I often am asked to explain the tax consequences associated with doing business outside the United States. These conversations typically result in the question “How is a business trying to make a profit supposed to keep track of all of the tax rules that come into play when doing business in a foreign jurisdiction?” While my actual response to the question will vary from time to time, the essence of complying with applicable tax law while doing business internationally boiled down to (i) compartmentalizing the potential sources of tax issues and (ii) then developing a rudimentary understanding of the rules applicable in each compartment so that when an issue does arise it is identified and properly handled. In an effort to help in developing the art of doing business outside the U.S. in compliance with applicable tax law, this article identifies the compartments in which the broad notion of “international taxation” can be placed and offers a basic explanation of the more important rules which will dictate the tax impact on a U.S. taxpayer doing business outside the U.S.
Compartmentalization
The first step in understanding the tax consequences attendant to doing business outside the United States is to separate the U.S. tax consequences from the “local” tax consequences (i.e. the tax obligations that arise in the foreign jurisdiction). Once a U.S. taxpayer accomplishes this first compartmentalization, it must consider the individual rules applicable in each jurisdiction and, finally, it must come full circle and determined how, if at all, these individual rules interact in respect of the taxpayer’s worldwide tax obligations.
Local Tax Consequences
For the most part, each jurisdiction, except perhaps so-called “tax-haven” jurisdictions, throughout the world impose an income-like tax on business profits earned in such jurisdiction. These taxes will e imposed on an entity formed in such jurisdiction for purposes of conducting the business or, if no entity is formed, on the owner of business enterprise if the profits generated in the local jurisdiction are related to a “permanent establishment.” An owner of a business enterprise conducted in a local jurisdiction without the benefit of an entity formed in such jurisdiction will have a permanent establishment in that local jurisdiction if it (i) has an office or fixed place of business in such jurisdiction, (ii) maintains an inventory in such jurisdiction or (iii) maintains an employee or dependent agent in such jurisdiction.
In addition to any taxes i posed on the profits of an entity formed in a local jurisdiction to conduct business, most jurisdictions also impost taxes on payments made from the local entity to its owner(s) located broad. These taxes take the form of withholding taxes on dividend payments, interest payments and royalty or license payments. The typical withholding tax is between 20% and 40%, unless reduced under an income tax treaty.
United States Tax Consequences
With the exception of certain taxes paid abroad and discussed below, a U.S. taxpayer who opts to do its business in a foreign jurisdiction directly for the United States (i.e. it does no form and own a local entity) must recognize the tax consequences attended to the endeavor in the same manner it would if the income and expense generated thereby were associated with its business in the U.S.
A U.S. taxpayer’s U.S. tax consequences from doing business in a foreign jurisdiction through an entity depend on whether the entity is classified as a partnership or corporation. It should be noted that where the non-U.S. entity has a single owner, it can be disregarded for U.S. tax purposes. Disregarded entities are treated, for U.S. tax purposes but not for local tax purposes, as a division of the U.S. owner and the tax consequences associated with the business are included on the U.S. owner’s federal income tax returns.
Setting aside disregarded entities, for the most part of a U.S. taxpayer has the option of electing (by filing a form with the Internal Revenue Service) to treat a non-U.S. entity as either a partnership or corporation. Once a taxpayer elects the form of its entity, the U.S. tax consequences can be determined.
Corporations
This article does not lend itself to an exhaustive review of the U.S. tax rules applicable to owners of foreign corporations. In general, however, the U.S. tax rules are designed to force a U.S. owner of a foreign corporation to include in its income each year an amount equal to what it would have received had the foreign corporation paid the U.S. taxpayer a dividend equal to the U.S. owner’s pro rata share of the corporation’s net earnings. The U.S. tax rules effectively create this deemed dividend construct through a series of classification mechanisms which focus on either or both of the types of income earned by the foreign corporation and/or the level of U.S. ownership. Depending on the level of U.S. ownership of or the types of income earned by a foreign corporation, the foreign corporation can be classified as a “controlled foreign corporation,” “passive foreign investment company” or “foreign personal holding company.” While the U.S. deemed dividend taxing regime will typically capture a significant amount of income earned outside the United States, there are limited exceptions to these rules for businesses that engage in active operations in foreign jurisdictions.
Partnerships
Like a partner in a U.S. based partnership, being a U.S. partner in foreign partnership will result in the current inclusion of a proportional share of the partnership’s income in the taxpayer’s U.S. income tax return. Unlike an ownership interest in a foreign corporation where some U.S. income tax deferral is possible (i.e. the exceptions to the deemed dividend regimes noted above), U.S. based partners in a foreign partnership are subject to U.S. taxation on their worldwide income, wherever such income is derived.
Overall Income Tax Liability
Having concluded that U.S. taxpayers with foreign business interests oftentimes will have an obligation to pay both local taxes and U.S. taxes on the same income, the core business and tax analysis turns to whether a U.S. taxpayer can find any relief from this extraordinarily expensive business construct. The two possible avenue that may lend a U.S. taxpayer facing double taxation some relief involve the ability use losses generate by a foreign business vehicle and the U.S. foreign tax credit system.
Losses
If a U.S. taxpayer elects to use a foreign corporation to conduct its business outside the United States, it cannot use any losses generated by the corporation on its U.S. income tax return. This results because the U.S. tax rules dealing with corporate consolidations do not permit the consolidation of non-U.S. corporations. Partners in non-U.S. partnerships, however, are free to use their proportional share of a non-U.S. partnership’s losses against their other U.S. income.
Tax Credits
The Internal Revenue Code permits U.S. taxpayers a tax deduction (worth about $.35 per dollar) or tax credit (worth $1.00 per dollar) for “income-like” taxes paid, either directly or indirectly, to foreign jurisdictions. Direct creditable taxes typically include withholding taxes on dividends, interest and royalty payments and license fees. Indirect creditable taxes include all income tax-like taxes paid by an “appropriate” conduit entity, including taxes on business profits. Neither direct or indirect creditable taxes include non-income related taxes like property taxes, value-added taxes and fees payable for privileges (i.e. licenses and the like).
While eligibility for the direct foreign tax credit is fairly easy to determine, eligibility for the indirect credits requires some analysis. For a U.S. taxpayer to use the indirect foreign tax credit, the entity actually paying the income tax in the foreign jurisdiction must be an “appropriate” conduit. Both corporations and partnerships can be an “appropriate” conduit. The real difference between the two is when the U.S. taxpayer can utilize the tax credit. In general, if the conduit is a partnership, the credits will flow through on a dollar-for-dollar basis to the U.S. taxpayer when the taxes are actually paid by the partnership. If the conduit is a corporation, the tax credits only begin to flow through upon the U.S. taxpayer’s recognition of dividend income (either actual or deemed) from the foreign corporation on its U.S. income tax return.
For more information, please contact djamieson@cohenlaw.com
