How to Avoid Permanent Establishment Risk with Global Employer of Record
Introduction
Globalization has recently resulted in national economies and markets becoming intertwined. Due to a surge in economic integration in recent years, it has become evident that current international tax regulations, established over one hundred years ago, are no longer adequate.
This lack of adaptation to modernity allows for BEPS (base erosion and profit shifting), which undermines trust in taxation systems and creates inequalities as profits are not taxed accurately. Therefore, tax policymakers and governments take decisive action to rectify this issue while quickly restoring faith in their taxation systems and ensuring taxes are collected where value is produced.
Currently, regulations are the primary method used to define whether or not a company is engaged in PE activity. Tax treaties may also be used to specify what constitutes a PE. In addition, some countries tax laws may specify what activities constitute a permanent establishment (PE) for their jurisdiction.
What Is a Permanent Establishment?
Harmonization of tax laws has led to many countries adopting the Organisation for Economic Co-operation and Development Model Tax Convention, which puts certain restrictions on when businesses will be considered permanent establishments (PEs) in another country. In brief, an organization will have a permanent establishment (PE) if any of the following applies:
1. The business has a physical presence in a foreign country.
2. The business is regularly present through employees or agents.
3. A sale is made from a fixed place of business.
4. The business is engaged in continuous and systematic activities in the foreign country.
Understanding the Concept of Permanent Establishment
Permanent Establishment (PE) is a concept in international taxation that refers to a fixed place of business through which an enterprise carries out its business activities. A PE can be a branch, office, factory, warehouse, or any other fixed place of business where the enterprise carries out its business activities, either wholly or partially.
When an enterprise operates through a (Permanent Establishment) PE in a country other than its home country, it may become subject to the tax laws of that country. This means that the income generated by a PE is potentially taxable in the country where the business is located and in the country where the business is incorporated.
Only income attributable to local activity should be subject to local tax, which can be determined through a profit attribution exercise. However, consideration must also be given to whether there is an applicable double tax treaty between the two countries.
Generating Taxable Income
For example, suppose you have a sales force that calls on customers in a foreign country on behalf of your organization. In that case, that presence is considered a Permanent Establishment, and you must pay tax for the income your salespeople generate.
If an enterprise is found to have a PE in a foreign country, it may be subject to tax on the profits earned in that country, as well as penalties and interest for failing to comply with the tax laws of that country. To avoid permanent establishment risk, enterprises must carefully assess their business activities in foreign countries and ensure that they do not create a fixed place of business or exceed the allowable time limit for employee presence in that country. They should also seek professional advice to understand the tax laws of foreign countries where they operate.
Permanent Establishment Management Control
Permanent Establishment (PE) Management Control refers to the extent to which the enterprise maintains direct control over the business operations in a foreign country.
If an enterprise wants to maintain direct control over everything from accounting procedures to staff management, it may choose to establish a foreign legal entity. This option allows the enterprise greater control over its operations in the foreign country, including hiring and managing employees, implementing its accounting procedures, and maintaining its banking relationships.
However, establishing a foreign legal entity can be costly and time-consuming. In addition, it requires the enterprise to comply with the legal and regulatory requirements of the foreign country, which may differ significantly from those of the home country.
Alternatively, an enterprise may choose to outsource some of its operations, except for managing assets and collecting profits. This option allows businesses to focus on their core competencies while outsourcing non-core activities to specialized service providers.
Permanent Establishment Risk: Addressing the Concerns
Permanent Establishment (PE) requires the most due diligence in tax risk management.
You may think you can conduct business overseas without registering a legal entity, but you would be wrong. You might need to register your business even if you only send an employee on a temporary assignment or establish a small promotional office. Failing to do so can result in serious consequences.
Different countries have different tax laws, and a multinational company must consider all of these when conducting business. The tax authorities of a particular country can determine which elements of the company’s economic activity take place in a particular country and how much profit is attributable to them. This process can be complex, but ensuring that the company complies with all applicable laws is essential.
25 Questions to Help You Assess Permanent Establishment Risk
Here are some additional questions that can help assess Permanent Establishment (PE) Risk:
1. Have you identified all the business activities that your company will perform in the target country?
2. Will your company have a fixed place of business in the target country, such as an office, warehouse, or factory?
3. Will your employees or contractors spend significant time in the target country?
4. Will your company have the authority to sign contracts or make decisions on behalf of your clients or customers in the host country?
5. Will your company have the authority to negotiate or conclude contracts on behalf of your clients or customers in the target country?
6. Will your company have the authority to bind your clients or customers in the target country?
7. Will your company have the authority to manage or supervise employees or contractors in the target country?
8. Will your company have the authority to provide after-sales services or technical support in the target country?
9. Will your company be able to receive payments or handle financial transactions in the target country?
10. Will your company have the authority to conduct research and development activities in the target country?
11. Will your company have the authority to control the use or disposal of assets in the targetcountry?
12. Will your company have the authority to make decisions on pricing, marketing, or distribution of goods or services in the target country?
13. Will your company have the authority to manage or oversee the supply chain in the target country?
14. Will your company have the authority to perform any other significant business functions in the target country?
15. Have you reviewed the tax laws and regulations of the target country to understand the criteria for determining whether a PE exists?
16. Have you reviewed the tax treaty between your home country and the target country to understand the provisions related to PE?
17. Have you considered the potential impact of transfer pricing regulations on your operations in the target country?
18. Have you assessed the potential penalties and fines for non-compliance with tax laws and regulations in the target country?
19. Have you considered the potential reputational risks associated with being deemed to have a PE in the target country?
20. Have you established a risk management plan to address PE risk, including strategies for minimizing risk, monitoring compliance, and managing potential disputes with tax authorities?
21. Are your employees in the target country extensively involved in sales or contract negotiations? They don’t need the power to sign contracts to qualify as being involved in contract negotiations.
22. Do your employees’ job titles or descriptions pertain to revenue generation?
23. Do your employees receive compensation related to sales, such as commissions or bonuses, for meeting sales targets?
24. Do they receive compensation based on sales, such as commissions or bonuses for their sales performance?
25. Have you reviewed the contractual agreements between your company and your clients or customers in the target country to understand the scope of your authority and obligations and whether they could create a PE?
Attributable Activity Test to Determine Permanent Establishment
Unlike the standard “permanent establishment” definition, which focuses on whether an entity is carrying on business through a fixed place of business, the permanent establishment definition for income tax purposes is broader. There are two main tests for determining if an organization has a PE.
The Attributable Activity Test is one of the criteria used to determine whether a foreign company has a Permanent Establishment (PE) in a host country for tax purposes. This test is used to determine whether the activities performed by the foreign company in the host country are sufficient to create a PE, even if there is no physical presence or fixed place of business in the host country.
The Attributable Activity Test focuses on the activities “attributable” to the foreign company in the host country. These activities are those that are carried out on behalf of the foreign company by its employees, agents, or other representatives in the host country.
To determine whether the foreign company has a PE under the Attributable Activity Test, the tax authorities will typically consider the following factors:
- Whether the activities performed by the foreign company in the host country are “core” activities that are essential to the company’s business.
- Whether the activities are performed for a “sufficient” period of time. There is no fixed rule for what constitutes a “sufficient” period of time, but it generally means that the activities must be ongoing and regular, rather than occasional or sporadic.
- Whether the activities are performed with a “sufficient” degree of authority. This means that the foreign company’s employees, agents, or other representatives must have the power to make decisions on behalf of the company that affect its business operations in the host country.
- Whether the activities are performed with a “sufficient” degree of continuity. This means the activities must be performed over a long period to establish a significant connection between the foreign company and the host country.
Activities that Can Create a PE under the Attributable Activity Test
- Negotiating contracts or concluding sales agreements on behalf of the foreign company.
- Providing technical assistance or after-sales support services to customers in the host country.
- Performing marketing or advertising activities directed at customers in the host country.
- Conducting research and development activities related to the company’s business operations in the host country.
- Providing management or supervisory services to local employees or agents of the foreign company.
- Providing training or education services to customers or employees in the host country.
It is important to note that the Attributable Activity Test is only one of several criteria tax authorities may use to determine whether a foreign company has a PE in a host country. Other factors that may be considered include the existence of a fixed place of business, the level of control and management exercised by the foreign company over its operations in the host country, and the nature and extent of the company’s activities in the host country.
5 Ways Minimize PE Risks with a Global Employer of Record
As a business owner, you may feel overwhelmed by the tax implications of expanding your business overseas. However, new ideas exist to reduce complexity and ease the burden on busy entrepreneurs.
Using a Global Employer of Record (EOR) can be an effective way for multinational employers to prevent or address Permanent Establishment (PE) risks. This third-party global employment solution enables compliance with local employment and tax laws while avoiding the establishment of a legal entity and taxable presence in the country.
1. No Establishment of a Foreign Legal Entity
The Global EOR model enables multinational employers to engage workers in different countries without establishing a legal entity. This helps to reduce the risk of creating a taxable presence in the country and triggering a PE.
2. Compliance with Local Employment Laws
The Global Employer of Record (EOR) handles employment’s legal and administrative aspects, including compliance with local labor laws and regulations. This ensures that the client company is not inadvertently creating a PE through non-compliance with local employment laws.
3. Tax Compliance
The Global Employer of Record (EOR) can also handle tax compliance, including payroll taxes and social security contributions. This ensures the company is not creating a PE through non-compliance with local tax laws.
4. Permanent Establishment Risk Mitigation
Using a Global Employer of Record (EOR), talent engagement model can help multinational employers mitigate the risk of a PE by ensuring that all legal and tax obligations are met. This helps to minimize the potential negative impact on the company’s reputation, financial statements, and regulatory compliance.
5. Flexibility of Global Moves
The Global Employer of Record (EOR) model allows multinational employers to engage workers flexibly in different countries. This helps minimize the risk of creating a PE by permanently establishing a business presence in the country.
Sample Employment Tax Calculation
How to Pro-actively Address Challenges of Permanent Establishment Risk
The challenge of Permanent Establishment (PE) risk can be addressed through a combination of preventive and corrective measures. Below are some suggestions to resolve the fundamental challenges of PE risk:
- Conduct a comprehensive risk assessment: This involves a review of the business operations and transactions to identify potential PE risks. It is important to consider the different types of taxes that could be affected, including corporate income tax, indirect tax (VAT/GST), and payroll taxes. The risk assessment should also consider the potential impact on the company’s reputation, financial statements, and regulatory compliance.
- Develop and implement a PE risk management strategy: The strategy should be tailored to the company’s specific operations and risks. This may involve implementing policies and procedures to ensure compliance with tax laws and regulations, including appropriate VAT registrations and payroll reporting. The strategy should also include ongoing monitoring of changes in tax laws and regulations and changes in the company’s business operations.
- Maintain accurate and complete records: Good record-keeping is essential to demonstrate compliance with tax laws and regulations. This includes maintaining records of all transactions, contracts, and agreements relating to the company’s operations in each jurisdiction.
- Engage in open and transparent communication with tax authorities: It is important to establish a good relationship with tax authorities and to be transparent about the company’s operations and tax position. This can help to prevent misunderstandings and reduce the risk of audits and penalties.
- Seek professional advice: Given the complexity of tax laws and labour regulations, it may be beneficial to seek professional advice from tax and global employment experts. This can help ensure that the company complies with all applicable tax laws and regulations and can help to identify potential risks and opportunities for optimization.
Companies expanding globally by taking a proactive approach to Permanent (PE) risk management can minimize the potential negative impact on their reputation, financial performance, and compliance obligations.
Benefits of Pro-active Permanent Establishment Risk Management
Concluding Thoughts
Managing Permanent Establishment (PE) risk is a smart business move for organizations with international operations. By proactively managing PE risk, companies can promote tax compliance, expand globally tax-compliantly, and avoid penalties and interest charges from tax authorities.
This approach provides a greater sense of security on a challenging issue and helps to prevent unnecessary taxation and interest payments due to mistakes or lack of awareness.
By taking control of PE risk, companies can minimize potential negative impacts on their reputation, financial performance, and regulatory compliance while maximizing the benefits of their global operations.
