DOING BUSINESS OVERSEAS
A BRIEF DISCUSSION OF ISSUES RELEVANT TO
There are many reasons why a U.S. business seeks to expand internationally. A company may want to sell overseas, set up an active foreign subsidiary for manufacturing or to provide services, for sophisticated tax planning based on tax treaties, or to accommodate foreign investors. The company may enter into foreign business partnerships or joint ventures to accomplish its purposes. International expansion requires consideration of many issues including tax Treaties, tax credit rules, foreign labor laws, country and local taxes, VAT issues, transfer pricing regulations, customs regulations, quotas and expenses, and of course U.S. and foreign tax reporting and accounting requirements.
The U.S. has tax treaties with most major trading partners, but not all countries. Income tax treaties, and treaties governing employee benefits, are not identical, and each relevant treaty must be examined. Income tax treaties cover commercial and personal tax obligations and generally serve to avoid double taxation through the tax credit system; however, the U.S. tax credit system is fraught with inconsistent regulations and ambiguity, and inconsistent legal precedent. For example, the issue of what foreign tax is creditable can be complicated. A U.S. corporation or person claiming a credit for foreign taxes paid on income must have at least a 10% interest in the foreign entity earning the income, and the foreign tax paid must be required and the U.S parent or owner must exhaust reasonable remedies to avoid the tax or secure a refund.
A tax credit would not be allowed for dividends received by a U.S. LLC or S corporation from its foreign corporate subsidiary because the shareholders are deemed to directly own the foreign corporation. The dividends might be taxed on the way out, unless reduced or exempt by treaty, and taxed again to the U.S. recipients. Some, but not all, types of foreign corporations are eligible for a U.S "check the box election" to be treated as a tax-transparent entity for U.S. tax purposes, which would allow the credit to the U.S. LLC or S corporation owner. The choice of entity is critical and advance planning a must. In any case, the U.S. tax credit cannot exceed the U.S. tax on the foreign source income.
Tax treaties also determine when and if a U.S. company has a "permanent establishment", subject to country and local taxes and employment benefits. This issue is often litigated, and each country has its own and evolving interpretation of "permanent establishment". The existence of a "permanent establishment" can indeed be a tax trap, and can take far less than having a physical office. For example, designating a foreign agent with substantial authority, such as to conclude agreements or appoint or hire sales representatives, could be deemed a "permanent establishment", or even a significant level of sales or service. The applicable law of each country must be examined, regardless of the Treaty language.
Tax on royalties, interest payments, and dividends are often substantially reduced by Treaty, and may influence where a subsidiary, holding company or finance company should be established.
Transfer pricing, or the allocation of costs and prices between related companies, is a favorite target of the IRS and of foreign tax authorities, which all want to ensure that profits are not being unreasonably sent out of the country as an expense tax deduction. The IRS is aggressive, actively auditing transfer pricing arrangements. It requires "contemporaneous" documentation to support transfer pricing, and professional review is highly recommended.
Foreign activity often involves foreign currency considerations, and currency "gains" can actually produce taxable income.
The U.S. imposes numerous reporting requirements on U.S. companies, on both "in-bound" and "out-bound" transactions. The list of reporting forms is outside the scope of this letter, but it is safe to assume that almost every form of foreign related transaction is covered by an IRS or Treasury form. Indeed, the extensive and increasing reporting requirements and the current aggressive IRS posture can be daunting and even anti-competitive to U.S. business. Failure to file required forms carries serious penalties.
While many foreign countries utilize "International Reporting Standards", the U.S has not adopted this same standard, which can introduce a level of financial statement and reporting complication.
Active foreign manufacturing and/or service companies may be eligible for U.S. tax deferral under the "Subpart F" rules. If available, deferral of U.S. tax until repatriated can be very beneficial. For a U.S. exporter, the use of an IC-Disc can provide up to a 20% tax benefit.
The various issues to be considered when expanding internationally can be resolved and with careful advance planning, doing business overseas can be well organized and profitable.