When should you switch from an employer of record to a legal entity?

25 August 2021
When hiring a small number of employees in another country, many organisations use an employer of record, or EOR. The EOR firm hires the employees and manages their benefits, while the organisation manages the employees’ day-to-day responsibilities.

An EOR is an excellent bridge solution for companies that want to test a market or begin limited operations before establishing a legal entity in the target country, but the solution isn’t designed to be permanent. Rules vary by country, but sooner or later, most companies will need to set up a legal entity before they outgrow the limits of an EOR and are considered under local law to have triggered a taxable presence, or permanent establishment (PE).

“An EOR should be a temporary solution. As your team grows, it becomes more challenging to maintain,” says Gino Zabeo, commercial director for Vistra in the UK. “You don’t have the scope of activities you might want — you can’t import or resell goods or open a bank account. You usually can’t sponsor employee visas.”

You also can’t scale operations very far without attracting the attention of tax authorities.

“By the time you’ve got people in-country for a significant amount of time and they are undertaking business activities, your ability to argue that you do not have a PE is limited,” says Tom Lickess, global head of Vistra’s international tax advisory.

So how do you know when to switch from an EOR to your own legal entity? How long is too long? How much business activity is too much?

Unfortunately, there are no simple answers to these questions. Laws vary by country, and permanent establishment determination is a matter of fact and degree, rather than a hard-and-fast trigger. There are, however, several important factors that serve as guideposts in nearly all jurisdictions.

Local time limits

One of the first questions to ask when setting up an EOR is whether there are time constraints. Germany, for example, generally limits EOR arrangements to 18 months. Certain other countries don’t specify a time limit, but frown on years-long EOR engagements.

Organisations also need to keep in mind that laws change. “It happens all the time,” says JP Gooch, VP of Vistra EOR operations. For example, Mexico recently passed a law that prevents the outsourcing of core economic activities, severely limiting the use of EORs in that country. Advisory firms have teams dedicated to tracking employment law changes and can help companies keep up with local regulatory changes, one of the most challenging aspects of international expansion and operations.

Number of employees — and what they do

In an EOR arrangement, it’s common for a handful of employees to engage in marketing and lower-level sales activities.

“A marketing showroom may be analogous for the activities of an EOR employee,” Lickess says. “But time and again, we see firms adding more and more employees, with the on-the-ground activities expanding into business-like operations.”

Most countries don’t set a maximum number for EOR workers, but there are rules of thumb. “If you have one or two employees for six to 12 months, subject to the activities of the individuals, you should generally be fine. By the time you have six employees for two or three years, however, your ability to argue you don’t have a PE is going to be difficult,” Lickess says.

Authorities pay equal attention to the activities employees engage in — and especially to the economic value attributable to those activities — than they do to headcounts.

“A large multinational group may have 30 to 40 people in-country doing genuine market scoping activities without creating a PE, whereas a small company with a single senior vice president or managing director may trigger PE,” Lickess says. “Handing out business cards, scoping the market and low-level lead generation may be acceptable. Contracting for sales in the host country is not.”

Companies sometimes try to get around the rules by eliminating a paper trail for sales contracts, but that may be flagged.

“Sourcing and negotiating with leads, then passing them on to the parent company for the contract to be rubber-stamped under its letterhead is a grey area that introduces risk,” Lickess says.

Another important PE determinant is whether employees are engaging in core activities for the parent company.

“Are the activities revenue-generating or creating economic value? Do they go towards delivering on the contractual obligations of the parent company?” Lickess asks. “Say a US company’s business is providing software with implementation. If you have people on the ground in the UK doing the implementation, they may be satisfying contractual obligations that the US entity is being paid for.”

Such activity may require a legal, tax-filing entity in the UK. The fact that the employees are employed by an EOR won’t necessarily mitigate this requirement.

“An EOR does not wholly do away with your permanent establishment risk. It’s a very real risk,” Lickess says.

Companies that don’t follow the rules — even inadvertently — may face harsh consequences, including double taxation.

“Perhaps a US company with a small UK-based sales team doesn’t believe it has a taxable presence in the UK, so it pays US taxes on its earnings attributable to for example UK or European customers,” Lickess says. “If the UK tax authority determines that the UK-based team constitutes a taxable presence or permanent establishment of the US company, then UK corporate tax may well be levied on this same income that has been subject to US tax.” Penalties and interest may also apply.

Making the transition

Knowing when to create a legal entity for employees who are being paid through an EOR means doing periodic monitoring.

“We check in with our clients every six months to see how their business is doing, how many employees they have, with a view to their potential PE risks,” Lickess says. As the first to know about growth, headcount and operational activities, businesses should also keep track themselves, he advises.

Organisations should act well in advance to set up a legal entity — in some countries, it can take six months or more. Establishing a legal entity can be expensive as well as time consuming, but once a company reaches a certain size in a market, an entity becomes more cost-effective than an EOR. It also allows firms to grow without worrying about their tax status.

“A legal entity is a future-proof, scalable solution. You don’t have to be looking over your shoulder wondering whether you have a PE risk,” Lickess says.

When managed correctly, an EOR offers an easy and quick way to start operations in a new location. But it’s not appropriate for every situation. Some companies should establish a legal entity from the beginning.

“If you have 30 individuals you want to hire or the on-the-ground activities are core to your business operations, an EOR route may not be the recommended solution,” Lickess says.

“Companies need to take a holistic view of their own unique situation,” adds Gooch. “There is no one-size-fits-all for international expansion.”

For more information download our eBook "Hiring across borders with an employer of record: Understanding the benefits and risks."