Key Points
- A PE triggers a corporate tax filing obligation in the host country, even when the enterprise has no legal entity there.
- The OECD Model Convention sets twelve months for a construction PE, but many bilateral treaties reduce this to six months.
- Failing to identify a PE means the group underreports current tax expense and may misstate the effective tax rate reconciliation in the notes.
- Double taxation relief depends on the applicable treaty; without a treaty or competent authority agreement, the same profit can be taxed twice.
What is Permanent Establishment?
Article 5(1) of the OECD Model Tax Convention defines a PE as a fixed place of business through which an enterprise wholly or partly carries on its business. The concept includes branches, offices, factories, and workshops. Article 5(3) adds a time-based rule for construction or installation projects: if the project lasts longer than twelve months (six months under many bilateral treaties), the site becomes a PE. Article 5(5) extends the definition to dependent agents who habitually conclude contracts on behalf of the enterprise in the host jurisdiction.
For the auditor, the accounting question is whether management has identified all jurisdictions where a PE exists and measured the resulting tax obligations correctly. IAS 12.46 requires current and deferred tax to be measured using the tax rates enacted or substantively enacted at the reporting date in the jurisdiction where the PE operates. When a PE exists but management has not registered for tax or filed returns in that jurisdiction, the exposure falls under uncertain tax positions (IFRIC 23, now incorporated into IAS 12). The auditor evaluates whether it is probable that the tax authority will accept the position. If the enterprise has been operating through an unregistered PE for several years, back-taxes, interest, penalties, and potential prosecution risk all form part of the exposure that must be assessed.
Worked example: Dupont Ingenierie S.A.S.
Client: French engineering services company, FY2025, revenue EUR 92M, IFRS reporter. Dupont sends teams of engineers to a client site in Germany to supervise the installation of industrial ventilation systems. The German project began in March 2024 and is scheduled to run until September 2026 (30 months total). Dupont has no German subsidiary.
Step 1 — Determine whether a PE exists
The France-Germany double taxation treaty follows the OECD Model Convention and sets a twelve-month threshold for construction and installation PEs. By 31 December 2025, Dupont's engineers have been present on-site for 22 months, exceeding the threshold. A PE exists in Germany from the date the twelve-month period was exceeded (March 2025).
Step 2 — Attribute profit to the PE
Under the OECD's Authorised OECD Approach (AOA), the PE is treated as a separate enterprise. Dupont attributes EUR 4.8M of revenue to the German PE (the portion of the contract price relating to the on-site installation supervision from March 2025 onwards). Direct costs allocated to the PE total EUR 3.6M (engineer salaries, travel, accommodation, and subcontractor costs). The PE reports a profit of EUR 1.2M.
Step 3 — Calculate the German tax obligation
Germany's combined corporate tax rate (Körperschaftsteuer at 15%, solidarity surcharge at 5.5% of KSt, and Gewerbesteuer at approximately 14%) produces an effective rate of roughly 30%. Applied to the PE profit of EUR 1.2M, the German current tax liability is approximately EUR 360,000.
Step 4 — Eliminate double taxation and assess the IAS 12 impact
France taxes Dupont on worldwide income. The France-Germany treaty provides relief through the credit method: France allows a credit for German tax paid against the French tax liability on the same income. IAS 12.46 requires Dupont to recognise the German current tax of EUR 360,000 and the corresponding foreign tax credit in the French computation. The net effect on total group tax expense depends on whether the French rate exceeds the German rate on the PE profit.
Conclusion: the German PE tax liability of EUR 360,000 is defensible because the twelve-month threshold is clearly exceeded, profit attribution follows the AOA, the German rate is applied to the attributed profit, and the treaty credit eliminates double taxation.
Why it matters in practice
Teams often fail to identify a PE in the first place. When a group sends employees abroad for project work, the tax team may not track the cumulative duration against treaty thresholds. IAS 12.46 requires measurement of tax using enacted laws in every jurisdiction where the entity has a taxable presence. If the PE goes unrecognised, the current tax liability and the effective tax rate reconciliation (IAS 12.81) are both incomplete, and the uncertain tax position assessment under IFRIC 23 is missing entirely.
Profit attribution to the PE is frequently based on revenue allocation alone, without proper allocation of costs and capital. The OECD's AOA (2010 Report on the Attribution of Profits to Permanent Establishments) requires the PE to be treated as if it were a separate and independent enterprise. Using a simplified revenue split instead of a functionally based allocation can produce either an overstatement or understatement of the PE's taxable profit.
Permanent establishment vs. subsidiary
| Dimension | Permanent establishment | Subsidiary |
|---|---|---|
| Legal form | Not a separate legal entity; part of the parent enterprise | Separate legal entity incorporated under local law |
| Tax filing | Files a tax return in the host jurisdiction for the PE's attributed profit | Files a standalone tax return on its own profit |
| Liability exposure | Parent enterprise bears full legal liability for the PE's activities | Liability is generally limited to the subsidiary's own assets |
| Financial reporting | No separate statutory financial statements required in most jurisdictions (though a PE tax return requires a profit computation) | Prepares statutory financial statements under local GAAP or IFRS |
| Consolidation | Not a separate entity for IFRS 10 purposes; the PE's results are already in the parent's books | Consolidated as a subsidiary under IFRS 10 when the parent controls it |
The practical distinction matters for the auditor because a PE's tax risk sits entirely within the parent entity's financial statements. If Dupont has a PE in Germany, the German tax liability appears in Dupont's own statement of financial position. A subsidiary's tax risk, by contrast, appears in the subsidiary's own financial statements and is consolidated from there.
Related terms
Frequently asked questions
How do I audit whether a client has a permanent establishment abroad?
Review employee travel records, project contracts with foreign clients, board minutes, and intercompany service agreements for references to overseas offices or long-term project sites. Ask management whether any employees habitually conclude contracts abroad on behalf of the entity. ISA 550.25 requires the auditor to evaluate related party disclosures, and ISA 250.15 requires attention to laws and regulations that may have a direct effect on financial statement amounts (including foreign tax obligations arising from a PE).
Does remote work create a permanent establishment?
It depends on the treaty and local law. The OECD Model Tax Convention requires a "fixed place of business" at the disposal of the enterprise (Article 5(1)). An employee working from home in another jurisdiction may create a PE if the enterprise requires or authorises the home office as a regular place of work and the arrangement persists over time. Several EU Member States updated their guidance post-2020 to clarify PE thresholds for remote workers, but treaty interpretation varies by jurisdiction.
What is the difference between a branch and a permanent establishment?
A branch is a legal and operational concept: a part of an enterprise that operates in another jurisdiction under the same legal entity. A PE is a tax concept: it determines where a jurisdiction has the right to tax the enterprise's profits. A branch almost always creates a PE, but a PE can exist without a formal branch (for example, a dependent agent who concludes contracts on behalf of the enterprise). IAS 12 treats the tax consequences identically regardless of whether the presence is labelled a branch or a PE.