Considering Expanding Operations in the U.S.? Here’s What You Need to Know
By Mary Vasilescu
According to United States (U.S.) Commerce Department data, the U.S. is the largest recipient of global Foreign Direct Investment (FDI), its inward FDI stock of $2.9 trillion on a historical-cost basis in 2014. On a current-cost basis, the U.S.’s FDI stock was more than three times larger than that of the next largest destination country in 2014. FDI inflows in 2015 alone totaled a record $348 billion. The largest sources of FDI into the U.S. are advanced economies, led by the United Kingdom, Japan, and Germany.
When a foreign business expands into the U.S. market, it must make several decisions regarding operating in the U.S. These tax considerations are an important component in this decision due to the high corporate income tax rates in the U.S. However, although tax considerations are important, there are also a variety of nontax (e.g., legal, business, regulatory) considerations to take into account when making a decision regarding the business form of U.S. operations.
It is important for a foreign business to use U.S. advisors to get informed before starting U.S. operations, from selecting the best business structure, complying with all tax and payroll reporting and disclosure requirements, preparing a solid transfer pricing that would meet the IRS’s standards, and understanding the tax treaty with the investor’s country.
Consideration for a foreign company entering the US market:
The structure of the U.S. business operations determines how the company will be taxed. The choice must be based on the nature and scale of the business operation. In the U.S., some business entities can elect their tax classification as either corporation, partnership or an entity disregarded from its owner. Each type of classification has its own advantages and disadvantages.
From a U.S. tax perspective, whether to operate as a branch or a corporate subsidiary may have important U.S. tax implications to the foreign owner. Branch operation activities are taxed in the U.S. as a division of its owner while a corporate subsidiary is a standalone entity taxed on its activities in the U.S. Operating a U.S. business through a partnership (or an LLC taxed as a partnership) causes its partners to be engaged in the U.S. trade or business conducted by the partnership. The foreign partners will be taxable on the share of the partnership effectively connected income and required to file a U.S. tax return since there is no tax at the partnership level.
Tax Treaties and Permanent Establishment
The U.S. has income tax treaties with over 60 foreign countries. The tax treaties provide that business profits are taxed in the U.S. only if the foreign company’s operations in the U.S. rise to the level of a permanent establishment (PE). Activities considered auxiliary and preparatory do not give rise to PE. The tax treaties reduce or eliminate the withholding tax on U.S. source “fixed, determinable, annual or periodic income” (FDAP). A U.S. subsidiary can trigger a U.S. PE for a parent company if the U.S. subsidiary acts as an agent of the non-U.S. supplier in the U.S. by having authority to negotiate and conclude contracts in the name of the non-U.S. supplier and regularly exercises that authority.
When a foreign entity does not have any U.S. effectively connected income or PE, it is a common practice for a foreign corporation to file a “protective” tax return to receive the benefit of the deductions and credits if it is later determined that the foreign corporation was subject to U.S. tax. Without a protective return filed, following a later determination that a U.S. trade or business exists, the foreign taxpayer loses the ability to claim deductions and credits, and is therefore taxed at graduated U.S. rates on the basis of its gross rather than net income.
Transfer Pricing Rules
Transfer pricing refers to the pricing of transactions between controlled entities. The transfer pricing regulations allows the IRS to make allocations to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the evasion of taxes. Controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances and under “arm’s length” standard. Treasury regulations require taxpayers to keep contemporaneous documentation to support the arm’s length prices. The documentation must be submitted to the IRS within 30 days of the request.
Capitalization of U.S. investment
A foreign investor needs to make a capital structure decision for its U.S. operations: whether to capitalize with debt, equity, or a mix of debt and equity. To distinguish between debt and equity, there is no single factor controlling, but the IRS has used the “substance over form” concept since there is no bright-line test. The regulations list a couple of factors that would be considered for a debt instrument to be classified as pure debt. In the case where a debt instrument is re-characterized as equity, all the interest payments will be re-characterized as dividends and therefore nondeductible. The deduction for accrued interest to a foreign related party is deferred until the interest is actually paid.
U.S. earnings stripping rules limit the interest deduction to an amount not in excess of 50 percent of EBITDA. This limitation of deduction does not apply when debt-to-equity ratio do not exceed 1.5 to 1.
State Taxation and sales taxes
While a tax treaty may exempt a foreign entity from federal U.S. income tax, state jurisdictions do not follow U.S. tax treaties and it may tax a foreign corporation if it has state tax nexus. The term “tax nexus” suggests that a business has enough connection to a state that it is subject to state taxation. Nexus, or a business connection for the employer, can occur when the employer has a business location, sales transactions, or employees performing services in a state.
Some states have adopted rules mandating that nexus is created for income tax by having a sufficient economic presence in the state. This “economic nexus” concept has not been adopted by all states, and rules are different for the states that have adopted it. Businesses would have nexus if they generate sales in these states without local physical presence. Some states offer several local credits and incentives based on different criteria so it is important to be informed before deciding the location of the U.S. business.
The U.S. does not have a federal sales tax or VAT, but most states and municipalities impose sales taxes. Sales taxes are imposed on sales of tangible property; however some states impose sales taxes on services, software sales and software as a service (SAAS). The responsibility to collect sales taxes is on the seller. A foreign distributor should consider sales taxes when title to products passes in the U.S. A resale certificate should be obtained from the purchaser, wholesale transactions are tax exempt.
Most foreign companies send foreign employees to the U.S. in the start-up phase of the U.S. business, creating tax issues for the foreign employer and the foreign employees. Foreign employees may be considered resident aliens and taxed on their worldwide income if their physical presence in the U.S. meets the substantial presence test (more than 183 days during the current year or the sum of the days calculated on a weighted average, spent in the U.S. during the most recent three-year period equals or exceeds 183 days). The foreign employees’ presence in the U.S. may trigger U.S. taxation for the foreign employer when there is no tax treaty with the investor’s country, or when the employees’ activity would fail the exemptions of tax treaty provision on permanent establishment. It is advisable to have the foreign employees on the payroll of the U.S. company to avoid taxation for the employer.
A foreign employer has the responsibility to withhold and remit the income and social security taxes from the wages of the foreign employees working in the U.S. A company must register for payroll taxes with the state where the employee is domiciled and the state where the employee performs the services. Most foreign companies entering the U.S. use professional employer organizations (PEOs) to manage their U.S. payroll and HR.
Generally, a citizen of a foreign country who wishes to enter the U.S. must first obtain a visa. Temporary worker visas are for persons who want to enter the U.S. for employment lasting a fixed period of time, and are not considered permanent or indefinite. These visas requires the prospective employer to first file a petition with U.S. Citizenship and Immigration Services (USCIS). An approved petition is required to apply for a work visa. U.S. immigration law provides foreign nationals with a variety of ways to become lawful permanent residents (e.g., obtaining a Green Card) through employment in the U.S.
A qualified U.S. immigration attorney should be consulted to ensure proper and timely filings in accordance with U.S. Immigration Laws.
U.S. Withholding Regime
Nonresident aliens and foreign corporations are subject to two different tax systems based on the type of income generated. Passive income from U.S. sources (not effectively connected with a U.S. business) is normally subject to a 30% tax rate on gross basis and it is withheld at the source. Passive income subject to the 30% tax includes interest, dividends, rents, salaries, and other non-periodic income (referred to as FDAP income). Income that is effectively connected with a U.S. business is subject to tax at the applicable graduated rates in effect for the person receiving the income, but (with certain exceptions, such as withholding on effectively connected income by partnerships) withholding is not required. The withholding regime is generally designed to place the burden of collecting this U.S. tax on the person from whom the IRS can most readily collect such tax. The 30% withholding is applicable unless an exemption or reduced withholding rate applies under an applicable treaty.
In 2010 The Foreign Account Tax Compliance Act (FATCA) was signed into law adding additional compliance burden and challenges for businesses making payments to non-U.S. entities. The FATCA rules were designed to combat tax evasion by U.S. persons holding accounts and other financial assets offshore. FATCA requires certain foreign financial institutions to report directly to the IRS information about financial accounts held by U.S. taxpayers or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. The rules under FATCA generally impose a 30% withholding requirement on certain “withholdable payments” made to “foreign financial institutions” (FFIs) or “non-financial foreign entities” (NFFEs), unless certain requirements are met.
Mary Vasilescu and the International Tax team advises clients on the formation, structure and taxation of business ventures, start-up enterprises and joint ventures in the U.S. and abroad, including mergers and acquisitions, restructuring, and international tax planning. Reach Mary at 973.994.9400 or firstname.lastname@example.org.