How to Avoid Creating a Tax Presence in Other Countries
By Kelly Kogan
When a company engages in cross-border business in another country, it should be careful, when possible, not to create a taxable presence in the other country.
An example is where a solar panel, wind turbine or fuel cell manufacturer puts some of its employees on the ground in another country to help with sales or overseeing the construction work on a project.
Recognizing the types of activities that will create a taxable presence is important to reducing tax costs. Project developers tend to form a subsidiary in the other country to own the project in that country. The subsidiary will be taxed in the project country
This article focuses on situations where a parent company also has employees on the ground.
The key is the level of business activity in the other country. Once a threshold level of business activity is exceeded, then the other country will assert its right to tax the parent and the employees both on the business income derived from sources within that country. It is one thing for a local project company to be subject fully to tax. What companies want to avoid is also having the parent company and its employees do too much directly in country so that they also become subject to local income tax.
The specific threshold is established by each country's own law, and local tax advisors should always be consulted. Also, there may be an income tax treaty that covers the situation and modifies the tax regime that would otherwise apply.
Putting tax treaties to the side, the US taxable presence rules are unusual. There are enough similarities in the taxable presence laws of many other countries to make a summary of the key features possible.
US Trade or Business
In the US, the threshold for recognizing a taxable presence is known as having a "US trade or business," and is quite low.
In the case of a foreign individual, any business activity by that individual while physically present in the US usually causes him or her to be taxed on the share of income he or she earns while physically present. Often this attribution is based on the proportion of time the individual spends working in the US relative to the time spent working outside the US.
For example, if a non-U.S. employee of a foreign turbine manufacturer travels to the US to solicit sales of turbines to US customers, stays for nine days, and on each of those nine days meets with numerous potential customers, then the US could assert the right to tax 9/365ths of the employee's salary for the year.
For manufacturing companies, the threshold for triggering a taxable presence in the US is less straightforward and requires consideration of both the qualitative and quantitative aspects of the company's activities in the US. Activities are qualitatively significant if they are material to the business as opposed to ministerial, clerical or incidental. Whether activities are quantitatively significant will often depend on the size of the business and the history of its activities in the US.
For example, suppose an employer is a large, well-established manufacturer that generates revenues from numerous sales to customers in other parts of the world and is now looking to enter the US market. A single visit to the US by its employee for nine days to solicit sales is unlikely to create a US trade or business for the employer, even if the employee is successful in signing a contract with a US customer. On the other hand, if the employee makes numerous visits to the US during the year and signs several contracts with US customers during those visits, then his or her activities in the US on behalf of the employer are likely to be qualitatively and quantitatively significant enough to cause the employer to have a US trade or business.
In the case of a foreign services company, the results are the same. For example, a foreign consultancy that provides testing services to PV projects around the world would not be treated as having a US trade or business based on a single visit by one of its employees to the US to conduct tests on a US project.
On the other hand, if the consultancy sends numerous employees on frequent short trips to the US, or if one or two employees it sends in a single year stay for extended periods, the activities would run the risk of creating a US trade or business.
Outside the US
Outside the US, an individual's liability for local income tax turns on whether the individual has spent enough time in the country to be considered a tax resident and what income he or she is considered to have earned in the country.
Depending on local law, individuals who qualify as tax residents of a host country may be taxed on their worldwide income. In most cases, an individual does not become a tax resident unless he or she spends a minimum number of days in the country during a 12-month period. This number can range from 183 to 365 days. In some countries, it may be even longer if the individual has a specific type of visa.
If an individual is not a tax resident, then he or she will usually be taxed only on the portion of the income that is considered from sources within the country. In this area, many countries follow the same approach as the US in that they will treat the salary an employee receives from his or her employer while physically present and working in the country as earned in the country even if the individual is not a tax resident and the employer does not have a local tax presence.
Turning to companies and what subjects them to local income taxes, the trigger in many countries is the existence of a level of activities referred to sometimes as a "branch" and other times as a "permanent establishment" or "PE." (The term "permanent establishment" is also used in income tax treaties, and it may have a different definition for treaty purposes. Treaties may spare companies from local income taxes if their activities do not rise to the level of a PE as defined in the treaty. The treaty definition of a PE usually has a slightly higher threshold for creation of a taxable presence than under local law. That is why it is always important to check treaties.)
In general, most countries require more significant business activity inside the country than the US before those countries view a company as having a taxable presence.
Most countries have adopted one of several general definitions of PE with possible local variations. The most common is a fixed place of business in the country through which at least some of the business of the company is conducted. This "fixed place PE" must meet two key requirements. First, it must be a distinct office or other place with a certain degree of permanence in the country. Second, it must be used to carry on business activities.
For a foreign manufacturer, a fixed place PE in a country includes a local office or factory used by its employees to engage in manufacturing or sales activities. It does not matter whether the office or factory is owned or leased by the foreign manufacturer. It is not a defense that the space is "borrowed" from an affiliate in the country (meaning that the manufacturer does not compensate the affiliate for its use of the affiliate's space) if the manufacturer's use of the space is lengthy or frequent. A fixed place PE can even be a hotel where the nonresident company's employees stay repeatedly and conduct business activities.
On the other hand, a fixed place PE is not established if it is not "fixed" or if it is not used to conduct business. For example, even if employees of a foreign manufacturer visit a country frequently during a 12-month period to solicit sales, the manufacturer is unlikely to have a fixed place PE if the employees visit different cities or stay in different hotels. On the other hand, if those employees repeatedly visit the same location and during each visit conduct business using the same conference room in the office of a local affiliate, then it is likely that the conference room will be treated as a fixed place PE of the foreign manufacturer.
Some countries may have specific exceptions where a fixed place PE is not considered to have been created. An example is for activities that are preparatory or auxiliary in nature. They can include, for example, certain storage facilities used to store goods on a temporary basis or a location used solely for the purpose of purchasing goods or merchandise or for collecting information. Because the scope of these exceptions can be rather opaque, local counsel should usually be consulted.
For a service provider, such as an EPC contractor, the existence of a PE may depend on whether it is performing its services as part of the construction or installation of a project inside the project country. Many countries have a special definition of PE that treats a building site or construction or installation project as a PE, but only if it lasts for a specified period of days or months. (This period generally ranges from 90 days in a 12-month period up to a full 12 months.)
There are typically two things that have to happen before a contractor has created a construction PE.
The first relates to the substantive activities that are taking place. They must qualify in most countries as "construction, assembly, or installation projects." What rises to the level of construction may vary from one country to the next. For example, construction activities could include the construction or renovation of access roads, the installation of cables needed to connect a power plant to the utility grid, or excavation and dredging activities. Assembly and installation may not be limited to a fully-blown construction project — they could also cover assembly or installation of new equipment, such as a complex machine, in an existing building or project. Some countries even treat as construction supervising a local construction company at the project site.
The second thing that must happen to have a construction PE is the activities in the country must last long enough to rise to the level of a construction PE. The critical question is when the activities begin and end. In most cases, a construction PE is considered to exist from the date on which a contractor begins its work, including any preparatory work, and ends when that work is completed. In addition, temporary or seasonal cessations of work, including those outside of the contractor's control, are usually included in determining how long the work lasts.
For example, assume an EPC contractor installs a trailer to serve as an office on April 1 at the site of a power plant that it has contracted to build, begins constructing the plant on June 1, is forced to halt construction during November and December due to equipment shortages and bad weather, and finally completes the plant on May 1 of the following year. The EPC contractor's construction site will be considered to have lasted 13 months (April 1 to May 1 of the following year) and not 10 months (May 1 of the first year when construction began to May 1 of the following year when construction ended, less the two months when construction ceased due to factors outside of the EPC contractor's control). If the temporal component of the construction PE definition is 12 months, then the EPC contractor in this instance will have a construction PE.
If an EPC contractor, which has undertaken a general contractor role on a project, subcontracts parts of the project to one or more subcontractors, the time spent by each subcontractor working on the construction site will likely count for purposes of determining whether the general contractor has a construction PE. This is because the time spent by the subcontractor working on the project will probably be considered time spent by the EPC contractor working on the project under general agency principles. Alternatively, if the country includes supervision as a construction-related activity, any time the general contractor spends supervising the subcontractor's work will have to be taken into account for purposes of determining whether the general contractor has a construction PE. The degree of supervision necessary to apply this rule will depend on local law.
As for a foreign subcontractor, it will have a construction PE only if its activities last longer than the period needed to trigger a construction PE.
To illustrate, assume an EPC contractor signs a contract to build a solar thermal facility that will be used to supply steam to a nearby power plant. The EPC contractor hires numerous subcontractors to perform various aspects of the EPC contract. The construction of the entire CSP facility takes more than 18 months to complete, while each subcontractor's activities take five months or less to complete. If the threshold for a construction PE is six months, only the EPC contractor will have a construction PE.
One other type of PE is an agency PE. This is a PE created by the activities of a dependent agent in a country who is acting on behalf of a foreign company.
Dependent agents may include employees and others under the control of the principal, regardless of whether they are residents of the country. They are on the ground. However, they do not include persons considered "independent" agents, such as local transportation companies and other established independent local service providers who have more say over how any work will be performed and no ability to bind the principal legally. A local subsidiary of the principal is not usually a dependent agent, unless the subsidiary is specifically acting in such a capacity. In some, but not all cases, a country's law may require that the dependent agent also have the authority to bind the principal legally to local contracts.
For example, assume that an employee of a foreign manufacturer visits a country once during the year, remains in the country for only a couple of days and, while there, finishes negotiating and signs a contract with the customer that is binding on the principal. Under these facts, it is unlikely that the employee's activities will have created a fixed place PE. However, if the country's laws also include a dependent agent PE, then the employee's activities run the risk of creating an agency PE.
Taxable presence rules are highly complex, fact dependent and sometimes counter-intuitive. They create both pitfalls for the unwary and opportunities to reduce overall tax exposure for those who plan ahead. Companies expanding outside their home bases should proceed with care.