The concept of permanent establishment (hereinafter: the PE concept or PE) is a concept accepted worldwide for determining whether a country can tax business profits of an entrepreneur who is not a tax resident of that country. According to the traditional PE definition, the existence of "a fixed place of a business" is the major assumption for the existence of a PE (except in the case of an agency PE) and thus for taxation of business profits of a non-resident. However, the increased development of services rendered electronically, use of the Internet in modern business, as well as mobility of capital and employees, trigger the question whether the traditional PE concept is adequate for modern business purposes.

In a modern environment it is more difficult to allocate taxing rights over services because physical presence is less important and various services can be rendered in a country with no physical presence there (e.g. consultancy services). Even bits and pieces of a single service can be performed in different countries (for example, a consultant thinks at one place (country A), writes one part of his expert opinion at another place on a laptop (country B), but finalizes the opinion in an aeroplane and sends the opinion by e-mail through an Internet provider in country C). Therefore, the adequacy of the traditional PE concept, especially in relation to services, is increasingly under pressure.

As services can be more and more easily performed in the country of the client, without using a fixed place there, the traditional OECD allocation of taxing rights leads ever more often to the situation where that state is obliged to grant a deduction for the fee but is unable to levy any tax on the fee. This is the inadequacy that leads states increasingly to define a PE in new treaties so as to include the performance of services in the country for a certain period of time or number of days.

An important question is whether the allocation of taxing rights to a jurisdiction for business profits earned from rendering services should be limited to business profits from services rendered through "a fixed place of business", or whether different criteria should apply to services. Some countries consider including a so-called service PE provision in the PE definition. Croatia is one of the countries which adopted the service PE provision, as explained below. The same issue has also been recently considered by the OECD.

Even though at the level of the OECD there have been certain considerations in this respect, the service PE provision has not been included in Article 5 of the OECD Model. As stated in the Proposed Commentary Changes,*) no change of the PE definition itself has been proposed, but states should feel free to include the service PE provision in bilateral tax treaties, and there has been a proposal to include such alternative provision in the changes of the Commentary on Article 5. The purpose of such alternative provision is to ensure that rendering of services can trigger a PE in a country even if there is no fixed place of business in that country. While extending the PE definition in relation to services is theoretically interesting, actual effects in practice are questionable, especially due to some interpretation problems (e.g. when are services considered to be performed in a country, what is considered to be one project, when are projects considered connected projects, etc.).

In Croatia the new PE definition, extended with a service PE provision, was introduced within the Croatian Profit Tax Act (hereinafter: CPTA) as of 1 January 2005. The wording of the service PE provision contained in the CPTA is: "A PE of a foreign entrepreneur, non-resident, shall exist in the case of rendering services, including consulting or business services, if for the same project or connected projects the rendering of services lasts for more than three months in continuation in any 12-month period.". The wording of the provision does not explicitly state that it relates to rendering of service "within Croatia", but this can be concluded from the fact that the provision is contained in the definition of what is considered as a PE in Croatia. Accordingly, based on that definition, the rendering of services with no fixed place of business in Croatia, if certain conditions are met, can trigger a PE. However, the terms "same", "connected" and "project" are not defined. Therefore different interpretations of these terms are possible and in practice this results in increased uncertainties at the level of the taxpayers. On the other hand, the question is whether the introduction of the service PE provision in Croatia has resulted in any increase of collected tax revenues, which is not very probable because the Croatian tax authorities are mainly focused on taxation of PEs registered in the form of a branch (as these can easily be identified). Therefore, in circumstances where even the traditional PE concept has not been fully implemented in practice, it is absurd that the PE definition has been further extended by a provision which is not precise enough and which cannot be easily implemented in practice. The focus of the Croatian tax authorities is a good example of a wider issue that is created when the PE definition is extended.

Extending the traditional PE definition (which is focused on physical presence because it was developed in light of an economy based on manufacturing of goods) with a service PE provision can theoretically be interesting, taking into account that the modern business environment is characterized by a knowledge-based economy, increased significance of personal services, globalization, electronic commerce and mobility of workforce and capital. However, there are many open questions and actual usage of such service PE provision and the final results in practice are questionable. Therefore, instead of attempts to improve the traditional PE definition by extending it with the service PE provision we could better ask whether the traditional PE concept should not be fully reconsidered.