Global business expansion is on the rise, with an estimated $7 trillion to $9 trillion in global trade being attributed to multinationals.
With such a substantial amount of taxable revenue, it’s no wonder foreign governments are eager to apply their corporate tax laws to companies operating within their borders.
That’s where the concept of permanent establishment (PE) risk comes into play—and why it’s so important for companies operating in foreign countries to be aware of and understand the risk.
When governments use permanent establishment as a barometer to levy local taxes, it’s up to the individual organization to know where they stand and how much they may be required to pay in foreign taxes based on PE statutes.
If not, companies doing business abroad may one day wake up to a big surprise—and a potentially bigger tax bill—if they don’t take permanent establishment risk seriously.
Permanent establishment explained
Foreign countries want to know at what level a company is operating, so they can accurately assess income levels that may fall within the range of its corporate tax laws.
This tax concept is known as permanent establishment, and by extension, it’s a scenario that comes with what global trade specialists call “permanent establishment risk.”
Broadly defined, the risk of permanent establishment is that foreign tax officials may deem a company operating within its jurisdiction a fixed place of business.
If a company is determined to be a fixed place of business, any revenue earned inside that country qualifies to be taxed accordingly based on local tax statutes and the amount of time the company is active as a permanent establishment.
Not every business activity undertaken in a foreign country activates a permanent establishment designation. For example, commercial activity that lays the groundwork for trade in a foreign country but does not create revenue, typically won’t classify as PE. Permanent establishment risk applies when a company begins marketing goods and services within a country’s borders and derives revenue from that commercial activity.
In terms of enforcement, a country’s local tax bureaus are the final arbiter on permanent establishment. It’s up to the business operating within that country’s borders to prove its commercial activities don’t warrant a permanent establishment designation.
Consequently, permanent establishment risk forces a company operating overseas to measure its tax liability, so it can accurately gauge its tax obligations and stay in compliance within a country where it trades commercially.
What business situations lead to permanent establishment risk?
Multiple factors can be in play for an organization seeking to weigh its permanent establishment risk. That’s especially the case when looking to see if PE risk is intentional (i.e., it follows company business strategy) or is inadvertent (i.e., it may be amended to avoid additional taxation.)
These business situations are linked to PE classifications by a foreign tax agency and likely represent permanent establishment risk for companies operating in foreign countries:
- Employing individuals that contribute to the creation and trade of products or services that translate into company revenue
- Withholding employee income and social security taxes
- Employing individuals with a lengthy fixed-term contract who regularly work inside a foreign country for an extended period of time, creating a “prolonged worksite” status
- Receiving payments from clients operating within the same country and withholding taxes as a result
- Signing contracts with in-country businesses and profiting from those contracts
Protecting your organization from permanent establishment risk
To guide your company through the maze of foreign country tax compliance and better insulate it from permanent establishment risk, consider taking the following actions:
Work with a local tax specialist. Although a permanent establishment designation in most cases will lead to full compliance mandates in the country of business operation, all outcomes don’t have to be negative.
For example, some local tax ordinances may not require taxes to be filed in the country where an organization is headquartered. If that’s the case, a foreign country’s tax rate and structure may prove beneficial for the organization.
That’s one good reason why knowledge is power when it comes to permanent establishment. Getting good tax advice beforehand from a local tax agency or accountant lets you know where your company stands, and you can act accordingly.
A reliable corporate tax advisor can aid in reviewing any service contracts with employees and local business partners, provide guidance on local tax liabilities, and generally protect your company from any major tax obligations linked to permanent establishment risk vulnerabilities.
Consider establishing a local business entity. To stay fully compliant with local tax authorities and take any mystery out of foreign tax status, a company can create a foreign subsidiary in its country of operation.
Subsidiary status has its advantages, tax-wise. A foreign subsidiary operates independently from its parent company, is responsible for its own assets and liabilities, and is deemed to be a separate legal entity for taxation and regulatory oversight by the subsidiary where the company is established—taking permanent establishment risk out of the equation.
However, a foreign subsidiary can be an expensive commitment—both financially and in time requirements. You’ll need to hire an international tax consultant to navigate in-country tax laws and it’s common to see capital requirements of several hundred thousand dollars and timeline requirements can last six to nine months.
Engage with a global employer of record. When the cost of establishing an entity in a foreign country is too high, working with a global employer of record may be the best option for reducing PE risk while achieving your global hiring and expansion goals.
An employer of record, like Global Employment Outsourcing (GEO), can act as your official and legal employer for overseas workers, so you can manage employees without worrying about their local tax payments and withholdings.
The employer of record, sometimes referred to as an international PEO, is responsible for remitting all employer and employee taxes in compliance with all local tax laws to avoid co-employment issues. With this employment solution, you get the benefits of entering new international markets and hiring foreign workers while reducing the risk of permanent establishment issues.