Tax Articles

The Economic Employer Rule

By Atty. Fulvio D. Dawilan

Technology has rendered time zones and borders irrelevant. Suppliers and providers of services can work with clients and colleagues across all corners of the globe regardless of whether they are in the same jurisdiction or not. Still, many things can be accomplished only through direct or physical presence. It follows that even in this age of virtual connectivity, cross-border movement of persons is still a necessity.

In taxation, international assignments of employees give rise to issues like – how shall the employee be taxed in his home country and in the host country and what are the obligations of the host entity? And will the assignment result in doing business or the creation of a permanent establishment for the foreign employer/assignor in the host country? The proper determination of the characteristics of the assignment will usually give the answers to these questions. We will discuss more on the tax implications in a subsequent article in this column.

In the meantime, we focus on the characterization of the assignment, specifically in relation to the “economic employer” concept. In international assignment, to avoid the creation of a permanent establishment for the foreign company, the traditional model is the "secondment" or "formal employment" concept. A formal employment arrangement is recognized between the assigned employee and the host company. The employee becomes an employee of the receiving company.

A global trend has emerged with the adoption of the “economic employer” concept veering away from the traditional “formal employer” model. Under this arrangement, the employee remains employed with his home country and yet will be economically employed in the host country. Some countries use the “economic employer” concept in determining the employer of the assignee. An “economic employer” is most commonly interpreted to be the entity controlling the day-to-day activities of the employee and the one that receives the benefits of the employee’s work. Other countries look at where the costs of an assignment are borne. They maintain that if the costs are borne in those countries, then those countries are expected to retain profits generated from the assignment and therefore economically becomes the employer of the individual for the period of the assignment.

The OECD Commentary on the Model Tax Convention, however, cautions that the question of whether the remuneration of the individual is directly charged by the formal employer to the enterprise to which the services are provided is only one of the subsidiary factors that are relevant to determine whether services rendered by the individual may properly be regarded as rendered in an employment relationship. Relevant domestic laws may ignore the way in which the services are characterized in the formal contracts. Instead, focus is made primarily on the nature of the services rendered by the individual and their integration into the business carried on by the enterprise that acquires the services. Substance prevails over form, such that the assignee will be considered an employee of the host entity if the services rendered by the employee are more integrated to the business activities carried on by the host entity. Thus, it is also important to determine whether the services rendered by the individual constitute an integral part of the business of the enterprise to which the services are provided.

The Commentary further provides that an analysis of some factors is necessary in determining the economic employer. Among these factors are the following: the party responsible or at risk for the results produced by the employee’s work, the entity with the authority to instruct the worker, who has control and responsibility in relation to the employee’s place of work, how the remuneration is calculated, who provides the tools and materials, and who determines the number and qualifications of the employees.

In the Philippines, we have not really adopted the “economic employer” concept in the area of taxation, such as in the application of the exemption from tax for short-term employment services based on tax treaty provisions. A look at the rulings issued by the tax authority as well as the decisions of the Courts would show that this “economic employer” principle had not reached that sophistication, for the tax authority or the Courts to scrutinize the economic substance of the arrangements between or among the assignor, the assignee and the host entity. Philippine taxpayers and tax authorities alike have relied heavily on the use of bilateral tax treaties in determining the taxation or exemption from income tax of the income of foreign individual assignees in the Philippines. But it has not gone enough to the extent of determining whether employer functions are exercised primarily by the employing entity in the home state or by the host entity.

Some quarters state that Philippine tax authorities are adopting the economic employer approach based on the principle that when there is a recharge to the Philippine entity, the host entity is considered to be the economic employer and the employee cannot claim tax exemption. I respect this view. However, this is a simple application of the treaty provision which states that if the cost is borne by a Philippine entity or permanent establishment, the exemption will not apply. The tax authorities do not tend to scrutinize whether there is “employer-employee” relationship so the exemption will not be available.

What we have in the Philippines is the four-fold test in determining employer-employee relationship for labor law purposes. These tests in determining the existence of employer-employee relationship approximates that of the tests or factors in determining the “economic employer”. Thus, an entity determined to be the employer under Philippine domestic law would easily be determined to be an “economic employer” using the factors stated in the OECD Commentary. Unfortunately, while these four-fold tests had been applied in labor disputes/issues, that is, in determining the rights and obligations between an (alleged) employer and an employee, it had not been applied in tax issues, specially so with respect to international assignments.

There are peculiarities in the characterization of employment in the area of taxation. The improper application of tax treaty provisions may lead to tax leaks or abuse. Also, application of general labor rules is not sufficient. Policy makers and tax administrators may need to consider this area and craft laws or rules to address this concern.