A growing number of businesses are turning their attention to global expansion, particularly when it comes to selling, setting up offices, hiring talent, and establishing production operations.
While embracing global business expansion opportunities can present many benefits to businesses, it's also important to keep in mind the potential risks it poses to enterprises of all sizes.
One such risk, which has attracted growing focus from tax authorities recently, is the concept of the permanent establishment, also referred to as PE. The Inclusive Framework on Base Erosion and Profit Shifting (BEPS) was established in June 2016, and it concentrates solely on this issue.
Governments aim to apply their corporate tax laws to foreign companies operating within their country, so it's important for companies undertaking business activities in a foreign country to fully understand the risk of permanent establishment and learn how to mitigate it.
This article will walk you through everything you need to know about PE, as well as how you can reduce the risk.
The definition of PE: What is a permanent establishment?
The term permanent establishment is a tax concept that refers to when a tax agent determines that a business has a steady, continuing, and taxable presence in a foreign country. This term is sometimes defined under a bilateral Income Tax Treaty between the host country and the country the business originates in.
According to the Organization for Economic Cooperation and Development guidelines OECD Model Tax Convention), a permanent establishment has several elements. It is "fixed," done in a particular "place" and for the purpose of "business."
The OECD is the leading multinational body that defines applications of PE. However, every nation has its measures to identify when business activity stops being sporadic or short-term and reaches a level that will prompt PE and subsequent double taxation.
The traditional benchmarks used in most countries for permanent establishment are:
- A fixed place of business, address, bank account, or other physical presence
- Activity by employees in a host country that directly generates revenue
- An adequate time frame to activate PE under local decrees or tax treaties
- Command and control of the employees' activity by the parent company
If a business is considered to have a permanent establishment, its tax burden increases significantly. Any revenue earned inside that country is required to be taxed accordingly based on domestic tax laws (notably value-added tax, but not only) and the period of time the company is deemed as a permanent establishment.
It's important to note that not all business activity carried out in a foreign country will trigger this PE risk, as not all business activities generate revenue. Examples include preliminary actions, such as early negotiation of sales contacts or testing the market through attending trade shows and collecting related information.
The types of permanent establishment
There are multiple types of permanent establishments that businesses should be aware of. We explain each of these in-depth below.
Fixed place of business
Historically, having a fixed place of business is the most common determining factor for a permanent establishment.
Fixed places of business might include:
- Offices
- Branches
- Factories
- Workshops
- Mines
- Gas or oil wells
In other words, it's a facility a business has access to when carrying out business in a foreign country.
Construction or project permanent establishment
Many agreements provide precise rules in regard to construction sites. Under those treaties, a building site or construction or installation project signifies a PE only if it lasts more than a particular time period. This amount of time varies by treaty.
Agency permanent establishment
Employees, who aren't considered independent agents, that work as sales agents and have the ability to complete contracts in the name of a company may also trigger permanent establishment. The deciding condition is that the authority must be exercised routinely rather than as a one-off. Also, the bulk of the discussion, drafting, and signing of contracts must have occurred in the foreign country.
Service permanent establishment
If a business or its employees are providing ongoing services (for example, technical, managerial, or consultancy services) to other businesses or individuals in a foreign country, then this may also trigger PE. Services permanent establishment differs from other types of PE, as there may not be a fixed type of business. Therefore, other elements of the permanent establishment are taken into account, such as the length of time or frequency of the service.
Our contracts comply with local laws in 150+ countries around the world. Focus on finding the perfect match for your team, we’ll take care of the rest.
What activities increase PE risk?
There are a number of activities a business might carry out which place them at an increased risk of being deemed as a permanent establishment. These include:
- Running the business from a specific and set location on a regular or continuous basis
- Having employees visit the same site to carry out work on behalf of the company when they visit a country
- Having access to a facility that isn't used exclusively for business but still remains in command of the business
- Sending an agent to a foreign country to close a deal or work on behalf of the company in ways that generate revenue
- Having the word "sales" in the title of a worker
- Making sporadic visits to a foreign country to provide maintenance on their product offerings, such as technical assistance or training
- Using a mailing address in a foreign country for your company's location or bank account
- Withholding employee income tax and social security taxes
- Receiving payments from customers working within the same country and withholding taxes as a result
How has the global pandemic impacted PE risk and global mobility?
Many tax agencies in various countries around the world agree to waive permanent establishment exposure due to Covid-19 travel bans and displaced workers.
The OECD lists scenarios such as cross-border workers who are unable to commute to their country of work. As such, they have become a temporary remote worker who must undertake their work from their home country. This may unintentionally shift the primary right of taxation from the work country to the home country.
The OECD notes that some agreements have conditions that may allow for days to be worked from the home country and still give the work country the first right to tax.
What are the risks if a permanent establishment isn't managed properly?
If a PE risk isn't managed effectively by a business, they face a number of threats and consequences. These include:
- Penalties and interest charges
- Potential regulatory issues
- Employer reporting requirements, including payroll and social security
- Heightened audits from tax authorities, which takes up a business' valuable time and resources
- Corporate tax liabilities
- Immigration matters for employees
- Possible unforeseen tax cost in a territory if appropriate VAT registrations have not been made
- Damage to a business' reputation
How can you protect your business from permanent establishment risk?
Thankfully, there are a number of steps you can take to minimize your business' risk of the permanent establishment while still achieving your global hiring and global expansion goals.
Work with a local tax specialist
The sooner you can seek advice from tax agents with expertise relating to any foreign countries you operate within, the better. This is because getting good tax advice early allows you to anticipate any problems that might arise with permanent residence and foreign taxpayer status. The insights could include items such as learning about local tax rates, planning for the taxes owed, and avoiding the risk of any legal actions.
A dependent agent can also assist your business by reviewing any service contracts with employees and local business partners, offering advice on local tax liabilities, and helping to protect your company from any major tax obligations linked to PE risk.
Establish a local business entity
You might also consider creating a foreign subsidiary in your country of business operations. This presents tax benefits to your company and removes your risk of PE because you're staying compliant with local tax authorities as a foreign subsidiary:
- Operates autonomously from its parent company
- Is accountable for its own assets and liabilities
- Is considered to be a separate legal entity for taxation and regulatory oversight
One thing to keep in mind when considering setting up a local business entity, however, is that it is a very costly and time-consuming task.
Work with a global employer of record
Because the cost of establishing an entity in a foreign country is very high, many businesses also consider working with a global employer of record, sometimes referred to as an international PEO. Such a company acts as your official and legal employer for foreign workers and is responsible for submitting all employer and employee taxes in accordance with all local tax rules.
How Deel can help
If you're looking for a trusted partner for managing your foreign independent contractors or employees and navigating international payroll and compliance, look no further than Deel. Create locally compliant contracts in seconds, pay your global teams in their preferred currency and method, and stay compliant wherever your team is.
