Beyond Pillar 2: The international tax issues that really count

In summary:

• Pillar 2 continues to dominate international tax discussions, but most UK private equity backed portfolio companies remain outside its scope and face more immediate international tax risks that can affect value and exit outcomes
• Key areas of concern include permanent establishment exposure, employment tax obligations, withholding tax compliance, and indirect taxes
• As businesses grow and expand internationally, gaps often develop between between the group’s operational activities and its tax compliance framework
• Portfolio companies need to take a proactive approach, through exit readiness reviews or practical controls and processes to identify and manage risks, depending on their maturity 

Read or listen to the headlines in recent weeks, and the football World Cup has dominated sports reporting. Yet, for most people, the greater practical impact of football on daily life is the risk of being hit by a wayward shot at the local park.

It’s a similar story with Pillar 2 in the tax press over the past 24 months. Yes, it needs to be considered, and it’s a significant issue for those within (or soon to be within) its scope. But it’s the less headline-worthy aspects of tax that will hit the majority of UK portfolio companies which have received private capital investment. This is because industry data consistently indicates that around 90% of private capital-backed companies in the UK are small and medium-sized enterprises and so well under the €750m revenue threshold for Pillar 2.

This is not to say the rules are irrelevant. Future acquisitions of these companies could bring them into groups that fall within the scope. There is always the possibility of accounting consolidation at the investor-level tipping them over the threshold, too. But outside a relatively limited set of scenarios, time is better spent on some of the less publicised but more relevant international tax risk areas.

The size of many portfolio companies means they will never face the complexities of a global tax department. Yet many will become increasingly international, whether through acquisitions, remote working arrangements, overseas customers or hiring employees abroad.

The tax risks that emerge are less a consequence of deliberate tax planning, and more the result of the increased complexity in corporate structures and supply chains that often accompanies growth. But deliberate or otherwise, these risks are the areas most likely to attract tax authority attention and due diligence scrutiny on an exit.

Permanent establishment risk remains one of the most significant international tax issues for growing portfolio companies. Many continue to hold the notion that PEs only arise with the opening of offices or factories in foreign jurisdictions, but the trigger can be far more subtle. A handful of sales employees, account managers or senior executives operating overseas could be enough to create a taxable presence outside the UK, and the increase in remote and hybrid working arrangements has only added to the risk.

The challenge for portfolio groups with a growing international footprint is that these PE issues can be triggered before management even thinks of the business as truly international. A company may generate most of its revenue in the UK, while still creating an overseas tax exposure. The resulting unexpected questions from tax authorities or during diligence about unintentional PEs are never a welcome surprise.

A portfolio group does not need a significant shift in the location of its operations to create international tax complexity. Recruiting just a few employees overseas can create payroll obligations, social security liabilities or local compliance requirements. Where international headcount growth outstrips the evolution of the organisation’s tax governance, gaps can develop between the group’s operational activities and its tax compliance.  

Groups that expand their operations through international hiring, remote working strategies and employer of record (EOR) arrangements should be mindful of the associated UK and international tax risks and obligations. For example, while EOR arrangements can facilitate overseas hiring, they do not remove potential employment tax or PE exposure. Maintaining visibility over overseas recruitment, workforce mobility and EOR engagements enables businesses to identify and manage tax risks proactively.

Open any tax step plan that includes cross-border payments and, depending on the territories involved, you’ll likely see references to accessing reduced withholding tax rates under domestic or treaty provisions. As a result, an international group’s ability to efficiently move cash across borders can often be taken for granted. But those step plans also include key caveats regarding matters such as meeting beneficial ownership requirements and submitting tax treaty clearances.  

The problem is, after the advice is filed, the commercial realities of running a growing business take up the time of those responsible for tax (who may well have other finance responsibilities to manage). The finer points concerning qualification requirements for reduced withholding tax rates on dividends, interest, royalties, service fees and other cross-border payments can easily be forgotten, leading to cash tax leakage.

What trips groups up isn’t an aggressive withholding tax position; it’s incorrect treaty claims, beneficial ownership issues or just local administrative requirements. The result can be an international structure that appears efficient on paper but is far less attractive on diligence.

Successful portfolio companies and their investors often find success through the evolution of the business model. But this change can see the structure of the acquired business transform significantly from both an operational and structural standpoint. Revenue streams diversify, acquisitions are integrated, functions move between jurisdictions, and management roles and personnel are reorganised.

If not properly monitored, this evolution can result in uncertainty around where profits are earned, which entities perform key activities and how intercompany arrangements should operate. Clearly, this has tax compliance implications, but the knock-on effect of this structural complexity can also create challenges during a sales process when buyers seek to understand how and where value is created. An unclear operating model can lead to extended diligence procedures and valuation pressure.

As with all the best tax advice, the answer starts with, “It depends”. 

A group thinking about these issues after five years of private equity ownership might want to undertake a compliance review as part of an exit readiness assessment. This should focus on unresolved historic risks, documentation quality, governance and audit readiness to give an accurate view of how the group might fare under diligence.

The position is different for a portfolio group either at an earlier stage of private equity ownership or for which international tax considerations and governance might be less mature. For these groups, it is more useful to consider the events and business decisions that could arise over the next few years that will create international tax complexity, and respond by building controls and developing simple tools that management can use to manage the risk.

Approval code: NTEH7072636