Resident of Country AWants to Act in Country B

Presented by Shimon Yarel

What makes an activityoutside of your own country

fall into the definition of"Permanent Establishment"?

Requiring to adhere to the tax liabilitiesunder the OECD treaty and when does this happens.

Organization and business activities in many industries underwent many changes over the last decade.

Manufacturers started to establish factories in countries with lower labor costs and with resources that are not available in their own country.

Exporters began opening representative offices and other marketing ventures in key marketing targets all over the world.

The world became a global world and the current trend of many companies is to become multi-national.

In the traditional manufacturing and commercial business the intense competition in the markets, continuously decreases the margin between the manufacturers, wholesalers, retailers and final users. Global economic crisis and other parameters also causes a continual decrease in profits.

The global economic environment forces the company to look for more cost-effective solutions in the manufacturing side on one end and in the marketing side on the other. Technology companies with new products are looking for R&D centers and for marketing support.

The consequence of this situation is that companies startto be active in countries where cost-effective solutions exist for their businesses.

This presentation is meant to provide basic information regarding taxation, HR, and various other factorsthat should be taken into consideration when initiating businesses in different countries.

In all of the “Doing Business” brochures that are available on the BKR website, we notice that one basic question triggered the required solution and company structure.

The question is:

When business activities in a different country creates a Permanent Establishment (“PE “ ), which local tax liabilities, according to the tax treaty between the two countries, are applicable?

Permanent Establishment The definition of "permanent establishment“is derived from the OECD’s treaty model. Therefore, countries that are in this organization must interpret the tax treaties according to the OECD guidelines.

Other countries usually adopt the OECD model of tax treaties. In most of the treaties the same articles refer to the term "permanent establishment".

According to Article 5 of the OECD treaty a “permanent establishment” is:

"A fixed place of business through which the business of an enterprise is wholly or partly carried on".

The term refers primarily to a physical place by which a resident of Country A engages in industrial or commercial activity in Country B.

The section does not interpret the meaning of the term "fixed" and therefore the term must be interpreted by its reasonable meaning which requires a certain degree of continuity in order to define such a place as a permanent establishment under article 5(1) of the OECD tax treaty.

The test is not necessarily physical.For example, a foreign company who has regular activitiesin Country B, but has no permanent offices in Country B, will still be considered as a permanent establishment in Country B.

In most tax treaties signed by countries, the existence of a permanent establishment depends upon the activity of the establishment – "industrial or commercial activity".The exact form of this term is not defined in the treaty.

However, Article 8 (5) of the treaty defines the term "industrial or commercial profits".

Industrial or commercial profits includes, but is not limited to, income derived from manufacturing, mercantile, banking, insurance, agricultural, fishing, or mining activities,the operation of ships or aircraft, the furnishing of services (not by an individual) etc.

The same interpretation should be given to the term "industrial or commercial activity".

In any case, these terms should be interpreted accordingto their logical meaning.

I.E. - All activities carried out within the businessand are related to manufacturing or commercial activities shall be included in the definition.

In contrast, non-business activities (for example, a citizen holding a private Chicago apartment for rent), will not be considered an industrial or commercial activity, therefore not creating a permanent establishment under article 5(1).

Fixed place of businessArticle 5(2) of the l United States tax treaties includes a list of ten cases in which a place of business will be considered as a "Fixed place of business".Cases presented are examples only and are not a closed list.A place included in this list will be considered as complying with two conditions:a.The existence of a fixed place (address) of businessb.this fixed place of business implies a continuation in business activity.

In most of the examples listed below the nature and the appearance of the activity indicates its being a fixed place of business:A branch, an office, a factory, a warehouse, a workshop,a farm or plantation, a store or other sales outlet, a mine,a quarry or other place of extraction of natural resources,a building site, or construction or assembly project (for a period of more than 6 months), the maintenance of substantial equipment or machinery (for a period of more than 6 months).

Article 5(3) of the treaty specifies which places and activities will not be considered as a permanent establishment notwithstanding articles 5(1) and 5(2).

Applicable to all cases is their low level of activity or their being related to the main activity:

• The maintenance of a stock of goods or merchandise for the purpose of storage, display, or delivery and which are not for the purpose of sale.

• Processing of goods belonging to the resident by another person (subcontractor).

• The maintenance of a fixed place of business for the purpose of collecting information for the resident, purchasing goods or merchandise, advertising or for similar activities which have a preparatory or auxiliary character for the resident.

Processing of goods or merchandiseArticle 5(4) of the tax treaty states that even though a resident of country A does not have a permanent establishment in country B under paragraphs 5(1) and 5(2), such resident will be deemed to have a permanent establishment country B if such resident sells in country B goods or merchandise which either were:a.subjected to substantial processing in country B (whether or not purchased in country B). •Were purchased in country B and not subjected to substantial processing outside country B.

For example: A U.S. jewelry company that uses Israel

as a platform for the European market.

The diamond processing is performed in Israel.

If the company will sell part of the diamonds in Israel instead of selling them in Europe, the U.S Company will be considered as a "permanent establishment" in Israel.

The incentive provided by the treaty is limited only to a case in which the company uses Israel as an intermediary, performing only the diamond processing.

Via an agentAlso, a non-independent agent acting in country B on behalf of a resident of country A will be deemed to constitute a permanent establishment for the entity from Country B.

"Permanent establishment" in regards to an independent agent is defined in article 5(5) of the United States tax treaties.

This article discusses the case where a resident of country A acts in country B via an agent.

There is a distinction between two types of agents:

1.An agent with an independent status- whose activities include: independence regarding foreign residency guidelines, running the business himself, conducting business activities not within the entity of the foreign company and mainly - independent non-related other business.

However, each case must be examined according to the individual circumstances.

2. Agent of a non- independent status – In this regard,

article 5(5) states that a person acting in country B on

behalf of a country A residence, will be deemed to

constitute a permanent establishment if: the agent acting on

behalf of a resident of country A, is an agent of an

independent status; the agent has an authority to conclude

contracts in country B in the name of the foreign resident

from country A, and regularly uses this right.

The combination of these activities requires the resident from country A to be perceived as performing - via its representative in the country B where the agent acts, or via employing employees directly by him in country B - standard commercial activity and therefore is considered as having a permanent establishment in country B.

Trade fair or conventionA resident of country A shall not be deemed to have a permanent establishment in country B merely because such resident sells at the termination of a trade fair or convention in country B, goods or merchandise which were displayed by such resident at the trade fair or convention. The trade fair exception is not intended to apply with respect to goods in the resident’s inventory [article 5(7)].

Sales during and at the end of a trade fair or convention in the country B is a wide field allowing sales during a few weeks in a way that ties the sales to the trade fair or convention.

One of the ways of selling is to generate sales by employing local employees before, during, and aftera trade show or convention without creating a PE in country B.

Staff employment Many countries permit foreign residents to be registered in their countries as authorized and registered employers.

This registration does not create a permanent establishment automatically and is not subject to prior registration as a foreign entity in the register of companies or register of commerce in country B.

It means that as long as the terms for having a PE do not apply, a resident of country A can employ local employees in country B without paying corporate tax on income tax generated in country B and without being subject to transfer pricing between country B and country A.

This process enables a company from country A to conduct business in country B that does not create a PE, at least in the first month up to a year.

Usually, the common structure is that the local employees generate the business, and the contracts are signed directly between the main entity in country A and the customer in country B. The billing is accordingly.

The main entity in country A finances the payroll costs of its employees in country B via a payroll provider and a trust account of a CPA .

This is an area where we can provide services to foreign entities in our countries as a first step, assist them in developing their activity as a Permanent Establishment, and provide them with additional services as required.