Architecture and Engineering Firms Doing Business Abroad: Tax and Financial Issues
As part of the strategic decision-making process of working on projects located outside the United States, architecture and engineering firms need to consider the tax and financial implications on the firm, its owners, and any employees involved in the work. Effective planning, structuring, and awareness can increase the likelihood of a firm’s financial success when doing business abroad.
Doing international work without an international office
As a first step in working internationally, many architecture and engineering firms will work on projects located outside the United States, but perform the majority of the tasks in their U.S. offices. This situation raises the subject of foreign taxes and foreign filing requirements. Some of the major factors to consider in these situations are as follows:
Income tax treaty provisions
The United States has tax treaties with many countries, and each treaty is specific to that country. The purpose of a tax treaty is to provide a definitive tax treatment for transactions between U.S. and foreign country taxpayers. Tax treaties will often provide relief from double-taxation or provide exemptions, deductions, or reductions in the rate of taxation on certain transactions that are not otherwise available to the taxpayers.
Physical presence in the foreign country
When a U.S. firm and its employees are working on projects that are located outside the United States, it is often necessary to be physically present in the foreign country for meetings, site visits, and coordination with foreign providers. Depending on the country, the level of physical presence may be an important factor in exposing a U.S. firm and its employees to foreign taxation or reporting.
A significant amount of time spent in a foreign country could lead the U.S. firm to be designated as having a permanent establishment (PE) in that county. This can be true even if the U.S. firm does not have an office or fixed place of business there. A firm with a PE in a foreign country is deemed to be doing business there and, as such, will generally be subject to taxation in that foreign jurisdiction. PE is a treaty concept only. For those countries with which the United States does not have a tax treaty, for example Brazil or Saudi Arabia, the threshold for doing business is measured under the domestic laws of the country and is usually a lower threshold than a treaty PE threshold. Foreign countries may use visa documentation or other information provided to them by foreign companies to assert a PE against a U.S. firm.
Structuring the firm’s overseas operations
When a greater physical presence is required overseas, many important operational issues such as local licensing, contract structure, and legal requirements must be considered. Tax and financial issues need to be addressed as well.
Different business structures each have their own advantages, disadvantages, and impacts. A firm should select a structure that best aligns with their international operating strategy, while also considering the goal of overall worldwide tax efficiency. The most common structures for U.S. architecture and engineering firms operating overseas are as follows:
The U.S. firm may open and operate an office directly in the foreign country, and because it has a PE, it will be subject to foreign taxes, tax filings, and possibly foreign financial reporting. This structure generally provides greater operating flexibility and U.S. staff can more freely travel to and from the branch office without creating PE exposure for the U.S. offices. The profit or loss of the branch office will be reported on the U.S. firm’s U.S. tax returns.
Separate legal entity
A firm may choose to establish a separate legal entity for its foreign operations owned by the U.S. firm (often a subsidiary) or some of its owners. Properly structured and operated, the U.S. firm could be shielded from having a PE and could defer U.S. taxation on foreign profits until those profits are repatriated to the United States. This structure generally provides greater tax flexibility and efficiency when compared to a branch; however, formalities related to separate legal existence, operations, and employment staffing must be more closely observed in order to prevent the U.S. firm from being deemed to have a PE.
Partnership or joint venture with foreign locals
Partnering with a non-U.S. entity or individuals may be useful in certain countries from a tax or reporting perspective. It may also provide a beneficial working relationship with a local provider who understands the business environment.
Tax implications for employees assigned overseas
When a U.S. employer sends its employees on assignment outside the country to work in the firm’s foreign office, the employee may be subject to individual taxation and tax reporting in the foreign tax jurisdiction on their foreign earnings. Since U.S. taxpayers are subject to U.S. taxation on their worldwide earnings, these employees will be taxed in the U.S. on this same income.
Foreign tax credit
With effective individual tax planning, a U.S. employee can typically take advantage of the foreign tax credit on their U.S. return to offset some or all of the foreign taxes on their foreign employment income. Depending on the tax rates in foreign countries, the foreign tax credit mechanism may not always result in a credit against all the U.S. tax on an employee’s foreign earnings. In addition, unless the employee changes their legal residence to the foreign country, they will still be subject to state and local tax on their worldwide earnings. Most states do not have a credit mechanism similar to the federal foreign tax credit so foreign assignments often result in some level of double taxation on employees.
Many firms, as an incentive to U.S. employees to take foreign assignments, will establish a tax equalization policy that is intended to compensate the U.S. employees for the difference between their actual worldwide tax burden and the hypothetical amount of federal and state tax on their earnings as if they were not on foreign assignment. This additional payment is often referred to as a “hypotax” payment.
Assignment of employees
A firm that has structured its foreign office as a separate legal entity must be aware of the risk of having its subsidiary’s PE imputed to it as a result of sending U.S. employees to that foreign office. One way to minimize this risk is for the U.S. employer to “assign” employees to the foreign subsidiary. This effectively makes them temporary employees of the subsidiary for tax purposes. It will subject those employees to taxation and tax reporting in the foreign jurisdiction, but it will also generally protect the U.S. employer.
Transfer pricing agreements and other considerations
Regardless of how your firm’s international operations are structured, transactions between the U.S. firm and its foreign office must be set on arm’s length terms. This is especially true for services provided by one entity for the other or when using staff on the other entity’s projects. The IRS and foreign taxing agencies have broad authority to require formal reporting to demonstrate that appropriate transfer pricing agreements are in place and are followed.
Foreign tax and financial reporting
Most foreign countries have both tax return and financial statement requirements related to the foreign operations which must be accounted for in the foreign currency. In general these tax filings and financial statements must both be prepared on the accrual basis of accounting, which will likely be different than the U.S. firms’ tax reporting.
Repatriation of foreign profits
Transferring foreign profits back to the United States may attract additional foreign taxes and fees and may be subject to approval or limitation by foreign exchange or regulatory bodies. There are planning strategies and options available to repatriate foreign profits in a tax-free manner.
Worldwide tax efficiency
A firm with international operations should look to its tax advisors to help structure business operations with worldwide tax efficiency in mind. All U.S. taxpayers, whether businesses or individuals, are generally subject to U.S. tax on their worldwide income in addition to any foreign tax on their foreign operations. Strategies to achieve worldwide tax efficiency through active planning include:
- Coordinating the foreign operations’ structure with existing U.S. operations
- Foreign tax credit analysis and planning
- Tax treaty planning
- Establishing an IC-DISC to permit distributions of foreign income to owners of the U.S. firm at favorable tax rates
Setting up a practice outside the United States is fundamentally different and much more complex than operating stateside. Even the most basic decisions — like what time the office opens — may require additional thought. You need advisors who are experienced in doing business abroad and a flexible and committed workforce to make opportunities abroad both profitable and positive.