Risk of Permanent Establishment when working abroad

12.2013

The following notes summarize several recent client queries received by our firm concerning a concept still largely unfamiliar to many business owners and employees who carry out regular or temporary work in a foreign country:

(1) A Spanish engineer, employed by a Spanish company, begins working for a German chemical company on a project in Germany. The engineer works at the German company’s premises from Monday to Thursday, returns to Barcelona—where his family lives—on Fridays, and flies back to Germany on Sunday evenings.
(2) A Dutch company director relocates with his family to the Barcelona area, while continuing to manage his Dutch company from the Netherlands (Monday to Thursday) and from Spain on Fridays.
(3) A French company hires a Spanish resident to seek clients in Spain. The employee not only presents the product to potential customers but also negotiates prices and contract terms directly and even signs the contracts, which are later sent to the employer in France for execution.

In all these cases, the company—based on how its employee carries out business—may be deemed to have a permanent establishment (PE) in the foreign jurisdiction for tax purposes.

The concept of a PE is a fiscal construct (it does not exist under commercial law) designed to give the State in which business activities take place the right to tax profits derived from such activities, even if the enterprise is resident elsewhere. In essence, it allows the foreign State to levy corporate income tax (for companies) or personal income tax (for individuals) on income generated within its territory.

In the first case described, the German tax authorities would require the Spanish employer to pay German corporate tax on the profits attributable to the engineer’s activities in Germany. Consequently, the Spanish company would have to maintain two sets of accounts—one in Spain for its domestic and non-PE foreign operations, and another in Germany, where the PE must be separately taxed.

If no PE exists in the foreign jurisdiction, that jurisdiction cannot tax the profits of a non-resident enterprise. This principle is set out in Article 5 of the Double Taxation Treaty (DTT) between Spain and Germany, which defines a PE as a “fixed place of business.”

As one might expect, in such cases the German tax authorities will try by every means to demonstrate the existence of a PE, while the Spanish taxpayer will seek to prove the contrary. This tension often leads to disputes that can have severe financial and legal consequences if not properly planned.

Should the German tax administration determine that a Spanish company had a PE in Germany but failed to declare it, the company could be required to pay back taxes, interest, and penalties. In some cases, the authorities may even threaten the initiation of criminal tax proceedings (Strafverfahren)—a common intimidation tactic against non-residents, even though such proceedings rarely materialize.

The unsuspecting engineer or architect who believed in the EU’s “single market” as equivalent to a domestic one may thus face an unpleasant surprise. What no one had explained to him is that “the economy goes global, but taxes stay national.”

In the example of the Spanish engineer, how did the German tax authorities discover the PE? According to the client’s account, the German tax investigation unit (Steuerfahndung), during an audit of the German company, noticed that the engineer’s name appeared on the internal telephone list and on a nameplate at the door of his small office. From this, the authorities swiftly concluded: there is a PE in Germany.

What should the engineer have done to avoid this tax exposure?
He should have informed the German tax authorities from the outset that his employer had a PE in Germany. The company would then have obtained a German tax identification number and regularly filed tax returns—essentially the same obligations as a domestic German company. Normally, the tax rules applicable to a PE of a foreign entity mirror those for resident entities (in Spain, Article 18.1 of the Non-Resident Income Tax Act refers to the Spanish Corporate Income Tax Act).

Additionally, if the engineer remains tax resident in Spain—because his family resides there—Article 4 of the Spain–Germany DTT provides that Spanish tax residence takes precedence over German residence. However, since the engineer receives his salary from a German PE, that PE must withhold German income tax on his remuneration for work performed in Germany, even if that income may later be treated as exempt under the treaty.

Determining whether a PE exists is an exceptionally complex and fact-dependent issue, which gives tax administrations significant discretion. A direct dispute between the residence State and the source State is often difficult and costly for taxpayers to manage. Effective tax planning and proactive compliance are therefore essential to mitigate the risks associated with cross-border employment situations within the European Union.

++ Article originally published in German in the magazine “Economía” (December 2013), issued by the German Chamber of Commerce in Spain ++