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The impact of changes to the permanent establishment principle

12 November 2018
– 9 Minute Read


The Organisation for Economic Cooperation and Development (OECD) has for some time now been addressing, on behalf of the G20 and other participating countries, concerns relating to Base Erosion and Profit Shifting (BEPS). 

BEPS is predominately occupied with ensuring that companies do not artificially extract profits from countries tax free. Simplistically, the BEPS philosophy is that income must be taxed where the functions are performed. 

A large part of this is analysing whether international tax laws used for centuries to govern the tax treatment of cross border arrangements remain appropriate for the modern economy (especially the digital economy) and whether they adequately address concerns relating to various areas of tax law, most especially the abuse of treaty benefits.

The OECD has been running various work steams to address the concerns arising from BEPS.  Some of these work streams result in recommendations for countries to include rules in their domestic legislation that would tackle the concerns identified (by way of example, the OECD has recommended the inclusion of or strengthening of control foreign company legislation to address tax leakage through the use of foreign structures that lack substance). 

A further outcome has been a requirement to modernise rules contained in the OECD Model Tax Convention on Income and Capital (Model Convention). This Model Convention is the basis for most of South Africa’s double tax agreements (DTA).  In this regard, one of the outcomes has been an update of the permanent establishment principle. 

A permanent establishment is a key concept used for many years in international tax law. In the context of a DTA it is used to allocate taxing rights to the source state. A resident of one country is typically fully taxable on income arising in another country, where that income is attributable to a permanent establishment of that enterprise in the other country. By way of example, if a UK company generates business profits from South African activities, those business profits would typically only be taxable in the UK, unless the UK company operates through a permanent establishment in South Africa and the profits are attributable to that South African permanent establishment. 

What is noteworthy is that many countries use the permanent establishment principle in their domestic law to tax non-residents deriving profits from their country. Typically countries would legislate their own permanent establishment standard (which may be similar to the OECD standard). 

In South Africa, we seek to tax a non-resident on any South African sourced income, regardless of whether that non-resident has a permanent establishment in South Africa.  By way of example, if a company based in Germany accrues income from services rendered in South Africa, the service fee income would be regarded as South African sourced. This may give rise to a South African tax liability for the non-resident. Of course in this case the non-resident may qualify for tax relief under the DTA between Germany and South Africa.  If the non-resident has a permanent establishment in South Africa to which the service fee income is attributable, the DTA would not restrict South Africa’s right to tax that income.   

What is however key to note is that South Africa has legislated when amounts will be regarded as being sourced in South Africa (Section 9 of the Income Tax Act). Often under our domestic legislation, the source of specific types of income will be dependent on whether the income in question or the asset giving rise to the income is attributable to a South African permanent establishment of the non-resident.

By way of example, the sale of movable goods will be sourced in South Africa, if the good is attributable to a South African permanent establishment of the non-resident. Of course, for this purpose it was necessary to have a definition of permanent establishment in our law. Section 1 defines it as the meaning ascribed to it from time to time in Article 5 of the Model Convention. This means that any changes made by the OECD to the definition of a permanent establishment in the Model Convention, will become part of our domestic law. The permanent establishment rule is also used for other taxing sections in the Income Tax Act, but we are focusing here on its relevance to the source principle.         

Coming back to the OECD BEPS outcomes, we note that not only was it necessary to modernise the Model Convention, it was also necessary to amend existing DTA networks of countries to incorporate these changes. Leaving this to bilateral negotiations would take many years.

For this reason, the concept of the Multilateral Instrument (MLI) was developed. The MLI is a mechanism to undertake changes to a country’s DTA network without having to enter into bilateral negotiations with each treaty partner. South Africa is a signatory to the MLI.  This means that once the MLI comes into force for South Africa (the timing is not yet known), South Africa’s DTA network will be amended through the MLI. 

What is important to note however is that there are certain compulsory changes that all signatories to the MLI need to adopt (the minimum standards chiefly aimed at addressing the improper use of DTAs through treaty shopping arrangements).

Then there are other proposed changes that countries get to decide whether they want to adopt. It is only in cases where both treaty partners have adopted the same changes that the DTA would be impacted. The changes being made to the permanent establishment are optional in the MLI and each country can decide which changes they are accepting.
In the case of a permanent establishment the following updates are made to the Model Convention and we note next to each one whether South Africa has agreed to accept the change into our DTA rules. 

We caution that these changes are in fact complex and below is merely a summary of the changes. You are advised to seek specific advice if you feel these changes may impact your specific facts):

Item being addressed Brief explanation of the item South Africa’s position

Artificial avoidance of permanent establishments through the use of certain agency arrangements 

 This is aimed at ensuring that income is taxed in the source state where in substance an agent operating on a regular basis in that state results in the non-resident earning income, even where the agent is not formally empowered to conclude contracts in the name of the non-resident. This is mainly aimed at dependent agents and a newly introduced concept of a closely-related party. 

 South Africa has reserved its right for this change not to apply to its DTA network. This means that even if a treaty partner of South Africa elects for this standard to apply, it will not apply to residents of South Africa operating in that country.

Artificial avoidance of permanent establishments through the specific activities test  

 The permanent establishment standard contains rules that deem a permanent establishment not to exist where the activities carried on in the other country are so remote from the earning of income, it would be difficult, if not impossible, to attribute income to that activity. The change is aimed at ensuring that this rule cannot be abused and that each activity undertaken in the other country must be considered remote from the earning of income.    

 South Africa has adopted this change.  In this regard there were various options provided. South Africa has adopted option A. This means that if any of South Africa’s DTA partners have also adopted option A, the change will apply to those DTAs.
If you are operating in South Africa and you are arguing that the activities you perform here are auxiliary and/ or preparatory in nature, you are advised to seek confirmation that these imminent changes would not impact your current position.  

Splitting up of contracts 

It is a common practice for companies working on projects that run for longer than six months to break up the various stages of the project or to split these requirements among different group companies to try to avoid the creation of a permanent establishment. This change is aimed at aggregating all these activities to assess holistically whether a permanent establishment arises. 

South Africa has again reserved its right for this change not to apply to its DTA network. Again, where DTA partners have elected this change to apply, the South African DTA network will be unaffected by this change.


As you can see from the above, South Africa has only agreed to one change that would impact on the permanent establishment standard within the South African DTA network. Even then, the change would only impact in cases where the counter-party country has elected the same standard.

The difficulty however is that the OECD new standard for a permanent establishment will come into our domestic law, through the definition of a permanent establishment. No amendment has been proposed for the domestic definition of what constitutes a permanent establishment to align this definition with South Africa’s position on the MLI.

This means that while the South African DTA network may be largely unaffected by the permanent establishment changes (please note that the DTA network is significantly impacted by other changes, especially the minimum standards and you are advised to seek clarity on what impact these changes may have on your structures), the domestic law standard will be impacted and the new laws will play a role in assessing whether a non-resident has South African sourced income. 

Many non-residents based in DTA countries are probably thinking that this anomaly is of no significant consequence because when assessing your tax liability in South Africa, the DTA permanent establishment definition will apply and the wider expanded definition under the South African domestic law would have no impact. 

However the problem is all non-residents that carry on a trade through a permanent establishment (as defined under South African law) or that accrue South African sourced income are required to register as taxpayers in South Africa and file returns.

You are therefore cautioned to assess whether your current activities give rise to South African sourced income or whether your current activities lead to a permanent establishment under South African law (i.e. the expended permanent establishment definition contained in the OECD Model Convention).