Tax withholding

When your company considers hiring its service providers as employees, you should be aware of different tax withholding and reporting rules. It would be best if you took both the US (assuming your company is in the US) and the local country of your service provider into the equation.

If the soon-to-become employee provides services that are outside of the US, you are not required to withhold any taxes. When that is not the case, you should withhold the foreign contractor's income tax at the same rate as US residents. You should also include Social Security and Medicare tax. The tax withholding can be reduced or exempt if the employee's country has a tax treaty with the US, and they claim this exemption through the Form 8233.

Permanent establishment in the foreign country

A permanent establishment of the company means that the business has stable and ongoing activities that result in locally created income. In some countries, having employees, particularly ones engaging in sales activities, is considered as sufficient grounds for the permanent establishment.

Each country has its regulations when it comes to a permanent establishment, with some countries more strict than others. You should seek counsel from local tax specialists before hiring employees in a foreign country.

Permanent establishment substitutes

One way to avoid permanent establishment would be to hire contractors who are incorporated in their local country as legal entities (companies, agencies, or others). A business-to-business contract will more likely be interpreted as "a contractor relationship" in many countries.

Moreover, you can hire individuals as leased employees through a temporary agency, or a partner business in the local country, which hires them as employees. That way, your business can have a contract with the said local company offering the services as a contractor.

Lastly, you can go for a PEO (Professional Employer Organization).

PEO are entities that provide payroll processing, benefits management and recruitment, or other employee management services to a company. Legally speaking, PEOs hire the employees directly in a process called co-employment or joint employment. PEOs could potentially assume the legal risk for the hired employees.

There are many paths you can take when you are switching your contractor to an employee. Take all the circumstances carefully and assess what the best scenario for your company is.