X

Thank you for sharing!

Your article was successfully shared with the contacts you provided.
As the global economy expands, practitioners increasingly encounter U.S. companies that undertake operations outside of the United States. These “outbound” operations raise numerous business and legal considerations absent in purely domestic scenarios. One of the key issues facing a company is structuring its foreign operations in a manner that achieves maximum tax efficiency (or at least avoids any unnecessary double taxation). Without effective tax planning, a well-conceived business plan could yield costly tax results that reduce cash flow during the critical start-up phase of a venture. Further, as the foreign operations grow in profitability and value, the tax cost of unwinding an inefficient structure may be compounded. The U.S. tax rules applicable to foreign operations are in many ways very different from those applicable to domestic matters. An effective transaction advisor must not only navigate the U.S. rules, but coordinate the structure of the transaction with foreign tax counsel and consider the effect of applicable tax treaties. International tax issues are often not intuitively apparent — even to transactional lawyers who are seasoned in the basic tax issues that drive domestic matters. This article provides a brief description of some key income tax issues worth noting when faced with a U.S. company that has foreign activities (referred to herein as USCo). It is by no means encyclopedic or comprehensive in approach; rather, we hope to provide readers with some basic issue-spotting savvy and to arm them with a few concepts that may increase their ability to effectively counsel a client on general aspects of international transactions. Nonincome taxes (such as sales tax or value added tax) and import duties are beyond the scope of this article, but often have a significant impact on cross-border transactions. FIRST STEPS — SELLING GOODS ABROAD Often, a company’s first steps in the international arena consist of the sale of its products to overseas markets. This can be accomplished through direct sales activities or through local distributors. Assuming, as is often the case, that the foreign country has entered into a comprehensive income tax treaty with the United States, the test for determining whether the foreign country may subject the locally generated income to its income tax regime (referred to as “nexus”) is whether USCo has a created a “permanent establishment” (PE) in that foreign jurisdiction. A PE is generally defined as “a fixed place of business through which the business of an enterprise is wholly or partly carried on.” See, for example, Article 5 of the U.S.-Netherlands Income Tax Treaty. There are numerous examples as well as exceptions that clarify what is and what is not a PE. Nonetheless, the test is very fact sensitive and often does not lend itself to precise determinations. But in general, as long as USCo’s activities in the foreign jurisdiction are minimal, USCo will not be subject to income tax in that jurisdiction. For example, occasional trips by a sales representative to the foreign jurisdiction do not generally result in sufficient “nexus” to attract foreign income taxation. Importantly, however, the use of agents in a foreign jurisdiction can result in a PE if sufficient authority is granted to and exercised by the agent. Sometimes, by undertaking certain acts outside of the foreign jurisdiction at issue (for example, executing agreements in the home country rather than in the foreign jurisdiction), USCo may avoid a PE (and thus avoid foreign income taxation). OPERATING AS A FOREIGN BRANCH For tax purposes, a “foreign branch” generally refers to the direct conduct of operations in a foreign country such that local income tax nexus is created. In cases where a tax treaty is applicable, the term branch is synonymous with PE (as described above). Often, a company’s initial activities in a foreign country will not rise to the level of a branch, but as the scope of activities expands, branch status can result. Operating through a branch has advantages and disadvantages. In general, the profits of USCo’s foreign branch are taxable both in the foreign country and the United States. This means that USCo will generally be required to file a tax return in the foreign country and subject itself to tax audits and disclosure obligations in that country. If USCo is a pass-through entity for tax purposes (e.g., a partnership), the foreign jurisdiction may require USCo’s partners to file tax returns and pay tax in that jurisdiction. To offset potential double taxation, USCo (or, in the case of a pass-through, USCo’s owners) U.S. tax law generally entitles taxpayers to a foreign tax credit (FTC) with respect to the foreign income taxes paid or accrued. IRC section 901. The FTC constitutes a dollar-for-dollar offset against U.S. federal income tax and can therefore be quite valuable. FTCs are, however, subject to numerous limitations and restrictions which can vary depending on the type (character) of income earned. IRC section 904. If the branch generates losses, those losses may generally be used to offset income generated by USCo elsewhere (e.g., in the United States). Restrictions can apply if the loss may also be utilized by a foreign taxpaying entity to offset its income. IRC section 1503(d). In the event the foreign branch becomes profitable and begins paying taxes in the foreign jurisdiction, the FTC available to offset U.S. income may be limited due to the prior use of losses in the United States. IRC section 904(f). Other loss recapture rules can apply if, for instance, the branch is eventually incorporated. IRC section 367(a)(3)(C). OPERATING AS A FOREIGN SUBSIDIARY When significant operations will be conducted in a foreign country, it may be preferable to form a local-country corporate subsidiary (referred to herein as “FSub”). (In comparison to forming a U.S. entity, it is frequently more burdensome and costly to form and capitalize a foreign corporate entity.) From a nontax perspective, a principal objective of this approach is achieving limited liability for FSub’s shareholder (i.e., USCo). The transfer of appreciated property from the USCo to FSub may result in US taxable gain, even if such a transaction would otherwise qualify for tax-free treatment (e.g., incorporation or reorganization). IRC section 367(a). Further, where certain types of intellectual property are transferred from the US to a foreign subsidiary, income can result. IRC section 367(d). FSub will ordinarily be subject to income taxation in the foreign jurisdiction at normal rates like other entities from that jurisdiction. However, unlike a foreign branch (above), FSub’s profits will not generally be subject to U.S. taxation until they are actually distributed to USCo, allowing for some management (deferral) of U.S. taxation. This article generally focuses on U.S. corporate shareholders; however, dividends paid by a foreign subsidiary to U.S. individual shareholders can sometimes qualify for favorable capital gains tax rates if the subsidiary qualifies for tax treaty benefits. U.S. tax law does, however, contain a number of fairly broad “anti-deferral” rules to prevent perceived abuses of the general deferral principal. See, e.g., IRC sections 551-558; 951-964; 1291-1298. The anti-deferral rules are largely designed to address situations in which foreign companies owned by one or more U.S. taxpayers generate passive or related party income. If applicable, U.S. shareholders may incur U.S. tax liability with no associated cash flow to pay the tax. For instance, anti-deferral rules can apply where FSub is a controlled foreign corporation (CFC) and any of the following occur: FSub owns one or more investments in U.S. property (e.g., U.S. real estate, stock of a domestic corporation, or a loan receivable from a U.S. person); FSub sells stock or securities at a gain; FSub receives dividend, interest, rent or royalty income or has foreign exchange rate gains; or FSub has income from transactions with related parties. When FSub makes payments to USCo, whether in the form of dividends, royalties or interest, many foreign countries will subject the payment to a withholding tax. The rate of the withholding tax can often be reduced or eliminated under an applicable tax treaty. U.S. corporate investors with a greater than 10 percent interest in FSub and that receive a taxable distribution (actual or deemed) from FSub are generally eligible to claim an FTC for the foreign income taxes paid or accrued by FSub. IRC sections 902 and 960. All U.S. corporate shareholders, regardless of ownership percentages, are generally eligible to claim an FTC for foreign withholding tax. ACQUIRING OR SELLING A FOREIGN SUBSIDIARY It is generally prudent to conduct tax due diligence on a foreign target company considering both U.S. and foreign tax issues and attributes that will exist after the acquisition. Further, when acquiring the stock of a foreign subsidiary, it is often beneficial to make an election to achieve a purchase price tax basis for the assets of the target company. The election can result in more efficient FTC usage and eliminate significant uncertainty regarding the tax attributes of the target. For foreign targets, see IRC section 338(g) rather than section 338(h)(10), which is often used in domestic transactions. Special rules apply on the sale or disposition of FSub. IRC section 1248. These rules can result in ordinary (dividend) income rather than capital gain treatment. OTHER CONCEPTS WORTH NOTING“Check-the-box” planning. As with U.S. limited liability companies, many types of foreign business entities can elect for U.S. tax purposes to be treated as either corporate entities or as pass-throughs. Treas. Reg. sections 301.7701-2 and -3. Note that certain types of entities (e.g., US corporations, Dutch NVs and German AGs) are not eligible for elective treatment. Careful selection of the entity type and its U.S. tax classification can significantly facilitate international tax planning. The classification elections are generally only recognized for U.S. tax purposes and can sometimes create tax arbitrage opportunities. � Transfer pricing. The United States seeks to protect the erosion of its tax base from a global company’s use of artificially low (or high) pricing in its cross-border related-party transactions. IRC section 482. Such related party transactions must generally be completed on arm’s-length terms and be supported by contemporaneously prepared documentation. Failure to do so can result in taxable adjustments as well as significant penalties. � Foreign currency gains. Transactions denominated in foreign currencies can result in taxable gain or loss to a U.S. taxpayer. For example, gain or loss can result where USCo has a loan denominated in foreign currency or where its foreign branch uses a non-U.S. currency. Helverson and Neuenhaus are partners at Neuenhaus Helverson of Morristown, a boutique international tax and transactional firm. The authors practiced tax law in Europe for several years and are frequent contributors to international tax publications.

This content has been archived. It is available exclusively through our partner LexisNexis®.

To view this content, please continue to Lexis Advance®.

Not a Lexis Advance® Subscriber? Subscribe Now

Why am I seeing this?

LexisNexis® is now the exclusive third party online distributor of the broad collection of current and archived versions of ALM's legal news publications. LexisNexis® customers will be able to access and use ALM's content by subscribing to the LexisNexis® services via Lexis Advance®. This includes content from the National Law Journal®, The American Lawyer®, Law Technology News®, The New York Law Journal® and Corporate Counsel®, as well as ALM's other newspapers, directories, legal treatises, published and unpublished court opinions, and other sources of legal information.

ALM's content plays a significant role in your work and research, and now through this alliance LexisNexis® will bring you access to an even more comprehensive collection of legal content.

For questions call 1-877-256-2472 or contact us at [email protected]

 
 

ALM Legal Publication Newsletters

Sign Up Today and Never Miss Another Story.

As part of your digital membership, you can sign up for an unlimited number of a wide range of complimentary newsletters. Visit your My Account page to make your selections. Get the timely legal news and critical analysis you cannot afford to miss. Tailored just for you. In your inbox. Every day.

Copyright © 2020 ALM Media Properties, LLC. All Rights Reserved.