This column discusses the key organizational, operational, and repatriation tax issues of foreign-owned U.S. enterprises. We start from the assumption that the foreign corporation is entitled to the benefits available under a U.S. income tax treaty (the tax treaty).
There are three possible choices for the organizational form of the U.S. operation of a foreign-owned company:
The choice depends on the nature of the business and the scale of the intended operations.
The formation of a corporate subsidiary is not a taxable event. However, a subsidiary will pay both U.S. federal and state income taxes on its income. Dividends paid by the subsidiary are subject to U.S. withholding tax reduced by the tax treaty, but dividend payments are not deductible by the subsidiary. Use of a subsidiary generally avoids any engagement in a U.S. trade or business by the foreign parent. The transactions between a subsidiary and its parent are generally subject to arms-length transfer pricing rules.
A branch is an extension of the parent company’s home office. The foreign parent is taxable on income effectively connected with the U.S. trade or business conducted by the branch. Under the tax treaty, tax is limited to income attributable to the parent’s “permanent establishment” (branch office). In addition to regular corporate income tax, operating through a branch triggers the possible application of a branch profits tax. The tax treaty, however, reduces the branch profits tax rate.
A partnership is not subject to tax. Its partners, however, are considered to be engaged in the partnership’s business and are taxed on their allocable share of the partnership’s effectively connected income. A corporate partner is also subject to the branch profits tax on its allocable income.
For both U.S. branches and partnerships, failure by the taxpayer to timely file a U.S. tax return will lead to the loss of otherwise available tax deductions. In addition, failure to file the proper IRS forms can result in significant penalties.
It is generally better to fund U.S. direct investment via debt rather than equity:
- Interest is deductible, whereas dividends are not.
- Debt can be repaid tax-free.
- The tax treaty reduces withholding tax on interest.
Despite the tax stakes, there are no statutory rules distinguishing debt from equity. Case law has established a number: documentation, fixed maturity date, thin or adequate capitalization, and credit-worthiness (though not one is conclusive).
Even if an investment is properly characterized as debt, there are limitations on the deduction of interest.
- No interest deduction for accrued, but unpaid, interest paid to a related foreign entity unless the interest is currently includable in the income of the foreign recipient.
- Earnings-stripping rules can defer the deduction of interest paid on related-party loans in certain instances when the issuer has a debt-to-equity ratio that exceeds 1.5 to 1.
- Earnings-stripping rules can apply to third-party loans if a treaty reduces the withholding tax imposed on interest and the loan is guaranteed by a related foreign person.
There is typically a choice between using U.S. employees or foreign employees. For the foreign employee, the issue is whether continued employment will give rise to U.S. tax residence (and tax on worldwide income). U.S. tax residence is determined under the “substantial presence” (day count) or green-card tests. For the foreign parent, the presence of its employees in the U.S. raises the possibility that their activities will give rise to a U.S. trade or business attributed to the parent.
Profits can be repatriated to the foreign parent in a number of ways:
Royalty payments are often a tax-efficient means to extract profits from the U.S. enterprise. Treaties typically reduce withholding tax on royalties to zero. Often the business activity contemplated is the sale of inventory products by the foreign parent to U.S. customers, i.e., inbound sales. Planning techniques are available to divide the total profit to be realized on the sale so as to minimize the income attributable to the U.S. affiliate. It is critical that the activities of the foreign parent do not constitute engaging in a U.S. trade or business through a permanent establishment, directly or through agency. So long as the parent company does not have a permanent establishment in the United States, it will not be subject to U.S. tax on gain from the sale of its inventory or the shares of its subsidiary.
A liquidation is treated as if the subsidiary sold its assets at fair market value, thus subjecting any asset appreciation to U.S. tax. The distribution of the assets to the foreign parent, however, is tax-free.
Leonard Schneidman, JD, is managing director for Andersen Tax in Boston. He can be reached at firstname.lastname@example.org.
Andrew M. Bernard Jr., CPA, is managing director for Andersen Tax in Philadelphia and a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at email@example.com.