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Estimating Marginal Tax Rates When Entering Foreign Markets (Part II) This two-part article discusses key decisions that U.S. companies face when entering foreign markets and the potential effect on marginal tax rates (MTRs). Part II focuses on how various organizational alternatives, transferring employees and different methods of remitting profits back to the U.S. company influence MTRs. Ernest R. Larkins, Ph.D. For more information about this article, contact Dr. Larkins at e_lark@bellsouth.net. Executive Summary
This two-part article addresses how establishing business operations in foreign jurisdictions raises tax issues having a potentially significant effect on the marginal tax rate (MTR). Part I, in the September 2004 issue, covered the ramifications of selecting a particular foreign business locale and conducting business through exporting and licensing arrangements. Part II, below, analyzes (1) organizational alternatives for conducting business in foreign countries, such as branch operations, joint ventures and subsidiaries; (2) transferring employees; and (3) the manner of remitting profits back to the U.S. taxpayer.
Organizational Alternatives Branch Operations Conducting foreign business through a branch has both advantages and disadvantages. During the early years, foreign branches may experience net losses while a U.S. corporation tries to establish a market. On the other hand, the corporation can deduct these losses against domestic income, which provides an immediate tax benefit and reduces its MTR from foreign operations. However, Sec. 904(f) requires the taxpayer to recapture losses via the foreign tax credit (FTC) when foreign operations turn profitable. Briefly, the unrecaptured overall foreign loss recharacterizes some of the U.S. corporations foreign-source income as U.S.-source income, reducing the FTC limit and potentially decreasing the FTC. Also, foreign branches with positive earnings trigger host country income tax and, in some jurisdictions, host country branch profits tax.15 One impediment to conducting business abroad through branches is unlimited liability. Branches are mere extensions of the corporate form, not separate entities. Thus, they can expose a U.S. corporation to legal liability from host country claimants. To allow deductible losses to flow through while limiting legal exposure, U.S. companies sometimes establish a hybrid entity in the foreign host country, such as a limited liability company (LLC), and make a check-the-box election to treat the LLC as a branch under U.S. law, achieving the best of both regimes.16 For example, U.S. companies often use a Socit Responsabilit Limite (SARL) or Gellschaft mit beschrnkter Haftung (GmbH) as a hybrid entity. When profitable, such hybrid entities pay the host countrys corporate income tax and may incur withholding taxes when remitting profits, both of which affect the MTR.
Joint Ventures Joint ventures are global strategic alliances in which a U.S. company makes a direct investment abroad, but permits a foreign investor to hold an equity interest. In some cases, the U.S. and foreign investors own equal sharesa 50-50 joint venturebut not always. For tax purposes, joint ventures are classified as follows: 1. Partnerships; 2. Minority corporate joint ventures, in which the U.S. investor owns at least 10%, but no more than 50%; or 3. Majority corporate joint ventures, in which the U.S. investor owns more than 50%. Because the majority corporate joint venture tax issues resemble those involving subsidiaries (discussed below), this section discusses only the first two types. Partnerships: When established as a partnership, a U.S. joint venturer includes its share of partnership profits and gains on its U.S. tax return and deducts its share of losses. If the host country treats the entity as a partnership, legal liability becomes an issue, as with the foreign branch. However, organizing a SARL, GmbH or similar LLC and checking the box to be treated as a partnership under Regs. Sec. 301.7701-2 can secure legal liability protection while retaining the benefits of the partnership form. As was mentioned, checking the box subjects a company to the host countrys corporate income tax (and possibly, withholding taxes when remitting profits). Minority corporate joint ventures: Unlike partnerships, minority corporate joint ventures allow U.S. owners to defer the U.S. residual tax on foreign earnings from low-tax jurisdictions.17 U.S. residual tax deferrals provide a significant tax benefit. For example, deferring $100 of residual tax for 10 years at a 10% discount rate results in a tax payment of $39 in present-value terms, a 61% savings. Establishing a minority corporate joint venture sometimes created FTC problems. For tax years beginning before 2003, U.S. taxpayers had to include dividends from each 10-50 foreign corporation in separate baskets, which restricted cross-crediting. They could not apply excess limits (or credits) in these baskets against excess credits (or limits) in other baskets, a constraint often resulting in double taxation and increased MTRs. Under Sec. 904(d)(2)(E)(iv), the separate-basket restriction continues to apply to dividends received from a 10-50 company that is a passive foreign investment company (PFIC). Under Sec. 1297(a), PFICs are foreign corporations deriving at least 75% of gross income from passive sources or possessing passive assets that are at least 50% of total assets. However, beginning in 2003, Sec. 904(d)(1)(E) allows U.S. taxpayers receiving dividends from two or more 10-50 companies (other than PFICs) out of pre-2003 earnings and profits (E&P) to combine them into a single basket, which facilitates cross-crediting. Also, a look-through rule operates under Sec. 904(d)(4) when 10-50 companies pay dividends from post-2002 E&P. The U.S. recipient looks through the dividends to the nature of each 10-50 companys underlying income in determining how to allocate dividends among FTC baskets.
Subsidiaries U.S. law refers to wholly owned foreign subsidiaries and majority owned corporate joint ventures as CFCs. Specifically, Sec. 957(a) defines CFCs as foreign corporations in which U.S. shareholders own more than 50% of either the voting power or stock value. Under Sec. 951(b), U.S. shareholders include only U.S. persons owning at least 10% of the voting power. Sec. 958 indirect and constructive ownership rules apply when identifying U.S. shareholders and CFCs. CFCs face more restrictive provisions than do other foreign corporations. They cannot defer U.S. residual tax on earnings characterized as subpart F income, which includes a laundry list of items in Sec. 952(a). For example, income from selling inventory is subpart F income when either the purchase or sale involves a related person, the use or consumption of the property occurs outside the CFCs country and the CFC does not manufacture the property within its country. The list also includes income derived from certain services, most passive investments, shipping, oil-related activities, insurance, boycott-related activities and certain misbehaving countries. Each of these categories involves exceptions, so one should not conclude, for instance, that all oil-related profit is subpart F income.18 To prevent deferral of U.S. residual tax on subpart F income, Sec. 951(a)(1) requires U.S. shareholders to recognize a constructive dividend, which is currently taxable in the U.S. To assure that the foreign profit attracts only a residual tax in the U.S. (i.e., avoids double taxation), Sec. 960(a) allows U.S. corporate shareholders to claim a deemed-paid FTC.
Transferring Employees Going global or expanding into foreign markets may require U.S. companies to transfer employees abroad. Such transfers can increase employees income tax and Social Security tax liabilities. To keep their employees whole, U.S. companies often reimburse them for these additional taxes. When significant, these taxes can increase the employers MTR in the foreign market.
Income Tax Whether employees transferred to a host country pay income tax is due in part to their length of stay. Employee transfers can be short-term (e.g., just during the start-up phase), occasional or periodic (e.g., supervisory visits) or long-term (e.g., on-site managerial or technical roles). The short-term or occasional traveler often avoids foreign income tax. Host country laws explain when temporary business visitors become subject to income tax. Usually, host countries do not impose income tax on individuals employment income until their stays exceed a statutory threshold (e.g., 90 days) and they meet certain other requirements. In host countries that have concluded income tax treaties with the U.S., the rules triggering income tax on employment earnings offer greater leniency. For example, the U.S. treaty with Mexico exempts a U.S. employees personal service income from tax if the employee spends no more than 183 days in Mexico during a 12-month period, an employer not residing in Mexico pays the income and some entity other than a Mexican permanent establishment or fixed base bears the payments expense.20 The last two requirements assure that no party deducts the employees earnings against income otherwise taxable in Mexico (i.e., Mexico exempts the personal service income only if no party reduces Mexican tax by deducting the payment). Long-term transfers usually result in host country income tax. However, in low-tax jurisdictions (e.g., Saudi Arabia), transferred employees may not experience an increase in their worldwide income tax liabilities. They pay the host country income tax (if any), claim it as an FTC on their U.S. return and pay the residual U.S. income tax. In these situations, the sum of host country and U.S. income taxes equals the U.S. income tax that would have resulted on the same income had the expatriate remained in the U.S. In high-tax jurisdictions, U.S. employees incur host country income taxes exceeding the U.S. income tax they otherwise would have incurred. Also, U.S. expatriates often receive cost-of-living adjustments, housing allowances, home leave allowances and other compensatory increases related to their foreign visit. To the extent the host country taxes these compensatory enhancements, they increase the amount the U.S. employer must reimburse its expatriate employees for additional taxes. Some U.S. expatriates qualify for the foreign earned income (FEI) exclusion under Sec. 911, thus lowering any income tax that might otherwise be due. When working abroad in low-tax jurisdictions, the FEI exclusion reduces worldwide income tax below the U.S. tax they would have incurred from rendering the same services within the U.S. To qualify for the exclusion, a U.S. citizen or resident must maintain a foreign tax home. Under Rev. Rul. 93-86,21 a tax home is located wherever an individuals regular or principal place of business exists. Also, the U.S. expatriate must meet either a bona fide resident or physical presence test under Sec. 911(d)(1). To meet the first test, a U.S. citizen must reside abroad for an uninterrupted period that includes an entire tax year. Because most individuals use the calendar year, the foreign residency must span January 1 to December 31 of the same year. U.S. individuals meet the physical presence test when they live abroad at least 330 days within any 12-month period. For those who qualify, Sec. 911(b)(2)(D) excludes up to $80,000 (adjusted for inflation beginning in 2008). In addition, qualified expatriates can exclude a housing cost amount in areas where housing expenses exceed 16% of a U.S. government employees compensation, calculated at step 1 of grade GS-14.22
Social Security Tax Under Sec. 3121(b) and (l)(1), the U.S. Social Security tax applies to U.S. individuals working abroad for U.S. employers and their electing foreign affiliates, for extended periods. Host countries control whether and when employment earnings also become subject to social security taxation under foreign law. When coverage overlaps, U.S. expatriates must pay social security tax to both the U.S. and foreign host countries on the same wages. The U.S. employer often must bear the cost of the resulting double tax (through its tax protection or equalization plan) and also pay the employers share of social security in both countries. In some cases, the cost can be draconian. For example, Sweden imposes a 32.82% social security tax on employers and a partially deductible 7% pension fee on employees.23 Totalization agreements mitigate the effect of double social security taxation for many U.S. individuals working abroad, through a detached employee rule. U.S. employees sent abroad on a temporary assignment of five years or less and who obtain a certificate of coverage under the U.S. Social Security system can often avoid host country social security taxes. The U.S. has concluded totalization agreements with 20 countries.24
Remitting Profits from Foreign Subsidiaries As mentioned earlier, host countries may impose branch profits tax on a foreign branchs earnings. However, when U.S. companies use foreign subsidiaries to conduct operations abroad, withholding tax applies often to dividend, interest and royalty remittances. Exhibit 1 below provides a sample of income and withholding tax rates in a variety of countries. These rates allow U.S. companies to reasonably estimate MTRs.
Strategies Before establishing operations abroad, a U.S. company should consider its remittance strategy, so that it can minimize tax costs when bringing offshore profits to the U.S. The most obvious way to remit profits is through dividends. Like the U.S., most foreign countries treat dividends as distributions of earnings, rather than as deductible business expenses. Thus, dividend remittances do not cause foreign profits to circumvent the host countrys income tax. Also, the host country may impose a dividend withholding tax, although recently signed treaty protocols (mentioned earlier) provide for zero withholding tax rates. In contrast to dividends, foreign countries often allow deductions when taxpayers remit profits through loans and licensing arrangements. Profits remitted as deductible interest and royalty expenses reduce the foreign host countrys income tax, but may be subject to withholding. When the effective foreign income tax rate is high and withholding taxes are low, deductible interest and royalties allow U.S. companies to remit some portion of foreign profits at a relatively low MTR.
Low-tax countries: Exhibit 2 below provides MTRs for profits earned in and remitted from several low-tax countries. When foreign subsidiaries in these countries remit profits during the year earned, the U.S. residual tax causes the MTR to equal the 35% U.S. statutory rate. However, when current profit is deferred for 10 years, the MTR drops. For example, an Australian subsidiary pays a combined 30% tax rate (see Exhibit 1). When the subsidiary remits after-tax profits to its U.S. parent, the remittance triggers a 5% U.S. residual tax. If the subsidiary remits the dividend in the same year it earns the profit, the MTR is 35% (30% + 5%). However, if the dividend is deferred for 10 years at a 10% discount rate, the present value of the 5% residual tax is only 1.9%, reducing the MTR to 31.9% (30% + 1.9%). The other MTRs appearing in Exhibit 2 are calculated similarly. Assuming profits other than subpart F income (which is currently taxable), the average MTR in the selected low-tax countries declines from 35% to 28.8% when U.S. taxpayers defer dividends.
High-tax countries: Exhibit 3 above shows MTRs from operating in a sample of high-tax countries. A comparison with Exhibit 1 reveals that remitting profits as a current dividend results in an MTR equal to the host countrys combined tax rate plus the dividend withholding tax rate, multiplied by the after-income-tax rate. For example, the MTR from operating in Belgium and remitting profits as current dividends is 43.2% (40.2% + 5% (1 40.2%)). Deferring the dividend remittance for 10 years reduces the present value of the dividend withholding tax. For the selected countries, deferring dividends reduces the MTR an average of 2.7% (41.6% 38.9%). Further reductions in the MTR occur when the foreign subsidiary remits some portion of its profits in deductible form. On average, the MTR declines 4.2% (41.6% 37.4%) when U.S. companies in the selected high-tax countries remit 40% of profits as interest and royalties and the remainder as delayed dividends. Successful remittance strategies often depend on whether a foreign host country permits deductions for interest and royalties paid to a U.S. parent. For a variety of reasons, these expenses are sometimes not deductible. Thin-capitalization ratios and related-person arms-length rules in the host country can limit interest deductions. For example, Japan may limit interest deductions when the debt-to-equity ratio exceeds 3:1.27 Other countries use financial ratios to restrict deductible royalty payments. For example, Chile limits deductions from using intangibles to 4% of income, unless the taxpayer can show that another country taxes the royalty income at a 30% rate or higher.28 This restriction dissuades nonresident companies from siphoning profits out of Chile using deductible royalties, a form of payment the Chilean government cannot carefully monitor.
Conclusion Although often not the primary factor driving decisions to conduct business abroad, tax consequences usually are a significant consideration that only the uninformed ignore. Establishing successful business operations in foreign jurisdictions involves several tax issues. Because MTRs for new investments abroad vary depending on the host country and organizational or contractual arrangement, U.S. companies should carefully select the jurisdiction and business form for offshore activities, to minimize MTRs. They should also consider the tax and other costs of transferring employees abroad and the effect on MTRs of remitting profits. |
