Tax Issues

A U.S. exporter that establishes a foreign sales office must decide whether to structure the foreign sales operations as branch or a subsidiary.

A U.S. exporter must determine its taxable income for foreign tax purposes.

A principal tax issue associated with entering into licensing and franchising arrangements with foreign arrangements with foreign persons is the appropriate foreign withholding tax rate on the U.S Company’s royalty income.

Most income tax treaties provide for reduced withholding tax rates on royalties derived by a foreign licensor.

Following is a chart of withholding tax rates:

Host Country Tax Issues

If the foreign taxes paid or accrued exceed the taxpayer’s foreign tax credit limitation, the resulting excess foreign tax credits represent an out of picket tax cost.

U.S exporters are subject to foreign taxation depending upon the nature of the taxpayer’s activities with in the foreign country, the internal tax laws of the foreign country, and the provisions of any income tax treaty between the foreign country and the United States.

Most tax treaties contain a permanent establishment provision under which a U.S exporter’s business profits are exempt from foreign taxation unless those profits are attributable to a permanent establishment located within the foreign country.

A permanent establishment includes a fixed place of business.

A permanent establishment also exists if employees or other dependent agents habitually exercise in the foreign country on authority to conclude sales contracts in the taxpayer’s name.

Structure of Foreign Operations

A U.S company can structure foreign operations as a branch or subsidiary.

Branches

An unincorporated foreign branch is simply an extension of the domestic corporation, as opposed to a separate legal entity.

Branch taxable income usually is determined on the basis of a separate accounting, whereby the branch reports a profit equal to the amount it would have earned if it were an independent enterprise.

The remittance of branch profits back to the U.S home office is not a taxable event for U.S tax purposes, except to the extent it triggers the recognition of a currency exchange gain or loss.

Subsidiaries

A foreign subsidiary is a corporation organized under the laws of the foreign country and, therefore, is a separate legal entity from its U.S parent.

The subsidiary’s earnings are usually subject to foreign country taxation by virtue of its foreign nationality or the source of its income.

The United States generally does not tax a U.S parent corporation on the active foreign business profits earned through a foreign subsidiary until the subsidiary distributes those earnings to the U.S parent as dividend.

Branch versus subsidiary

Advantages of subsidiaries

A subsidiary generally allows a U.S parent to defer the residual U.S tax on low-tax foreign source income.

The subsidiary form provides more control over the timing of income recognition, which may be useful in foreign tax credit planning.

Local tax incentives, such as a tax holiday, may be available only to a locally incorporated entity.

The sale of stock in a subsidiary results in a capital gain, which may be exempt from foreign taxation.

The separate legal status of a subsidiary may make it easier to justify management fees and other intercompany charges to foreign authorities.

Advantages of branch form

A domestic corporation can deduct foreign losses of a branch against its U.S profits. These losses are recaptured if the branch later incorporates.

The transfer of assets to a branch is a nontaxable event.

S corporation shareholders, who are generally individuals, cannot claim a deemed paid credit for foreign taxes incurred by a foreign corporation. However, these individuals can claim a direct credit for the foreign taxes paid directly on the income of a branch.

There may be no foreign taxes when a branch repatriates its profits, whereas dividends paid by a subsidiary attract foreign withholding taxes.

Considerations when choosing between the branch and subsidiary

A subsidiary insulates the U.S parent from legal liability issues in the foreign country.

A subsidiary may present a better local image to potential customers and employees.

A branch may be simpler to operate.

Foreign laws may require a subsidiary to have outside foreign shareholders or directors.

A subsidiary may make it easier to involve foreign investors in the venture, because a subsidiary can issue additional shares to those foreign investors.

The use of a branch avoids the minimum capitalization requirements imposed by some countries.

Hybrid Entities

A hybrid entity is a foreign business entity that is treated as a corporation for foreign tax purposes, but as a disregarded entity or partnership for U.S tax purposes.

Hybrid entities provide the tax advantages of the flow through entity from, while still providing the U.S parent corporation with limited liability and a “corporate” presence in the foreign country.

Reverse Hybrid Entities

Reverse hybrid entities are foreign business entities that are treated as corporations for U.S tax purposes, but as partnerships for foreign tax purposes.

Information reporting for foreign partnerships

Foreign partnerships controlled by U.S persons have information reporting requirements that are similar to the information reporting rules that apply to controlled foreign corporations. Under these provisions, a U.S partner that controls a foreign partnership must file an annual information return.

References:

Practical Guide to US Taxation of International transactions 9^th Edition

Robert J. Misey Jr.

Michael S. Schadewald

Publishers: Wolter Kluwer, CCH Incorporated.