Inadvertent permanent establishment

Unintentional Permanent Establishment – A Silent Threat to International Business

This automatic creation has significant tax implications. A lack of intent or knowledge offers no protection against penalties from foreign tax authorities. In the event of a tax audit, ignorance of the rules is often interpreted as negligence, increasing the risk of high fines and late payment interest.

Our lawyers at ARROWS International deal with permanent establishment issues on a daily basis in more than 70 countries worldwide. For an immediate solution to your situation, write to us at consultation@arws.cz. 

Basic Tax Concepts: Where to Find the Rules of the Game?

The basic definition of a Permanent Establishment (hereinafter "PE") is based on Article 5 of the so-called OECD Model Tax Convention. This convention serves as a crucial reference framework for allocating the right to tax profits between the state of residence and the source state.

In the OECD Model Tax Convention, a PE is described as "a fixed place of business through which the business of an enterprise is wholly or partly carried on".

When interpreting a specific Double Taxation Treaty, it is essential to refer to the accompanying Commentary on the OECD Model Tax Convention. It is important to realize that the Commentary evolves, and countries may have specific reservations about different versions (for example, the CZ-AT DTT requires reference to the 2003 version of the Commentary). ARROWS knows these details, which are decisive in the outcome of a dispute.

Distribution of Risks and Taxation: The Three Pillars of an Unintentional PE

The creation of a PE is typically divided into categories, such as a fixed place of business (fixed place PE), a service PE, and a dependent agent PE.

Permanence Criteria: How is a "Fixed Place" PE Created?

A so-called Fixed Place Permanent Establishment requires a certain degree of geographical and temporal permanence in the performance of activities. This includes any premises available to the enterprise (even implicitly) that are used to carry out its core business activities.

It is necessary to correctly distinguish that a PE is not created if only auxiliary or preparatory activities are carried out at the location, such as mere storage of goods or purchasing. The creation of a PE also entails the need to comply with local obligations that go beyond tax law. For example, under Czech legislation, business premises must be properly marked and a legal title for their use must be documented.

If a foreign PE were created in the Czech Republic and failed to meet these obligations, it would face penalties under the Trade Licensing Act, including the suspension of its business activities for up to one year. ARROWS ensures compliance with obligations towards registers and regulators.

Correct Profit Attribution (Authorized OECD Approach)

Once a PE is created, the key question is what portion of the company's profits is subject to taxation in the foreign state. It is always only the profits that can be attributed (allocated) to the PE.

For profit allocation, a modern approach called the Authorized OECD Approach (AOA) is applied. It fully recognizes and reports intra-company transactions, which are valued in accordance with the arm's length principle.

Incorrect application of the AOA or the use of an older (so-called non-AOA) approach can lead to the foreign tax authority taxing a larger portion of profits than is fair, without deducting your intra-company costs (e.g., payments for management services or license fees). This risk can significantly reduce the profitability of cross-border operations.

Our lawyers will prepare legal opinions and analyses to determine the optimal method for establishing the tax base. We also utilize the instrument of a binding ruling on the method of determining the tax base for a tax non-resident. Our lawyers are ready to help you – write to us at consultation@arws.cz. 

Home Office: When the Couch Becomes the Company's Office

Working from home abroad (Work From Anywhere, WFA) represents the most current and least expected risk for corporations, which has become massive following the spread of flexible work arrangements.

The professional community is fully aware of this risk. For example, the Danish Tax Agency confirmed the creation of a PE for a Swedish company on the basis that its CEO worked 40% of the time from his home in Denmark.

This case showed that for a PE to be created, it is not essential whether the activity is aimed at the Danish market. The CEO's activity was purely internal and related to the management of the company in Sweden. However, its significant influence on the daily management of the company and the permanent, planned nature of the work were sufficient to establish a Permanent Establishment. This is a critical insight for all top managers.

According to information from experts, the Czech Tax Administration holds a similar view on planned and permanent work from home, which clearly indicates a global trend of tax authorities tightening their stance on WFA.

Service Permanent Establishment: The 183-Day Trap

A service permanent establishment under Section 22(2) of the Income Tax Act arises from the provision of services (e.g., technical, IT, or consulting) in a foreign state if the time limit set in the relevant DTT is exceeded.

The most common limit for the creation of a service permanent establishment is 183 days in any twelve-month period. This applies, for example, to the provision of IT services.

Tax authorities (for example, in Austria and the Czech Republic) often aggregate the duration of service provision even across different individual contracts and service packages if there is a material connection within a twelve-month period. Entrepreneurs often make the mistake of tracking only the length of individual contracts, not the total time accumulated in the given territory, which leads to unintentionally exceeding the limit.

Legal consultation with ARROWS protects against fines by assessing the risks of time aggregation in advance and proposing contractual structures (e.g., for IT and consulting firms).

Construction Site Permanent Establishment: Risks in Subcontractor Chains

For construction and assembly projects, the test for creating a PE is typically shorter, usually 6 months. The existence of this type of permanent establishment is assessed based on a single location factor, a time factor, and a material factor (the delivery of a complete construction project).

Many general contractors underestimate the danger posed by subcontractors. Even if only your subcontractors are active on the construction site, the time spent on the site by all suppliers is counted cumulatively toward the period relevant for the creation of the general contractor's PE.

Our Prague-based firm ensures the preparation or review of contracts so that the risks arising from the time tests of subcontractors are managed transparently. Need legal help? Contact us at consultation@arws.cz. 

Dependent Agent Permanent Establishment

Another type of unintentional permanent establishment is the dependent agent PE. This situation arises if a person acts in a foreign state who is dependent on the enterprise (e.g., economically) and who has the authority to conclude contracts on behalf of the enterprise, or habitually negotiates such contracts.

If the person is an independent broker or agent, a PE is not created. The crucial assessment is whether the agent has the ability to act in your favor and bind the company without your subsequent authorization. How can you avoid problems? It is key to review all contracts with commercial agents and distributors and ensure that they perform only auxiliary and preparatory roles, without the authority to conclude binding contracts. For an immediate solution to your situation, write to us at consultation@arws.cz. 

Strategic Prevention: Internal Policies, Training, and Audits

Tax authorities always assess the actual state of affairs and the factual activity in a given territory, not just what is written in a contract. Therefore, robust internal policies are key evidence to demonstrate that the company is actively managing and mitigating the risk.

A Work From Anywhere policy must contain clear limits on the length of stay abroad and a list of positions that are not permitted to work across borders (e.g., C-level managers, sales representatives, purchasers). It must also include a monitoring protocol (e.g., recording of stays).

Drafting internal policies that protect against fines and penalties is one of the key services that ARROWS offers. Our lawyers have many years of experience with this agenda. Our lawyers are ready to help you – write to us at consultation@arws.cz. 

Professional Training as a Compliance Tool

Most unintentional permanent establishments arise due to errors by employees who are unaware of the tax consequences of their trips abroad.

ARROWS provides professional training for employees or management, including a certificate, with the aim of raising awareness about the risks of Service PEs and WFA. Effective training demonstrates active risk management to tax authorities and minimizes subsequent penalties. Need legal help? Contact us at consultation@arws.cz. 

The International Strength of ARROWS: Expertise Without Borders

To correctly assess the risk of creating a Permanent Establishment, it is necessary to analyze not only the text of the OECD Model Tax Convention but also the specific DTT and the reservations of individual countries. For example, the interpretation of the service PE concept within the CZ-AT DTT differs from other treaties and requires knowledge of the historical context of the negotiations.

Thanks to the ARROWS International network, built over ten years, we can provide you with legal and tax services in 90 countries worldwide. From the Czech Republic, we can solve your legal problem in more than 70 countries, practically anywhere in the world.

Our experience from providing long-term services to our clients will ensure your certainty in international business. Our portfolio includes more than 150 joint-stock companies and 250 limited liability companies, which demonstrates the depth of our knowledge. We pride ourselves on speed and high quality.

Readiness for Tax Audits and Inspections

If a PE has already been created unintentionally, it is necessary to act quickly. ARROWS will provide not only legal advice in obtaining the necessary permits and licenses in the foreign state but also representation before registers and regulators, including the fulfillment of all obligations.

We provide analysis of double taxation treaties, assessment of the risk of creating a permanent establishment, and proposals for an optimal business structure. We can connect clients with each other if they have interesting investment or business opportunities. And we are also happy to listen to interesting entrepreneurial or business ideas.

Conclusion and Final Call: Don't Let Your Profits Be Taxed Twice

An unintentional permanent establishment is a silent but very real threat to any company engaged in cross-border activities – from large-scale construction projects and services to flexible work-from-home arrangements for key managers. The risk of high fines and double taxation is a direct consequence of neglected tax and legal prevention.

Do not underestimate the tax reality. The ARROWS law firm will help you in this area and has demonstrable experience, which is confirmed by our client portfolio, including 150 joint-stock companies.

We will provide key legal services for you:

• Drafting internal policies for WFA and international projects.

• Legal opinions on the risk of PE creation in specific countries.

• Representation before courts and administrative authorities during audits.

• Preparation and review of contracts that minimize tax exposure.

Do not hesitate to contact our specialists. For the secure setup of your international operations, write to us at consultation@arws.cz and get a tailor-made legal solution.