Okay, let’s admit it—plenty of us had absolutely no interest whatsoever in becoming tax specialists when we started law school. And so here we are, all these years later, serving as employment counsel to our corporate clients. But as many of you in-house attorneys know, your corporate “clients” consider you responsible for every possible legal aspect of the employment relationship between your company and its thousands of employees. So when an issue comes up and you—“Legal”—get brought in, the last thing your management team will suffer is, “that’s not my area of expertise.” We get that. Multiple disciplines get triggered when an issue hits your desk. And when that happens, the last thing you want to do is call multiple outside experts just to get a sense of the basics. That’s where these tax considerations can help.
Example? You find out an employee has been hired to work from home . . . from another country. There are so many good business drivers for this—the employee is a key person with special expertise who happens to live in Denmark; we’re exploring the market in Brazil; we’re sending someone to help manage our partners in Canada. So now it’s your job to make sure the company takes care of all the compliance issues. You know how to assess the employment law issues here—find out about the statutory rights and benefits, work through the extent to which you’re ready to subject your organization to those obligations, figure out whether there are alternatives, etc. But on the tax side, what’s the deal?
Even though we’re not tax lawyers, you’re not tax lawyers, and none of us ever envisioned being tax lawyers, we thought we’d give you a little crib sheet starting you out with some basics to help you issue-spot this situation. This will help you know when to call in the experts. It also will help you to partner up with your finance and tax team, so they can help you deal with issues other than the pure employment law issues in your wheelhouse.
Bilateral Tax Treaties 101
A bilateral tax treaty (sometimes called an “income tax treaty” or just a “tax treaty”) is a tax agreement between two countries that may apply when companies from one country do business in the other. The United States has entered into these types of treaties with nearly 70 countries. A primary goal is to avoid “double taxation”—having to pay taxes twice on the same income.
From an HR perspective, why should I care about bilateral tax treaties?
Tax treaties become important when a company does business abroad via a services arrangement, like an employment relationship. Generally, if you are generating revenue and employing people in a foreign country, you can expect that country’s revenue authorities to want a piece of your revenues and to want to ensure you are contributing to its social insurance systems (although social insurance is a subject for a future post—stay tuned!). A tax treaty between your country and the other country (which we will refer to as the “host country”) will determine:
- whether the host country can tax your company’s profits, which were generated in the host country;
- whether the employee or independent contractor working in the host country is subject to income taxes in the host country; and
- whether the employee/contractor and/or the company must file a tax return in the host country.
Where a company fails to comply with host-country taxation requirements, host-country tax authorities may initiate an audit or investigation, which could result in administrative burdens, back taxes and interest, and penalties. In some countries, like China, even if your company is not actually generating revenue, the Chinese revenue authorities may just “deem” a certain amount as taxable income. This is why your partners in finance and audit get so agitated.
If no bilateral tax treaty exists between the two countries, the items listed above will be determined by local law in the host country. Without a tax treaty, there is a higher risk of double taxation for both individuals and companies. Moreover, while tax treaties generally limit corporate tax liability to just the income generated in the country with which we have a treaty, without a treaty the company’s worldwide income could be subject to taxation. So it’s really important to know whether we have a tax treaty with the country where the solo employee is going to be working, in order to quantify the extent to which that country is going to claim a stake in your company’s revenues.
How do I find out whether there is a bilateral tax treaty between my country and the host country?
This is the best kept secret in town. Finding out about whether there is a tax treaty and what it says is not only easy; it’s free. The Internal Revenue Service (IRS) maintains a list of all current tax treaties to which the United States is a party with links to the full text. You can find it here. Tax authorities in other countries keep similar lists and we are happy to help you navigate those.
How do I read a bilateral tax treaty?
Each bilateral tax treaty is different, but here are some key terms to look for:
- Definition of “Resident”: Usually only “residents” of one of the two party-countries may benefit from the treaty. A company or individual is usually “resident” of a country when it is subject to taxation in that country because it (or he or she) lives, is domiciled, or is incorporated there. This definition becomes important where a person is a “resident” of both countries. Under the United States-China treaty, for example, the U.S. and Chinese tax authorities must determine of which country a dual resident will be deemed a “resident” for treaty purposes—and if they cannot, the person will not qualify for benefits under the treaty (see article 4 of the United States-The People’s Republic of China Income Tax Convention (effective January 1, 1987)).
- Definition of “Permanent Establishment”: This is a big-ticket issue for your internal and external audit team. It is generally the key to whether the company is going to be subject to corporate taxation for doing business in the host country. In general, under bilateral tax treaties, the host country only taxes a foreign company’s business profits if such profits are generated by a “permanent establishment” in the host country. What is a permanent establishment? The simplest and most obvious example is a host-country subsidiary. But even if the company does not have a subsidiary in the host country, it may still be deemed to have a “permanent establishment” there. How? Although the definition of “permanent establishment” is treaty specific, here are some general patterns for which you should keep a lookout.
- A company will probably be deemed to have a permanent establishment in the host country where an employee (or independent contractor fully devoted to the company) has the authority to enter into contracts in the host country on behalf of the company (for example, see Article 5 of the United States-Mexico Income Tax Convention (effective January 1, 1994)).
- A place of business devoted only to storage, advertising, marketing, or purchasing on behalf of the company, is not usually considered a permanent establishment (for example, see Article 5 of the Convention Between the Government of the United States of America and the Government of the State of Israel with Respect to Taxes on Income (effective January 1, 1995)).
- Taxation of Business Profits: Even if there is a permanent establishment under the treaty, the host country usually only taxes profits attributable to that permanent establishment. This is important because it means that, for example, a company with a subsidiary in China can file tax returns on behalf of the subsidiary only and pay taxes only on profits that the subsidiary generated (provided that the subsidiary is independent and deals with the company at arm’s length). On the other hand, a foreign company with an independent contractor later deemed a “permanent establishment” may find itself required to file returns showing the entire company’s profits—and the amounts the host country may ultimately tax will be less clear.
- Income Taxation of Employees and Independent Contractors: Many treaties provide that the host country taxes income only where the employee or independent contractor in question is present in the host country for 183 days or more in a 12-month period. Look for the articles in the treaty titled “Independent Personal Services” (contractors) and “Dependent Personal Services” (employees) (see, for example, articles 18 and 19 of the United States-Republic of Korea Income Tax Convention (effective January 1, 1980)).
- Other Provisions: Treaties generally provide for taxation of income from real property, royalties, capital gains, dividends, and interest and may contain other specialized provisions.