Given the ease of access to markets as globalization expands, U.S. businesses are facing international tax issues on a more frequent basis than in the past. We aim to provide a preliminary level of awareness of the general tax issues to consider.
For purposes of this article, a small and midsized business is a Subchapter S corporation, a limited liability company treated as a flow-through entity, or a partnership, and are referred to as the U.S. business. S corporation shareholders, individual/noncorporate LLC members, or individual/noncorporate partners are referred to as U.S. taxpayers.
The first consideration in international expansion is whether the U.S. business’ foreign presence gives rise to a permanent establishment in the foreign country. The creation of a permanent establishment abroad by a U.S. business generally requires the business to file an annual foreign income tax return, to pay foreign income taxes, to be subject to the subpoena powers of the foreign tax authority, and to possibly be subject to other requirements.
Similar to the state tax concept of nexus, a U.S. business can create a permanent establishment in a foreign country when the presence and activity of the U.S. business in that country crosses a certain threshold — for instance, by performing any one of the following in the foreign country:
- Opening an office.
- Hiring employees.
- Engaging third-party contractors or other agents.
- Performing services.
- Holding/storing inventory.
- Having the power to conclude contracts.
- Conducting other business activities.
Note that the ability of employees or dependent agents to conclude contracts in the name of the U.S. business while physically present in the foreign country is generally the most common way for the U.S. business to create a permanent establishment. However, a permanent establishment is more clearly defined and standardized in the income tax treaties concluded between the U.S. and about 70 foreign jurisdictions. In addition, a permanent establishment under a U.S. income tax treaty generally requires a higher (taxpayer-friendly) threshold of activity and presence relative to the determination under the foreign country’s local tax laws.
Some countries permit non-resident companies to conduct limited activities as a representative office without creating a permanent establishment. Here, the U.S. business might need to register the representative office with the local tax authorities and limit its activities to creating market awareness, conducting market research, communicating with the local government, or other similar limited business activities. Practically speaking, many businesses do not like the restrictions of a representative office, and will use it in the beginning stages to determine market viability of the foreign jurisdiction, and then move to a more substantive arrangement.
CHOICE OF ENTITY
In most foreign jurisdictions, U.S. businesses can conduct operations through a branch, a partnership or a corporation.
Branch. As a branch, the U.S. business does not create a legal entity in the foreign country. Rather, it directly conducts business activities through employees or contractors. If the U.S. business is treated as having a permanent establishment through its branch operations, it will be required to file foreign income tax returns, pay foreign income taxes, and possibly be subject to other requirements and obligations. All of the activities attributed to the branch operations are included in the computation of the U.S. business’ U.S. taxable income that flows to the U.S. taxpayers. In the event the branch is profitable and the U.S. business pays foreign income taxes on foreign income, these foreign income taxes are eligible to be claimed by the U.S. taxpayers as foreign tax credits. Foreign income taxes can also be claimed as a deduction in the computation of U.S. taxable income.
Please note that the foreign tax credit is subject to numerous limitations and complex rules. Therefore, U.S. taxpayers should never assume that foreign income taxes paid will be eligible as a foreign tax credit.
Partnership. With a partnership, the U.S. business (with another) forms a legal entity in a foreign country that is treated as a partnership under the tax laws of that foreign country. The foreign partnership generally does not pay foreign income taxes, and the partner receives its distributive share of foreign income, loss, deductions, and other items. However, the foreign partnership might withhold foreign income taxes on the distributable income to its U.S. partner, who might also be required to file a foreign income tax return to report such income. The same issues around the foreign tax credit limitation associated with branches are applicable to foreign partnerships as well. Furthermore, some foreign partnerships may be eligible to make a certain U.S. federal income tax election to be treated as a corporation only for U.S. federal income tax purposes (known as the “check-the box” election). Such an election would “block” any income (or loss) of the partnership from entering the computation of taxable income of the U.S. business.
Corporation. U.S. businesses can incorporate legal entities in the foreign country that are treated as corporations under the tax laws of the foreign country. The U.S. business is generally not subject to U.S. taxation on the earnings of its foreign subsidiaries unless there is an actual or deemed repatriation of foreign earnings to the U.S. business. Similarly, the U.S. business cannot benefit from any of the losses the foreign corporation might incur. It should be mentioned here that, without a check-the-box election, U.S. taxpayers cannot claim a foreign tax credit for the foreign income taxes paid directly by a foreign corporate subsidiary. Therefore, the U.S. taxpayers would experience double taxation upon the repatriation of any earnings from the foreign corporation.
If the foreign corporation is incorporated in one of the 70 countries that have concluded an income tax treaty with the U.S., then the dividend could be eligible for a qualified dividend tax rate. If the foreign corporation is not incorporated in a treaty country, then dividends paid out of the foreign corporation will be taxable at ordinary income tax rates.
U.S. taxpayers need to consider the following when deciding to make a check-the-box election:
Whether the U.S. taxpayer should defer taxation on foreign earnings and be subject to the qualified dividend rate (if applicable) plus the net investment tax of 3.8 percent in the future upon repatriation.
Whether the U.S. taxpayer should forego deferral and be subject to immediate taxation at 39.6 percent with the potential ability to claim foreign tax credits.
U.S. taxpayers are generally subject to U.S. taxation on the income earned by their foreign subsidiaries only when that income is actually repatriated. As such, many U.S. businesses defer U.S. taxation on such earnings by operating abroad in foreign corporate form without making a check-the-box election while maintaining overseas profits offshore. Since this deferral rule had created opportunities for larger U.S. multinationals to shift profits to low-tax jurisdictions without paying U.S. tax, there are exceptions to this general rule under the anti-deferral regime of the Internal Revenue Code (Subpart F Income).
Under the Subpart F Income regime, some types of income earned and assets held by certain types of foreign entities are subject to immediate U.S. taxation by certain U.S. persons, even if no actual payment or distribution was made to the U.S. business. Only U.S. shareholders of a controlled foreign corporation are subject to Subpart F Income. A U.S. shareholder is any U.S. person who holds at least 10 percent of the voting power of a CFC. A CFC is a foreign corporation where more than 50 percent of either its vote or value are held by U.S. shareholders. The types of income that are subject to Subpart F Income include passive income (such as dividends, interest, rents and royalties) and certain types of operating income (such as specific types of related-party sales/purchases of inventory). If the CFC loans money to related U.S. persons, holds rights to exploit intellectual property in the U.S., or owns other designated investments in U.S. property, then the adjusted tax basis of these assets in the hands of the CFC can also constitute Subpart F Income to the U.S. shareholder.
Subpart F Income is taxed at ordinary income tax rates and is ineligible for qualified dividend rates, even if an actual dividend paid by the CFC would be eligible for the qualified dividend rate. In addition, since U.S. taxpayers are not eligible to claim foreign income tax credits for foreign income taxes paid by CFCs, Subpart F Income results in double taxation. U.S. businesses must consider whether proposed foreign operations will give rise to Subpart F Income, and consider this potential tax cost. It may be possible to structure proposed foreign business operations in a manner that minimizes or eliminates Subpart F Income. To the extent such planning is not possible, then the U.S. business should consider making a check-the-box election on the CFC to eliminate the possibility of Subpart F Income. However, such an election would subject the U.S. business to immediate taxation of foreign earnings at ordinary income tax rates, but with the possibility of using the foreign income taxes paid by the CFC as eligible foreign tax credits.
Whenever a U.S. business enters into an intercompany transaction with a related foreign party, the transaction must be priced at arm’s-length terms pursuant to certain tax rules of both jurisdictions, also known as transfer pricing. U.S. and foreign jurisdictions generally require companies to determine an arm’s-length price based on certain methodologies and analyses intended to compute what an unrelated third party would charge for the specific transaction.
Transfer pricing is generally required for the following common intercompany transactions (not an exhaustive list), with specified methodologies for each category of transaction:
- Sales or purchases of inventory.
- Licensing or sales of intangible assets.
- Provision of services.
- Interest rates on loans.
Proper transfer planning with supporting documentation is recommended to avoid transfer-pricing-related adjustments and penalties that can arise during a tax audit. In addition, properly supported transfer pricing methodologies and strategies can reduce the effective global tax rate of the global operations of a U.S. business.
Withholding taxes. Whenever the U.S. business receives certain income (such as dividends, interest, rents, royalties and sometimes service income from a foreign person), it is possible that foreign withholding tax could apply. Foreign withholding tax can be reduced or even eliminated under a U.S. income tax treaty. Certain procedures may need to be complied with to claim a reduced rate of foreign withholding tax. Foreign withholding taxes are generally eligible to be claimed as a foreign tax credit or deducted as a business expense.
Similarly, whenever U.S. businesses make payments of certain U.S.-sourced income, they must comply with certain U.S. withholding tax rules and filing obligations.
Thin capitalization. When financing a foreign subsidiary, U.S. businesses should be aware that many countries impose limits on the amount of related-party debt a foreign subsidiary can bear (thin capitalization rules). Intercompany debt amounts in excess of thin capitalization rules generally result in the excess amount being recharacterized as an equity investment, where any payments on the investment would be viewed as nondeductible dividends, rather than deductible interest payments.
Value-added taxes. Many jurisdictions impose VAT and other local sales taxes based on the sale and purchase of certain goods and services in addition to registration and filing obligations. VAT and foreign country sales tax can significantly differ from the sales tax in the United States.
State income taxes. U.S. businesses and U.S. taxpayers should be aware of certain state income tax consequences that can arise when foreign-sourced income is earned at the U.S. federal level. U.S. states generally exempt certain foreign dividends (including deemed inclusions as Subpart F Income), disallow the use of foreign tax credits to reduce state income tax liability, and may require other adjustments to state taxable income as applicable to foreign operations.
As the world continues to get smaller with improved technology and the increase in globalization, U.S. businesses will be exposed to these international tax issues more often than in the past. Therefore, the need for international tax experience and expertise will continue to grow.
Scott M. Robins, JD, is a senior manager in international tax services at Grant Thornton in Philadelphia. Reach him at email@example.com. Emily E. Horvat, CPA, is a manager in international tax services at Grant Thornton. Reach her at firstname.lastname@example.org. David Magarian, CPA, is a senior associate in international tax services at Grant Thornton. Reach him at email@example.com. Reprinted with permission from The Pennsylvania CPA Journal, a publication of the Pennsylvania Institute of CPAs.
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