Parties entering into cross-border transactions must consider the possibility of the transaction giving rise to a permanent establishment for either party, with an eye to avoiding this problem where possible. Under most international Double Tax Agreements, where a permanent establishment exists, the country in which the permanent establishment is situated will have the right to tax any business profits which are attributable to that permanent establishment.
Generally speaking a permanent establishment arises where a foreign investor has some sort of presence in another country (over and above a back office or storage facility), or where the foreign investor is represented by a dependent agent in that country who habitually exercises an authority to contract on that foreigner's behalf.
It is often quite clear that a permanent establishment exists in relation to a foreign investor and, in these instances, no amount of clever structuring or tinkering will alter this fact. For example, a foreign investor that opens up a place of business in another jurisdiction, or is clearly conducting a physical trade there will find it difficult, if not impossible, to avoid the creation of a permanent establishment.
However, many investments undertaken by foreigners, although they may not amount to the 'carrying on' of a trade or business in the foreign country, can give rise to a permanent establishment and thus make the non-resident taxable in the country where the investment is located. It is these more marginal activities that this article is concerned with.
Consider, for example, an inward bound investment into South Africa. The first issue to be addressed is whether or not a foreign investor is subject to tax in South Africa at all under the Income Tax Act, 1962. Entities or persons that are not tax resident in South Africa will only be subject to income tax locally where the income in question arises from a 'source' in South Africa. Further, non-residents will only be subject to Capital Gains Tax in South Africa in respect of disposals of immovable property, or where the asset disposed of is attributable to a permanent establishment of that non-resident located in South Africa.
Unfortunately the Income Tax Act does not contain a clear and precise definition of what the concept 'source' means. Rather, the rules regarding the source of any particular income arising have been developed under the common law over many years. The courts have frequently held that the source of any income is its originating cause, and this will differ depending on the income in question. Accordingly, each income stream must be tested against these rules and there is no universal rule that can be set out.
Once it has been established that a foreign investor is earning income that arises from a source within South Africa, the permanent establishment issue becomes relevant and it must then be considered whether or not any Double Tax Agreement is applicable, which may provide that investor relief against the source rules.
When applying the provisions of the Double Tax Agreements regarding permanent establishments, the precise facts and circumstances of each investment or transaction are of vital importance in determining whether or not a permanent establishment exists on either of the presence or agency bases. This is because it is a question of degree whether or not an investor's presence in South Africa, or the extent of a representative agent's authority, qualifies under the permanent establishment rules. Problems of degree are inherently the most difficult to adjudicate upon without resorting to seemingly arbitrary criteria to support a particular decision.
In circumstances where an investor is not clearly conducting a trade or operation in another country, it may be relatively uncomplicated to avoid the creation of a permanent establishment in a foreign location through careful planning before implementing the investment in question. Understanding the limits of what will constitute a permanent establishment will often allow non-residents to ensure that they do not, for example, undertake unnecessary steps which are not crucial to the investment but could have given rise to a permanent establishment.
Take for example a non-resident that manufactures products offshore, which it wishes to sell in South Africa. Should it sell its product to a South African distributor on consignment? Should it sell its products out-and-out to the South African distributor, which will then make the full margin on the subsequent sale in South Africa? Should it merely create some sort of franchise relationship where the product is sold by the non-resident as the principal, but with local distributor making some sort of commission income arising from the sale?
The answers to questions such as to these may or may not have a significant impact on whether or not that non-resident will create a permanent establishment in South Africa and thus be brought within the South African tax net.
Therefore, whenever one is considering any sort of international transaction, specialised advice should be sought to ensure, insofar as is possible, that the structures or processes to be utilised for the implementation of the investment do not unnecessarily bring one within the tax net of the country where the investment will take place.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.