For many early-stage start-ups, international expansion is an exciting and defining stage in their growth. Breaking into a new market can open the door to new customers, increased sales and greater profitability.
Business owners naturally focus on winning sales, delivering to customers and getting paid. However, in the excitement of international expansion, some of the less glamorous considerations, such as local regulations and tax, can easily be overlooked.
LOCAL VAT AND SALES TAXES
One of the first tax areas to consider is VAT, or its local equivalent. This is relevant whether or not you establish a permanent establishment (see below), in the country.
From a UK perspective, when a business sells goods or services to an overseas customer, the VAT treatment will depend on a number of factors, including what is being supplied, where the customer is based and whether the customer is a business or consumer. In many cases, UK VAT will not be charged, but the specific rules need to be considered carefully.
Selling outside the UK does not automatically mean that a UK business must register for VAT or sales tax in every country where it has customers. Each country has its own rules, registration thresholds and requirements, so it is important to understand the position in each market.
The risk of creating a local VAT or sales tax obligation can increase where a business holds stock abroad, imports goods in its own name, sells directly to consumers, or carries out work connected with local land or property. Online marketplaces can also affect who is treated as making the supply and who is responsible for accounting for the relevant tax.
For example, a UK e-commerce business shipping each order directly from England may have a very different VAT or sales tax position from the same business moving stock to a warehouse in Spain before making local sales. The second model may create a local VAT registration and reporting obligation because the goods are already in Spain when they are supplied.
We recently supported a UK e-commerce business with its sale. The business sold a consumer product and had one of its largest customer bases in the USA, but it had failed to fully address US state and local sales tax requirements.
Best practice is therefore not simply to understand the tax compliance requirements, but also to consider the impact on pricing and margins. The tax position should be assessed alongside the planned method of delivery, whether that involves a local fulfilment centre, warehouse, distributor or direct e-commerce sales.
PERMANENT ESTABLISHMENT – WHAT IS IT AND WHY IS IT RELEVANT?
A permanent establishment ("PE") is an important concept when considering whether a business may become subject to tax on its business profits in another country.
However, the definition of a PE is complicated, and tax obligations can arise in another country before a business establishes a local company or has an obvious physical presence, such as an office or warehouse.
The concept of a PE is broadly recognised internationally and is addressed in many double tax treaties. However, the precise rules can vary between countries and depend on both domestic legislation and the relevant treaty.
In simple terms, a PE can arise where a business has sufficient business activity or a sufficient presence in another country for that country to have taxing rights over some of its profits. Importantly, a PE does not necessarily require substantial operations or a large physical presence. Tax authorities increasingly focus on where business activity actually takes place, rather than simply where a company is legally incorporated.
Many businesses assume that they need to establish a registered legal entity overseas before local tax obligations can arise. This is not necessarily the case. Depending on the circumstances, the following activities could create a PE or other local tax obligations:
- Hiring employees in another country;
- Recruiting a local sales representative;
- Appointing a country manager;
- Allowing overseas team members to negotiate or conclude contracts;
- Delivering long-term projects overseas;
- Operating from a fixed place of business, such as an office or warehouse.
We have recently been advising a couple of UK business owners whose businesses are UK-based and trade only in the UK, but whose director/shareholder has moved overseas.
Although the businesses remain registered and trading in the UK, there may be local tax implications if the businesses are effectively managed and controlled from the country where the director is now based. This can raise issues around corporate tax residence and other local tax obligations, quite apart from the question of whether a PE exists.
WITHHOLDING TAXES
Another potential issue is Withholding tax. Some countries require tax to be deducted at source from certain payments made to overseas businesses, which can include dividends, interest, royalties and, depending on the circumstances, other types of payments.
It is therefore important to understand the local rules and the position under the relevant double tax treaty. Businesses should consider whether withholding tax applies, whether a reduced treaty rate or exemption is available, whether the tax can be reclaimed, and the resulting impact on cash flow.
One of our clients, which undertook a construction contract in Saudi Arabia, was still trying to recover withholding tax two years after completing the work.
TRANSFER PRICING
Where a UK business operates through overseas subsidiaries or other related entities, transactions between the entities may need to comply with transfer-pricing rules.
In general terms, related-party transactions should be priced on an arm's-length basis, broadly, as if the parties were independent businesses dealing with each other.
Businesses may also need to maintain appropriate documentation to demonstrate that their pricing is commercially supportable and compliant with the relevant rules. Failure to comply can result in adjustments, additional tax, interest and potentially significant penalties in the UK and overseas.
INCREASING TRANSPARENCY
Governments are investing heavily in tax compliance, data sharing and international cooperation, supported by increasingly sophisticated digital systems.
Cross-border business activity is therefore becoming more transparent, making it increasingly difficult for potential tax issues to remain unnoticed.
Even if a business does not attract the attention of a local tax authority, an issue may still come to light during due diligence as part of a funding round, acquisition or pre-sale process. This is what happened with the UK e-commerce business mentioned earlier.
PLAN BEFORE YOU EXPAND
Before entering a new market, businesses should understand the local tax and regulatory requirements alongside the legal, operational and people considerations.
The aim should be to establish the most appropriate way to enter the market before committing significant resources – whether that involves direct sales from the UK, a local distributor, a fulfilment centre, employees, a branch or an overseas subsidiary.
Getting the structure right at the outset can help avoid unexpected tax liabilities, compliance costs and problems further down the line.
Harbour Key can assist businesses with planning their overseas expansion, working with experts in the relevant local jurisdictions to help identify and address tax, legal and operational considerations before entering a new market.
