If your company is considering a global expansion or hiring employees in other countries, you need to understand permanent establishment (PE) risk.
Global tax authorities have increased their scrutiny of foreign businesses operating within their borders in recent years, and not being on top of any potential PE risk can land businesses in serious trouble. Any violations could result in regulatory fines, back taxes, and long-term damage to a company’s international public image.
Successful global businesses are the ones able to tap into international talent and revenue streams without running the risk of permanent establishment in the process.
What is Permanent Establishment Risk?
PE risk refers to the possibility that local authorities in a different country will view your company as a permanent and ongoing enterprise. If that happens, you’ll be liable for corporate taxes in that jurisdiction.
PE scrutiny among international tax authorities is on the rise after the introduction of OECD Action 7, which aims to keep multinational businesses from avoiding taxes. Mishandling your company’s PE risk while operating internationally can lead to a variety of financial problems.
Penalties and Fines
PE fines and penalties can vary depending on the severity of your company’s violations. For example, say you unknowingly triggered PE in Mexico and then kept operating tax-free for six months. That would result in a much higher penalty than if you had realized the error sooner and registered for a local employer ID.
When it comes to what you can expect with PE penalties, one of the main questions tax authorities will use to weigh your case is, “Does it look like they were trying to get away with something?”
Unfortunately, an honest PE mistake can look far more deliberate to international authorities. That’s why you need to be proactive about risk management.
Back Tax Payments
If your organization triggers PE and becomes liable for back income taxes, you’ll also have to pay any interest that accrued as well.
On top of regulatory fines and penalties, tax arrears with interest can pose a major threat to your cash flow. That’s money that you could’ve used for growth initiatives and strategic advancements.
Depending on your company’s financial situation, accidentally triggering PE and corporate taxation could be a major financial setback.
More Frequent and Aggressive Audits
If your company mishandles its PE risk, the authorities’ interest in you won’t just disappear once you pay corporate taxes. They’ll increase the frequency and thoroughness of their audits, using the logic that if your company slipped up once, it could happen again.
It’s worthwhile to get your PE risk squared away from the beginning, as opposed to dealing with heightened scrutiny. Audits are expensive, a logistical headache, and can interfere with your day-to-day operations.
4 Types of Permanent Establishments
When operating globally or employing individuals internationally, there are four categories of potential risks to be mindful of.
- Fixed place of business PE: Brick-and-mortar stores, offices, or another type of physical presence for conducting business.
- Agency PE: Employing a dependent agent — someone who acts on your company’s behalf — to close customer contracts or somehow generate global revenue.
- Service PE: Providing physical or non-physical services (like SaaS products) in another country on an ongoing basis. You can be labeled a service PE even without offices or stores in your host country. If you’re a SaaS provider expanding into India, for example, you’ll likely want to hire independent contractors rather than full-time employees to avoid PE risk.
- Construction PE: Carrying out a construction or installation project for more than a specified amount of time. The length of time it takes to trigger the construction PE label varies by jurisdiction. So if your company plans on starting a construction project in Germany, for instance, you should carefully review the applicable tax treaties to learn the time it takes to trigger PE.
By understanding the different PE classifications, you can enjoy the benefits of doing global business without increasing your legal risks or tax exposure.
Understanding Permanent Establishment Risk
International expansion is growing more common among startups and established organizations alike.
However, to avoid financial and legal trouble, multinational expansion must be approached correctly. Failure to understand PE risk can lead to a variety of lasting consequences.
Unwanted Tax Exposure
If you’re deemed a PE in another country, you’ll have to pay taxes on revenue generated in that jurisdiction.
Over time, this can significantly decrease your company’s available resources for growth activities.
You might also be liable for back taxes on your earned revenue. The amount of annual revenue that triggers corporate taxation varies worldwide.
Fines and Other Regulatory Penalties
If your business is found to be operating as a PE without paying the necessary taxes, you could be hit with hefty fines.
Say your company hired a small overseas sales team on an ongoing basis. You also supplied this team with a physical office from which to conduct business.
Technically, this creates a PE. However, since your company didn’t understand the PE risk, you failed to pay taxes on the revenue you earned. Eventually, local tax authorities assess the situation and award you a sizable penalty.
Reputational Damage
When expanding internationally, your company’s reputation is an important factor. If you become known for bucking local rules and local tax laws, you’ll find it harder to maintain growth and build lasting business relationships.
Common Business Situations That Can Result in PE Risk
Some business decisions are especially likely to raise your PE risk.
A permanent office — this includes co-working spaces and home offices in some areas — could generate an unwanted PE label. You should also steer clear of management hubs, factories, warehouses, and mines.
Any of these will signal to local tax authorities that you’re generating enough revenue to be on their PE radar.
High-Risk PE Behavior
An ongoing physical business location isn’t the only thing that could make you a candidate for a PE classification.
Some other high-risk situations include:
- Engaging a local employee or contractor with authority to sign contracts on behalf of your company.
- Hiring local employees for senior management or C-suite positions, or who provide core-level work for your company — a banker at a bank, for example — or perform work that generates revenue. This includes anyone in a sales role, however some focused strictly on lead generation isn’t a PE concern.
- In some locations, seconded employees — employees assigned to work in other countries for a period of time — can be a PE trigger.
- Establishing a board of directors that operates, holds board meetings, or makes strategic decisions in another country can prompt a PE label.
- Your PE risk can rise if your employees frequently travel internationally for revenue-generating business. Local tax authorities are going to want a percentage of corporate revenue generated in their country, whether or not the employees in question are full-time residents.
- Holding a significant degree of economic influence in a given area. For example, are a significant portion of local businesses somehow dependent on your own in order to function? That level of economic entanglement can be a large PE risk.
- Operating in other countries for extended periods of time. The longer you’ve been conducting business activities in a given location, the more closely you’ll be watched by local tax authorities to ensure you’re not a PE.
Luckily, there are lower-risk corporate strategies you can pursue.
Low-Risk PE Behavior
Hiring part-time contractors for “supporting activities” in lieu of full-time employees is a common way to manage PE risk. This goes back to the idea of core-level work that we talked about earlier.
A marketer could be considered a supporting role for a dental office, for example. The job is part of the business but not central to the core enterprise. A dentist, however, couldn’t qualify as a supporting role because they provide services that are crucial to day-to-day operations.
Other common examples of supporting activities include:
- Marketing and public relations
- Accounting and finance
- Legal and administrative support
However, the definition of a “supporting activity” will always be subjective. If you run a marketing agency, a marketer or public relations professional won’t qualify for supporting roles, that would be considered a misclassification. The same goes for a lawyer at a law firm.
Frequently Asked PE Questions
Do “groundwork-laying” activities such as business introductions trigger PE?
No, activities that set the stage for future business operations but do not actually generate revenue are not considered a PE risk.
How long can a company conduct business internationally before triggering PE?
There’s no universal agreement on this point. It varies from country to country based on their specific tax treaty.
3. If my company has accidentally created a PE, what should we do next?
If you’ve accidentally triggered PE, you should register for a local employer ID and consult with a tax specialist.
How to Protect Your Organization from Permanent Establishment Risk
One way that multinational companies safeguard themselves from PE risk is to set up a foreign subsidiary. This is a separate legal entity that pays taxes on revenue earned in a given jurisdiction. Meanwhile, the parent company’s corporate revenue in their home country remains untouched.
While this might make sense for larger companies who are hiring many employees, smaller companies are typically better off using an Employer of Record (EOR).
EORs can help with global employment by managing talent on your behalf, with an established local presence across many locations. They offer services and deep expertise in local tax codes and compliance mandates. They essentially act as a proxy employer for your global team.
Working with an EOR won’t necessarily prevent corporate tax liabilities. However, they prevent businesses from unknowingly creating a PE and getting hit with compliance fines and back taxes (plus interest).
An EOR like RemoFirst can help your organization with:
- Localized contracts: Hiring employees internationally requires compliance with specific employment laws. Every jurisdiction has unique requirements, but an EOR can provide you with locally tailored employment contracts.
- Compliant global payroll: Payroll laws and regulations vary by jurisdiction. An EOR can assist you in maintaining payroll compliance while paying employees in the appropriate currency.
- Global benefits administration: EORs can provide local benefits administration for a global workforce. This is important because different jurisdictions have different laws about the benefits that employees are entitled to.
- Hiring local contractors: Not every role needs to be full-time — and as we discussed, hiring full-time employees can sometimes be a PE risk. Not all EORs provide onboarding services for contractors, but RemoFirst can hire and pay remote contractors as well as employees in 180+ countries.
By working with an EOR like RemoFirst, you can access top talent while minimizing your PE risk.
To learn more, request a demo today and we can discuss your company’s specific needs.
