International businesses go out of their way to avoid having their business being designated a permanent establishment. They do this in order to avoid taxes on profits made in foreign countries and collecting and remitting VAT tax. They know that if they are deemed a permanent establishment in a particular country, they will be subject to significant tax liabilities.
A permanent establishment (PE) designation results in their having to pay taxes on profits made in that country. A PE is obligated to pay corporate taxes on any money that is generated from sales in that country. Corporate taxes also have to be paid on any revenue generated from activities in that country where revenue was generated. Examples of these types of activities would be manufacturing a product or extracting minerals from a mine.
A permanent establishment designation can also result in a company having to collect and remit VAT tax (Value Added Tax) or GST Tax (Goods and Services Tax) on the products and services sold in that country. Many companies don’t realize that they have to collect these taxes. These taxes can be very difficult to collect in retrospect and could potentially result in significant tax liability.
Another big drawback of getting deemed a permanent establishment is that your employees working in a foreign country can be subject to double taxation. In this scenario, they are forced to pay income taxes and social security taxes to both the IRS and to the foreign country that they are working in. In order to get employees to accept a foreign assignment, companies often have to offer tax equalization arrangements which guarantee that any added taxes will not reduce an employee’s income. When companies do this, they agree to increase an employee’s income to cover the added cost of the host country’s additional income tax and social security taxes. This can often increase their payroll costs 65-70%.
In most cases, the conditions that result in your foreign subsidiary being deemed a permanent establishment are spelled out in tax treaties between the United States and other countries it trades with. As a result, it is important that you review the rules regarding permanent establishment with a tax advisor before doing business overseas.
There are several things that will automatically trigger a permanent establishment designation in a foreign country. If you open up a branch office, have a place of management or have a factory in a foreign country, this would be considered a permanent establishment. Mines and oil drilling operations are also considered permanent establishments.
It is important to note that even home offices can trigger a permanent establishment designation. This can occur if a home office’s address is used on stationary and business cards or if it is utilized as a postal address for company correspondence. A dedicated business phone or fax line can also be used as criteria that establishes a home office as a permanent establishment.
The rules are a bit trickier when it comes to whether or not a warehouse is considered a permanent establishment. If it’s being used solely for packaging and storage of goods for delivery to customers or another company, it will not be designated a permanent establishment. Warehouses that are used for purchasing goods in a foreign country are usually not considered a permanent establishment activity. A warehouse can lose its exclusion from being a permanent establishment if non-excluded activities such as management or manufacturing are performed there.
Your company does not necessarily have to have an office or a factory to be considered a permanent establishment. A country can make a permanent establishment designation just based on your company having one or more employees in their country for a period of time. This usually occurs whenever a company operates in a country using dependent agents. A person is considered a dependent agent when they are operating under your control. They are also deemed a dependent agent if their business activities are devoted wholly or almost wholly on behalf of your business.
The way to avoid being designated a permanent establishment is to utilize independent agents. Examples of the types of independent agents that could be contracted include: import agents, distributor agents, and consignment agents. These persons must be legally and economically independent. They can’t be receiving a salary. In addition, the majority of their livelihood cannot be coming from your company.
Determining whether a person will be deemed a dependent agent or an independent agent can be very difficult to discern. For example a sales agent that receives sales commissions, or bonuses or stock options will be considered a dependent agent. A sales agent that has a substantial involvement in negotiating the terms of a sales agreement in that country will usually trigger a permanent establishment designation.
In summary, you want to avoid a permanent establishment designation if you are a business operating in a foreign country. If you are deemed a PE, your company and your employees will be subject to significantly higher taxes. As a result, a country giving your business a permanent establishment designation can significantly impact your potential profits. It could even make doing business in that country a losing proposition.
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Written by: Mark J. Krupp, Cofounder of