Whether you’re tapping into global talent or have workers based in another country temporarily, your business could be affected by Permanent Establishment (PE) risk and be liable for corporate taxes. What’s even worse is if you mismanage PE, you could incur fines, penalties, and reputational damage.
However, this shouldn’t dissuade you from growing your business abroad, as there are many ways you can reduce PE risk while growing your business internationally. This article will help you understand how to enjoy all the benefits of internationalization without suffering the consequences of mismanaged Permanent Establishment.
Why Does Your Business Need to Understand Permanent Establishment Risk?
Understanding Permanent Establishment risk is crucial for any company that does (or plans to do) business abroad or employs international talent. As more and more companies enjoy the benefits of a globalized economy and workforce, tax authorities around the world are tightening regulations to ensure businesses pay corporate taxes in appropriate jurisdictions.
Many businesses function internationally without creating PE, but the risk starts to increase significantly when you employ people who permanently reside outside of your company’s home country. If you have employees abroad - or you want to start hiring international talent - you should be aware of how PE works and the impact it might have on your business.
This understanding is essential because the consequences of mismanaging Permanent Establishment risk could significantly hinder your growth and lead to:
- Fines, penalties, interest charges, and back-payments
- Increased tax exposure
- Reputational damage
- Increased tax audits
- Regulatory issues
- Complications with employee immigration
Having said that, Permanent Establishment risk shouldn’t put you off hiring great talent from across the globe or expanding your business internationally. We’re here to help you understand the risks well and manage them effectively.
If you’d like to discover how to reduce PE risk now, feel free to skip ahead.
What is Permanent Establishment?
Permanent Establishment (PE) refers to a business that is considered by a local tax authority to be a permanent and ongoing setup. As a result, the business may be liable to pay corporate taxes or VAT on the revenue generated in that country or jurisdiction.
There isn’t a universal definition for ‘Permanent Establishment’ - the criteria and benchmarks for creating a PE depend on the local tax authority and/or tax treaty regulations. However, the Organisation for Economic Cooperation and Development (OECD)’s Permanent Establishment definition is considered to be the global standard, and many jurisdictions create their regulations based on it.
“[A Permanent Establishment is] a fixed place of business through which the business of an enterprise is wholly or partly carried on.”
While you may think of a ‘fixed place of business’ as an office or factory, Permanent Establishment is unfortunately much more complicated than that. You could unknowingly create a PE by using third-party companies to do your sales, marketing, and business development in a new market, hiring contractors, or even securing international talent through an Employer of Record (EOR) service.
Ultimately, Permanent Establishment and the associated tax burden depends on what you’re doing within a country or jurisdiction, for how long, and what the outcomes are.
Many countries have entered into income tax treaties (also called Double Tax Agreements), which help businesses avoid double taxation and reduce financial risk. However, these treaties aren’t always available, particularly if your business creates a Permanent Establishment in a tax haven, where there are low or no corporate taxes to pay.
Because of all the above complexities, you should seek professional tax advice before you start any business activities abroad.
Types of Permanent Establishment
Permanent Establishment generally falls under four categories. Here are the types of Permanent Establishment that may apply to your business:
- Fixed place of business Permanent Establishment: Having offices and other physical places of business in a foreign country or jurisdiction.
- Agency Permanent Establishment: Hiring a dependent agent to conduct revenue-generating sales activities abroad.
- Service Permanent Establishment: Providing ongoing services in another country or jurisdiction, even without a physical place of work.
- Construction permanent establishment: Having a construction site or installation project in a country or jurisdiction for a specified period of time.
What Triggers Permanent Establishment?
While countries and local tax authorities define PE differently, there are universally common factors that can trigger Permanent Establishment. Use our Permanent Establish risk checklist to better understand high and low-risk triggers.
High-risk PE Triggers
The most common high-risk Permanent Establishment triggers are:
- Having an office or other fixed place of business. This could include:
- A branch, warehouse, factory, mine, or place of management
- A co-working space or home office (in certain jurisdictions)
- Having someone based locally, such as a contractor, agent, an employee on secondment, or an employee via an Employer of Record (EOR) or Professional Employment Organization (PEO) who:
- Has authority to sign contracts on your behalf; or
- Has an executive or senior management role; or
- Provides core business services (e.g., a lawyer at a law firm); or
- Undertakes sales activities.
The definition of ‘sales activities’ for PE can be pretty broad, and not every activity will automatically create a PE. Generally speaking, if you have workers abroad doing general business development, introductions, and/or lead generation, the permanent Establishment risk will be low.
However, if you hire or work with anyone who closes deals or makes direct product or service sales, your Permanent Establishment tax risk will generally be much higher.
Low-risk PE Triggers
Here are the most common low-risk PE triggers that may apply to your business:
- Conducting business trips to another country; or
- Engaging a local supplier or having a local customer; or
- Having workers in a country or jurisdiction who perform supporting, non-revenue generating activities
Again, the definition of ‘supporting activities’ is unique to each business and local tax authority. In many cases, supporting activities would likely be roles within accounts, finance, legal, admin, marketing, PR, design, among others.
But, again, that depends on the type of business you run. If your business is an accounting firm, for example, hiring accountants abroad would be considered part of your core revenue-generating activities, making it a high-risk PE trigger.
Permanent Establishment risk factors and triggers aren’t clear-cut, and ultimately it’s up to the local tax authority to decide whether your business should be classified as a PE based on their criteria.
The COVID-19 Pandemic & Permanent Establishment Risk
The COVID-19 pandemic and consequent travel restrictions forced many people to work away from the country they normally reside in. As a result, businesses were concerned about unwillingly creating Permanent Establishments abroad.
To combat this, many jurisdictions offered leniency to businesses whose employees were temporarily working from another country or jurisdiction. This meant that as long as the change of location was temporary, the business wouldn’t be considered a Permanent Establishment.
For example, the local authorities in China released a set of Q&As in 2020 to clarify how PE rules would apply in the context of the pandemic. The Q&As stated that temporary remote working would not trigger the presence of a PE in China as long as the intention for permanence is not given.
However, as we move out of the pandemic, many workers may wish to continue working abroad permanently. This could expose your business to new tax obligations, which you can learn more about here.
How to Avoid Permanent Establishment Risk
The only way to completely avoid the risk of Permanent Establishment is to restrict all business activities to the jurisdiction your company is based in. But that would limit your growth significantly. All companies, large and small, start-up and established, should be taking advantage of the many benefits of expanding business operations globally, including increased revenue, reduced business costs, and access to top talent.
The good news is, there are a few ways you can reduce PE risk and manage it effectively.
Seek Local Tax Advice
Working with a local tax professional is the recommended way to manage PE risk. By working with a local tax expert, you’ll gain a deeper understanding of your tax obligations before you start any new activity abroad. This will allow you to expand strategically, mitigate risk, and grow your business sustainably.
Set up a Foreign Subsidiary
When hiring talent abroad, you have two main options to ensure compliance and reduce PE risk.
One of these options is to set up a foreign subsidiary, otherwise known as a local entity. While expensive and time-consuming, creating a foreign subsidiary allows you to pay taxes separately for revenue generated within that jurisdiction. This is because foreign subsidiaries are separate legal entities and are responsible for their own assets and taxes.
However, foreign subsidiaries may still expose you to PE tax risk if your parent company is found to be conducting business for itself through the subsidiary.
Where Double Taxation Agreements or Tax Treaties apply, it may be simpler and more cost-effective to avoid creating a foreign subsidiary and opt for an EOR service to hire talent instead. This is especially true if you’re only hiring a handful of workers per country.