Germany, Ireland, Sweden and many other countries are challenging the traditional model for granting income-tax exemptions to temporary foreign workers. Tax authorities in these jurisdictions are increasingly considering not just the duration of an expat employee’s stay, but the nature of the work performed, who controls that work and who benefits from it. As companies increase the number of workers they send abroad, it’s important to pay attention to these trends to avoid back taxes, penalties and reputational damage.
The 183-day rule of thumb
Companies have traditionally followed a rule of thumb — often called the “183-day rule” — that states an employee who is sent to a country on assignment for no more than 183 days in a calendar year or other 12-month rolling period doesn’t need to pay income taxes in the host country.
This rule of thumb is derived from three basic rules set forth in Article 15 of the OECD Model Tax Convention, which is used as the basis for most bilateral tax treaties. The convention says that host countries have the right to tax temporary foreign workers on their income. However, the convention describes three conditions for providing an exemption to paying income tax:
- The employee stays in the host country for no longer than 183 days a year (defined as a calendar year, a fiscal year or any other 12-month period)
- The employee is paid by an employer who is not a resident of the host country
- The remuneration paid to the employee is not borne by a permanent establishment in the host country
Interpreting the rules
Many companies still follow the 183-day rule of thumb, assuming that if one of their expat workers stays less than 183 days in a host country, he or she will not be subject to host-country income tax. That premise, however, has never been true everywhere, and is even less likely to be accurate today.
Over the past few years, tax authorities in an increasing number of countries — especially in Europe — have questioned the traditional meaning of “employer,” a term that is rarely defined in tax treaties. Is the employer necessarily the company that sends a worker abroad, or might it really be the company located in the host country?
A company that sends a short-term expat worker is typically the “formal employer,” or the employer that has the contract with the worker. Increasingly, tax authorities in countries around the world are looking beyond this formal relationship to determine which entity — the company in the home country or the company in the host country — is the employer “in substance,” also known as the economic employer. This is often called the “substance-over-form” test, and it means that even if an expat employee doesn’t exceed the 183-day threshold (or other time threshold as defined by a treaty or local law), he or she may still be subject to income tax in the host country.
Taking their cue from the OECD Model Tax Commentaries, many countries are embracing this concept of economic employer or employer in substance. The economic employer is generally interpreted as being the company that specializes in the kind of work the employee is engaged in, directly supervises the employee, has control over the work, bears any risks associated with the work, and/or profits from the employee’s presence. Let’s take a look at this concept in more detail.
The economic employer concept
Many tax treaties and local tax laws follow the OECD commentaries, which provide scenarios for determining who the economic employer is.
For example, if a parent company containing several groups sends an HR or marketing executive to a group in a different country to unify strategy, the work’s purpose is integral to the parent company’s purpose, and the parent company is considered the economic employer. The same holds true if a technology company sends workers abroad to train other companies to use its software.
But if a company in the business of supplying temporary workers sends a specialized engineer to a foreign company, and the foreign company supervises the engineer’s work and agrees to indemnify the sending company if he makes a mistake, it’s a different story.
Who has direct control over this employee and bears the responsibility for his work? The foreign company does. Who mainly benefits from the work the employee does? Again, the foreign company does. Is engineering integral to the business of the company that sent the engineer? No.
The company in the host country of our last example will be considered the economic employer by tax authorities in an increasing number of countries.
This is of course just one example among countless possible scenarios. A comprehensive list of factors (beyond the formal contractual relationship) for determining an economic employer relationship is available in section 8.14 of Article 15 of the OECD’s commentaries. Below is verbatim copy of those factors, which are mostly presented as questions that employers should ask themselves when making a determination.
- who has the authority to instruct the individual regarding the manner in which the work has to be performed
- who controls and has responsibility for the place at which the work is performed
- the remuneration of the individual is directly charged by the formal employer to the enterprise to which the services are provided
- who puts the tools and materials necessary for the work at the individual’s disposal
- who determines the number and qualifications of the individuals performing the work
- who has the right to select the individual who will perform the work and to terminate the contractual arrangements entered into with that individual for that purpose
- who has the right to impose disciplinary sanctions related to the work of that individual
- who determines the holidays and work schedule of that individual
Steps employers should take to comply
The OECD acknowledges that determining the economic employer is not always a straightforward decision. The process is in many ways similar to making determinations about whether a worker is in substance an employee or an independent contractor in a particular jurisdiction. Often, the answer is not clear-cut and there is a certain amount of room for interpretation. In most cases, an employer will want to seek the guidance of an expert familiar with home- and host-country tax laws and how those laws are being interpreted by local authorities now.
It’s also important to remember that OECD issues guidelines, not laws. Countries are not obligated to follow its advice when drafting and interpreting treaties or local tax laws. But it is certainly true that European nations are increasingly adopting the economic employer concept, with some interpreting it more aggressively than others.
Germany is an economic employer country, for example, and Sweden plans to introduce the concept starting in 2021. In its current version of the planned law, if the Swedish company benefits from the foreign employee’s work, the employee must be taxed from the date of arrival — a far cry from the widely assumed 183-day exemption period.
Clearly, keeping up with international laws and treaties concerning temporary foreign workers is critical. Multinationals should also make sure short-term expat assignments are written as contracts to help avoid triggering the host-country company as the economic employer, especially in countries that are aggressively enforcing the concept.
In all cases, the employer should make sure it complies with applicable tax laws (domestic and foreign) and pays foreign income tax when necessary. That may entail setting up a shadow payroll to pay income tax to host-country authorities while the expat is being paid through a separate home-country payroll.
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