A previous version of this article was published online in the March issue of CFO Magazine.
With companies of all sizes looking to either enter or further expand into international markets—and with young companies aiming to do so earlier in their life cycles—it’s vital they’re equipped to manage the resulting tax implications.
Top of mind for many CFOs will be the potential effect of changes to 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’s been previously, and even companies that pursued international expansion 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 in international tax law, because what was previously common knowledge may quickly be rendered obsolete.
Reaping the Benefits of an International Push
There are major benefits to be gained by tapping into foreign markets, and as long as executives have a clear understanding of the implications of year-end financial activities, it may be worth exploring the additional risk global expansion brings.
The key to lowering a company’s tax burden is recognizing which provisions apply to the company and when they’ll 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 (for example, value-added tax, also known as VAT).
To get a full understanding of a company’s stress points, along with a simple cost-benefit analysis, it’s important to run a sensitivity analysis.
For example, if a company misses its revenue target by 5 percent, it’s important to determine how that will affect the overall financial success of the expansion. Once a company understands these stress points and is honest about the probability of hitting year-end targets, the CFO can more easily determine whether the benefits of expansion are worth the associated cost and risk.
Understanding Changes to BEPS Regulations
Changes to Base Erosion and Profit Shifting (BEPS) regulations are some of the most important new developments in the international tax landscape to be aware of.
Implemented by the Organization for Economic Cooperation and Development (OECD) in 2014, the BEPS project aims to eliminate exploitation of discrepancies in the tax rules of different nations to ensure profits are taxed in the country where the activities that generate those profits occur.
It’s becoming increasingly 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 do 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, it must consider where it physically has employees or contractors working, what they’re doing, and how their work impacts the bottom line.
Hiring Foreign Employees
Hiring employees is one of the most common activities that can create a taxable presence in a foreign jurisdiction. 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 definitions of employee versus contractor in that country, and whether there’s 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 local governments will view their work as taxable substance.
Identifying Hidden Costs
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.
These hidden costs will have a larger impact on a start-up or smaller company, because these companies typically have limited infrastructure and staff with the experience to handle the additional logistic responsibilities. Depending on the market being entered, additional hurdles that can create hidden cost burdens may include:
- Time zone issues
- Language difficulties
- Currency familiarity
- General business logistics
Acknowledging Noncompliance Penalties
Although businesses don’t willfully become noncompliant with country tax regulations, it can be useful to know what the penalties would be. This helps ensure projected benefits are worth potential risks.
Each country has its own approach to noncompliance, which typically includes imposing heavy fiduciary penalties of varying amounts 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 as a penalty, this is unlikely. Countries generally want to host an open market, and banning a company is a drastic step that runs counter to that goal.
With 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. This means now might be a good time for CFOs to reevaluate their company’s position.
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For more information on how global expansion and the resulting tax effects may impact your organization, contact your Moss Adams professional.