Editor: Mindy Tyson Weber, CPA, M.Tax.
Foreign Income & Taxpayers
A taxpayer that ventures into international business by acquiring a multinational target may encounter a number of tax issues that could result in significant unanticipated tax liabilities. Both sellers and buyers should perform a thorough and thoughtful due-diligence review to identify all potential tax (and other) exposures to arrive at a final purchase price that reflects the parties’ best assessment of the value of the business.
Proper due diligence will allow the buyer to request any warranted purchase price reductions (or an increase of tax escrow). Additionally, thorough due diligence will allow the buyer to demand the best possible valuation of an acquisition target. While these issues vary from case to case, four areas of tax exposure often arise in acquisitions of multinational businesses with U.S. operations. This item discusses these areas—transfer pricing, limitations on interest deductions, permanent establishment, and U.S. withholding taxes.
Improper or inadequate documentation of intercompany pricing practices likely is the most significant tax exposure for companies performing due diligence on acquiring a multinational business. In transactions with their non-U.S. subsidiaries or partners, U.S. companies may have intercompany commission payments, loans, interest, royalties, or dividends flowing from one entity to another. U.S. transfer-pricing regulations generally require that these related-party transactions occur at a price that unrelated parties would charge each other when dealing at arm’s length and that is supported by contemporaneous documentation (Regs. Sec. 1.6662-6(d)(2)(iii)).
The contemporaneous-documentation requirement can be satisfied only if an annual transfer-pricing report has been prepared when an annual tax return is filed (Regs. Sec. 1.6662-6(d)(2)(iii)(A)). If a taxpayer does not have contemporaneous documentation of an arm’s-length price reasonably determined under an allowable method and the IRS makes an adjustment, an additional 20% penalty tax can be applied if either (1) the price for any property or service is 200% or more, or 50% or less, of the amount determined to be the correct price, or (2) the transfer-pricing adjustment exceeds the lesser of $5 million or 10% of gross receipts (Sec. 6662(e)).
In many cases, multinational companies have substantial intercompany transactions with transfer prices that do not reflect appropriate arm’s-length rates or lack contemporaneous supporting documentation. For example, U.S. companies often capitalize a foreign business with low- or no-interest debt. The IRS can reallocate income, credits, deductions, or basis resulting from a non-arm’s-length transaction for purposes of arriving at the true taxable income of the parent and its foreign subsidiary.
This allocation may result not only in additional tax due but also in a 20% penalty on any significant understatement of income. Accordingly, a future reallocation could subject a target entity to additional taxes, penalties, and interest. The easiest way to minimize this exposure is to prepare contemporaneous transfer-pricing documentation for related-party transactions every year. In addition, the documentation should be reevaluated when the facts change or the relevant third-party benchmarks become obsolete.
Limitations on Interest Deductions Under Sec. 163(j)
Sec. 163(j) limits the deductibility of interest paid or accrued by U.S. and certain foreign corporations to related persons where all or a portion of the interest is exempt from U.S. tax. This provision is designed to prevent the earnings and profits of thinly capitalized corporations from being reduced through deductible interest payments made to related persons that are not subject to U.S. income tax (see generally Treasury’s Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties (Nov. 2007)). The deduction for interest paid to a related foreign corporation on which the rate of tax is reduced under a tax treaty is also subject to limitation. Sec. 163(j) applies to interest paid by a U.S. corporation to a related party if the corporation’s debt-to-equity ratio exceeds 1.5 to 1 as of the end of its tax year, but only to the extent that net interest expense exceeds 50% of the corporation’s adjusted taxable income. Corporations must report disallowed interest on Form 8926, Disqualified Corporate Interest Expense Disallowed Under Section 163(j) and Related Information; and interest disallowed under Sec. 163(j) may be carried forward and deducted in subsequent years, subject to the limitations that would normally apply (including Sec. 163(j)).
Often, target companies fail to apply the Sec. 163(j) limitation, creating potential tax exposure for open tax years. Buyers should negotiate an escrow (or a purchase price adjustment) for these potential liabilities. Moreover, buyers should incorporate the effect of Sec. 163(j) in their valuation of the target entity’s future cash flows because, in many cases, the acquisition creates intercompany debt owed to a foreign related party. Any potential disallowance under Sec. 163(j) will likely reduce the value of the target and could influence the ultimate mix of equity and debt used to acquire the target.
Many target companies have unidentified tax exposures from business activities in other countries. In some cases, these potential liabilities may be reduced under an income tax treaty if a valid claim is filed. This exposure should be analyzed and quantified as part of a buyer’s due diligence.
Under U.S. income tax treaties, a foreign company operating in the United States generally is not taxed in the United States on its business income unless the income is attributable to a permanent establishment (PE) located in the United States (see United States Model Income Tax Convention, Art. 7(1) (2006)). Similarly, foreign treaty partners generally do not tax the business income of a U.S. person unless that person has a PE in the foreign country. A PE may include a fixed place of business, but it can also include the activity of independent agents located in the host country. For example, under many treaties, a PE can arise if a U.S.-related corporation has the authority to conclude contracts in the name of a foreign principal and habitually exercises that authority (see United States Model Income Tax Convention, Art. 5(5)). In addition, a PE can arise if a taxpayer’s activities in a host country go beyond certain enumerated activities generally viewed as preparatory or auxiliary in nature (see United States Model Income Tax Convention, Art. 5(4)).
A company is generally taxed on the income allocable to the PE and required to file a tax return (see Sec. 864(c)(4)(B)). In the United States, where a PE does not exist and U.S. law would otherwise require filing a tax return, a foreign related company must file a U.S. tax return to claim exemption under a relevant treaty, even though no U.S. income tax is due (see Regs. Sec. 301.6114-1).
Failure to file a return in this situation could expose the taxpayer to significant penalties. For example, a foreign corporation that claims an exemption from U.S. tax but fails to file a return may be subject to tax of $10,000 with respect to each income payment or income item for which the taxpayer fails to disclose a treaty-based return position (Regs. Sec. 301.6712-1). The penalty applies to each separate income payment or separate income item received by the foreign taxpayer from the same ultimate payer, even if all of the income at issue arises from the same transaction (e.g., a single loan with multiple payments of interest).
Moreover, under U.S. law, failure to file a return tolls the statute of limitation on both the underlying tax and any related penalties, allowing the IRS to collect the tax or penalty over an indefinite period. Because the tax and penalty exposure can be significant, buyers of multinational business entities should conduct full due diligence for any exposure arising from failure to properly claim treaty benefits. Following an acquisition, buyers should implement controls to limit the activities that may create a PE in a host country. In addition, controls should be appropriately examined and structured to ensure that returns necessary to properly claim treaty benefits are filed.
U.S. Withholding Taxes
Payments to a nonresident alien individual of U.S.-source income such as interest, dividends, and royalties are generally subject to a 30% withholding tax, subject to reduction by a relevant income tax treaty (see Secs. 871 and 872). This tax must be collected by the payer of the income (the withholding agent) and reported on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, and Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. A foreign taxpayer that claims a lower withholding tax rate under a treaty must provide the withholding agent with a properly completed Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding, to receive the lower rate at source. U.S. withholding agents that fail to properly withhold on payments to foreign persons are liable for any withholding taxes, as well as associated penalties.
The penalties for applying a reduced rate under a treaty without proper substantiation can be significant. They include up to $100 for each failure to file a correct Form 1042-S when due (including extensions); the maximum penalty is $1.5 million per year ($500,000 if the person’s average gross receipts for the previous three years did not exceed $5 million) (Sec. 6721). A further penalty of up to $100 per form (with an aggregate maximum penalty of $1.5 million) can be imposed for each failure to timely furnish a correct Form 1042-S to a foreign payee (Sec. 6722).
In addition, failure to timely file Form 1042 can result in a penalty of up to 25% of the unpaid tax (Sec. 6651(a)(1)). An extra penalty of up to 25% of the full amount of the withholding tax may result if the withholding agent fails to pay the tax on time (Sec. 6651(a)(2)). Additional penalties of up to 10% of the amount due may also apply to failures to make timely deposits of the withholding tax (Sec. 6656). Interest on the penalties imposed accrues from the due date of the return to the date of payment (Sec. 6601).
Of course, payments made by foreign targets also may be subject to withholding taxes (and penalties) in the home country of the target entity. Buyers should assess this potential exposure in conjunction with qualified local advisers.
In light of the potential for significant tax and penalty liabilities, every acquisition of a multinational business should begin with thorough due diligence of the potential exposure arising from cross-border transactions.
Mindy Tyson Weber is a director, Washington National Tax in Atlanta for McGladrey LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or email@example.com.
Unless otherwise noted, contributors are members of or associated with McGladrey LLP.