The Organization for Economic Cooperation and Development (OECD) issued guidance on April 3, 2020, suggesting that employees temporarily working outside of their employer’s home country of operation due to Covid-19 related travel restrictions or shelter in place orders are not likely to trigger new income tax obligations or establish tax residency in new countries under global taxation treaties. This clarification is good news for companies concerned that involuntarily remote work arrangements could give rise to additional foreign tax obligations. However, as governments gradually ease travel restrictions, employers should take steps to limit their international tax exposure in light of any cross-border telework and mobile workforce practices that they retain as a permanent part of their business model.
International Taxation of Permanent Establishments
A company with operations in a jurisdiction other than its home country is typically subject to taxation in that foreign country in respect of all income sourced to that country. However, when the company qualifies for benefits under an income tax treaty in effect between those countries, it is generally relieved of any tax obligations in the foreign country except to the extent it has created a permanent establishment and income is attributable to that permanent establishment.
A permanent establishment is broadly defined as a fixed place of business, which generally requires (i) a certain degree of permanency, and(ii) that the location is at the disposal of the business. A fixed place of business should not create a permanent establishment if the activities attributable to the fixed place of business are of a preparatory or auxiliary character and carried on for the benefit of the enterprise, rather than third parties. An employee can trigger a permanent establishment for an employer if the employee, acting as a dependent agent, habitually concludes contracts on behalf of the company.
The commentary to the 2017 OECD Model Tax Convention on Income and on Capital (model treaty) applies a facts and circumstances test to determine when an employee’s home office can create a permanent establishment for an employer. The analysis looks to whether the use of the home office is “so intermittent or incidental that the home will not be considered to be a location at the disposal of the employer.” The primary factor is whether the employer requires an employee to use his or her home to carry out the employer’s business. For example, an employee should not create a permanent establishment if the employee performs most of his work at home in one country instead of in an office made available by his or her employer in a different country where a vast majority of the workforce operates.
Determination of a Company’s Tax Residency Status
A company’s country of tax residency has significant implications from both a domestic tax law and international tax treaty perspective. Tax residency under domestic law typically allows a country to tax a resident company’s worldwide taxable income. For purposes of a tax treaty, establishing tax residency is a preliminary requirement in order for a taxpayer to avoid potential double taxation by claiming treaty benefits.
Depending on the relevant jurisdiction, a company’s country of residence under domestic law can be determined based on its place of incorporation, its place of effective management, or a combination of the two factors. Under this framework, it is possible that two separate countries could assert that a company is a tax resident, and therefore subject to domestic tax, in both jurisdictions. In those cases, the taxpayer would seek clarification under the applicable tax treaty.
Most tax treaties follow the OECD model treaty tax residency determination, which generally defines a tax resident as a company that is subject to tax under applicable domestic laws by reason of its domicile, residence, place of management, or other similar criterion. The OECD model treaty also includes a tie-breaker provision to determine which country will be treated as a taxpayer’s place of residency in the case of dual resident companies. Under the 2017 OECD model treaty tie-breaker rule, competent authorities handle dual residency determinations on a case-by-case basis by mutual agreement, taking into consideration all relevant facts and circumstances. By contrast, the pre-2017 OECD model treaty tie-breaker rule uses a company’s place of effective management as the sole criterion to determine the residence of a dual-resident entity.
OECD Addresses Immediate Concerns Related to Permanent Establishments
Based on the OECD’s recent announcement, it is unlikely that the Covid-19 travel restrictions and shelter in place orders will necessitate that employers redetermine their existing permanent establishments in the short term. In particular, the OECD guidance primarily addresses the concerns of companies with workers either (i) stranded in a foreign country due to travel restrictions, or (ii) forced to abandon their usual cross-border commutes in favor of working remotely from their home country. In reaching its conclusion, the OECD explained that these temporary employee home offices should not create permanent establishments for employers because such arrangements lack the required degree of permanency, the companies have no access or control over the home offices, and the employers provide offices that are available to their employees under normal circumstances. However, the OECD warned that this reasoning cannot be used to support a company’s argument that there is no permanent establishment if remote work becomes the new normal course of business that endures after the Covid-19 crisis.
The OECD guidance also addressed whether the activities of an individual temporarily working out of country could be deemed to be a dependent agent of his or her employer and therefore give rise to a taxable presence. According to the OECD, this determination turns on whether the employee’s conclusion of contracts is “habitual.” An employee’s activities are unlikely to be treated as habitual if the employee is only working from home for a finite period due to government-imposed travel restrictions. A different conclusion may result, however, if the employee regularly concluded contracts on the employer’s behalf in such home country prior to the Covid-19 crisis or continues to do so after travel restrictions are lifted.
The OECD’s analysis is limited to the taxes covered by international tax treaties, which typically include income and withholding taxes. Therefore, the OECD guidance does not impact domestic corporate income tax laws or registration requirements. Taxpayers should monitor for local country guidance regarding corporate income tax filing requirements and other non-income tax obligations that may be implicated by remote workers in the Covid-19 crisis. For example, Her Majesty’s Revenue and Customs (HMRC) explicitly confirmed that the U.K. would not consider nonresident companies with employees conducting business temporarily from the U.K. due to Covid-19 travel restrictions to have created a taxable presence, since a degree certain of permanence is required to create a permanent establishment.
Place of Effective Management Should Remain Unchanged Due to Travel Restrictions
The OECD also concluded that a temporary change in location of the chief executive officer and other senior executives generally should not trigger a change in a company’s tax residency. First, this change is not relevant if the company’s home country utilizes place of incorporation as the basis for tax residency under domestic law. Second, a brief change in location of a company’s senior executives and board meetings due to the Covid-19 crisis is an extraordinary and temporary situation, and in most cases should not be sufficient to change the place of effective management and control. Moreover, the commentary to the 2017 OECD model treaty notes that situations of dual residency are relatively rare and that countries should be hesitant to make domestic legal claims to be the place of effective management due to the temporary relocation of management.
In situations where government-imposed travel restrictions trigger dual residency under domestic law, treaty tie-breaker provisions should ensure that the entity is resident in only one of the states for tax treaty purposes. The OECD guidance notes that under both the pre-2017 OECD model treaty and 2017 OECD model treaty tie-breaker rules, the determination focuses on the “usual” and “ordinary” place of management and should not take into account facts and circumstances that pertain to an exceptional and temporary period such as the Covid-19 crisis.
Similar to the permanent establishment analysis, the OECD guidance is limited to tax residency as determined under international tax treaties. Accordingly, taxpayers should monitor for country-specific guidelines regarding domestic tax residency determinations. For example, the governments of Australia, Jersey, Guernsey, the U.K., and Ireland have already announced they will adopt a taxpayer-friendly approach to making tax residency determinations in light of the exceptional nature of current travel restrictions.
Remote Work and the New Normal
While the OECD’s guidance provides comfort to companies that implement temporary cross-border work arrangements as a direct result of government-imposed restrictions, a different analysis applies to the extent these practices continue after travel restrictions are relaxed. This could be the case where employees and management are given the flexibility to return to their original working locations during a transitional period or where companies formally adopt telework and work mobility policies going forward.
The risk of triggering a permanent establishment materially increases if employers permit their employees to work remotely after the Covid-19 crisis. However, companies can manage this risk by building a factual argument that employees’ home offices are not attributable to, or at the disposal of, the company by implementing the following guidelines:
- Employees should not be required to work from a home office or other fixed remote location.
- Employees should not be reimbursed for expenses incurred in setting up or maintaining a home office, and the company should not provide furnishings or other home office equipment.
- The company should continue to maintain office space that is available to all employees.
- Management and client-facing roles should not be performed outside of the company’s home country.
- Remote work arrangements should be limited to internal support and back office roles to the extent possible.
In addition, in order to avoid creating a permanent establishment though a dependent agent, companies should restrict remote employees as follows:
- Employees should not be authorized to conclude contracts on behalf of the company.
- Employees should not hold themselves out as having the authority to conclude contracts on behalf of the company.
- Contract negotiations should primarily take place in the company’s home country.
In the event that a permanent establishment is unavoidable, certain tax structuring strategies may help limit the adverse tax consequences in connection with such taxable presence. In particular, a company can cap (or ringfence) the pool of taxable income potentially attributable to the permanent establishment by organizing a wholly owned subsidiary and transferring the remote employee(s) to such entity. The parent company would then engage the subsidiary as an intercompany service provider in exchange for an arm’s-length services fee. In that scenario, any permanent establishment created by the transferred employee(s) would be imputed to the subsidiary, rather than the parent company. As such, only the limited taxable income (i.e., the services fee less deductible expenses) earned by the subsidiary would be subject to foreign income tax, effectively shielding the parent company’s profits. From a domestic tax perspective, the parent company and its subsidiary should be consolidated through a tax grouping arrangement or through the use of a hybrid disregarded entity.
For example, assume: (i) a U.S. corporation (US Co) has a development engineer permanently working remotely from a home office in Singapore; (ii) US Co forms a single member limited liability company (SMLLC) and the engineer becomes an employee of SMLLC; and (iii) US Co engages SMLLC to provide intercompany development services in exchange for an arm’s-length cost-plus services fee. In this example, SMLLC should only be subject to potential Singaporean tax with respect to the margin it generates on the intercompany services fee paid by US Co. This effectively ringfences the Singaporean tax liability and shields the broader profits of US Co from the Singaporean corporate tax net. From a U.S. tax perspective, US Co and SMLLC are treated as a single taxpayer, and US Co should be entitled to any foreign tax credits generated by the Singapore taxes paid by SMLLC.
Corporate Tax Residency
Moving forward from the Covid-19 crisis, companies should carefully monitor tax residency rules in any country where high-level executives reside once the Covid-19 travel restrictions are lifted. In countries that utilize a country of incorporation test for tax residency, companies need not worry about the tax residency impact of remote employees. However, executives and key members of management will not have the same flexibility to continue to work remotely in those countries where tax residency is determined based on the place of effective management. In order to manage the risk of inadvertently triggering corporate tax residency in other countries, the following guidelines should be implemented:
- Board members and executives should resume traveling to the company’s country of tax residence for board meetings and any other meetings where high-level operational and strategic decisions are made.
- To the extent individuals are hesitant to travel, reduce the minimum number of board members that are required to attend board meetings in person and utilize virtual board meetings where possible.
- Amend the composition of the board to ensure sufficient attendance.
- To the extent board meetings must be held remotely, limit matters discussed to those that are routine or administrative in nature.
- Only discuss strategic business decisions at in-person meetings, if possible.
Individual and payroll tax implications of government travel restrictions and remote work arrangements, which are discussed in detail in the OECD guidance, are outside the scope of this article. Companies should also evaluate these issues as a part of their response to the Covid-19 crisis.
It is expected that the Covid-19 crisis will change the landscape for how people conduct business going forward. To the extent telework and remote work arrangements are adopted as a new model that continues after the current public safety directives are eased, companies should revisit their international tax profiles and operational procedures to ensure they are not inadvertently creating taxable presence in other countries.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Friedemann Thomma is a partner and chair of Venable LLP’s International Tax Practice. Becca Chappell is a counsel, and Molly Schneider and Misha Goodwin are associates in the International Tax Practice.