- Structure U.S. operations effectively from the outset, to create flexibility in a changing global tax and business landscape.
- Understand how the inbound company’s global organizational structure and supply chain can impact U.S. tax consequences.
- CLA can help you navigate the ever-increasing burden of new regulations.
Are you a foreign-owned company that needs help with tax planning and preparation?
For many inbound companies, U.S. tax law can present a significant challenge. The decisions you make today about your global tax structure, financing of U.S. operations, and intercompany transactions can have far-reaching — and sometimes unintended — tax implications. Consider these strategies to help avoid typical pitfalls.
Tax structure (and restructure) opportunities
To start, the tax structure of your U.S. company impacts your:
- Federal and state tax reporting requirements
- Ability to claim certain deductions and foreign tax credits
- Eligibility for relief under applicable income tax treaties
- U.S. customers’ withholding and reporting obligations
Therefore, you need to understand the ramifications under federal and applicable state income tax law of classifying your U.S. company as either a pass-through entity or a corporation.
For example, a foreign company may form a U.S. entity that is classified either as a pass-through entity or corporate entity under U.S. tax law. A domestic pass-through entity with only one owner is considered disregarded as a separate entity for purposes of U.S. tax law and is treated as a branch of the foreign investor. When a foreign corporation has a U.S. branch, that corporation is subject to federal (and frequently state) income tax on the taxable income generated by the disregarded entity and must file a U.S. corporate income tax return.
It is not uncommon for a domestic pass-through entity to have more than one owner creating a partnership. If a U.S. LLC is used, the LLC is treated as a partnership for all purposes of U.S. tax law and this structure may create an added complexity of the LLC being a hybrid entity if the foreign jurisdiction classifies the U.S. LLC as a corporation under its law . While the partnership is not itself subject to U.S. federal income tax at the entity level, it is required to annually file a U.S. partnership return on which it reports the taxable income generated during the tax year. A foreign corporate partner of a U.S. partnership is required to file its own U.S. federal income tax return and must include its distributive share of partnership income on that return.
Foreign corporations that are considering an investment in a U.S. partnership may be well-advised to consider investing through a U.S. blocker company, rather than investing directly in a U.S. partnership or LLC. In such a structure, the U.S. blocker company, rather than the foreign investor, would be subject to the U.S. income tax return filing requirements as the direct partner in the partnership. Additionally, with a U.S. blocker company acting as the direct investor, a foreign corporation would not be subject to the new U.S. withholding and reporting requirements that arise when a foreign partner transfers an interest in a U.S. partnership (see discussion of Section 864(c)(8) below).
Note that a foreign corporation may also choose to form a U.S. corporation as a subsidiary. The foreign corporation can incorporate an entity under state law. In such a case, the U.S. entity would be subject to tax on its taxable income and would need to file a federal corporate income tax return.
One potential tax benefit available only to domestic corporations is the foreign-derived intangible income (FDII) deduction for corporations that sell goods and services to non-U.S. customers. Evaluate the supply chain of the domestic corporation’s revenue stream to help determine whether to form a U.S. corporate subsidiary.
Financing U.S. operations
The capital structure your U.S. company adopts can significantly impact the taxation of its operating profits and the repatriation of such profits to its foreign parent. Federal income tax law generally favors debt over equity funding because:
- Interest expense is tax deductible, whereas dividends are non-deductible
- Interest payments typically attract lower withholding tax rates than dividends under most U.S. tax treaties
- Repayments of principal under a debt instrument can be made tax-free
Nevertheless, the compliance requirements for debt financing can be more onerous than equity funding, due to stringent documentation standards and a litany of interest expense deferral and disallowance rules, such as Section 163(j).
The interest expense limitation under Section 163(j) can be a significant consideration for funding inbound U.S. investment. Generally, a U.S. taxpayer is not allowed to take deductions for a business interest expense to the extent the expense exceeds 30% of the taxpayer’s adjusted taxable income, which closely approximates earnings before interest, taxes, depreciation, and amortization (EBITDA). Any disallowed excess interest expense is carried forward to the next taxable year.
Pitfalls can’t always be avoided, but with proper planning you should not be blindsided by unexpected U.S. tax liabilities.
The Tax Cuts and Jobs Act (TCJA) added the anti-hybrid rules under Section 267A creating a level of complexity. Section 267A restricts the deductibility of expenses paid by a U.S. taxpayer to a related party when the related party is a hybrid entity. A foreign entity is considered a hybrid entity when its tax classification (for U.S. tax purposes) differs from its tax classification for purposes of the tax law of the country in which it is formed. Therefore, you must understand the local and U.S. tax classifications not only of the U.S. company, but of all related parties with which that U.S. company transacts business.
The base erosion and anti-abuse tax (BEAT), which was also added to the federal income tax code under the TCJA, functions as an alternative minimum tax on U.S. corporations that meet certain U.S. gross receipts thresholds for related companies. The BEAT provision requires applicable taxpayers to add back deductions that qualify as base erosion payments, which results in additional federal income tax liability.
Foreign corporations with an interest in a U.S. partnership should also be aware of Section 864(c)(8), which could impose withholding tax on the transfer of the partnership interest. While there are several exceptions under this provision, you must disclose the transaction, as well as any such exceptions claimed by the foreign corporation, no later than 20 days after the transaction is effected. As noted above, foreign investors in a U.S. partnership may choose to structure their U.S. partnership investments through a U.S. blocker corporation.
Inadequate transfer pricing
In the area of transfer pricing, federal income tax law grants the IRS authority to reallocate income and deductions between controlled taxpayers (e.g., a foreign corporation and its U.S. subsidiary) if transactions between such parties are not priced at arm’s length. These adjustments can bring increased U.S. federal income tax liabilities, plus interest and penalties, without corresponding tax reductions in the foreign jurisdiction.
To protect against such exposure, U.S. taxpayers should conduct transfer pricing studies that benchmark pricing on intercompany transactions against pricing on comparable third-party transactions. Your transfer pricing policy should be updated frequently, applied consistently, and comply with documentation standards mandated by federal tax law.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act provided significant relief to U.S. taxpayers, which included a temporary increase of the limitation on deductible business interest expense under Section 163(j) to 50% rather than 30%. Additionally, the CARES Act allows a five-year carryback of net operating losses that were generated in a taxable year beginning after December 31, 2017, and before January 1, 2020.
Federal and state tax law changes are inevitable, as evidenced by TCJA and COVID-19. Change is again likely with 2020 being a presidential election year. U.S. taxpayers will need to monitor and model the variable of tax rate changes and other temporary provisions that may occur with a new political landscape.
How we can help
If your company ventures into the U.S. for the first time or intends to expand existing U.S. operations, CLA can help you understand the impact of federal and state tax laws on your business decisions. Our global tax services team provides services to foreign-owned companies with a focus on privately owned businesses, so we can help you navigate the ever-increasing burden of new regulations.