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Due Diligence: Permanent Establishment Risks

Depending on the size and nature of a proposed acquisition or merger, the acquiring company (“Buyer”) may undertake due diligence services to determine the risks the target company (“Target”) may possess, if any, for both accounting and tax purposes. From an income tax perspective, the Buyer will assess the Target’s income tax risks by reviewing various documents and written agreements. These documents and written agreements would typically include prior year federal and state income tax returns, property and payroll tax returns, certain legal agreements, intercompany agreements (commonly referred to as transfer pricing agreements) and other miscellaneous documents. Based on the tax profile of the Target, the due diligence review can be an extensive review that could last a couple of weeks or it can take less than a day. If there are any material uncertain tax positions, the Buyer will often include such amounts (or portions of them) as part of its purchase price as an assumed liability of the Target.

One often-ignored area of tax risk for a Target is international tax. US companies generally file an annual US federal income tax return and certain state income tax returns. State income tax returns, such as with California, are filed based on where the company has “nexus.” Broadly speaking, nexus is defined as having a physical connection to a state or business presence. This can be in the form of sales, payroll or assets attributable to a single state or multiple states. However, US companies can have a foreign income tax filing requirement even though a US company does not have any foreign subsidiaries. These foreign income tax returns are often in the form of a foreign branch income tax return.

Companies are required to file foreign branch income tax returns when it is determined a company has a “permanent establishment” in one or more foreign jurisdictions. The concept of permanent establishment, according to the Organization for Economic Cooperation and Development (“OECD”) and the United Nations in their Model Tax Conventions, is based on the premise that an enterprise carries on a business in a country for an extended period of time through a fixed place of business, its personnel or dependent agent. The “extended period of time” is generally defined to be six months, while the “fixed place of business” is determined by the presence of physical assets such as premises, facilities or installations at the use of that enterprise. Activities that are regarded as preparatory or auxiliary in nature are usually excluded from the definition of permanent establishment activities. These include activities that do not form an essential or significant part of the activity of the enterprise as a whole. Income tax treaties of developed countries typically include standard language defining the term “permanent establishment” that is based on the OECD Model Income Tax Convention.

If it is determined that a company has a permanent establishment in one or more foreign jurisdictions, then such company must generally file a branch income tax return beginning on the date the company’s permanent establishment commenced. Frequently, companies will have to go back more than one year to file branch income tax returns once it determines a foreign business presence gives rise to a permanent establishment. In addition, since an income tax return was not filed for one or more prior years, the statute of limitations is not applicable. Interest and penalties could also be assessed by the foreign jurisdiction. However, it is possible that a US company could claim a US foreign tax credit on foreign income taxes paid, but this will depend on numerous other factors and variables. If a company acquires a target that has one or more foreign permanent establishments, then the acquiring company will generally assume this foreign income tax exposure immediately after the close of the acquisition.

To mitigate these aforementioned risks, it is recommended that a foreign permanent establishment review be added to the Buyer’s due diligence checklist. It is recommended that a payroll listing and an independent contractor listing by jurisdiction be obtained to determine whether there are any foreign employees or foreign dependent agents. Real estate holdings, including lease agreements, should also be included in the request list from the Target. It is also important to understand how the Target operates its foreign business to determine whether this gives rise to a foreign permanent establishment. Once these items have been obtained and analyzed, the Buyer can assesses the foreign tax risks of the Target, if any, and adjust its purchase price accordingly; or, at the very least, have a clearer picture of the income tax risks, including foreign income tax, before the proposed transaction is consummated.

If you have questions about this article, please contact Sean McFerson at or 844.4WINDES (844.494.6337).
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