I. Overview of Inbound Tax Planning
The U.S. system governing the taxation of income earned by non-U.S. persons draws a fundamental distinction in the U.S. tax treatment of income that has a nexus with the U.S. based on the level and extent of the non-U.S. person’s U.S. presence. A U.S. individual or corporation is taxed on its worldwide income, whereas a non-U.S. person generally is taxed in the United States only on its income derived from its U.S. investments or business activities. A non-U.S. person who is engaged in a trade or business within the United States and earns income from that business generally will be taxed on its U.S.-source income, and potentially on certain foreign-source income, that is considered “effectively connected” with that business. The meaning of the term “trade or business within the United States” is generally based upon judicial precedent and IRS rulings and depends on the regularity, continuity, and substantiality of the U.S. business activity. U.S. tax law provides a “safe harbor” exception that generally treats the activity of investing and trading in securities and regulated commodities as not being a trade or business. Income tax treaties may bring some relief in potentially limiting the amount of income that can attract U.S. taxation and in providing a slightly higher threshold, “permanent establishment,” which must be met in order for the income derived from the business to be subject to source-state (i.e., in the case of U.S. inbound, U.S.) taxation. Income that is effectively connected with the non-U.S. person’s U.S. trade or business is taxed on a net basis at graduated rates, with the benefit of certain credits and deductions.
Consideration of State Taxes
A foreign company operating in the United States must also consider the impact of state taxes on its business activities. These state taxes can often be “hidden” business costs that should be taken into account when considering establishing operations in the United States. The taxes that are imposed and methods by which they are levied vary from state to state.
State income taxes are imposed on, or measured by, net income attributed to the state. Entities that are subject to state income taxes are generally those that have nexus, or a sufficient connection with such state. Although most states tax entities by application of an income tax base, some states also levy taxes by means of a franchise or net worth tax base, which may be imposed in addition to the income tax. These taxes are generally levied on the capital and/or net worth of an entity that is engaged in a business, trade, or profession in the state. Some states have adopted gross receipts-type taxes that are imposed on gross income, gross margin, gross sales, or other gross proceeds of a business.
Most states impose a sales tax on transactions involving the sale or transfer of certain property or services, for value, between parties. The property or services that are subject to sales taxes vary from state to state. Complementary to sales taxes, use taxes are typically assessed on purchases of property made out-of-state that are brought into the jurisdiction for use, storage, or consumption. Use tax also applies to taxable in-state purchases upon which the seller did not collect tax. In theory, the sales tax is imposed on the seller’s privilege to do business in the jurisdiction. In contrast, the use tax is imposed on the consumer’s privilege of ownership, possession, or use of the property in the jurisdiction.
Personal and real property taxes are generally administered at the city and county level and are the primary source of income for most local jurisdictions. These taxes are imposed according to the type of property that is subject to tax, such as real property, tangible property, and intangible property. In addition, real property transfer taxes are excise taxes levied on each deed or instrument by which any real estate is sold, transferred, or conveyed.
Formation of a U.S. Business
Foreign businesses seeking to operate in the United States must decide what legal form the investment should take. Should the foreign entity operate directly? Should it form a separate entity (either U.S. or foreign)? The U.S. tax system provides foreign persons a significant amount of flexibility when choosing the U.S. tax treatment of entities that earn U.S.-source income. Most notably, foreign (and domestic) taxpayers are able to elect the desired U.S. tax treatment of many entities by filing a form with the U.S. Internal Revenue Service (IRS). The form-of-business decision carries with it a variety of nontax (e.g., legal, business, and regulatory) considerations that must be taken into account when planning to extend operations into the United States.
From a U.S. tax perspective, operating a U.S. business as a branch or as a subsidiary can have important implications for the foreign owner. This determination must be made based on a variety of factors, including the level of U.S. presence the business operations will require. Such presence may be viewed as falling along a continuum, from minimal presence to a high degree of presence. Activities that extend along this continuum may include those associated with a representative office, sales office, purchasing or procurement office, manufacturing branch, and full-fledged sales or manufacturing operation. To the extent the foreign parent’s activities fall closer to the minimal degree of presence, operating in branch form may be appropriate; where the activities fall closer to the high degree of presence, it may be more practical to operate as a U.S. corporate subsidiary. In addition to the operating forms of a U.S. branch or subsidiary, a foreign business may wish to administer its U.S. operations through a U.S. partnership. Each form carries with it distinct compliance requirements that should be considered.
Financing U.S. Subsidiary Options
An important decision faced by foreign-based multinationals is the extent to which they leverage their U.S. operations. Interest paid on arm’s-length debt generally is deductible at the federal level (but not necessarily across the states), subject to several limitations. It is often exempt from U.S. tax in the hands of the non-U.S. recipient (either because U.S. tax law exempts such interest from U.S. tax, or because an applicable tax treaty eliminates the U.S. tax).
There are various considerations that must be kept in mind from a planning perspective, with respect to financing U.S. subsidiary operations. These include the treatment of hybrid financial instruments, which are treated either as debt or as equity in varying circumstances; securities lending transactions, such as sale and repurchase transactions; and guaranteed third-party debt. The treatment is often impacted by the application of certain common law doctrines that address questions of substance and form. There are specific rules applied in a U.S. income tax treaty context that also impact the treatment within a given context, such as those involving hybrid entities. In addition, there are provisions outlined in regulations, such as the conduit financing rules, which could potentially re-characterize transactions and, as a result, render an income tax treaty inapplicable to certain interest payments.
Ownership of Intangibles
An important aspect of operating a global business is the ownership and use of intangible property. This has resulted in an increase in intangible property ownership by U.S. companies and their affiliates. Critical considerations include the tax treatment of associated costs, which varies by jurisdiction; who owns the intangible property for tax purposes; who benefits from its development; and how is it used throughout the group. In this respect, appropriate transfer pricing documentation is critical.
Inbound M&A, Dispositions, and Restructurings
Companies undertake acquisitions and internal restructurings based upon their business needs, synergies, opportunities for growth, and other factors. Such transactions can have important group-wide tax implications. From a U.S. tax perspective, acquisitions of U.S. companies can be structured in a taxable or tax-free manner. The implications of each structuring alternative must be weighed carefully, as different alternatives can result in markedly different tax consequences for the seller, buyer, and target.
II. Framing the Tax on Inbound Income
At its core, the U.S. tax framework governing the taxation of income earned by non-U.S. persons is straightforward. Key to understanding it is the concept that it treats a non-U.S. person differently depending on the level and extent of that person’s U.S. activities. A non-U.S. person who is engaged in an active trade or business in the United States and earns income from that business generally is taxed on its U.S.-source (and some foreign-source) income that is considered “effectively connected” with that business. Treaties may bring relief, mainly to limit the amount of income that can attract U.S. tax and to provide a slightly higher threshold — “permanent establishment” — that must be met to tax income derived from that business. Income that is effectively connected with the non-U.S. person’s U.S. trade or business is taxed on a net basis at graduated rates — that is, with the benefit of deductions.
Not all non-U.S. persons operate in the United States with sufficient regularity and continuity to create a U.S. trade or business. To those persons, an entirely different set of rules applies. In the absence of a U.S. trade or business, a non-U.S. person who does not operate a U.S. trade or business is taxed only on U.S.-source passive-type income (dividends, interest, royalties, rents — defined as “fixed or determinable annual or periodical” income, or “FDAP”). FDAP income is taxed at a rate of 30%, but this rate often is reduced or eliminated under an applicable U.S. income tax treaty and when certain procedural requirements are met. Unlike the U.S. tax on income that is effectively connected with a U.S. trade or business, the 30% tax on U.S.-source FDAP income is a gross basis tax — no relief for deductions is given.
As you might expect, these frameworks are full of different nuanced exceptions.
There are various questions that must be answered in order to get to the right treatment of inbound income:
- Is the person deriving the income a U.S. person or a non-U.S. person? We concern ourselves in this article mainly with non-U.S. persons.
- Does the non-U.S. person derive U.S.-source income? With certain exceptions (mainly certain types of foreign-source income effectively connected (or deemed to be so connected) with a U.S. trade or business), non-U.S. persons are taxed in the United States only on their U.S.-source income.
- Is the non-U.S. person engaged in a U.S. trade or business? If so, what income is effectively connected to that U.S. trade or business?
- If not, is the income U.S.-source FDAP? If so, does an exemption (e.g., portfolio interest, bank interest) apply, or does a U.S. income tax treaty apply to reduce or exempt the payment from U.S. tax?
Is the Person Earning the Income a Non-U.S. Person?
The threshold question to determine how a person is taxed under US law is whether they are a US or non-US person. This definition is determined the be Internal Revenue Code (IRC).
Generally, a U.S. person includes a U.S. citizen or resident alien individual, a domestic corporation, a domestic partnership, a domestic estate, or a domestic trust. Conversely, a non-U.S. person is any person other than a U.S. person.
A corporation or partnership is domestic if it is created or organized in the United States or under the law of the United States or of any State, unless, in the case of a partnership, the regulations provide otherwise.
If So, Is the Income Earned by the Non-U.S. Person U.S. Source Income?
As noted above, a non-U.S. person generally is taxed in the United States only on income from U.S. sources.
There are specific sourcing rules for periodic payments, such as interest, dividends, rents, or royalties:
- Interest and Dividends: With certain important exceptions, interest and dividends generally are sourced based on the residence of the payor.
- Rents: Rents are sourced based on where the subject property is located.
- Royalties: Royalties are sourced based on where the property is used or where the property is located, depending upon the type of royalty.
- Real Estate Sales: Income from the disposition of U.S. real property is U.S. source.
- Personal Services: Compensation for labor or personal services performed in the United States is U.S.-source income, unless—
- the labor or services are performed by a nonresident alien individual temporarily present in the United States for a period or periods not exceeding a total of 90 days during the taxable year;
- such compensation does not exceed $3,000 in the aggregate; and
- the compensation is for labor or services performed as an employee of or under a contract with a nonresident alien, foreign partnership, or foreign corporation, not engaged in trade or business within the United States, or an individual who is a citizen or resident of the United States, a U.S. partnership, or a U.S. corporation, if such labor or services are performed for an office or place of business maintained in a foreign country or in a possession of the United States by such individual, partnership, or corporation.
- Sales of Personal Property: Generally, income from the sale of personal property is sourced based on the residence of the seller. There are exceptions to this general rule for sales of inventory, depreciable property, intangibles, and sales through offices or fixed places of business.
- Insurance Income: Underwriting income derived in connection with the insurance or reinsurance of U.S. risks is U.S.-source income. Such U.S. risks are derived “in connection with property in, liability arising out of an activity in, or in connection with the lives or health of residents of, the United States.”
- Payment of Guarantees of Debt: Guarantee fees are sourced based on the residence of the payor of the fee, rather than the residence of the guarantor, except where the fee is paid by a foreign person in connection with effectively connected income.
Is the Income ’Effectively Connected With a U.S. Trade or Business?
The next questions to be answered are whether the non-U.S. person is engaged in a U.S. trade or business and, if so, what items of income and deductions are considered effectively connected to such trade or business. The resulting net income is taxed at graduated rates.
1. Is there a “U.S. Trade or Business”?
Whether a non-U.S. taxpayer is engaged in a trade or business within the United States depends on the applicable facts and circumstances. In general, a U.S. trade or business exists if the foreign corporation’s activities within the United States are “considerable” and “continuous and regular.” These definitions rely heavily upon US case law. Furthermore, while a certain activity in isolation may not give rise to a trade or business in the United States, when this activity is considered as a part of an overall set of activities, all activities in the aggregate may be considered to be a part of a single trade or business in the United States.
The Implications of Agency. The activities of certain agents of a foreign corporation may be imputed to the corporation and taken into account in determining whether such corporation is engaged in a trade or business within the United States. These agents include persons acting exclusively or almost exclusively for the corporation, such as employees of the foreign corporation or dependent agents, including a subsidiary of the foreign corporation. Additionally, U.S. courts in some cases have also imputed the activities of independent agents to a foreign corporation when the relationship between the independent agent and the foreign corporation is characterized by some degree of “regularity” or where “extensive” activities are performed by an agent on behalf of the foreign corporation.
The Personal Service Exception. An activity is excepted from being deemed as a US trade or business if performance of certain personal services in the United States by a nonresident alien individual, where such individual is present in the United States for a period or periods not exceeding 90 days during the taxable year and where such individual’s compensation for these services does not exceed $3,000.
The Commodities “Trading Safe Harbor” Exception. An activity is no a US trade or business to a taxpayer trading in stocks or securities or commodities through a resident broker, commission agent, custodian, or other independent agent.
Holding Companies and Senior Management Functions. The determination of whether a foreign holding company that does not conduct an active business on its own is engaged in a U.S. trade or business generally focuses on the company’s dealings with, and involvement in the operation of, its U.S. subsidiaries. This determination involves an analysis of the specific activities of the holding company’s directors, officers, and employees, including activities in their capacity as directors or officers of the subsidiaries. Generally, a foreign holding company generally should not be considered to be engaged in a U.S. trade or business solely as a result of its directors, officers, or employees: (1) exercising management oversight and stewardship of the company’s investment in a U.S. operating subsidiary; or (2) investigating business opportunities in the United States, such as potential acquisitions or sales of subsidiaries.
2. If So, Is the Income Earned by the Business “Effectively Connected?”
Once it is determined that a U.S. trade or business exists, the next question is what income such U.S. trade or business causes to be subject to U.S. taxation, as it is this income that is taxed in the United States on a net basis at graduated rates. More precisely, taxpayers must determine which items of income are considered effectively connected with such U.S. trade or business.
The following three categories of income are considered to be effectively connected with a U.S. trade or business: (a) U.S.-source income that is not passive-type income regardless of whether the income is attributable to the U.S. trade or business; (b) certain items of passive U.S.-source income but only if factually attributable to the U.S. trade or business; and (c) certain types of foreign-source income.
Once it’s been determined there is income that is “effectively connected” to ta U.S. trade or business, related expenses must be accounted for. Unlike passive income earned by non-U.S. persons, income that is taxed in the United States as effectively connected with a U.S. trade or business is taxed on a net basis. A taxpayer is permitted to allocate and apportion deductions against gross income effectively connected with a U.S. trade or business, to the extent such expenses are properly connected to such income.
3. The Base Erosion Anti-Abuse Tax (BEAT)
One of the newer provisions brought about by the Tax Cuts and Jobs act is the Base Erosion Anti-Abuse Tax, better know as “BEAT”. This may apply to a U.S. corporation or a U.S. branch of a foreign corporation, including any foreign corporation with income that is effectively connected with a U.S. trade or business.
The BEAT is a similar regime to that of the “alternative minimum tax” (AMT) in that it may be payable in addition to other taxes imposed by the U.S. government. Generally, it ensures that at a minimum, a foreign corporation engaged in a US trade or business is subject to tax in the US. Generally, to be subject to the BEAT, a foreign corporation must qualify as an applicable taxpayer, earn income that is effectively connected with a U.S. trade or business, and make or accrue base erosion payments from which a base erosion benefit is derived (discussed below) in a taxable year beginning after 2017.
Applicability of the BEAT. A taxpayer is subject to the BEAT if—
- it is a corporation;
- its average annual gross receipts for the three-taxable-year period ending with the preceding taxable year are at least $500 million, which for a foreign corporation would include only gross receipts that are taken into account in determining income that is effectively connected with a U.S. trade or business; and
- its “base erosion percentage” is at least 3%.
Calculation of the BEAT. The calculation of the BEAT is very formulaic. Generally, the BEAT is equal to the “base erosion minimum tax amount” (BEMTA) for the taxable year which is equal to the excess, if any, of (i) the applicable BEAT rate multiplied by the taxpayer’s modified taxable income; over (ii) an amount determined on the basis of the taxpayer’s adjusted regular tax liability for the taxable year.
The applicable BEAT rate was 5% for taxable years beginning in 2018, 10% for taxable years beginning in calendar years 2018 through 2025, and 12.5% for taxable years beginning in 2026 or later.
“Modified taxable income” (MTI) is equal to the taxpayer’s taxable income without regard to: (1) any base erosion tax benefit with respect to any base erosion payment; and (2) the base erosion percentage of any net operating loss (NOL) deduction allowed under §172 for the taxable year.
“Base erosion payment” generally consists of a tax deductible payment made to a foreign, related person to the taxpayer making said payment. It also includes amounts paid to purchase depreciable or amortizable property form the foreign, related party.
“Base Erosion Tax Benefit” generally includes a deduction or reduction to income that results from the corresponding base erosion payment. Finally, the “base erosion percentage” is determined by dividing the aggregate amount of the base erosion tax benefits of the taxpayer for the taxable year (the numerator), by the sum of the aggregate amount of income tax deductions allowable to the taxpayer.
4. Taxes on Foreign Corporation’s U.S. Branches
Generally speaking, the U.S. tax rules impose a 30% branch level tax in addition to U.S. corporate level income taxes on a foreign corporation’s U.S. branch earnings and profits that are effectively connected with a U.S. business and that are considered remitted to the head office. The term “branch” is misleading as this tax can be applicable to any foreign corporation that has effectively connected income with the U.S., whether a formal branches exists or not.
Calculation of the Branch Profits Tax. The U.S. imposes a 30% tax (which may be reduced or eliminated by an applicable treaty) on the “dividend equivalent amount,” as defined below, of a foreign corporation’s U.S. branch. This is in addition to the U.S. tax imposed on the foreign corporation’s effectively connected income.
To calculate the branch profits tax, the foreign corporation first calculates its current and accumulated U.S. effectively connected earnings and profits and those earnings and profits are then deemed distributed to the extent the U.S. net equity (U.S. assets less liabilities) decrease during the taxable year. The resulting deemed distribution is the “dividend equivalent amount” to which the tax is applied.
The ”dividend equivalent amount” of a U.S. branch essentially is the branch’s current year U.S. “effectively connected earnings and profits,” adjusted upward for a decrease in the branch’s U.S. net equity or downward to reflect an increase in U.S. net equity.
The term “effectively connected earnings and profits” means earnings and profits that are attributable to income that is effectively connected with the conduct of a U.S. trade or business.
The Treaty Exception to the Branch Profits Tax. In certain circumstances, a U.S. treaty can exempt a foreign corporation from the branch profits tax. To qualify for this exception, (1) the treaty must be an income tax treaty (as opposed to, for example, a shipping and air transport agreement); and (2) the foreign corporation must be a qualified resident of the foreign country with which the United States has the income tax treaty.The Branch Interest Tax. With certain exceptions, a 30% branch-level tax, which may be reduced or eliminated under an applicable tax treaty, is imposed on interest payments treated as made by a U.S. trade or business (e.g., a branch) to foreign lenders. Any interest paid by such U.S. trade or business is treated as if it were paid by a U.S. corporation.
5. The “Permanent Establishment” Difference
As we have discussed, the United States taxes the income of foreign persons on income that is effectively connected with a U.S. trade or business. However, where the foreign person is a tax resident of a jurisdiction with which the United States has an income tax treaty, the permanent establishment rules of the applicable treaty, rather than the U.S. trade or business rules, may apply. If the permanent establishment rules apply under a U.S. tax treaty, the domestic tax law rules are not applied. An objective of tax treaties, and of the permanent establishment rules for taxing trade or business profits, is to prevent double taxation and to allocate taxing jurisdiction to the contracting state where the permanent establishment operates.
“Permanent establishment” is defined differently in every treaty. Generally, it consists of “a fixed place of business through which the business of an enterprise is wholly or partially carried on.” A general principle in determining whether a permanent establishment exists is that “the place of business must be ‘fixed’ in the sense that a particular building or physical location is used by the enterprise for the conduct of its business, and that it must be foreseeable that the enterprise’s use of this building or other physical location will be more than temporary.” In a U.S. income tax treaty context, if a company that is a tax resident of a country that has an income tax treaty with the United States has a permanent establishment in the United States, the benefits otherwise afforded under certain articles of the treaty — those related to the taxation of dividends, interest, royalties, gain, and other income — do not apply, and the profits of the permanent establishment are taxed in the United States under the business profits article. The implications of having a permanent establishment, therefore, include a potential loss of the ability to use a treaty to reduce or eliminate U.S. tax on certain income that is sourced in the United States.
If the Taxpayer Is Not Engaged in a U.S. Trade or Business, Is It U.S. Source FDAP Income?
Generally, a non-U.S. person that is not engaged in a U.S. trade or business is taxed in the United States on such person’s U.S.-source fixed or determinable annual or periodical (FDAP) income. This income is taxed on a gross basis, no deductions are permitted. The tax is collected through withholding at a 30% rate, unless the rate is reduced by an applicable income tax treaty.
FDAP income generally consist of investment-type income, such as interest, dividends, and rents or royalties. It also includes U.S.-source salaries and wages and U.S.-source gains from the sale of intangible property.214 Excluded from FDAP are: (1) gains from property, except for certain original issue discount amounts; and (2) any income the IRS determines is not FDAP income.
Portfolio Interest Exception. Under the portfolio interest exception, U.S.-source interest paid to foreign persons on obligations that meet certain requirements (described below) is exempt from U.S. tax. This allows nonresidents and foreign portfolio investors to invest in U.S. issued obligations, without interest on such obligations being subject to U.S. tax.
Portfolio interest includes interest paid on obligations that are in registered form, as discussed below, and with respect to which the person who would otherwise be required to deduct and withhold tax from such interest receives a statement that the beneficial owner of the obligation is not a U.S. person.
However, it does not include—
- to a bank that receives interest on an extension of credit made under a loan agreement entered into in the ordinary course of its trade or business;
- to interest paid by a corporation to any person who owns 10% or more of the total combined voting power of all classes of stock of such corporation entitled to vote;
- to interest paid by a partnership to any person who owns 10% or more of the capital or profits interest in such partnership;
- to interest received by a controlled foreign corporation (CFC) from a related person; or
- certain contingent interest, which is generally depend upon sales and/or cash flow of the debtor or a related person.
Bank Deposit Exception. There is also an exception from U.S. tax for interest on deposits, if such interest is not effectively connected with the conduct of a U.S. trade or business. Essentially, this allows foreign investors to invest funds in U.S. banking institutions without being subject to 30% U.S. tax on the interest earned.
Foreign Investment in U.S. Real Property
As noted above, U.S.-source capital gains and losses from the sale of property by nonresident aliens and foreign corporations that are not engaged in a U.S. business are statutorily exempt from U.S. tax and thus, are not subject to withholding.
However, the Foreign Investment in Real Property Tax Act (FIRPTA), which was enacted in 1980, provides an important exception to this rule, as these rules relate to the U.S. taxation of foreign persons on dispositions of U.S. real property interests.
U.S. real property interests can include he term U.S. real property interests can include interests in a domestic corporation that predominately holds U.S. real estate at any time during a testing period, which is the shorter of five years or the period the shareholder has held an interest in the corporation.
The FIRPTA rules treat the gain or loss on the disposition of a U.S. real property interest (USRPI) by a foreign person as though the person were engaged in a trade or business within the United States, and as if the gain or loss were effectively connected with the conduct of that trade or business. Thus, any gain is subject to U.S. income tax at graduated rates.
USRPIs include direct (i.e. land and buildings, mines, wells or other natural deposits, and certain personal property) and indirect (i.e. stock in any U.S. corporation) interests in U.S. real property. An interest in a U.S. corporation also constitutes a USRPI if the corporation is a U.S. real property holding corporation, which includes any corporation, U.S. or foreign, that has 50% or more of its assets in the form of USRPIs.
Non-U.S. shareholders of a foreign corporation that has substantial USRPIs are not subject to U.S. tax on the sale of their stock, unless an election is made by such foreign corporation to be treated as a domestic corporation. If a foreign corporation with substantial USRPIs elects to be treated as a domestic corporation, any gain on their sale of stock may be treated as effectively connected income; and, therefore, the shareholders may be subject to U.S. income tax. On the other hand, a non-U.S. person with an interest in a partnership that has a USRPI may be subject to U.S. income tax on the sale by the partnership of U.S. real property or on the sale by the non-U.S. person of its partnership interest. In this case, the partners, and not the entity, are taxed on the gain that is deemed to be effectively connected income.
III. State Tax Considerations
A major component that U.S. inbound companies and investor should consider as part of their tax planning are those State taxes applicable to their operations while in the U.S. As a general matter, the form of taxation varies from state to state and can have a major impact on a companies impact. For example, it makes a large difference for a foreign corporation operating in California with a corporate income tax rate of ~9.0%, versus a foreign corporation operating in South Dakota or Wyoming without any type of corporate income tax.
State taxes generally apply to persons or entities based upon their “nexus” with the state. This generally stands for a minimum level of connection between the taxing state and the activity it seeks to burden through taxation, sufficient to justify the imposition of tax. Sufficient nexus to justify taxation may spring from the presence of tangible property or employees within a state, or from transacting business within a state. There are various taxes besides an income tax that States impose, all of which are discussed below.
As a general matter, state “income taxes” are taxes that are imposed on, or measured by, net income attributed to the state. While there is a great deal of diversity among state income taxation schemes, generally, states may only constitutionally impose income tax on entities that have nexus, or a sufficient connection, with the state. Nexus is generally found to exist when a taxable entity is engaging in a business, trade or profession within the state. Once nexus is established, most states begin the calculation of state taxable income with federal taxable income. From this starting point, states then reflect their individual tax policy preferences by requiring a number of addition or subtraction modifications. Corporate taxable income is then spread among the states or other filing jurisdictions in which a multi-state enterprise does business, according to allocation and apportionment principles.
Gross Receipts Taxes
Budgetary concerns and fundamental tax policy reviews have prompted states to consider, and in some cases adopt, gross receipts taxes to supplement or replace other business taxes. Gross receipts taxes may be defined in general terms as taxes based on the gross income, gross sales, or other gross proceeds of a business; certain deductions may be allowed. Gross receipts taxes may be imposed broadly, such as on all businesses for the “privilege” of engaging in business in a state, or may be imposed narrowly on particular industries. Such a tax may be imposed on gross proceeds from transactions at each stage of the supply chain, i.e. on the manufacturer, distributor, and the retailer. As a result, the gross receipts tax may be applied multiple times to the same value, albeit to different taxpayers (note that these taxpayers may be within the same federal group or enterprise). Further, unlike a corporate income tax, gross receipts taxes are imposed and collected regardless of the profitability of the taxpayer.
Franchise taxes are generally imposed upon either a capital account base or a capital value base. The capital account base tax is measured by the corporation’s authorized, issued or outstanding capital stock, usually valued at par, or according to a set formula.
Alternatively, under a capital value base tax, the tax is computed based on the corporation’s capital accounts. Generally, the taxable value is determined by reviewing the shareholders’ equity section of the financial accounting balance sheet. Income taxes and franchise taxes generally apply independently. In some cases, a franchise tax payment obligation arises only to the extent that the franchise tax liability exceeds the income tax liability. This can present difficulties in years of negative cash flow and net operating losses, as the net worth component of the tax is still payable and not sympathetic in any mathematical way to the business difficulties of the taxpayer.
Personal and Real Property Taxes
Personal and real property taxes are generally administered at the city and county level, and are typically the chief revenue source for cities, counties, and smaller districts. Property taxes are administered according to the type of property that is subject to the tax, such as real property, tangible personal property, and intangible property.
Real property taxes are assessed on land and its associated structures by the taxing jurisdiction providing the services that create and protect valuable rights associated with the real property. Valuation is determined periodically by a local assessor. The assessed value may change due to factors such as: (1) changes in market conditions; (2) adjustments to assessed value as the property is sold or otherwise transferred; and (3) changes due to modifications in the size, quality, and nature of the property. In addition, the appraisal method may directly affect the assessed value.
Under a personal property tax system, property other than real estate is valued annually on a specific assessment date. Annual reports are filed by the taxpayer to report such values. States may also impose taxes on intangible personal property, including stocks, bonds, or other marketable securities. Furthermore, states may also choose to base the tax on more commonly encountered business intangibles, such as goodwill, copyrights, trademarks, patents, exploration rights, and assembled workforces.
Most states impose a sales tax on transactions involving the sale or transfer of certain property, for value, between parties. A sales tax is imposed on the transfer of title or possession of tangible personal property and certain services. The sales tax is a tax on consumption, but it is not a “consumption tax.” It may more accurately be termed a “transaction tax,” as the tax falls on specific transactions for value, including the assumption of liabilities, as well as transactions involving cash, credit, installment sales, and barter transactions between identified sellers involving non-exempted property.
The use tax complements the sales tax. It is typically assessed on purchases of property made out of state and brought into the jurisdiction for use, storage, or consumption, or upon in-state purchases where the seller has not collected sales tax. In theory, the sales tax is imposed on the seller’s privilege to do business in the jurisdiction. In contrast, the use tax is imposed on the consumer’s privilege of ownership, possession, or use of the property in the jurisdiction. Thus, for example, the use tax may be imposed on material converted from exempt to taxable use, such as inventory previously held for resale that was purchased exempt from tax and later converted to business use by the purchaser.
Real Property Transfer Taxes
A real property transfer tax is an excise tax levied on each deed or instrument by which any realty is sold, transferred, or conveyed. States may also impose either a recordation tax or a recordation tax in addition to the real property transfer tax. A recordation tax is a one-time fee on the recordation of a deed that conveys title to real property, or on the recordation of the transfer of an underlying mortgage. States may also impose real estate transfer taxes on transactions involving the transfer of a controlling interest in real property, even if the technical title to the property is not changing hands.
An employer must withhold income and employment taxes for employees, paid with respect to wages, salary, bonus, and any other payment for services, including in-kind payments. Federal, state, and city governments often provide a formula or table to assist employers with computing the amount to withhold. These amounts are strictly the employee’s monies, and the employee provides information to the employer so that withholding amounts may be properly computed. Because this collection mechanism is primarily a means to ensure collection and compliance, failure to withhold or remit payroll taxes generally results in substantial penalties at the entity level.
IV. Formation of a U.S. Business
When a foreign business expands into the U.S. market, it must decide how it will operate in the United States. U.S. tax considerations are an important component in this decision due to the comparatively high corporate income tax rates in the United States. However, U.S. tax considerations, while important, are but one consideration in conducting a U.S. business. There are also a variety of non-tax (i.e. legal, business, regulatory) considerations to take into account when making a decision regarding the business form of U.S. operations.
Branch v. Subsidiary
If a foreign person or business has presence in the U.S. that rises to a trade or business, a determination of whether they should operate through a U.S. branch or U.S. subsidiary will need to be addressed. The tax consequences of these different operating forms from one another and need to be analyzed to best fit the business’s needs.
Overview of U.S. Branches. A U.S. branch is an extension in the United States of its foreign corporate owner. Setting up a branch operation generally does not require a prescribed formation procedure, other than registration to obtain the authority to do business in the jurisdiction (i.e. state, local) in which the branch is located.
A foreign corporation is responsible for the liabilities of its branch, and it must maintain adequate books and records to clearly reflect the taxable income of the branch. Setting up and running a branch operation is administratively simpler than setting up a U.S. corporate subsidiary. It generally involves fewer legal expenses and less tax complexity because it does not require establishing and running a corporate entity.
Federal Taxation of Branches. A branch is taxed as a division of its parent and is not a legal entity subject to entity-level tax in the United States. The interest holders of a branch are taxed on income that is effectively connected with a U.S. trade or business, and are subject to branch profits tax on certain unremitted earnings, and to branch interest tax on certain payments from the branch to the foreign shareholders as discussed above.
A branch can exist in a variety of forms. It can merely be the operations of a foreign company here in the U.S. or it can be operated through a State entity, such as a Limited Liability Company (LLC) that is treated as a “disregarded entity” for U.S. tax purposes.
The U.S. tax system provides flexibility in terms of permitting certain types of entities to elect their entity classification for U.S. federal tax purposes. An entity may make a election to be treated as either an entity disregarded from its owner, a partnership, if the entity has multiple owners, or as a corporation.
For example, a limited liability company (LLC) formed in the United States, by default, is disregarded as an entity separate from its owner if it has one owner, or is treated as a partnership if it has more than one owner. However, the LLC may elect to be treated as a corporation for tax purposes. If an entity elects to be disregarded as an entity separate from its owner, its activities are treated in the same manner as a sole proprietorship, branch, or division of its owner for tax purposes.
State Taxation of LLCs and Branches. Generally, States follow the federal tax treatment of LLCs as disregarded entities, partnership or as corporations. However, there are few states that characterize LLCs as taxable entities, whether or not they are disregarded entities for federal tax purposes.
As mentioned above, single member LLCs are generally disregarded as a separate entity for tax purposes. However, what is import ant to note is that they are still regarded as a separate entity for state legal liability purposes. For example, this distinction would allow a single member LLC, that is disregarded, which is running an unprofitable business to be combined with another profitable business owned by the same person/entity can offset its losses against the profitable business’s income. However, the important thing to note is that each respective LLC’s business will be legally protected separate from each other such that the profitable LLC cannot be sued or be obligated for the debts and liabilities of the unprofitable LLC.
Converting a Branch into a Corporation. When a foreign company’s operations in the U.S. rise to a substantial enough level, they may cause the company to re-evaluate how their business is run in the U.S., and convert the branch into a U.S. corporation. This can occur in a scenario where a foreign company operating in the U.S. would like to expand its workforce to expand its presence in the U.S. market.
This conversion does not come without tax consequences, however. Upon the conversion, the branch profits tax will be triggered as the conversion causes a reduction in the U.S. net equity for the branch. There are exceptions to this trigger to avoid the incidence of taxation, but they need to be closely followed.
Overview of U.S. Subsidiaries. Even if a subsidiary is wholly owned by a foreign company, its formation is governed the laws of the State in which it is formed. A corporation is formed and recognized for State law purposes when a certificate of incorporation is filed with the secretary of state in the state in which the foreign company chooses to incorporate.
When incorporated, the subsidiary is treated as a corporation for federal tax purposes. Thus, it becomes subject to an annual filing requirement whereby it must file an Form 1120, U.S. Corporation Income Tax Return, on an annual basis.
Federal Taxation of U.S. Subsidiary. A U.S. subsidiary corporation is subject to tax on its worldwide income, no matter where earned. The income of the U.S. subsidiary corporation is subject to tax in the U.S. at the going corporate rate (21% in 2020), and on its net taxable income. Remittances to foreign persons or its foreign parent, such as dividends, interest, rents, royalties, is subject to the flat 30% withholding tax discussed earlier. Generally, the payor (i.e. the U.S. subsidiary corporation) is required to conduct the withholding and remit it to the federal government.
State Taxation of a US Subsidiary. States generally conform to the federal treatment of corporations and treat corporations as taxpaying entities separate from the shareholders. Corporate state income tax liabilities are determined by separately computing taxable income at the corporate level, apportioning that income among the states, and applying a statutory tax rate. In addition to being subject to income taxes, corporations doing business within the states may be subject to a broad range of taxes, including business net worth, property, transaction, and employment taxes as discussed previously.
Conducting Business Through a U.S. Partnership
In certain circumstances, two or more parties may wish to invest in a shared U.S. venture. A foreign corporation may wish to partner with another foreign or U.S. entity to operate a U.S. business. Business reasons for such a U.S. joint venture include a strategic pairing of capital, know-how, management, and other resources. One option that is available for such an investment is to form a U.S. or a foreign partnership.
Furthermore, the partners can rather form an LLC to operate through, but have it treated as a partnership for federal tax purposes.
Federal Taxation of a U.S. Partnership. Under federal tax law, a partnership itself is not subject to tax, but rather, its income and loss flows through to tis partners based upon their respective profit and loss allocations. Thus, if a partnership is engaged in a U.S. trade or business with foreign partners, the foreign partners themselves are treated as if they are engaged in a U.S. trade or business. The partners in this scenario are subject to comparable regimes of tax as if they were the owner of a branch.
If a foreign partner decides to dispose of its interest in a partnership that engages in a U.S. trade or business, any income from such a disposition may be sourced to the United States as effectively connected income to the extent attributable to assets of the partnership used in the U.S. trade or business.
State Taxation of a U.S. Partnership. Just as it is for corporations, generally states follow the federal tax treatment for purposes of determining the taxable income of a partnership. Accordingly, for state income tax purposes, partnerships are not typically taxpaying entities. Instead, profit or loss realized at the partnership level generally “passes through” to the partners according to each partner’s interest in the entity’s profits and losses. Since partnerships are typically not taxpaying entities for state income tax purposes, the reporting requirements for partnerships are generally informational in nature, and require the disclosure of information related to partnership income, losses, assets, liabilities, capital accounts, as well as the identities and locations of the partners. However, while a particular state may not impose a tax directly upon the income or loss generated by the partnership, some states may impose a tax on the partnership’s gross receipts, gross margin, or capital.
Compliance Considerations of Operating in the U.S.
Obtaining an Federal Tax Identification Number (e.g. EIN). When a branch or subsidiary is formed, the first U.S. tax form that must be filed is a Form SS-4, Application for Employer Identification Number. An employer identification number (EIN) is required for all entities with operations in the United States. An EIN is necessary for many purposes, including all tax filings, entity classification elections, and withholding.
Foreign Corporation Engaged in a U.S. Trade or Business, Form 1120-F. Foreign corporations that are engaged in a US trade or business must file a Form 1120-F to report its activity to the IRS. This is even the case if the foreign corporation did not have effectively connected income with a US trade or business, no U.S. source income, or its income is exempt by reason of a tax treaty or a code section in the IRC.
Reporting the Branch Profits Tax. As discussed above, a foreign corporation operating in the U.S. though a branch is subject to the branch profits tax. The U.S. branch is not responsible for reporting this amount, but rather, the foreign parent of such U.S. branch must report such income and tax on Form 1120-F.
Protective 1120-F Filings. Even if a foreign parent does not believe it has any effectively connected income with a US trade or business, it is common practice to ifle a protective Form 1120-F if there is a risk that the IRS could disagree with this position.
Form 5472. Form 5472, Information Return of a 25% Foreign-Owned Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, is required to be filed by a 25% foreign-owned U.S. corporation or a foreign corporation engaged in a business within the United States if it conducts certain reportable transactions with a related party. Form 5472 must be filed with the corporation’s tax return by the due date, including extensions, and a copy of the form must be filed separately with IRS.
Form 1042-S. If a U.S. corporate subsidiary makes distributions or other periodic payments (i.e. interest, dividends, royalties) to its foreign owner, the U.S. corporate subsidiary must file Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding and 1042-T, Annual Summary and Transmittal of Forms 1042-S, and potentially withhold on such payments, depending on the type of payment and the potential application of relevant income tax treaty.
However, if an income tax treaty applies, a W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals), or a W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities), must be obtained from the foreign owner prior to a distribution or payment in order for the payor (the “withholding agent”), whether foreign or domestic, to be able to either withhold at a reduced rate or not withhold. This form is necessary to document that the income recipient is not a U.S. person, and, potentially is eligible to claim any applicable treaty benefits. Further, a taxpayer taking the position that a U.S. tax treaty overrides or otherwise modifies a provision of U.S. tax law to disclose such position by attaching to its income tax return a fully completed 8833, Treaty-Based Return Position Disclosure Under §6114 or §7701(b).
Compliance Notes for U.S. Partnerships. Since a foreign partner is themselves treated as being engaged in a U.S. trade or business when operating through a U.S. partnership, the foreign partners are themselves required to file form 1120-F (in the case of a corporate partner) or Form 1040NR (in the case of a nonresident individual partner). The foreign partners’ income tax liability is collected in part by requiring the partnership (foreign or domestic) that has income effectively connected with a U.S. trade or business to withhold and remit 35% of the effectively connected taxable income that is allocable to its foreign partners. Payments of U.S. tax through withholding must be made during the partnership’s tax year in which the effectively connected taxable income is derived. A partnership must pay the IRS a portion of the annual withholding for its foreign partners by the 15th day of the fourth, sixth, ninth, and 12th months of its tax year for U.S. income tax purposes. Form 8813, Partnership Withholding Tax Payment Voucher (Section 1446), is used to pay the required withholding tax. Any additional amounts due are to be paid with Form 8804, Annual Return for Partnership Withholding Tax (Section 1446). The partnership must send a Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax, to each foreign partner at the end of the partnership’s tax year, whether or not any U.S. tax is withheld and paid on the partner’s behalf. Form 8805 presents the amount of effectively connected taxable income and any withholding payments allocable to a foreign partner during the partnership’s tax year.
V. State Tax Credits and Incentives
When a foreign company is considering an initial investment project or expansion in the United States, there is sometimes an opportunity to take advantage of a variety of state and local, as well as federal, as-of-right and/or discretionary economic development tax credits and economic incentives, also referred to as “tax holidays,” “subsidies,” and “investment allowances.” Regardless of the terminology, credits and incentives can help defray a significant portion of up-front project investment costs, as well as recurring operating costs.
The primary drivers of most economic development credits and incentives are: (1) creation of jobs paying a higher-than-average wage that also provide health care benefits; (2) capital investments in buildings, machinery, and equipment; and (3) the location of the project. An overview of the major State credits and incentives is outlined below:
- Research and Development Tax Credits: Some states offer R&D credits that can be applied against income or franchise tax to encourage businesses to invest in activities that promote innovation, product development, and improvements in quality and efficiency.
- Job Creation Tax Credits: Many states offer new job creation credits to increase employment. In some areas targeted for redevelopment (often referred to as “enterprise zones”), or in areas in need of environmental remediation prior to development (often referred to as “Brownfields”), enhanced job tax credits may be available.
- Investment Tax Credits: majority of states offer some form of tax credits to encourage in-state investment in real or tangible personal property. These credits typically focus on investment in equipment and facilities used in manufacturing or technology-related operations.
- Employee Training Credits and Incentives: A significant number of states offer credits against certain taxes, free training of employees in state-sponsored centers, or cash incentives to offset or subsidize the cost of providing certain forms of employee training.
- Sustainability or “Green” Tax Credits: More states are providing “green” tax credits, exemptions, or cash incentives in order to promote environmentally-friendly business practices. Green tax credits or incentives may be available for the production and/or use of energy produced by wind,848 biomass, hydrogen-power, photovoltaic, remediation of contaminated “Brownfield” sites, other investments in environmentally friendly building structures.
- Targeted Economic Development Areas: A movement across the states is to create some form of location-based economic development attraction and incentive, frequently referred to as “enterprise zones.” Enterprise zones are generally economically depressed areas designated by government agencies where incentives are offered to encourage and stimulate growth, development, and new job creation.
- Sales and Use Tax Exemptions: Many states provide certain types of sales and use tax exemptions, or reduced sales and use tax rates for purchases of equipment used in qualifying activities. Such qualifying activities may include manufacturing, processing, assembling, refining, or research and development property. Almost all states offer exemptions on sales to manufacturers of tangible personal property that will become an ingredient or component of the manufactured products.
- Exempt Storage for Goods in Transit: Many states that levy a personal property tax provide “Freeport” exemptions, which allow temporary storage of finished goods in “transit” status (i.e., designated to be shipped out of state, without paying personal property tax).
- Foreign Trading Zones: Foreign Trade Zones (FTZs) are secure areas located in or near U.S. Customs ports of entry, but legally considered to be outside the customs territory for the purpose of tariff laws and customs entry procedures. Any foreign or domestic merchandise not prohibited by law or certain exceptions, as noted below, whether dutiable or not, may be taken into a FTZ for manufacture, storage, exhibition, assembly, and processing, free of U.S. duty and excise tax.
- Negotiable Discretionary Incentives: In addition to the general incentives listed above, States provide “wiggle” room to negotiate and rovid other favorable economic incentives to persons/companies looking to work within their State. This can come in the form of utility incentives, free or discounted land or buildings, and/or bond financing.
VI. Financing U.S. Subsidiary Operations
Capital structure decisions — that is, how one commits and allocates capital to an enterprise — are at the core of prudent treasury and tax planning. More often than not, a foreign multinational’s treasury group will seek to pool cash generated world-wide into one location — often the foreign parent’s headquarters location — which, in turn, influences how a foreign multinational funds its U.S. operations. In turn, this decision will influence the extent to which the foreign parent can access cash generated by the U.S. operations in a tax-efficient manner.
Thoughts on the Use of Debt v. Equity. There are no bright-line tests in the U.S. tax rules regarding the distinction between what is debt and what is equity. Instead, the United States has largely adopted a facts-and-circumstances approach to the debt classification issue, requiring a review of the economics created by the arrangement to determine its tax classification.
From a corporate governance and treasury perspective, there are several advantages to debt financing. They include lower governance costs by virtue of creating a commitment by debt which managers must adhere to, as well as capital structure efficiency at low to mid-range levels of debt whereby managers can enhance shareholder value. From a tax perspective, debt financing permits a U.S. subsidiary to deduct interest payments, subject to certain applicable limitations. There is generally no U.S. tax on principal repayments. In addition, if a U.S. income tax treaty applies with respect to payments made to a foreign parent or foreign affiliate, the rate of U.S. tax on such interest payments may reduced or eliminated.
Making a Determination on What is Debt and What is Equity. The framework of analysis used to distinguish debt from equity for U.S. federal income tax purposes has evolved to become a patchwork that draws upon principles outlined in the statute and regulations, an IRS notice, and case law. There are no bright-line rules. The question is ultimately one of intent — that is, whether the parties intended to create a genuine debtor-creditor relationship — which is not easily susceptible to being reduced to a series of mechanical tests. The terms of debt and/or equity used by a company must be analyzed under the framework to decide how it will be treated for U.S. tax purposes. While the initial treatment of the instrument is binding upon the companies and the instrument’s holders, such treatment is susceptible to a later challenge by the IRS.
Cancellation of Subsidiary Debt
If a foreign parent uses debt to fund its U.S. subsidiary, and the economic and business conditions change such that the U.S. subsidiary can no longer service the debt, companies must consider ways to restructure the U.S. subsidiary’s capital structure. For example, a foreign parent may decide to simply forgive all or part of the debt or waive its rights of default if interest payments are not made. There are several aspects that must be considered from a U.S. tax perspective, including whether the U.S. subsidiary will be liable for U.S. tax on cancellation of the debt, whether changes made to the original loan will have U.S. tax implications, and whether there are any U.S. withholding consequences.
Cancellation of Debt Income. Gross income generally includes income from the discharge of indebtedness (“cancellation of debt” or “COD” income). In an inbound context, a U.S. subsidiary of a non-U.S. group would recognize income from the discharge of indebtedness upon the repurchase of its debt instrument for an amount less than its adjusted issue price.
However, there is an exception from the recognition of some COD income. This includes scenarios in which there is a discharge of debt in a bankruptcy case, when the taxpayer is insolvent, and a discharge when the taxpayer is not a C corporation and the indebtedness is related to a qualified real property business.
Significant Modifications of a Debt Instrument. A taxable exchange occurs if there is a “significant modification” of an existing debt instrument. A “significant modification” of a debt instrument results in a deemed exchange of the original debt instrument for a modified instrument that differs materially either in kind or in extent.
A modification is any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. As a general matter, a significant modification occurs when, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered is economically significant.
Withholding on Deemed Interest Payments. The IRS has taken the position that a foreign parent’s forgiveness of a U.S. subsidiaries debt can and does result in a deemed payment of interest arising/accrued at the time of forgiveness. In further consideration of this point, the IRS takes the position that such deemed payments of interest are subject to the flat 30% withholding rate that otherwise apply to FDAP income.
Capitalizing Interest into Principal. Even if no changes are made to the terms of a loan and the parent does not forgive an amount of the debt, there are circumstances where a borrower may capitalize interest due under a loan agreement into the principal on the note. The capitalization of interest into principal, which will be repaid as part of the principal repayment, capitalizes the interest into “payable in kind,” or “PIK” interest, which is a type of OID. OID is FDAP income that is generally subject to tax. OID is subject to tax upon a sale or exchange of the obligation or when a payment is made on such obligation.
Loans to U.S. Branches – The Branch Profits Tax. A loan between a foreign parent and its U.S. branch is generally disregarded for U.S. tax purposes, and, therefore, the forgiveness of such loan should not give rise to branch profits tax.
Cross Border Hybrid and Other Financing Transactions
At its core, a cross-border hybrid financing transaction is a financing transaction that is treated differently for tax purposes in different jurisdictions. In the inbound context, hybrid financing most often is thought of as an arrangement that is treated as debt for U.S. federal tax purposes but equity for non-U.S. federal tax purposes.
In comparison with a loan in the jurisdiction where the entity advancing the funds is a tax resident, a hybrid financing generally results in a lower incidence of tax in that jurisdiction. Most often, this results from the different lens through which the foreign tax authorities view the transaction. In practice, this means that the differing tax result needs to be affirmatively addressed in the United States or in the foreign jurisdiction.
These instruments are highly scrutinized from the perspective of the IRS as they allow for asymmetric treatment of income and expenses, and can lead to double tax benefits.
Hybrid Instruments. A hybrid instrument has features that are viewed as characteristic of debt in some jurisdictions and as equity in others. The specific facts of a particular transaction are relevant to the determination whether or not a instrument is treated as debt or equity.
There are sections under the Internal Revenue Code and applicable tax treaties that address these issues. The regulations address, among other things, the U.S. tax treatment of payments of U.S. source FDAP income by U.S. entities that are not fiscally transparent under U.S. law but are fiscally transparent under the laws of the jurisdiction of the person claiming treaty benefits. Such entities are referred to as domestic reverse hybrid entities. The rules were put in place to limit the use of structures enabling a U.S. group’s domestic reverse hybrid entity to make deductible interest payments that are not taxed in the United States under an applicable treaty, while paying little or no tax in the foreign jurisdiction.
Guaranteed Third-Party Debt. It is common for a subsidiary to be requires by a bank to obtain a guarantee from a parent company in order to obtain funding. In this scenario, there is need for an analysis as to whether the parent’s guarantee recasts the loan as a loan from the lender to the guarantor (i.e. the parent) followed by an equity contribution to the borrowing subsidiary.
In the context of a foreign subsidiary, this in turn would result in any interest payments made by the foreign subsidiary borrower to be viewed as a non deductible distribution to the guarantor that may be tax in the U.S. at 30%, reduced by an applicable income tax treaty.
The U.S. has recognized the common need for this type of guarantee, and courts have looked into who is the true borrower for tax purposes. The court cases on point have looked at the following factors: (1) he examination of credit and reliance upon collateral; (2) thin capitalization; and (3) the ability to secure alternative financing. Each factor is examined below. If giving a guarantee on a loan, these factors need to be analyzed to determine who the borrower is for tax purposes.
Ownership of Intangible
A critical element in planning for the structure and operation of a U.S. business involves the ownership and use of the intangible property of the business. In structuring the ownership of the intangible assets of the business, the potential application of U.S. transfer pricing rules becomes a paramount tax consideration. Various arrangements relating to the transfer and ownership of patents, trademarks, and other items of intangible property have given rise to serious transfer pricing controversies and can be a source of material tax exposure. When ownership of intangible assets is properly structured, and when appropriate transfer pricing arrangements are properly documented, payments for intangible property rights can be used to significantly reduce the overall U.S. tax liability of the foreign-owned U.S. business.
Transfer pricing rules come into play in three scenarios—
- When an entity that is the “owner” of intangible property makes an interest in that property available to a related entity, the owner of the intangible property is entitled to receive arm’s-length compensation for the intangible property it makes available.
- In dealings between related persons not involving the transfer of an interest in intangible property, the owner of any interest in intangible property is entitled to the income attributable to the intangible property.
- Where one entity undertakes activities or services that enhance the value of interests in intangible property owned by a related entity, the intangible property owner is obligated to make an arm’s-length payment for such services or activities.
Situations Where Transfer Pricing is Imperative. The following sections describe situations in which careful documentation in intercompany agreements of the arrangements related to intangible assets is imperative—
- Research and development activities;
- Licensing arrangements;
- Cost sharing arrangements;
- Sales and distribution models; and
- Ownership of marketing intangible returns.