Permanent establishment versus subsidiary

Companies with global operations can found a permanent establishment or a subsidiary abroad. The decision for the appropriate organisational structure has considerable consequences in terms of tax.

 

 

In addition to exporting without an office abroad (direct business), there is always the possibility of a direct investment with the founding of a permanent establishment or a subsidiary. In this process the entrepreneur is particularly focused on the taxation of the organisational form he chooses which can vary significantly.
  

Taxation of permanent establishments abroad

According to the criteria laid down by the OECD, the permanent establishment as a legally dependent part of the company based in the domestic market is defined as a fixed place of business which is used to fully or partly carry out the business operations of a company. This includes, for example, the location of the management, a branch office or the execution of construction or assembly work as far as the latter is conducted for longer than 12 months. The base erosion and profit shifting (BEPS) action 7 designed to artificially prevent the founding of a permanent establishment results in a stricter interpretation of the expression permanent establishment, in particular with regard to the representation activity.

 
The permanent establishment, however, appears only at first glance due to its lower founding and set-up costs to be the presumed simpler form of investment. In spite of its legal dependence in relation to the parent company in the domestic market it is subject to the independent obligations regarding registration and taxation in the country where the permanent establishment is located. Furthermore, the profit deferrals between the parent company and the permanent establishment through the implementation of the authorised OECD approach (AOA) into national law now has to be undertaken in the same way as with stock corporations under consideration of the so-called arm's length principle. As a result, also within the unitary enterprise, i.e. for business relations between the parent company and the permanent establishment, the transfer pricing is determined according to the arm's length principle.

 
If there is a double taxation treaty in existence, the taxation of the profits of the permanent establishment falls within the competence of the country where the permanent establishment is set up. The actual tax burden depends on the assessment basis determined according to the foreign tax law and the amount of the foreign tax rate and also the legal form of the parent company in Germany. For a sole proprietor the profits in the country of the permanent establishment are subject to the tax rate in the foreign country. If the parent company is a stock corporation, the profits of the permanent establishment are subject to the corporate tax in the foreign country. In Germany the profits of the permanent establishment are usually exempted from taxation subject to the progression clause. As a result, there is just a single taxation of the profits of the permanent establishment in the foreign country. As far as the parent company withdraws the profits from the permanent establishment, there is no further taxation in the country of the parent company.

 

Taxation of subsidiaries abroad

If on the other hand the founding of a company is intended in a foreign country, the legal form of the partnership as a legally independent company can be considered for which for the main part the same tax principles as for the permanent establishment apply. If the partnership is recognised as such in the foreign country, there is nothing to prevent a transparent taxation process. The consequence is that independent of the withdrawal of profits from the partnership by the shareholder there is a single taxation of the profits of the partnership in the country where the partnership is located.

 
In order to achieve a strict separation of the levels of taxation (company, shareholders), the founding of a subsidiary in the form of a stock corporation can be considered. In this process the amount of the taxation of the foreign subsidiary is made according to the corporate tax rate in the country of the subsidiary.

 
Distributed profits from the foreign subsidiary are regularly subject to withholding tax in the country of the subsidiary. In the case of a double taxation treaty the withholding tax is usually limited to 15 percent for natural persons and 0 percent or 5 percent for legal entities as shareholders of the foreign subsidiary. Within the EU, the parent-subsidiary directive is to be observed according to which under certain conditions (including a minimum participation to the amount of 10 percent, minimum holding period of 12 months) the withholding tax, independent of any double taxation treaty regulations, can be reduced to 0 percent. In Germany, dependent on the shareholders, distributed profit is subject to the partial income method (sole proprietor, partnerships with natural persons as shareholders, i.e. only 60 percent taxation liability for dividends) or the possible preferential taxation acc. to § 8b par. 1, 5 of the German Corporation tax Act (KStG) (for stock corporations with a participation of at least 10 percent; i.e. only a 5 percent tax liability for dividends). In order to avoid double taxation, in the course of a partial income procedure any foreign withholding tax can be offset against the German tax burden of the shareholder.

 

Conclusion

A general recommendation for the legal form of the business entity to be established abroad cannot be made. Before start of the business operations a careful planning process must take place. After it is known which factors can influence the tax burden the available alternatives can be examined to determine their advantages and disadvantages.