The rise of remote work has led to more employees working across borders. This trend introduces new Permanent Establishment (PE) risks. PE risk means a company could face additional tax responsibilities if considered a permanent establishment under another country's tax laws.
In this article, we explore how overseas remote work can affect a company's tax obligations. We aim to help you understand PE risks, their impact on businesses, and strategies to manage them.
1. Understanding PE Risk
PE risk occurs when a company's activities in a foreign country classify it as a "permanent establishment," leading to unexpected tax liabilities. Countries have tax treaties to avoid double taxation. The OECD Model, an influential framework, says "no PE, no tax." A company only pays taxes where it has a PE. If there's no PE, typically, there's no tax in that country.
Under the OECD Model, a PE is a fixed place where business is partially or fully conducted. This includes:
- Fixed PE: Management places, branches, offices, factories, workshops, natural resource sites.
- Construction PE: A construction, assembly, or installation project continuing for a certain period (usually over 12 months).
- Agency PE: An agent acting on behalf of the enterprise and holding the authority to conclude contracts in that country, except for brokers, general commission agents, and other independent agents.
Taxable income attributed to a PE is calculated based on the "attribution principle," treating the PE as an independent enterprise and transactions between the head office and PE as per market principles. In contrast, the "comprehensive approach" taxes all income generated in a country, regardless of PE presence. Japan shifted from the comprehensive to the attribution approach in its 2014 tax reform.
2. PE Risk in Remote Work
PE risk is significant when employees work remotely across borders. If an employee works remotely from abroad for a long time, their activity might create a PE, leading to tax liabilities.
For example, if a company sends employees overseas to serve clients and their activity forms a PE, the company might have to pay taxes on income earned there. The risk depends on the employee's location, activity nature, and stay duration.
Start-ups and smaller companies might unknowingly face PE risks with remote work. For larger firms, PE risk can be a key reason to limit such work.
For larger corporations, PE risk can be actually a primary reason to restrict overseas remote work in the most of cases. Some companies without fully functional legal departments such as start-ups and ventures might unknowingly allow remote work that incurs PE risks.
3. Real Impact of PE Risk: Case in Japan
Penalty taxes apply when companies fail to report taxes properly. This not only adds financial burdens but also affects reputation. Being seen as committing tax malpractice can damage trust with clients and partners.
A notable example in Japan is Amazon.com. In 2009, the Tokyo National Tax Bureau imposed approximately 14 billion yen in back taxes on Amazon.com for conducting sales operations in Japan through a Japanese entity, while contracts were made by a U.S. affiliate, and profits were reported in the U.S. Amazon contested this decision and sought tax negotiations between Japan and the U.S., leading to their claims being recognized. However, Amazon now pays corporate taxes in Japan as it expands its operations there.
4. Strategies to Reduce PE Risk
For companies wanting to allow remote work from overseas, there are three approaches:
(1) Consult International Tax Experts
Work with global accounting firms or tax professionals to assess and manage tax risks. Understand each country's tax laws where employees work remotely. Develop internal policies for tax compliance related to remote work. Remember, consulting with big firms can be expensive.
(2) Establish Local Entities
To avoid unexpected taxes, set up local entities and file taxes properly. Requirements and forms differ by country, so seek local expert advice. Costs and timeframes vary; for example, setting up in Japan can be costly and lengthy.
(3) Use Employer of Record (EOR) Services
EOR services can help manage PE risks. An EOR legally employs staff abroad on behalf of a company. This way, the original company avoids establishing a PE and direct employment in countries where it doesn't have bases, reducing risks. EOR providers handle payroll, insurance, and tax filings, easing administrative tasks.
Many EOR providers in Japan are Western and might not fully understand local laws and culture. "No boundaries" specializes in Japan, offering tailored services for foreign companies. For Japan-related remote work queries, contact "No boundaries" for a free consultation.
Kiyotsugu Manabe (No boundaries Ltd. CEO / Specially Appointed Associate Professor at Kyoto University's office of Society Academia Collaboration for Innovation)
Kiyotsugu Manabe brings a wealth of expertise in international development and management, backed by a robust academic foundation with a Master's degree from the Johns Hopkins University School of Advanced International Studies (SAIS) and the Graduate School of Frontier Sciences at the University of Tokyo, where he specialized in International Cooperation. His professional journey is marked by significant roles at leading international organizations, including the World Bank, JICA, and McKinsey & Company, where he has offered strategic consulting services to governments and multinational corporations across the globe. Manabe's extensive field experience spans a diverse array of countries, including the USA, Vietnam, Thailand, Bangladesh, Iraq, Jordan, South Africa, and Kenya, underscoring his deep understanding of global development challenges and solutions.