[Ask a Lawyer] What permanent establishment means to multinational companies

Q: Why does a multinational need to pay attention to permanent establishment issues?

A: A permanent establishment is a fixed place of business through which the business of an enterprise is wholly or partly carried on. Korean tax laws state that the corporate tax should be imposed on a foreign entity that has a permanent establishment in Korea.

Multinationals have reduced taxes by eroding their tax bases in countries with high tax rates by transferring profits earned there to subsidiaries in countries with low rates under the pretext of royalties, interests, and so on. This strategy takes advantage of variances in tax laws of different countries and loopholes in tax treaties or international taxation systems. Individual countries introduced the Google tax to prevent such behavior, but it has not been very effective. 

Hence, the OECD initiated a project to prevent such base erosion and profit shifting (BEPS) in 2012 with the G20 and have been making efforts to effectuate this project by signing the “Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting” at the OECD meeting that was held in Paris in June 2017. One of the key implementations of the BEPS prevention project is the expansion and active application of the concept of a permanent establishment.

In the past, Korea determined whether a foreign corporation had a permanent establishment in Korea by strictly applying criteria such as (1) whether it has a “fixed place of business” in Korea, (2) whether it possesses the authority to dispose of or use such place of business, and (3) whether it performs “essential and significant business activities” in the fixed place of business.

However, technologies, such as the internet and smartphones, have linked the world and created a new economic environment known as the “digital economy,” which is represented by mobility and shapelessness. In such digital economy, multinationals are enabled to continuously generate enormous profits without establishing a fixed place of business in a specific country. The representative example is application markets like Google’s Play Store and Apple’s App Store. When consumers in Korea purchase applications at the Play Store or the App Store, which have servers in foreign countries, no corporate income taxes are imposed under the current laws because there is no permanent establishment in Korea.

Taking this into consideration, the Supreme Court of Korea recently interpreted the existing criteria for determining a permanent entity more broadly, actively recognizing a foreign corporation’s possession of one in Korea. Korean tax authorities are also actively attempting to impose taxes on multinationals based on the existence of a permanent establishment in Korea separate from their Korean subsidiaries, and tax authorities of other countries are paying attention to such efforts of Korean tax authorities.

Considering such changes in Korea and throughout the world, taxation on multinationals based on the existence of a permanent establishment would be expanded both in Korea and other countries. Such expansion of the concept and application thereof is directly linked to the profits or future business directions of multinationals, because multinationals would face increased tax burdens in the countries where they have a permanent establishment. In this regard, multinationals need to prepare for tax risks in advance. Only those who prepare properly would survive in the limitless competition.

By Jeon Wan-kyu
Attorney and partner of law firm Yoon & Yang LLC