International Tax Planning Part I – Going Abroad
From a tax standpoint international acquisitions – whether starting your own subsidiary or buying a foreign company — require special attention. Offshore operations offer unique tax and business opportunities; they also present unique tax traps.
Reaching foreign markets. Foreign subsidiaries not only ease access to foreign markets for your goods or services (possibly at reduced overhead costs), they also frequently offer lower tax rates on the profits you make there. And those profits can stay in the low-tax jurisdiction until you need them in the U.S., can be used to build offshore operations or, within limits, can simply earn investment income at a low tax rate.
But U.S. tax law has rules to prevent using foreign subsidiaries primarily to avoid U.S. tax. Subsidiaries in low tax countries cannot be invoicing stations – where the goods are produced by the parent in the U.S., sold cheap to the foreign subsidiary, then marked way up on resale to the ultimate customer so that most of the profit comes down in the low-tax jurisdiction. If the foreign subsidiary buys goods from its parent and sells them outside its country of incorporation without adding much value, the IRS can disregard the subsidiary for tax purposes and tax its income straight to its parent.
Foreign subsidiaries used primarily to generate investment income in a low-tax jurisdiction don’t work, either. Passive income is taxed straight through the foreign subsidiary to the U.S. parent. A foreign subsidiary that actually generates trading income can earn a certain amount of passive income free of U.S. tax – usually 5% of its gross trading income up to $1 million – but anything above that is taxed back to the U.S. parent.
Producing for the U.S. market. Foreign subsidiaries can also be used to produce raw materials for further manufacture or assembly by the U.S. parent, or even finished products for distribution by the parent back in the U.S. And reasonable production profits can be left in the low tax jurisdiction for further growth or until needed in the U.S. But to prevent abuse the IRS applies comprehensive inter-company pricing rules to make sure that the subsidiary does not sell to the parent at an inflated price (and bring most of the profit down in the low-tax country).
Intellectual property and royalties. The use of intellectual property abroad – know how, patents, information technology – also provides unique tax planning opportunities. You may be able to exploit IP in a country that taxes royalty income at a lower rate than the U.S., so that when your foreign subsidiary licenses the property world-wide the income incurs less tax. But the rules on royalty income are complex and those royalties may be taxed to the U.S. parent unless the subsidiary created the IP, or adds substantial value to it, or engages in substantial marketing or servicing activity in the country where it is incorporated. When royalties are being earned from a related party – the U.S. parent or other foreign subsidiaries — it is more difficult to prevent the royalty income from being taxed to the parent.
Setting up the foreign entity. Most tax-free reorganization rules apply to international acquisitions so you can transfer stock or property abroad to set up or acquire a foreign company, just as you would incorporate a subsidiary in the U.S. tax-free. But if you’re transferring appreciated property outside the United States – whether it’s stock or property – the IRS fears that, once those assets leave the U.S., it will never collect the tax on the appreciation, so it tries to tax the appreciation on the transfer out. To defer the tax on the outbound transfer, the IRS usually requires an agreement that, once those assets are sold (by your company’s foreign affiliate) you will pay tax on the appreciation that accrued while the asset was still U.S.-owned. It’s called a “gain recognition agreement” and a failure to submit it could trigger a tax on the transfer out.
If you transfer IP to a foreign subsidiary, special rules apply: regardless of how you characterize the transfer, the IRS usually requires you to treat it as a sale of IP rights contingent on productivity or use, and to report a reasonable profit from the sale every year regardless of actual productivity or use – i.e., regardless of whether you actually receive any royalty or licensing income. So when transferring IP abroad you need to know that your foreign subsidiary can actually generate income from that IP; otherwise your U.S. company will pay tax on the “phantom” income – income that your foreign affiliate might not even earn.
Tax treaties. International tax planning also requires consideration of the impact of tax treaties. Tax treaties will address the extent to which each country can tax your profits, including profits that are repatriated to the U.S., as well as the extent to which you can claim expenses, including interest expense, on inter-corporate transactions. Most important, treaties are intended to avoid paying tax to both countries. Some tax havens won’t have tax treaties with the U.S., so the impact of the absence of a treaty needs to be taken into account.
The U.S. wants its domestic companies to go into foreign countries. But because U.S. tax rates may differ substantially from rates in foreign countries, the U.S. has rules to prevent abuse – rules that you may have never encountered because often they don’t apply to purely domestic companies. Understanding these rules before getting started is important because once you choose a path in international tax planning it’s often too complicated or too expensive, from a tax standpoint, to change it.
The information in this article is for general, educational purposes only and should not be taken as specific legal advice.
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