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Updated: Sep 14, 2022

Learn about permanent establishment risk, what it means for your business, and how to mitigate this risk.

Permanent establishment risk affects companies who engage in business overseas. The risk of creating a permanent establishment is a key risk area for multinational companies. However, for the purposes of this article, we’ll focus on the risks to companies as related to engaging foreign freelancers, overseas independent contractors, and global vendors.

What is permanent establishment?

Permanent establishment generally refers to a local tax authority’s decision that a company is operating in that country continuously and is therefore subject to corporate taxes and possibly VAT. VAT (value-added tax) is a tax concept that varies from country to country and is paid at every point in the supply chain.

What is permanent establishment risk?

Permanent establishment risk is the risk of local tax authority in a foreign country determining that your business has permanent establishment — a stable and ongoing presence in that country. Making this determination can then allow that foreign tax authority to declare the business a permanent establishment, which makes that business liable for corporate taxes on profits generated in the country. In addition, the local tax authorities — depending on the country — can charge interest on unpaid taxes.  

What determines permanent establishment?

Two main factors determine permanent establishment risk: the fixed place of business test and the dependent agent test.

What is the fixed place of business test?

The fixed place of business test states that a business has a permanent establishment in another country if it has a fixed place of business there through which it carries on its business in that country or elsewhere. If your company operates from a specific location overseas on a continuous — or even regular recurring — basis, it could be deemed to have a fixed place of business. For example, if your freelancers receive mail on behalf of your business, there is a risk that your company could be considered a permanent establishment.

What is the dependent agent test?

The dependent agent test states that a business has a permanent establishment in another country if it has a person — other than an independent agent — acting on its behalf to execute contracts in the business’s name in that other country.

What activities increase permanent establishment risk?

Many companies have some activities or operations aboard without setting up corporate entities in those foreign countries. For example, a business might:

  1. Make occasional visits to customers in foreign countries to provide technical assistance or support;

  2. Send an executive or salesperson abroad to close an import or export deal; or

  3. Hire foreign freelancers to work as sales representatives; or

  4. Having a regular place of work when you visit another country — even a co-working space.

Depending on the country and the circumstances, these activities may be enough to cause a significant risk. If any of those persons generate sales or profits, it could lead local tax authorities to investigate further. If those assistance or support visits are determined to be long-term (and not sporadic), then it could be enough to lead to a permanent establishment. 

In some countries, having the word “sales” in the title of one of your overseas freelancers may be enough to be deemed as having a permanent establishment. 

What happens if the permanent establishment is mismanaged?

As stated above, mismanaging your permanent establishment risk can lead to tax liabilities — including penalties and interest charges. In addition, it can lead to increased audits from local tax authorities, employer reporting obligations including payroll and social security, and in some cases damage to your business’s reputation and other issues.

How does permanent establishment risk relate to working with international freelancers / independent contractors?

In many countries, including the United States, there are tax and compliance risks associated with improperly classifying a worker as a freelancer / independent contractor instead of an employee. The main points that affect a contractor’s status overseas are very similar to those here in the United States — behavioral factors, financial factors, and relationship factors.

Some warning signs include:

  1. Your overseas freelancer does not have other clients.

  2. Your foreign independent contractor works for you full-time.

  3. You have been working with your overseas contractor for a long time.

  4. Your international freelancer is doing work critical to the success of your business (for example, sales)

  5. You control how, when, and/or where your overseas independent contractor works.

How can I mitigate permanent establishment risk as it relates to working with overseas freelancers / independent contractors?

One way to mitigate permanent establishment risk is to use a PEO or an employer of record to report taxes in local areas where you do business or hire freelancers. 

Another way to mitigate this risk is to have clear documentation of your independent contractor relationship. Using a system like Liquid, which was designed for independent contractor and freelancer management, has built-in features and protections to help you with the behavioral, financial, and relationship factors that affect independent contractor compliance — both domestically and internationally. 

Ready to improve your freelancer compliance procedures? Try Liquid today



4 min read

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