One thing that scares many businesses about expanding into a new country (a ‘target country’), is how to deal with compliance and tax. One significant risk that needs to be considered is the tax concept of ‘permanent establishment’. In this article, we survey some of the risks that need to be managed when expanding globally, explain what permanent establishment is, and look at four tips for managing the risk associated with permanent establishment.
Note this article provides general information, for specific advice on tax and compliance obligations, you must seek professional advice about your situation.
What are the risks when expanding your business internationally?
The benefits of international expansion, are clear. Growing globally can reduce your costs, improve your recruitment, spread broader economic risks, and allow you to explore new market opportunities.
However, as with any major business change, there are risks that need to be carefully managed. These include:
- The status of contractors. Compliance obligations in many countries attach to whether or not the business constitutes an employer. An employment relationship may be found to exist, whether or not a written employment contract or agreement is in existence;
- The status of intellectual property rights. If your intellectual property is not protected in the new country, there is a significant risk of competitors exploiting this;
- Scaling up too quickly. Doing business in a new country can be very expensive, and there is a risk that when setting up shop in a new country, your business does not grow quickly enough to sustain your presence there;
- Tax status. While the rules differ by country, in general, if you have a ‘permanent establishment’ in a new country, you will be liable for corporate income tax in that country.
This last risk is the focus of this article.
Summary: While global expansion doesn’t have many downsides, it needs to be carried out so as to carefully manage some of the risks involved. In this article, we focus on the ‘permanent establishment’ risk.
What is permanent establishment?
Permanent establishment (‘PE’) is a concept defined in the tax laws of individual countries, based on the bilateral treaties that they enter into with other countries. These tax treaties themselves usually define the concept based on the concept of PE set out in the OECD Model Tax Convention on Income and on Capital (the ‘OECD Model’). Article 5(1) of that model provides: “The term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on”.
As defined there, and in the accompanying commentary, there are three key components to the concept of PE:
- A ‘place of business’ in the target country. These premises need to be ‘at the disposal’ of the enterprise;
- The location must be ‘fixed’. There must be a ‘degree of permanence’ to this location;
- The business must be wholly or partly carried on through the location.
There is no definitive list of what will count as a PE and what will not. However, there are a list of prima facie PEs. That is, these set-ups will often be a PE, according to the standard definition:
- A branch of the business;
- A factory;
- A mine or place of extraction of natural resources;
- A warehouse;
- A place of management.
Summary: There is not always a simple answer to whether or not your enterprise will constitute a PE in a target country. It will depend on the specifics of your business operations.
What is the effect of a permanent establishment?
The existence of a PE means that, corporate income tax will be applied to the profits of that permanent establishment (see article 7 of the OECD model). The profits are, in turn, determined by attributing the revenue and expenses arising from that specific PE, treating it as if it were an independent enterprise.
Summary: The existence of a PE means paying corporate tax in the target country.
How to avoid or mitigate permanent establishment risk
The risks of creating a PE need to be managed. We recommend:
- Get early advice on the likelihood and effect of a PE. The existence of a PE is not always a bad thing. For example, according to tax laws in some countries, the existence of a PE in a target country will eliminate the need to file taxes in the country of headquarters (‘residence country’). If the target country has a lower corporate tax rate, this could be to the enterprise’s advantage;
- Set up a local entity. By setting up a company in the target country, you can eliminate uncertainty about your tax situation in that country. You will be liable to pay corporate tax in that country just like any other local company. Note, however, that this usually carries a range of significant compliance obligations. For example, setting up a limited liability company in Germany (a ‘Gesellschaft mit beschränkter Haftung’ or ‘GmbH’) requires depositing EUR 25,000 of share capital, with half the amount provided on registration;
- Pay attention to global mobility. By sending an employee of your company from head office to manage affairs in the target country, you may inadvertently be creating a PE in the country;
- Engage a PEO. By using a global Professional Employer Organization or ‘PEO’, you may be able to avoid setting up a ‘fixed place of business’ in the target country, meaning a PE doesn’t exist. A PEO acts as the ‘employer of record’ for your workforce, and takes on a range of compliance obligations for those employees. However, this is a complex issue, depending on your circumstances and you need to seek professional advice before taking this step.
Summary: As part of your international expansion, ensure you get early advice on the effect of a PE, consider the effects of sending your employees overseas, and explore the possibilities of setting up a legal entity or engaging a PEO.
One of the challenges to setting up your business in a new country is ensuring that you are fully compliant with the tax laws and any other compliance obligations. One of the most significant risks is that you inadvertently create a ‘permanent establishment’ in a new country, and get hit with an unexpected tax bill and/or penalties.
This is not something that is easy to work out on your own. Different countries incorporate the concept of PE into their tax laws in different ways, and it is crucial that you have advice from experienced operators on the ground.
This is where you need professional advice. New Horizons Global Partners provides expert advice on how to set up your business operations in another country. We can advise on whether global PEO, outsourcing, or setting up a new legal entity is the right way of structuring your overseas expansion.