Whether you're looking to hire in a foreign country or your remote workers are in another country, your organization undertakes Permanent Establishment (PE) risk. And with PE risk come heavy penalties, corporate taxes, and reputational damage.
For example, if you're a foreign company that has an extended period of presence in India for carrying out any kind of business activity, the income you make for that period is taxable in India.
Article 5 of the Double Tax Avoidance Agreement defines PE as "A Fixed place of business through which the business of an enterprise is wholly or partly carried on.”
For example, if you're a construction PE (more on this later) and present in India for more than six months or if the charges payable for project or supervisory activity exceeds 10% of machinery and equipment sale price, it is regarded as Construction PE.
You may incur penalties and fines if you have unintentionally established a PE and have not paid the taxes. However, the fine and penalty amount will depend on the situation.
For example, in the case of Galileo International Inc, the Delhi Tribunal observed that no guidelines were available regarding the fine amount. It had to be determined by the factual situation of the case and several factors like the risk involved, functions carried out, and assets used.
This guide has everything you must know about PE risk.
What is PE?
A permanent establishment or PE is a fixed place a foreign company uses to conduct its operations in another country.
A PE involves tax liabilities. So, if you operate remotely or have a distributed team, you need to know about permanent establishment risk and how you can avoid penalties.
The permanent establishment can be of different types.
Fixed location PE
For fixed location PE occurs under the following circumstances.
The location of the business is fixed for a reasonable period, and the location must be available to the foreign company.
For example, consider a foreign business located at another company’s business premise in India. If the foreign company has regular access to this premise in India, it will be deemed as the foreign company’s PE in India. Needless to say, the PE must carry out commercial activities.
If a foreign establishment delivers services in India that exceed a threshold limit, this can trigger the PE establishment in India.
According to Indian treaties, the threshold limit is
- 90 to 120 days if the services are provided to unrelated enterprises, and
- 1 to 30 days if the services are rendered to associated enterprises.
Dependent Agency PE
If a person who lives in India acts on behalf of or represents a foreign company, it might trigger a dependent agency PE in India for the foreign company.
Having a subsidiary company in India doesn't mean a foreign company has a PE in India. The subsidiary becomes a PE only when the parent company runs its operations through the PE in India.
When a foreign company conducts construction work longer than a specified duration as per tax law, the foreign company's operations are considered a construction PE.
For example, in the case of CIT International vs. Bellasea Ltd., the threshold period was 12 months. Since the facts and materials were insufficient to prove that the assessee’s activity had crossed 12 months, the court declared no establishment of PE in India, according to Article 5(2)(g).
Does the business operate from a fixed location?
A PE can be triggered if the foreign company has an office in another country. This can be a branch office, a place of management, a factory, a co-working space, or a mine.
Do the employees receive a commission?
If domestic employees in the host country earn sales-related compensation, like sales commissions and bonuses, this could result in forming a PE.
Does the business generate revenue in the country?
If a foreign company's revenue surpasses the threshold limit imposed by domestic regulation, it may trigger the establishment of a PE. The type of revenue generated, recurring or one-time, may also impact the PE valuation.
Does the company make strategic decisions in the country?
If vital strategic decisions that affect the foreign company's overall operations are made within domestic borders, a PE risk might arise. These decisions could range from financial planning to marketing strategies and could impact the extent of the PE.
Does the business make sales to customers in the country?
Selling goods or delivering services to customers within a country could lead to establishing a PE for the foreign company. Additionally, the nature of the sales - whether through a physical presence like a store or online sales - could be a relevant factor in the PE evaluation.
What company situations lead to PE?
Signing contracts with in-country businesses
When a company signs a contract with in-country businesses, it may establish a fixed place of business in that country. This can trigger the risk of PE. The bulk of the agreement, like discussion, drafting, and signing of the contracts, must have occurred in the foreign country to lead to a PE situation.
Receiving payment from clients within the country
If a foreign company regularly receives payments for goods or services from clients in a foreign country, this can create a permanent establishment risk. Such regular revenue generation suggests an established business presence and economic ties in the host country.
Withholding employee income and social taxes
When a foreign company has employees working in a foreign country, and income tax or social security contributions are withheld from their salaries in that country, it may give rise to a permanent establishment risk. Withholding employee taxes indicates a formal employment relationship and a certain level of business activity within the host country.
Employing fixed-term contract employees
Engaging fixed-term contract employees in a foreign country may contribute to establishing a PE. Using fixed-term employees suggests an ongoing business presence and involvement in the local labor market.
Employee contribution to company revenue
If a foreign company’s domestic employees play a large role in revenue generation, a PE may have formed. The domestic employees’ significant contribution illustrates the foreign company’s link to and economic worth in the host country.
Companies doing cross-border operations should be aware of these circumstances and carefully evaluate their activities in foreign jurisdictions. Understanding local tax rules and regulations is critical for managing permanent establishment risks proactively and avoiding unanticipated tax payments and fines. Seeking expert guidance and conducting frequent evaluations of company activities can help in compliance and effective PE risk mitigation.
What are the consequences of not managing PE risks?
Inappropriate management of risks associated with Permanent Establishments can have severe consequences for a foreign company. Some of these include:
Mismanagement of PE risks may result in double taxation. It occurs when a foreign firm is taxed on the same income in its home and host countries, where the PE is established.
Penalties and Fines
Tax authorities may impose penalties and fines on the foreign company for not complying with the tax laws related to PE. These penalties can be substantial and may strain the company financially.
In India, the Double Tax Avoidance Agreement between countries and the Income Tax Act of 1961 defines the concept of PE. If a foreign enterprise has a PE in India, the income generated through the business activities carried out in India is taxable in India under Article 7 of the Income Tax Treaty. Failing to carry out all the compliances (like, filing of tax return) as per Income Tax Act 1961 may result in a penalty ranging between 100% to 300% of the unpaid tax liability.
Dealing with tax-related controversies and legal disputes can harm a company's reputation, losing customer, partner, and investor trust.
Avoid reputational damage by adhering to the local labor and taxation laws of the country. Check out how international PEOs can help you.
Misinterpreting PE regulations or arguments with tax authorities can result in protracted and expensive legal battles that drain resources and attention away from crucial business activities.
Impact on Profit Margins
Taxation in a foreign country can substantially impact a company's profit margins and diminish the overall profitability of its worldwide activities.
How to mitigate PE risks?
There are strategies to minimize the permanent establishment risks, such as,
Foreign Subsidiary Establishment
Establishing an individual legal entity, such as a subsidiary, in a foreign country can help segregate the activities and risks, reducing the likelihood of a PE being created. By operating through a subsidiary, the foreign company can conduct business locally, which may be subject to different tax rules and regulations than the parent company. This can help limit exposure to PE risk and potential tax liabilities in the host country’s jurisdiction.
Local Tax Specialist
Engaging a local tax specialist or tax advisor with expertise in the host country's tax laws can help navigate the complexities of PE regulations and ensure compliance. Local tax professionals can provide significant insight into the rules regulating the establishment of a PE in the host nation. They can also assist in structuring business activities to reduce PE risk and maximize tax efficiency.
Utilize Double Taxation Treaties
Many nations have Double Taxation Avoidance Agreements (DTAs), which are meant to prevent double taxation and clarify the conditions under which a PE exists. Companies should take advantage of these treaties.
Review Business Activities
Conduct a thorough review of the company's business activities in foreign jurisdictions to identify potential PE risks and take necessary corrective actions. Examine the company's operations in the host country, including sales, marketing, distribution, customer service, and strategic decision-making. Identifying and addressing possible PE triggers early on can assist businesses in taking necessary corrective actions while avoiding unwanted tax penalties.
Contracts should be carefully structured to ensure that critical decisions and key duties are not made in the foreign country, limiting the probability of a PE being established. Thoughtfully drafted contracts can clarify the roles and responsibilities of different entities involved in cross-border transactions and operations. Such contracts give a clear picture of the business activities conducted in each jurisdiction.
Work with an Employer of Record (EOR)
An EOR is a provider of third-party services that becomes the company's legal employer in the host country. By collaborating with an EOR, the foreign firm can maintain compliance with local employment and tax rules while avoiding the establishment of a formal legal presence, which could result in a PE.
If you wish to hire remotely, working with an EOR like Gloroots is a great idea. Gloroots does all the heavy lifting of the paperwork. It helps you stay compliant and avoid permanent establishment risks.
With our multi-currency feature, you can easily manage global payroll, maintain transparency with our transparent reports, and generate employment contracts in a few clicks. In short, you can accelerate your onboarding process while seamlessly managing your remote workforce.
Book a call to learn more about our services.