Avoiding Accidental Foreign Taxable Presence: Permanent Establishment Risk

As U.S. companies expand operations around the world, one common risk that is often overlooked is the accidental creation of a taxable presence in another country.  You don’t need to have a formal legal entity in another country to subject your U.S. company to taxation there.  There are numerous ways to create a taxable presence. Two common examples are either a fixed place of business (office, warehouse, etc.) or an employee with authority to conclude contracts in another country. 

Absent a bilateral income tax treaty between the U.S. and the country you’re expanding into, a U.S. company becomes subject to tax in that country if its activities trigger taxation under that country’s local tax laws.  The threshold for creating a taxable presence under local law is usually fairly low.  However, if such a treaty exists between the U.S. and the other country, it will raise the threshold for what constitutes a taxable presence. A taxable presence in treaties is referred to as a permanent establishment (“PE”).

A PE is similar to the concept of a taxable presence in a state (i.e., nexus).  Formally, a PE is used to determine the right of a treaty country to tax the profits of a foreign company. Article VII of the U.S. Model Income Tax Treaty prevents a country from taxing a foreign company’s profits unless the company carries on business through a PE situated therein.  If a PE is deemed to exist in the other country, the profits of attributable to the PE may be taxed there.

Under Article V, paragraph 1, a PE can result from a fixed place of business which is defined to include, among other things, a place of management, and an office.  Note that home offices can constitute a PE.  There are many exceptions for what constitutes a fixed place of business under paragraph 4.

In addition to a fixed place of business, paragraph 5 provides that employees and dependent agents can create a PE if they habitually exercise authority to conclude contracts for the U.S. company in the other country.   

Under paragraph 6, the use of an independent agent will generally not create a PE for the principal as long as the agent is working in the ordinary course of the agent’s business and the commercial and financial arrangements are consistent with a typical independent agent relationship. 

The list below is a simplistic summary of some items to either “Do” or “Don’t Do” to avoid a PE:

Things to DO

• Identify the activities in the foreign country that may create a taxable presence or a PE
• Train employees on PE concerns relevant to the foreign country before they go
• Use independent agents
• If you use employees or dependent agents, limit their authority to bind the company in the foreign country, specifically the ability to execute contracts
• Have employees notify customers of their limited authority and that U.S. executives will make the final decision
• Have contracts that are negotiated in the foreign country submitted to U.S. home office for legitimate review and approval
• Sign contracts in the U.S.

DON’T DO

• Don’t give employees or dependent agents authority to bind the U.S. company in the foreign country
• Don’t open an office, warehouse, etc., unless it fits within the exceptions of Article V, paragraph 4 of the Income Tax Treaty with such country
• Don’t give business cards with a foreign country address
• Don’t send employees to foreign country for long terms assignments (or excessive cumulative short-term assignments) without consulting tax department
• Don’t give employees authority to resolve open issues with customers, such as settling accounts receivable, warranty, pricing, etc. while visiting customers in foreign country

If you have any questions regarding the above discussion, please contact Greg at 971 339 2739