Exporting and licensing are relatively low-risk means of penetrating foreign markets.
Four major decisions confront domestic companies “going global” for the first time and U.S. multinationals expanding into new geographical areas:
1. Where should a company base new operations or otherwise conduct business?
2. What organizational structure or contractual arrangement should the company use to conduct business abroad?
3. Which U.S. employees (if any) must be transferred to assure success?
4. How will the company remit profits to the U.S. from its foreign subsidiaries?
Each question involves significant tax issues that affect the marginal tax rate (MTR). For U.S. companies, the MTR on foreign profits equals the present value of worldwide taxes arising from foreign business activities, divided by foreign profits. This definition characterizes foreign profits as incremental or marginal income (over and above domestic profits) and focuses attention on key decisions.
This two-part article examines the tax implications of these issues and provides guidance on estimating MTRs when entering foreign markets. Part I covers the effects of selecting a particular foreign business locale and conducting business through exporting and licensing arrangements. Part II, in the September 2004 issue, will examine (1) organizational alternatives for conducting business in foreign countries, such as branch operations, joint ventures and subsidiaries; (2) the effect of transferring employees; and (3) the manner of remitting profits back to the U.S. taxpayer.
Selecting a Country
Choosing a country in which to conduct foreign business activities is not straightforward; a country’s economic, political, cultural and regulatory environment can affect a U.S. company’s risk-adjusted rate of return. For example, hyperinflation, the threat of expropriation, cultural mores against buying from nonresident companies and internal laws limiting foreign ownership of local entities, restrict opportunities for conducting business abroad in countries with such characteristics, even if the tax laws are otherwise favorable.
In fact, taxation rarely drives choice of location.1 However, once a U.S. company decides to invest abroad, tax planning becomes a major factor in selecting the best entry approach. To properly evaluate the tax factors, U.S. companies entering foreign markets should consider the host country’s tax laws and income tax rates, the interaction between national tax systems and income tax treaties between the host country and the U.S.2
Combined Tax Rates
An important aspect of a country’s tax structure is its income tax rate.3 Because many countries impose more than one tax on profits, separate rates have to be combined to obtain a single pre-remittance “combined tax rate.” Determining a foreign host country’s combined rate requires consideration of its national income tax, applicable surtaxes, local or provincial income taxes and deductibility. Relying solely on a country’s national income tax rate, without considering these other components, can significantly understate MTRs (as explained below) and lead to less-informed, suboptimal decisions. The examples below illustrate how to combine tax rates in three host countries:
- Brazil has a 15% income tax rate, a 10% nondeductible surcharge based on profits and a 9% nondeductible social contribution tax, resulting in a combined rate of 34% (15% + 10% + 9%).4
- Germany has a 25% corporate tax on profits, a nondeductible 5.5% solidarity levy imposed on the corporate tax and a deductible trade tax imposed on profits. The trade tax varies by location; typically, it is 18% in large cities. Thus, the combined rate in such cities is 39.6% ((25% (1 – 18%)) + (5.5% (25%) (1 – 18%)) + 18%).5
- Korea has a 27%
corporate income tax and a nondeductible 10%
surcharge on the income tax; thus, its combined
rate is 29.7% (27% + (10%
x
27%)).6
Interaction Between Tax Systems
U.S. companies conducting business abroad directly are subject to income tax in two countries on their business profits—the U.S. and the host country. To encourage foreign commerce and mitigate the effect of double taxation, the U.S. permits a foreign tax credit (FTC). U.S. businesses can claim an FTC for the lesser of:
1. Foreign income taxes paid or accrued under Sec. 901(a)7 or
Basically, the FTC can be viewed as the lesser of two components:
1. Foreign-source income
x host country’s combined tax rate (explained above) or
2. Foreign-source income
x U.S. tax rate.8
This alternative formula focuses on the host country and U.S. tax rates. Because U.S. corporations can claim a deemed-paid credit under Sec. 902 (i.e., FTC for foreign income taxes that foreign subsidiaries pay or accrue), the discussion below generally applies to businesses conducted abroad though either foreign branches or foreign subsidiaries.
High-tax countries: U.S. companies operating only in high-tax host countries can claim an FTC equal to component #2 above. In effect, they cannot claim an FTC for all foreign income tax paid in the applicable year (i.e., all of component #1). Ignoring the possibility of foreign withholding taxes, operating abroad in high-tax host countries results in an MTR on foreign profits equal to the host country’s combined tax rate. The foreign income tax U.S. companies pay for which they cannot claim an FTC (i.e., component #1
#2) is an “excess credit.” Sec. 904(c) allows excess credits to be carried to other tax years and treated as foreign income taxes paid. The carryover period is two years back and five years forward. Excess credits carried back to other tax years generate tax refunds, lowering the MTR.
Low-tax countries: Conducting business in low-tax host countries allows a U.S. company to claim an FTC for all foreign income tax paid in the applicable year (i.e., all of component #1). The difference between #2 and #1 is an “excess limit.” Excess credits from other tax years can be carried over and claimed against excess limits within the carryover period mentioned above. Further, excess credits from high-tax activities can offset excess limits from low-tax activities within the same year.
Planning foreign operations so that excess limits absorb excess credits before they expire reduces double taxation in a process known as “cross-crediting.” Absent cross-credits, conducting business in low-tax countries results in a “residual” U.S. tax when foreign profits are remitted and, for profits actually or deemed remitted when earned, an MTR on foreign profits equal to the U.S. tax rate. For example, a U.S. corporation earning and remitting profits from Australia pays a 30% income tax to Australia and, assuming no excess credits from high-tax countries, a 5% residual income tax to the U.S.9 The worldwide MTR is 35%, the same as the U.S statutory rate.
The interaction between foreign taxes and the FTC creates opportunities for U.S. companies. Specifically, U.S. companies operating in high-tax foreign jurisdictions often have excess credits that, if unabsorbed within the two-year carryback and five-year carryforward periods, represent instances of double taxation. Persistent excess credits create an incentive for U.S. companies to begin new business activities in low-tax countries or to otherwise generate low-taxed foreign-source income (e.g., from exporting or licensing intangibles for use abroad, both discussed below). Firms avoid the U.S. residual tax normally due from low-taxed foreign income through cross-crediting. In effect, the excess limit from low-taxed activities absorbs the excess credit from operating in high-tax countries before the latter expires.
Cross-credits can occur only within Sec. 904(d)(1) “baskets,” or categories of income. For example, an excess limit from low-taxed passive income cannot offset an excess credit from high-taxed business profits, because the Code requires separate FTC calculations (or baskets) for passive and business activities. Recent legislative proposals would reduce the number of FTC baskets from nine to three, increasing cross-credit opportunities and, in those instances, reducing MTRs.
Income Tax Treaties
Income tax treaties bestow significant benefits on U.S. companies conducting business abroad. Among those benefits are exemptions for some types of income (discussed below) and lower withholding tax rates. Exemptions and lower rates reduce the combined foreign tax rate and, in many cases, the MTR on foreign profits.
U.S. income tax treaties often reduce withholding rates below those applicable to income from nontreaty countries. With most U.S. trading partners, treaties reduce the interest and royalty withholding rates to 10% or lower. Similarly, they usually reduce dividend withholding rates to 5% when a U.S. corporation owns more than a specified interest in the host country’s distributor (e.g., 10% or more of the distributor’s equity) and 15% otherwise. Recent treaty negotiations with Australia, Mexico and the U.K. have even resulted in dividend withholding rates of zero.10 Japan has also agreed to a new treaty providing for no dividend withholding in certain circumstances. This trend toward zero withholding on dividends, if it continues, should reduce instances of double taxation and lower MTRs.
If foreign business profits are not attributable to a U.S. investor’s permanent establishment (PE) in a host country, treaties preclude host countries from taxing such profits. What constitutes a PE varies from one treaty to the next, but generally includes fixed business locations that might be characterized as branches or divisions. Also, long-term projects involving construction, installation or similar activities can be treated as PEs. Further, a U.S. company’s dependent agent in the host country usually is treated as a PE if the agent has the power to contract in its principal’s name and regularly does so.11 Particularly in high-tax countries, conducting business without a PE avoids excess credits that can inflate MTRs.
Organizational or Contractual Arrangement
In addition to choosing a foreign country, U.S. companies must decide the best business form for marketing their products and services abroad. The options range from exporting to establishing a wholly owned foreign subsidiary. Generally, the choices differ in the amount of risk the U.S. company must bear, which varies directly with expected rates of return. Thus, lower-risk approaches (such as exporting) usually involve less market penetration, while higher-risk approaches (such as wholly owned subsidiaries) provide greater opportunities for higher-than-normal profits.
Exporting
Exporting is a relatively low-risk means of penetrating foreign markets. No foreign income tax usually results, because U.S. exports rarely depend on PEs (discussed above) in the foreign market. However, limited foreign presence may restrict a U.S. exporter’s foreign market share. In effect, the lower risk often coincides with a lower expected investment return.
NOLs: U.S. companies with net operating loss (NOL) carryovers from prior years can use export profits to absorb them.12 In a sense, the losses exempt export profits from U.S. taxation. If the loss carryovers expire unused, the MTR applicable to the export profits would be zero. If the loss carryovers would be absorbed by domestic profits in future years, such that the export profits merely accelerate the absorption of loss carryovers, the MTR on such profits would be lower than the statutory tax rate otherwise applicable, but not zero. Thus, the MTR depends on when the exporter expects future profits (other than from exports) to absorb the loss carryover.
Example 1: D Corp., a domestic corporation, has a $5 million NOL carryover from 2003 and anticipates annual domestic profits of $1 million. Thus, it expects domestic profits for the next five years to absorb the loss carryforward. If D decides to export in 2004 and its export profits are $1 million, it will absorb $2 million of the loss carryforward that year, leaving nothing to shield 2008 domestic profits. Assuming a 35% statutory tax rate and a 10% discount rate, the MTR applicable to export profits in 2004 is determined as follows:
On a present-value basis, the additional U.S. tax D expects to incur in 2008 as a result of the 2004 export profits appears in the numerator. The denominator contains the export profits in 2004.
FTC credit: Another tax attribute that can affect the MTR on export profits is a U.S. company’s FTC carryover (i.e., excess credits). As noted earlier, the FTC for a given year equals the foreign income tax paid or accrued, but is limited to foreign-source income multiplied by the U.S. tax rate. When foreign income tax paid or accrued exceeds this limit, Sec. 904(c) permits the taxpayer to carry the excess credit back two and forward five years.
Excess credits often result from conducting business in high-tax foreign jurisdictions. To absorb excess credits before they expire, taxpayers may seek foreign profits attracting little or no foreign income tax. Exporting is a common means of excess credit planning, because it does not depend on a foreign PE and, thus, avoids host country income tax. When a U.S. manufacturer exports, Regs. Sec. 1.863-3(b)(1) treats half of its profits as U.S.-source income and half as foreign-source income (i.e., the 50-50 rule). The foreign-source portion inflates the FTC limit without attracting a foreign income tax. Thus, U.S. manufacturers can use the profits from selling abroad to absorb excess credits. If the excess credits expire unused without tax planning, the MTR would be half of the U.S. tax rate otherwise applicable.
Example 2: E Corp., a domestic corporation, has a joint venture with a Japanese company that has resulted in significant excess credits. Absent tax planning, the excess credits will expire unused in five years. E decides to export during 2004 and earns $2 million in foreign-source profits that year. Under the 50-50 rule, $1 million is U.S.-source income, currently taxable at 35%. The remaining $1 million is foreign-source income. Although taxable in the U.S., the foreign-source income also increases the FTC limit (see formula above), which allows E to absorb excess credits from prior years. Thus, U.S. law treats the foreign-source income as though it is exempt; the MTR on the full $2 million of export profits is only 17.5% (i.e., half of 35%).
ETI: Although the benefits often are smaller than NOL carryforwards or excess credits may provide, U.S. companies may qualify for the Sec. 114 extraterritorial income exclusion (ETI). In most cases, the ETI provides a 15% tax benefit. For corporations in the 35% tax bracket, the MTR on export sales qualifying for the ETI is 29.75% (35%
x (1
15%)). However, many policy analysts expect Congress to repeal the ETI in 2004 based on a World Trade Organization finding that it constitutes an illegal export subsidy.13
ICDs: Exporters also can establish an interest-charge domestic international sales corporation (ICD). Under Secs. 991 and 992(a)(1), ICDs are nontaxable corporations that:
- Organize in the U.S.;
- Have only one class of stock;
- Have outstanding shares each day with a par or stated value of $2,500 or more;
- Derive at least 95% of annual receipts from exporting; and
- Own export-related assets at year-end equal to 95% or more of total assets.
ICDs involve nominal set-up and maintenance expenses, because they usually have no employees and little capital and function on a commission basis. In effect, they operate as paper entities that perform no substantial economic functions.
Notwithstanding their lack of substance, ICDs often provide significant tax benefits, especially to small and medium-sized companies. They allow most U.S. companies to defer approximately 47% of the U.S. income tax applicable to export profits. However, under Sec. 995(b)(1)(E), the deferral benefit extends only to annual export sales of $10 million. Sec. 995(f) requires U.S. exporters to pay interest on each year’s accumulated deferred tax at the one-year Treasury-bill (T-bill) rate. For the year ending Sept. 30, 2003, Rev. Rul. 2003-11114 set the applicable T-bill rate as 1.30%.
The ICD’s tax deferral reduces the present value of an exporter’s U.S. tax liability. Even after considering the low-rate interest charge, the tax deferral reduces the MTR on export profits below the rate otherwise applicable without an ICD. However, determining the MTR is an involved process that depends, among other things, on the exporter’s cost of capital, the T-bill rate and the deferral period.
Thus, the MTR from export profits often depends on domestic and foreign activities from prior years and whether the exporter qualifies for special incentives, such as those provided by the ETI and ICD. Exhibit 1 summarizes the different ways in which these characteristics and incentives sometimes affect the MTR on export profits.
Licensing
Licensing patents, trademarks, know-how, technology or similar intangibles to an unrelated business within a host country represents another way to conduct business abroad short of a foreign direct investment. Like exporting, licensing involves relatively low risk and little investment. However, unlike some of the foreign direct investment options, the U.S. licensor may lose some control over product quality or marketing. Also, the U.S. licensor sometimes discovers that the licensee becomes a competitor after the licensing agreement expires.
The foreign licensee pays a royalty (or similar fee) to the U.S. licensor. Because the payment is for an intangible asset’s use in another country, Sec. 862(a)(4) treats the royalty as foreign-source income. The host country may impose a withholding tax on the royalty. If the withholding tax rate is low, the resulting low-taxed foreign-source income provides FTC relief for a U.S. multinational with excess credits, because business profits and royalties fall into the same FTC basket. Specifically, the U.S. licensor avoids the U.S. residual tax on the royalty income, because the low-taxed royalty absorbs the excess credit. Stated differently, the excess credit carried forward from prior years shields the foreign-source royalty income from U.S. taxation.
Example 3: G Corp., a domestic corporation, has an excess credit that will otherwise expire unused from conducting business abroad in Belgium. To absorb the excess credit, G licenses know-how to F Corp., an unrelated Belgian entity. Under Article 12(1) of the 1970 U.S.-Belgium Tax Treaty, no withholding tax applies to royalty income. Even though G’s royalties are gross income under U.S. law, they increase the numerator of the FTC limit (see formula above), which allows G to absorb excess credits from prior years. In effect, the royalty income does not increase either U.S. or foreign income taxes. Thus, the MTR applicable to the royalty income is zero.
Conclusion
Part II, in the September 2004 issue, will examine tax issues resulting from the conduct of foreign business through branch operations, joint ventures and subsidiaries, and employee transfer issues and remitting profits to the U.S. company.
