TAX PLANNING FOR INTERNATIONAL BUSINESS
A BRIEF OVERVIEW
The U.S. Company looking to do business outside the U.S will sooner or later recognize that tax planning to legally minimize U.S. income tax is not just wise, it may be necessary to survive.
The U.S. has the highest corporate tax rate in the developed world, and it generally taxes individuals and corporations on world- wide income, possibly but not always with a credit for foreign income taxes paid on the same type of income. This, coupled with the incredible complexity of the tax code, puts U.S. business at a substantial disadvantage. (Click here to see the list of tax rates).
To highlight the complexity of the tax Code, It is reported that United Technologies Corporation's tax return is 19,000 pages; General Electric's return is 24,000 pages. Much smaller companies engaged in international activity struggle with complex and confusing regulations and lengthy reporting requirements.
The U.S. taxes the earnings of foreign subsidiaries or "related" companies, absent legitimate tax planning, while some Countries, like France, Hong Kong, Belgium and The Netherlands, tax only income earned in their respective Countries, on a "territorial" tax system. There is much discussion about changing the U.S. to a territorial tax system, but this writer doubts that will happen soon or ever; opponents argue such a system will, for example, encourage the outflow of capital, more deferral of foreign income, and lower wages.
There are many planning opportunities for a U.S. business engaged in some area of international activity, and this article briefly highlights a few possible opportunities.
1. FOREIGN TAX CREDITS: U.S. Tax treaties generally allow income tax paid to a foreign County on the same income to be credited against U.S. tax. But, not all taxes paid overseas are income taxes, and are therefore not creditable. Complex regulations, recently revised by the American Jobs Creation Act (a misnomer at best), limited the "baskets" of income for tax crediting (two) to ensure that the credits are applied to essentially the same types of business income.
Depending on the situation and business plan, the use of tax credits can be used to shelter income from high tax jurisdictions by using credits from low tax jurisdictions, perhaps by using hybrid entities, which are usually designed to be recognized as different taxable entities in the relevant Countries. While this is a common and often highly beneficial form of planning, the use of hybrids is a subject of interest to both U.S. and European Regulators and must be carefully designed.
2. INCOME DEFERRAL: The basic form of income tax deferral can be realized when a foreign subsidiary is manufacturing in the Country where it is incorporated, or if such subsidiary contracts with a foreign manufacturer and meets all the requirements to avoid "subpart F" income; this Code section essentially requires the recognition of foreign income for U.S. tax purposes. Such planning to defer taxable income should be considered by a U.S. Company manufacturing outside the U.S.
"Transfer pricing" rules govern sales between a U.S. parent and its foreign subsidiary, and pricing arrangements must be observed and documented. These rules are designed to prevent unreasonable payments to a related foreign entity to increase foreign deferred income. Many Countries have their own rules.
The use of "hybrids" and/or the election by the U.S. parent to "check the box" to disregard one foreign subsidiary but not another, can, in the right circumstances, produce substantial tax benefits. A so-called hybrid entity is generally one that is recognized as a corporation in one jurisdiction, but disregarded for tax purposes in another. The various forms and uses of hybrid entities is a complex subject. Possible benefits are, for example, a deduction for interest paid by a high-tax subsidiary to a low tax subsidiary. Both the U.S. and certainly many Countries in Europe are taking a hard look at the use of hybrid entities, and careful planning is necessary.
3. CORPORATE INVERSIONS: This term describes the process when a U.S. corporation merges with a foreign Corporation in a lower tax rate jurisdiction, and then treats the foreign corporation as the "Parent" and the U.S. Corporation as the "subsidiary". This can result in overseas profits being out of the U.S. tax system, and taxed a lower rate. Such low taxed profits may eventually repatriated and taxed in the U.S. The amount of money kept overseas is a popular press topic and it has been targeted by the Obama Administration as "unpatriotic". The Obama Administration and the IRS have recently tried to at least curb this technique by interpretation of existing law to prevent the U.S. Corporation from borrowing from its foreign "Parent". Nevertheless, and for both large and smaller companies, this technique is still viable, especially if there is a strong business purpose. The risk of future legislation to further curb this activity has to be considered, but there remain many legislators who insist there should be no such legislation without tax reform.
4. INTELLECTUAL PROPERTY: The transfer of intellectual property to a foreign subsidiary or related company is regulated by the tax Code and Regulations. The IRS is alert to ensure that transfers of IP to a foreign related company will not take all the royalty or licensing income out of the U.S. The basic rule is that the transfer is treated as an "exchange" for payments to the U.S. Company of the "arms-length" value of the IP, and recognized over a period of time as taxable income. Valuation of IP which is transferred or "sold" is the subject of much IRS litigation. The use of foreign subsidiaries or hybrids may nevertheless be appropriate and tax-wise in the right situation, such as when royalty or licensing income is expected from foreign sources. Advance planning and valuations ae critical.
5. TAX HAVEN COUNTRIES: There is rarely if ever a tax benefit for simply incorporating in a very low or zero tax Country. The U.S. allows no tax deferral to a "CFC" or controlled foreign corporation, absent, the manufacturing or "same Country" exceptions discussed above. As in most all foreign arrangements, the CFC must report all its income.
Nevertheless, in some circumstances the use of a so-called tax haven may be justified. Just for example, the U.S. Virgin Islands offers a program by which a qualifying company's income is essentially tax free (taxed on only a 10% of its income, which might subsequently be repatriated to the U.S. shareholders as a qualifying dividend taxed as low as 15%.
The OECD continues to try to make the use of such jurisdictions as unattractive as possible. It is interesting to note that the U.S. if often criticized for its lack of transparency. For example, it is still possible to incorporate in some States without a public record of ownership. However, full disclosure of beneficial ownership will be required by financial institutions both here and by many (most) other Countries. This Article does not discuss FATCA and the surge in cooperative tax reporting by one Country to another.
6. CAPTIVE INSURANCE: There are many insurance companies which specialize in insuring various risks arising from overseas business activity. If the desired insurance is either not available or too expensive, the U.S. Company can consider forming a Captive Insurance Company to essentially "self-insure", and/or benefit from a pool of insurance.
The statutory type of Captive (831(b), for example, is typically owned by the principals of a company, which can pay deductible premiums of up to $1.2mm a year to the Captive for such casualty insurance. (See my Articles on Captives). A Captive must meet the statutory and regulatory requirements, but if can be both a beneficial business and tax planning opportunity.
7. TAX REPORTING: A U.S. person and corporation must determine which IRS reports are required relating to foreign ownership and foreign transactions. The list of IRS reporting forms is formidable, and it may be assumed that IRS reporting will be required for any foreign activity. Failure to timely file the required forms carries severe penalties.
SUMMATION: Tax planning for the business which is engaged in foreign activity, or which is planning to do so, can provide business and tax advantages which can make the business more competitive, and it may be the difference between financial success and the failure of the overseas effort. The current legislative "climate" in both the U.S. and other Countries should be considered.