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Permanent Establishment Changes – Italy, Japan and EU

As the international business marketplace evolves in the modern age, countries are amending their tax laws to broaden the scope of permanent establishment (PE).  PE is what allows a country to tax foreign companies who earn revenue locally, or have a sufficient business presence within a country’s borders.  Naturally, governments are focused on increasing tax revenues where a business profits from sales of goods or services to local residents or companies.

The crux of permanent establishment is the definition used, and those are being amended to widen the net of taxation for cross-border commerce.  The definition of PE varies between countries, depending on tax treaties and domestic laws.  A country or region (such as the EU) has the right to define PE how they choose, and foreign businesses must comply with any taxation imposed. 

As these permanent establishment laws and definitions change, it is incumbent upon multinationals to stay up to date with new tax liabilities they may face when doing business in new or existing markets.  The previous method of selecting a favorable corporate tax residency, and then avoiding tax in a country where the company does business, will no longer be effective or legal.

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The European Union Proposal: Virtual Permanent Establishment (PE) in the Digital Economy

The Council of the European Union has recently issued a draft of PE changes to be taken to the EU Commission. Titled “Responding to the Challenges of Taxation of Profits in the Digital Economy”, the draft clearly targets tech companies who are generating revenues without a significant physical presence in a country.

Instead, the focus is now shifting to “value creation”, which would impose PE taxation on companies that engage in digital commerce, just as with those that have a more traditional physical business presence.  If adopted by the EU as legislation, this new definition would apply to all EU members states, and notably would fall outside the scope of any double taxation treaties often used to avoid payment of local taxes.  What this means is that the company would pay tax both at home and in the foreign location.

Japan’s Tax Reform Proposal 2018

Japan is taking a broader approach in changing their permanent establishment rules with a tax proposal set for vote this year.  The Japanese PE definition changes would make taxation of foreign businesses more encompassing, cracking down on strategies of ‘PE avoidance’.

These measures would include:

  • Broadening the definition of ‘agency PE’, to include any independent agent who works for only one or two primary clients (acting more like an employee)
  • Imposing PE taxation for storage, delivery and display of goods in a warehouse
  • Curtailing the practice of splitting construction contracts into shorter time periods to avoid the duration element for construction PE (typically more than 6 months)

These are all designed to limit PE avoidance tactics widely used by multinationals, and demonstrate that almost any type of business activity will be scrutinized as a source of revenue creation leading to PE taxation.

New Definitions of PE in Italy

Even if the EU proposal is adopted, member countries remain free to impose even broader measures and definitions, and Italy is in the process of doing just that.  The new law if adopted would include the same items as in Japan’s tax proposal, but would also address the problem of taxing in the digital economy.

The amendment would add to the “fixed place of business” definition of PE to include businesses with “a significant and continuous economic presence in the territory of Italy, built in such a way that it will not result in a physical presence in Italy.”  Obviously, the substitution of ‘economic presence’ for ‘physical presence’ would capture any revenues that originate from Italy, whether digital or otherwise, if occurring over a period of time.

The Shield GEO Solution

These examples underscore how serious governments are in taxing companies that do business either physically or virtually inside the country.  Additional tax liability will impact the bottom line for multinationals, and in some cases, may inhibit international expansion into some markets.

However, not every instance of business activity will bring tax liability, and it is important to have some way to enter a foreign market for exploratory or initial research purposes.  Since business visas are often limited in duration (30-60 days), a company may need a more flexible solution that is not as costly or committing as establishing a branch office.

This is where the Shield GEO solution is ideal, where a company can legally employ staff through our local, established entity for any type of business activity.  The local employer of record cannot insulate a company from PE tax compliance, but does offer one way to enter a country that is both simple and efficient.  Our local experts can also help advise on PE standards and definitions being applied to a wide range of businesses, and assist with any compliance concerns that arise by sending staff to work inside the country.

The trend is clear: if your company is going to generate revenue of any type in a foreign country, governments are being proactive in taxing those revenues.  However, Shield GEO can help your business bridge the gap between short business trips and the long-term step of setting up a corporate entity, and help minimize unnecessary taxation as you evaluate a new market.

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