How to switch from an EOR to a legal entity?

Many growing businesses use an Employer of Record to simplify global expansion. With the ability to hire employees without having to create a local legal entity, they can enter new target markets quickly and without taking any finance- or compliance-related risks. 

As long as their local employees are hired via the Employer of Record (EOR), businesses don’t have to worry about HR or payroll. However, this changes the moment they decide to establish a legal presence in the country. 

Once an organization is properly incorporated in a new market, it’s no longer possible to rely on the EOR model to employ local employees. Instead, the EOR hires then need to be brought to the new entity. But how can businesses master the transition from EOR to their own legal entity?

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There are many different reasons for businesses to incorporate abroad. Here are the most common ones that also take into account the previous use of an Employer of Record: 

• Growing number of employees in a market, which makes the use of an EOR solution for the local employee population a more expensive option than direct hiring via a fully owned entity.

• Local restrictions on the maximum duration for EOR arrangements: In some countries (e. g. AUG in Germany), employees can only be hired via an Employer of Record during a certain amount of time, leaving the business with the choice of either terminating employees after this period or setting up an entity to hire them directly.

• Avoiding permanent establishment risk: Using an Employer of Record doesn’t protect businesses from the tax liabilities and legal consequences linked to permanent establishment. To stop tax liabilities from falling back onto the foreign entity—which could mean having to pay tax on the organization’s total corporate income—the business needs to create a separate legal entity in the foreign country where it generates revenue.

• Becoming fully operational in a new market: This goes together with permanent establishment risks. Organizations not wanting to trigger tax liabilities in foreign jurisdictions need to be careful about which business activities they engage in—this particularly holds true for sales and other revenue-generating activities. But there are also many other aspects of doing business abroad for which a legal entity is needed, such as importing goods or sponsoring employee visas. 

Any of these reasons could render the creation of a legal entity necessary and, consequently, trigger the need to bring the former EOR hires to the business’s new entity. 

Also read in the Lano Academy: Employer of Record vs own entity: Which option to choose?

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Bridging the gap between the EOR model and setting up a legal entity in a foreign country is a challenge, and organizations should plan ahead to avoid falling into the many pitfalls that wait along the way. Here are a few things to consider.

Planning ahead

Setting up a legal entity is not a walk in the park—at least in most countries it’s not. There are a multitude of registration processes to go through, legal documentation to provide, and much more. That’s why the whole incorporation process can take up to 6 months in some cases. 

Businesses should therefore plan ahead and be prepared for when they need to transition from EOR to setting up a legal entity. This includes working out a timeline and gathering information about the incorporation process in the respective jurisdiction. It can also be helpful to closely monitor business growth and development in new markets.

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Continuity of employee benefits

Managing employee benefits is a big part of payroll, and every country has its own rules regarding the statutory benefits employees are entitled to. When using EORs to hire talent globally, benefits are provided and administered by the EOR provider; however, once businesses decide to turn their EOR hires into direct employees, they have to take charge of global benefits management.

The key thing to remember is that all the benefits employees were entitled to under the Employer of Record arrangement should be continued. This includes leave entitlements, insurance coverage, pension fund payments, allowances, and more—regardless of whether the benefits are mandatory by law or were offered to the employee on a voluntary basis. Of course, there’s no legal requirement to keep offering employees the same standards in terms of additional benefits, but after several years of service employees will have certain expectations. 

For mandatory social security schemes, the account that has been set up for each individual employee will just be continued. For additional benefits that were offered to the employees, such as private pension funds or private health insurance, the business has to think about how to ensure their continuity—for instance, if they want to continue using the same pension fund provider or change to another one.

Payroll registration requirements

Setting up a legal entity usually involves several different processes, including the mandatory employer registrations that are needed in order to process payroll. Although the registration requirements and formalities vary from one country to the next, they often involve: 

• Registering with the local tax and social security authorities

• Obtaining access to the online portals administered by said authorities in order to be able to make tax and social security contribution payments and to file reports and declarations

• Taking out additional insurance for employees

• Registering employment contracts with the local Ministry of Labor and/or inform local authorities about new hires

• Setting up an in-country bank account

There usually is a specific deadline for each registration step, so businesses should make sure to gather all the information they need before they start the incorporation process. 

For example, when setting up payroll in the United Kingdom, new employers have to register with the HMRC (Her Majesty’s Revenue and Customs) for the national PAYE (Pay- As-You-Earn) system, inform the HMRC about new hires, set up pension funds for eligible employees, and take out employee compensation insurance. 

Payroll management strategy

Apart from registering with local authorities, businesses looking to set up payroll for their international hires also need to choose a strategy for their payroll management. This basically means deciding between in-house processing and payroll outsourcing and, if they choose to process payroll themselves, selecting a payroll software that allows them to automate otherwise manual processes.

There is no one-size-fits-all solution when it comes to managing payroll in a foreign country, and the decision for or against working with a local payroll service provider largely depends on the local knowledge the business can count on. After all, if payroll is processed in house, the entire tax and compliance burden is on the internal team, which is why additional payroll training might be necessary.

EOR contract clauses

Shifting from EOR to entity set-up doesn’t just involve major changes in the business’s global employment model, but it also means the end of a service contract concluded between the business and a service provider. And as with any other service contract, there are contractual obligations that need to be fulfilled. 

Before starting the incorporation process and making any plans for their current EOR hires, organizations should carefully check their EOR contract to see what conditions apply in the case of contract termination. How far in advance does the EOR partner need to be notified, and are there any fees for ending the arrangement?

Payroll information gathering

Once the EOR employees have been moved to the business’s new entity, it won’t be long until the first payroll run. But before that, there’s a ton of information that needs to be collected—regardless of whether the company runs payroll in-house or outsources its payroll calculations to an external provider. 

Data needed to run payroll includes: 

• Employee personal information (names, date of birth, marital status, tax ID, previous payslips, bank details…)

• Contract information regarding compensation and benefits (salary, wages, overtime pay rate, bonuses…)

And of course, there needs to be a system in place to track employee working hours and PTO. 

Outstanding payments and accrual payouts

Outstanding payments are another aspect to consider when switching from EOR to legal entity. Businesses will probably want to make sure to have a clean break with their EOR partner, so checking if there are any outstanding payments is a must. The same applies to the EOR employees.

Moving EOR hires into a direct employment arrangement might not impact the business’s operations—since the employees will keep working for the business in the same way and capacity as during the EOR arrangement— but legally speaking, the shift means the end of an employment relationship and the start of a new one with a different employer. Therefore, any accruals such as unused vacation days need to be paid out. 

No overlap between EOR and legal entity

Organizations should further make sure to avoid any overlap between using the EOR and having a fully operational legal entity, meaning that the organization needs to time the start of business operations under its new entity in such a way that it aligns with the end of the EOR arrangement. 

The reason for this is simple. In most countries, businesses are legally not allowed to continue hiring employees via an EOR after setting up their own local entity. So timing and good planning are crucial.