With companies of all sizes and industries looking to expand, or expand further into international markets — and with young companies aiming to do so earlier in their lifecycles — it is vital that they are equipped to manage the resulting tax implications.
Top of mind for many CFOs will be the potential effects and implementation of these changes on their international tax bills and the company’s bottom line.
As tax professionals, we try to predict where the market is headed, but the path is uneven and change is often not a smooth process. Rapid shifts mean the door is open to more risk now than there has been previously, and even companies that pushed into international expansions in the not-so-distant past would benefit from a refresher course on the current situation.
It’s important for companies to reacquaint themselves with recent developments, because what was previously common knowledge may have quickly been rendered obsolete.
Reaping the Benefits of an International Push
There are major business benefits to be gained by tapping into foreign markets, and so as long as executives have a clear understanding of the implications for year-end financial activities, it may be worth exploring the additional risk.
The key to lowering a company’s tax burden is recognizing which provisions do in fact apply to the company and when they will be triggered. This includes both income taxes, which can sometimes be triggered even if companies have no physical presence in a country (most commonly through a withholding tax), and consumption taxes (e.g. value-added tax, or VAT).
To get a full understanding, alongside a simple cost vs. benefit analysis, it’s important to run a sensitivity analysis to understand where a company’s stress points are.
For example, if a company misses its revenue target by 5%, how will that affect the overall financial success of the expansion? Once a company understand these stress points and is honest about the probability of hitting year-end targets, CFOs can more easily determine whether the benefits of expansion are worth the associated costs and risks.
In terms of new developments in the international tax landscape, change in Base Erosion and Profit Shifting (BEPS) regulations is one of the most important items to be aware of.
Implemented by the Organization for Economic Cooperation and Development (OECD) in 2014, the BEPS Project aims to eliminate exploitations of discrepancies in the tax rules of different nations and ensure profits are taxed in the country where the activities that generate those profits take place.
Increasingly, it’s becoming important to have a physical presence in a jurisdiction to take advantage of the related tax benefits, as many governments are moving toward a tax system that is based on “substance.”
In this case, substance largely refers to employees and contractors in a particular jurisdiction and what they’re doing to drive organizational value. Contractual relationships are still considered, but this is just one factor in looking at the totality of the business practice conducted in each country.
Before a company recognizes revenue, consider where it physically has employees or contractors working, what they’re doing, and how that impacts the bottom line.
Hiring Foreign Employees
One of the most common activities that can create a taxable presence in a foreign jurisdiction is hiring employees. A thorough understanding of the potential new hire’s job functions in conjunction with local rules is crucial before taking this step.
A few considerations to determine whether the planned activities may create a taxable presence include whether a company is establishing a legal relationship with a new employee, the definition of “employee” vs. “contractor” in that country, and whether there is an applicable tax treaty that affords benefits relevant to your specific fact pattern.
One interim step that’s gaining traction is the use of professional employer organizations (PEOs). A PEO can be enlisted to perform a range of services, such as human resources tasks and training development. This can be convenient, as it allows smaller businesses to gain experience with a foreign jurisdiction without necessarily forming an entity.
However, a PEO should generally be considered only a short- to medium-term solution, because of the high associated expenses and the potential that the local government views this as taxable substance.
It should come as no surprise that entering a new market requires a major investment of time and effort, but many companies neglect to factor in the full cost of added administrative expenses into their profitability projections.
This will of course have a larger impact for a startup or smaller company that will typically have a more limited infrastructure and staff with the necessary experience to handle the additional logistical responsibilities. Depending on the market being entered, additional hurdles may include time zone issues, language difficulties, currency familiarity, and general business logistics, all of which can create hidden cost burdens.
Penalties for Non-Compliance
While businesses do not willfully plan to become noncompliant with country tax regulations, it can be helpful to know what the penalties would be in the face of such a situation, to ensure the projected benefits are worth the potential risks.
Each country has its own approach to noncompliance, which typically includes imposing heavy fiduciary penalties, with the amounts varying based on the type and severity of the illegal act. While it’s possible for a country to bar a specific company from doing business, countries generally want to host an open market, and that’s a drastic step that runs counter to that goal.
Given the Trump Administration’s recent executive order that requires two federal regulations to be removed for each new one issued, the IRS and Treasury Department seem to be in a relative quiet period, so now is a good time for CFOs to reevaluate their company’s position.
Christine Ballard and Roy Deaver are partners at public accounting firm Moss Adams.