International Tax
1882. Permanent establishment in respect of services rendered
October 2010 - Issue 134

Article 5(1) of most Double Taxation Agreements ("DTA’s") concluded between contracting States provides that a permanent establishment exists or is created when a foreign enterprise has a fixed place of business through which its business is wholly or partly carried on. The existence of a permanent establishment in another State, in terms of the DTA’s shifts the power of taxation from the country of residence or effective management to the other State in which the foreign enterprise conducts its business.

The requirements for a permanent establishment under Article 5(1) are; firstly that there must be a fixed physical location in the other State, secondly, this location should be used for the carrying on of the business of the foreign enterprise and finally, the business of the foreign enterprise must be partly or wholly carried on, at that location.

In addition, Article 5(2) of the DTA’s provides that the term "permanent establishment" includes especially a place of management, branch, office, factory, workshop, mine, an oil or gas well, a quarry or other place of extraction of natural resources, warehouse, store, ship, drilling rig, building site or construction, installation or assembly project or supervisory activities in connection therewith, where such site, project or activities lasts more than twelve months.

The phrase "includes especially" in Article 5(2) means that the requirements for a permanent establishment as set out in Article 5(1) apply to all of the places referred to in Article 5(2). Hence, when a foreign enterprise has an office or warehouse or access to same in the other State, an enquiry must be conducted as to whether Article 5(1) applies, namely, to establish whether such office or warehouse constitutes a fixed place of business through which the business of the foreign enterprise is carried on. The mere existence of the office in the foreign State will not create a permanent establishment for the foreign enterprise.

This view is held to be trite law by leading commentators on Model Tax Conventions. In fact, the Organisation for Economic Co-operation and Development ("OECD"), in its commentary on the Model Tax Convention on Income and on Capital provides that the Contracting States should interpret the terms listed under Article 5(2), "a place of management", "a branch", "an office", etc. in such a way that such places of business constitute permanent establishments only if they meet the requirements of Article 5(1).

In addition, P Baker, in his commentary (Double Taxation Conventions, Loose-leaf Edition at Para. SB.14 p5-2/7), comments that since a place of business within the illustrative list of Article 5(2) must meet the requirements of Article 5(1), one wonders whether the illustrative list serves much purpose any longer. Baker expresses the concern that there is a danger that a revenue authority or tribunal might conclude that a place of business within the illustrative list was a permanent establishment even though it did not satisfy all of the requirements of Article 5(1).

We have recently become aware of a few instances in SA where Baker’s fear has been realised. In this regard, the provisions of the United States of America and South Africa DTA ("USA / SA DTA") provide a valuable example. Article 5(2)(k) of the USA / SA DTA provides that the term permanent establishment includes especially:

"(k)  the furnishing of services, including consultancy services, within a Contracting State by an enterprise through employees or other personnel engaged by the enterprise for such purposes, but only if activities of that nature continue (for the same or a connected project) within that State for a period or periods aggregating more than 183 days in any 12-month period commencing or ending in the taxable year concerned."

It has been suggested that the provisions of Article 5(2), should be interpreted to mean that once services are rendered in the other Contracting State, by a foreign enterprise for a period in excess of the 183 days in a 12 month-period, then a permanent establishment has been created for the foreign enterprise and the requirements or provisions of Article 5(1) do not fall to be considered.

In support of the above interpretation, reference is made to the Technical Explanation of the Convention between the United States of America and South Africa, which, in respect of Article 5(2) states the following:

"the furnishing of services, including consultancy services, within a Contracting State by an enterprise through employees or other personnel engaged by the enterprise for such purposes, but only if activities of that nature continue (for the same or a connected project) within that State for a period or periods aggregating more than 183 days in any 12-month period commencing or ending in the taxable year concerned."

There have been attempts to interpret this paragraph of the Technical Explanation to mean that Article 5(1) applies to all of the places listed under Article 5(2) of the USA / SA DTA, except for paragraph (k), which deals with the provision of services.

Such an interpretation appears to be erroneous and not supported by the text, despite an obvious typographical error in the text. It is submitted that a proper reading of the paragraph from the Technical Explanation is intended to provided that in relation to services furnished as set out in subparagraph (k), the "fixed place" requirement under the general rule in Article 5(1) should be disregarded. It could not have been the intention that none of the requirements of Article 5(1) should apply Article 5(2) (k).

It must be noted that the Technical Explanation of the Convention between the United States of America and South Africa is not a protocol or a convention and therefore, while persuasive, it is not binding. Thus, upon a strict reading of the USA / SA DTA, for services rendered in South Africa by an America entity, to create a permanent establishment in South Africa, such services must not only fall within the provisions of paragraph (k), but also that the provisions of Article 5(1) must also apply to these services.

Therefore, according to the USA / SA DTA, the provision of services by an American enterprise in South Africa will only create a permanent establishment to the extent that such services are provided for longer than 183 days over a 12-month period. In addition, such provision of services must also constitute a fixed place of business through which the business of the American entity is wholly or partly carried on.

Editorial comment: This area of tax is likely to be developed further in future. Please see also Article 1851.

Edward Nathan Sonnenbergs

IT Act:S 1 definition of "permanent establishment"

OECD Model Tax Convention-Article 5, 5(1), 5(2) and Article 5(2)(k) of the USA/SA DTA