When you hire independent contractors in foreign countries, you don’t expect a potential tax liability. However, it could happen and this depends on a couple of factors. It could depend on factors surrounding the contractors working on your behalf. It could also depend on whether they are triggering permanent establishment (PE) by their activities.
This article will explore PE definitions and the type of activities that could result in corporate taxation for your company when you hire foreign contractors. You can minimize the risk of PE taxation by taking a few simple steps when creating and managing the contractor relationship overseas.
What is permanent establishment?
Permanent establishment (and resulting corporate tax) is triggered by business activity inside a foreign country that creates local revenue for your company. The activity does have to be ongoing and habitual, rather than sporadic or isolated. Usually, it will also involve having a fixed business presence. This includes an office or facility, but there are exceptions to that.
Activities that trigger permanent establishment
If your company does not have a fixed place of business in the foreign country, then PE could still be triggered by employee or contractor activity on your behalf. This activity does have to result in some type of local revenue that would be subject to corporate tax.
The most frequent example is ‘agency PE’. Here, a worker acts as your agent and concludes sales contracts with local customers. The host country has an interest in taxing that revenue, as you are deriving a financial benefit inside its borders. However, agency PE will only be triggered if the sales activity and revenue are ongoing and regular, and not just one or two isolated contracts.
Another way to meet the PE criteria is through ‘service PE’. In this case, the worker is providing some type of ongoing consulting, maintenance, or repair services that create revenue or add value. This would not apply to common remote worker positions such as customer service (which could include communications with other countries via a call centre), marketing, or IT development.
The Time Factor
The amount of time involved in the business activity inside the country is also another component. Many countries use a continuous 183 days in a calendar year limit, but some like China apply the 183 days to be cumulative within any 12 months. That way, you can’t avoid the PE time factor by giving your contractor a month off, and then re-hiring them. This is similar to the test used to establish tax residency based on length of stay. In both cases, these exclude business trips and short work projects.
Can independent contractors create a permanent establishment?
All of this does raise questions for companies that hire independent contractors in foreign countries, and whether that brings a risk of creating PE. Normally, PE is more likely to be triggered by employee activity, because many countries use criteria that include having ‘control’ over the worker. Typical contractor relationships do not exhibit the same level of control as you would have over an employee.
However, you shouldn’t think that hiring a contractor instead of an employee will allow you to escape PE on that basis alone. If it appears that you are directing the contractor’s work schedule and methods, and they are creating regular revenue for your company, then the hiring method would not automatically insulate you from PE. For example, if the contractor is signing contracts on your behalf and at your direction, that could meet the criteria.
Another factor is whether the contractor is working solely for your company in an agency relationship, or if they are performing the same services for multiple clients in the country. In China, if a non-employee is representing multiple companies, PE will not be applied to the activity and revenue.
Permanent establishment around the globe
The imposition of permanent establishment does vary among countries, and the risk can be greater depending on where the worker is located. For example, China is the strictest country in Asia when it comes to PE, and many European countries such as France and Ireland are stretching the definition of PE to capture many types of business activity, including digital sales.
The effect of trade treaties on PE risk
Many countries have trade treaties with one another, or between a region of countries, that will affect the PE criteria. To encourage trade, those treaties will often have PE rules that are more relaxed than those in the individual countries, which would take priority over local laws.
How to avoid permanent establishment risk when hiring contractors
In addition to the factors of client control and single-client contractors, other factors could result in PE corporate taxation. You should make sure that you are not creating an ‘employee-like’ relationship with the contractor. This includes offering a fixed monthly salary, paying expenses, or extending benefits.
It is possible that at some point your contractor could claim misclassification and want employee status. Then, the entire scope of activity would be viewed within employee activity definitions for PE, and increase the risk of PE being imposed.
Before you hire a worker for PE-related work activities like sales, you should see if there is a tax treaty between the foreign country and your home country with more permissive definitions. It is also advisable to do some research on the PE laws of the host country to see how they are being applied. Given that PE corporate tax rates can range from 10-30% of total revenue, you may also want to engage local legal expertise if you are concerned that PE may be triggered.