With the world getting flatter everyday, a company doesn’t necessarily need to be a big corporation to do business in other countries today. Your business can be relatively small and still have overseas operations outside the United States.
But once you start hiring people in other countries or establishing offices or a base of operations, certain tax implications can kick in. Unless you take steps to minimize and/or comply with the taxes, you could end up with a big surprise tax bill on your hands — and other headaches.
Do you and your team know how to minimize these taxes so your profits are not completely eaten up?
I went to my interview source for establishing a business presence in other countries and related tax implications: Larry Harding, CEO of High Street Partners. High Street Partners helps SMBs expand globally by providing cross-border accounting, finance, HR and other business operation services. Over the years, he has provided some great pointers about what can sometimes seem like a mine field: opening offices and/or staffing up in countries outside the U.S.
Here are 3 international tax pitfalls he says small and midsize businesses sometimes fall prey to:
1. Permanent Establishment (PE) Tax: A permanent establishment exists if someone is outside the United States and conducting business at a profit-making level. The business becomes responsible for paying corporate income taxes to that country. International income tax rates can run quite steep and paying these taxes can be financially burdensome for SMBs.
So, how do you minimize the permanent establishment tax?
According to Harding, you should create a legal foreign subsidiary so as to pay the foreign income tax rate on only the percentage of business that was actually conducted in that country.
Don’t wait too long, either. When I asked Harding the optimum time to set up the subsidiary he noted:
“Companies can be compliant while they set up branches and a non resident employer status when beginning to grow into another country, but they should create a subsidiary to reduce PE tax risk once they start to recognize sales to customers in that country.
There would not be an ability to retroactively eliminate corporate income taxes triggered by a PE, so if an American company recorded $1 million in sales revenue in the U.K. in 2008, but did not set up their subsidiary until 2009, then the 2009 revenue will be protected from an inadvertent PE risk, but the income deemed earned in the UK in 2008 could be exposed to UK income taxes.
With a 50% gross margin and roughly a 30% corporate income tax rate in the U.K. on the 2008 $1M in sales, that same company would owe $150,000 in taxes – a number that is much greater than the cost differential (maybe $10K) between setting up a subsidiary vs a branch.”
2. Employee Labor Tax: Just like in the U.S., you can get snared in a mess by incorrectly classifying someone as an independent contractor instead of an employee. Your business could face a potential lawsuit for not implementing employer benefits and be fined for not paying that country’s social security taxes. The U.S.’s FICA rate runs around 6%. But international social security taxes can be astronomically higher — nearly 40% in a country like Brazil.
The lesson is that if someone is acting on your company’s behalf in a foreign country, that person’s status as an independent contractor must be accurately established and documented. There can be significant consequences otherwise, according to Harding:
“There is one company we worked with that hired what they called a contractor in the Netherlands for a few years and eventually decided to let that person go. The contractor was irate and requested a two year’s severance package. He threatened to blow the whistle on this company by asserting he was really a de facto employee during all those years. He would have likely prevailed, because the threshold for where a contractor is really a de facto employee is surprisingly low.
He stated that he would claim that this was an unfair dismissal of an employee, and that further the company did not properly withhold employee income taxes and pay employer social security taxes.
The company realized that it would be cheaper to meet this demand than to pay the severance, plus tax penalties, plus employer social taxes, plus legal fees, and complied with the demand.”
3. Value Added Tax (VAT): The European Union has established its tax system so that businesses collect VAT taxes in each of the 27 EU countries. Businesses pay the collected VAT over to the government, and receive a refund on any of these taxes either paid to vendors or on imports. These rules state that a business must be VAT registered and maintain VAT records if it is to regain those paid VAT taxes. Failure to follow the rules means that not only do companies not retrieve the paid VAT money, but they are also going to pay hefty fines for not complying with the VAT rules and regulations.
But recovering VAT taxes should be fairly straight forward, shouldn’t it? That’s what I thought — why not just look up the rules on the Internet.
It’s not that easy, says Harding:
“It is not in any country’s best interest to have VAT money returned, and thus they purposely make it laborious and detailed. With no incentive to make it easy, they make it difficult to meet VAT deadlines. This process is further complicated because VAT guidelines and specifics are not available where most people look for information nowadays – the Internet. Also, each country has a different governmental hiding place to find VAT answers, so the VAT information in France is going to be in a different department than in the U.K.”
So there you have it. If your company is doing business in foreign countries or could be considered to be doing business there, it pays to be aware of and comply with the local tax laws and regulations. Otherwise, all those profits you thought you’d make through international expansion could be flushed down the drain due to lack of advance tax planning, documentation and procedures.
Finally, remember that the information in this article is just that: information. Every company is different and every country is different, and the rules can be complex. So please, consult your tax advisor.