International Tax Planning II — Inbound
In our last blog post covering international tax planning, we focused on the unique tax traps related to international acquisitions. In our final installment, we discuss the tax considerations for foreign businesses looking to acquire companies in the U.S.
The U.S. is still the big apple for most foreign businesses, but deciding how to get a bite of it requires careful tax planning.
Inbound acquisitions – subsidiaries. Foreign companies first need to choose between coming into the U.S. through a U.S. subsidiary or a branch. One downside to a U.S. subsidiary is that, unlike most countries, the U.S. taxes a U.S. company on its world-wide income. So a subsidiary may be advisable if its business will be limited to the U.S., but if it’s expected to turn into a gateway for sales to South America or Canada, you may, depending on the nature of the business, want to consider alternatives – including offshore tax havens – to avoid running up a U.S. tax bill that could have been avoided.
Inbound transfers – branches. A branch is taxed in the U.S. only on business that it conducts here, but with a branch you need to file a tax return for the entire company, then allocate a portion of the company’s total profits to the U.S. It’s not hard to imagine the host of problems that can lead to, particularly since U.S. corporate tax rates are among the highest in the world and the IRS wants to allocate as much income as possible to the U.S. operation. With a subsidiary, the U.S. company stands alone from a tax perspective and the IRS has no right to look into the affairs of the parent (but see Intercompany Transactions, below).
Inbound transfers – LLC partnerships. It is usually a mistake (for all parties concerned) for a foreign company to come into the U.S. as a partner in a partnership (or a limited liability company taxed as a partnership). When a U.S. partnership has a foreign partner, it must withhold 30% of the foreign partner’s share of partnership or LLC profits every year, and pay it over to the IRS, regardless of whether the partnership actually distributes profits. Since the U.S. partners have to pay tax on their share of the profits (whether distributed or not), and since the foreign partner may not file tax returns here, the partnership is required to submit the withholding tax on behalf of the foreign partner (who can then file a return to try to get it back). The foreign partner won’t be happy about this (because, based on other activities, it may not owe any tax) and the withholding requirement may be a strain on the partnership’s cash resources.
Sometimes a U.S. partnership won’t accept a foreign entity as a partner (because it doesn’t want to be responsible for withholding) and will insist that the foreign entity form a U.S. corporation as the investment vehicle. This may not be a good solution for the foreign entity, however, because a domestic corporation will be taxed twice – once on its share of partnership profits, and again (through a withholding tax of 15 – 30% depending on applicable tax treaties) when it distributes those profits to its shareholders. In these circumstances, the foreign entity would be better off forming a domestic partnership (or LLC) of its own to avoid the two-tier tax. To do that, however, it needs a second partner, since a one-member LLC will be disregarded for withholding purposes and the U.S. partnership will still refuse admission. Often, therefore, there is simply no good solution to this problem.
Intercompany transactions. When a branch or subsidiary buys goods or services from its foreign owner – even if it’s just paying for the foreign owner’s accounting personnel to keep its books – the IRS diligently applies inter-company pricing rules to prevent excessive income or expenses from being allocated to a low-tax jurisdiction. The same rule applies to intercompany sales when a subsidiary is used: if the foreign parents sells goods to the U.S. subsidiary for further resale, the IRS will examine whether the price paid by the U.S. company is a fair one, or whether the foreign parent is trying to minimize profits in the U.S. by charging a higher price in order to bring down most of the overall profit in its lower tax rate home jurisdiction. The intercompany transfer rules are intended to determine a reasonable price for goods or services, based on prices paid by unrelated parties.
Tax treaties; branch profits taxes. Foreign companies also need to consider the impact of tax treaties. Subsidiaries may be able to declare tax-free or low-tax (15% withholding) dividends to the parent if a favorable treaty exists. A branch may have to pay a branch-profits tax of 30% on repatriation of earnings to the home country even if dividend payments would have been tax-free under a treaty. On the other hand, for a branch, tax treaties will often spell out the rules on which country can tax profits in which jurisdiction, and will often prevent profits being taxed in both jurisdictions.
What’s the exit strategy? Foreign companies also need to remember that once the U.S. latches onto you for tax purposes it is reluctant to let go, and there may be a stiff tax on the liquidation of the company or the retransfer of its assets outside the U.S. Foreign companies should have a plan for getting out of the U.S. before they come into it.
The U.S. wants foreign companies to set up a business here. But because these companies are usually controlled from abroad, possibly in a lower tax jurisdiction, the U.S. also wants to make sure that it gets (what it see as) its fair share of the overall profits on the business. As with outbound transfers, incoming foreign companies run into rules that are different from those that apply to purely domestic taxpayers.
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