Tax Implications for International Branches
09 Dec 2016
Irrespective of whether a South African company is expanding its business offshore, or whether international businesses set up shop in South Africa, companies trading internationally are often confronted with the complex tax implications for doing so. This article explores the tax implications linked to international branches of a company specifically; it does not consider the scenario where a corporate group would operate through separate companies set up in each of the various jurisdictions in which it operates. With a branch, it is contemplated therefore that a company tax resident in one country carries on operations in another country either by selling trading stock in that other country or rendering services there.
Two main tax implications arise for trading activities conducted through international branches, these being that so-called “permanent establishments” are being created, and secondly that transfer pricing principles would also apply to these permanent establishments.
Dependent on the level of activities involved, for income tax purposes where a non-tax resident company carries on business in another country that company will be considered to have a branch in that other country (known as a “permanent establishment”). Typically, permanent establishments are treated as separate taxpayers by the countries in which these are situated, thus able to earn taxable income of its own in that country. This may potentially give rise to double taxation. For example, A (Pty) Ltd is tax resident in country X, and carries on a business in country Y through a branch there and with sufficient activities to constitute a “permanent establishment”. By virtue of the level of activities in Y, country Y will seek to tax the profits of the branch in that country. However, as A is a tax resident in country X and which would likewise want to tax the worldwide income of its residents. In this instance, double taxation will arise, and A will be taxed in both countries X and Y on the income of its branch in Y, unless there is a double tax treaty in place (and which will typically allocate taxing rights to country Y exclusively). Where both countries have a taxing right to the branches taxable income, the country of residence (in this eg. country X) will likely grant a foreign tax credit to eliminate any potential double taxation.
Whether a permanent establishment exists or not therefore may involve a matter of planning: dependent on the various income tax rates in countries X and Y above, it may be beneficial for A to ensure that sufficient substance is present in country Y to have a permanent establishment recognised in that country if that country for example has more beneficial tax rates than country X.
The further tax consequence linked to permanent establishments relates to that of transfer pricing. In its simplest form transfer pricing would involve ensuring the cross-border charges between related parties are conducted on an arm’s length basis. Transfer pricing adjustments would kick in where a company in a higher income tax jurisdiction were to inflate its deductible expenditure by paying amounts over to a related tax resident situated in another country. In this manner, profits are artificially shifted within the same group to jurisdictions with the lowest tax rates.
The same abuse could potentially apply where permanent establishments are concerned. Take the example of A above carrying on business through a branch in country Y. Transfer pricing legislation (contained in section 31 of the South African Income Tax Act, 58 of 1962) dictates that an arm’s length amount of expenditure be allocated to the branch – no more and no less. Where for example therefore a group company of A would lend money to A’s branch in country X, one would need to interrogate what the interest rate would have been on the debt had a third party provided the debt financing. If the interest payable on the loan between the group company and branch be anything else, transfer pricing legislation would become applicable to adjust any interest paid (or not paid) to arm’s length values.
Based on the above, it is imperative that proper consultation is obtained prior to setting up such structure to ensure tax efficiency.