Generally, businesses try very hard to avoid creating a permanent establishment (PE) when they operate cross-border. However, there are a few instances where it is actually BETTER to create a PE! Sounds wild? The reality is that where countries levy a high service withholding tax, which, sigh, is usually the case in Africa, a PE may actually result in lower tax.

What is a PE anyway?

A PE is basically a taxable branch that an entity from one country creates in another country by operating or having a presence there.  Each country has its own specific definition and rules around what a PE is, but generally, it is a fixed place of business (e.g. a shop or office) through which the company conducts business activities in that other country.  For a PE to exist, the company usually has to have a presence in the foreign country for at least six months (although this trigger can be shorter in some countries or for certain activities). When calculating the period of time spent in a country, the aggregate time spent by all employees is added together to determine whether the six-month threshold has been breached. So if you have three salespersons each spending a month per year in a country, this could give rise to a PE.

There are various exemptions, e.g. if the work being undertaken is preparatory (e.g. conducting a feasibility study) or ancillary (i.e. not part of the “real” business of the company), or if the fixed presence is used simply to store goods.  However, typically these exemptions only apply where there is a double taxation agreement (DTA) between the two relevant countries. This, along with reduced withholding taxes, is a key reason why DTAs are so helpful and why we always consider available DTAs when structuring.

Why don’t we want PE’s?

Where a company creates a PE in a foreign country, all the profits earned as a result of the activities conducted in that foreign country can be taxed there. However, the PE profits will also be taxed in the home country as foreign branch profits are generally included in a company’s taxable income.  So double taxation arises.  Also, in terms of compliance, the company would have to register for tax in the foreign country, submit tax returns and also prepare branch accounts and comply with in-country company law and regulatory requirements.

So the PE will be taxed in the foreign country, but how do we determine what profits should be allocated to a PE?  Ah, that’s where the ubiquitous spectre? of transfer pricing (TP) comes in.  So, the PE will then have to conduct a TP exercise to justify its allocation of profits to the Revenue Authorities.

A royal pain all around.  The other problem with a PE is that it pulls a legal entity resident in one country into another country’s tax and legal regime which is messy and limits country-risk and company-risk ring-fencing.  So generally, our advice is to avoid a PE, or if it cannot be avoided, i.e. if you really are going to be trading in that other country, to rather set up a subsidiary instead of a PE as the tax and compliance burden should be similar but country and company ring-fencing can be effected.

So why would it ever be better to create a PE?

A PE equals in-country tax and double taxation so surely that should be avoided if possible?  Well, as we know, African countries love withholding tax (WHT), even more than transfer pricing.  And their favourite form of withholding tax is on service fees.  And even where there is a DTA in place that essentially prohibits WHT on services unless the foreign company has a PE in that country, they still like to apply them. So, although in most cases where there is no PE, there should be no services WHT, many African countries merrily levy the services WHT.  This is why it can be better to establish a PE and essentially pay foreign corporate tax on your margin rather than foreign WHT on your gross income.

Let’s consider with an example, let’s say South Africa and Azania have a DTA in place which contains a service / technical fees article so that Azania is entitled to levy a 20% service WHT, so where a South African company invoices ZAR 100 to an Azanian client, the client will deduct a 20% services WHT.

However, where a PE is created in Azania, the PE would be subject to corporate tax in Azania on their locally-sourced income at the corporate tax rate of let’s say 30%.

At first glance, it seems a local PE is worse due to a corporate tax rate of 30% compared to a WHT of 20%. However, the difference is that the WHT is levied on the gross amount of income, whereas corporate tax is levied on the net amount of income. Depending on the gross profit margin of a company, this could result in significant tax savings. So, assuming a gross profit margin of 25%, the PE would be subject to tax at 30% x $25 profit = $7,5 tax, versus a WHT of $100 x 20% = $20.   South African tax relief would also come into play, as well as potentially branch dividend WHT on the after-tax profits, but the former is generally limited in terms of service fees as these are often SA sourced and the latter is on a net amount, so the overall tax bill can end up being lower with a PE.  As a rule of thumb, the higher the WHT and the lower the margin (especially if on SA-source services) the more likely it is that a PE could give a better result.

So, what should we do?

The answer, as always in international tax is “it depends”. Companies should definitely carefully consider if they are at risk of creating a PE, and if so the implications if they were to do so.  Where a high service withholding tax is levied, creating a PE may actually be cheaper from a tax perspective than not having a PE.

Of course, the administrative costs of registering for tax and submitting tax returns in-country should be borne in mind. A company should also consider how easy it would be to allocate the profits between the PE and the head office company.

If you would like to discuss how this could apply to your company, please contact us.

How can we help?

How you structure your business is a critical question as you expand globally.  The right structure will protect your assets, improve your currency position, support your business operations, facilitate future business expansion and changes, and optimise your overall tax rate. Trying to unscramble a sub-optimal structure entered into in haste or without full consideration of relevant facts is complex and expensive, so it’s important to plan upfront.

Structuring an international business is both a science and an art – this is our specialist area of expertise. Regan van Rooy is an international tax and structuring advisory firm focussing on Africa. We have offices in South Africa, Mauritius and Ireland and we can help you with any international tax or structuring query.