- Foreign Business Entities: Planning A Careful Route To Tax Savings
- February 17, 2004
- Law Firm: McLane, Graf, Raulerson & Middleton, Professional Association - Manchester Office
Anyone conducting business in the United States knows that the Internal Revenue Service ("IRS") will tax the income from this domestic business. It is less commonly known that the IRS will also tax many activities outside of the United States. Before you begin conducting business abroad it is imperative to understand the major United States tax issues, including the benefits and risks that arise from such an endeavor.
All countries tax business activity within their borders. For example, if a U.S. company conducts business in a foreign country, the foreign country will tax the income earned by that company from sources within its own borders. This territorial taxation system is used by most countries because it is relatively simple and administratively manageable. In addition, territorial taxation favors certain policy goals. Exporting companies are not taxed in their home jurisdiction and capital outflows are taxed.
The United States employs the worldwide taxation system whereby all income earned throughout the world by residents and citizens of the U.S. is taxed. As a result, a U.S. taxpayer's ability to avoid taxation on foreign income is greatly reduced. However, U.S. taxpayers with significant foreign business may still benefit from the territorial taxation system by creating a separate entity to conduct that foreign business. U.S. taxpayers with overseas activity should consider their options and obligations.
Creation of a separate entity to conduct foreign business can shelter the U.S. company from the liabilities of the foreign entity. If the separate entity is a U.S. subsidiary of the U.S. parent, the U.S. parent can offset the start up expenses and initial losses of the foreign business against the income of the U.S. business. The downside is that the U.S. subsidiary's income from the foreign business will be taxed in the United States, even if the foreign income remains overseas. In contrast, if the separate entity is a foreign company, then the United States parent can generally defer recognition of foreign income unless it is returned to the United States parent. This deferral strategy is typically a cornerstone of foreign tax planning for United States taxpayers. Another advantage of this structure is that a U.S. parent company that is taxed as a C corporation will maximize its benefit under the tax credit rules. The company will reduce its U.S. tax liability by the amount of allowable foreign tax credits under the foreign tax credit rules of the Internal Revenue Code ("IRC") when the foreign company's income is repatriated to the United States. One cost of deferring taxation of the foreign income is that the United States parent generally cannot offset the foreign start up expenses and losses against the U.S. income. Risks and benefits of these practices must be carefully weighed.
Anti Deferral Rules
The IRC incorporates a number of rules that limit deferred taxation of income earned by U.S.-controlled foreign entities. The most important provisions, known as the "subpart F" rules, tax U.S. shareholders on a wide range of income earned by foreign corporations, even if the income is not repatriated to the shareholder. Subpart F income includes passive income such as dividends, interests, royalties, rents and annuities, and foreign sales and service income. Avoiding subpart F generally requires business activity with unrelated customers, or substantial manufacturing or service activity in the country where the foreign company is organized.
United States Trade or Business
If the foreign company conducts a U.S. trade or business, then the foreign company could be subject to the IRS's jurisdiction. The amount of activity in the United States, including employees and physical presence, and the applicable tax treaties, if any, can affect this determination.
Foreign business activities generally require additional tax reporting. If a foreign company has a United States trade or business, it must generally file a tax return with the IRS. In addition, U.S. taxpayers must notify the IRS when they acquire or dispose of a foreign company or when they receive income from a foreign company. Taxpayers must also report transfers of property to a foreign company or person.
Creating a separate company in a foreign country really can produce valuable benefits such as liability protection and deferral of taxation. Before opting for this approach, taxpayers should carefully analyze the business tax issues involved in order to maximize the benefits and to ensure compliance with complex IRS requirements.