permanent Establishment when expanding abroad. Especially where minimum capital requirements are low [€0.01 in the Netherlands] and incorporation logistics and costs are limited, the blocker on foreign -and therefore often unknow and unpredicatble- legal risks and costs quickly outweigh the marginally higher administrative burden of maintaining an additional legal entity, while the tax burdens are generally designed to be largely similar if not identical.

However, in specific cases where such costs are very high and/or where no or a very poor treaty applies, one may find that minority case in which a Permanent Establishment is the superior option. Either way, we are happy to advise and quarterback the process, both inbound and outbound. We’ve got good preferred suppliers at home, as well as abroad through the CLA Global network. So: let’s talk.

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