There are two segments of international tax planning that you should be aware of—that around outbound operations (i.e. US company operating offshore) and inbound operations (foreign companies operating in the US). Each of these segments have their own unique planning considerations. In this article, we will touch upon outbound tax planning considerations.
Setting Tax Planning Framework
Outbound tax planning considers the tax impact of cross border transactions for US-based individuals and businesses alike operating in foreign countries. It goes without being said that cross border planning such as this is nuanced, complex and requires a comprehensive approach.
In order to plan and put a US individual or business in a tax efficient position when operating overseas there are many factors that need to be considered. Generally, this requires continuous planning, monitoring, and measuring of the tax consequences of these activities to maintain a competitive effective tax rate (ETR) and maximize corporate earnings.
Tax planning is not a static exercise because the facts surrounding international business are ever-changing. Thus, a business must respond with a planning process that continually evaluates the company’s operational and financial positions and responds with tax analysis that prospectively addresses the needs of the business.
Effective planning also requires coordination with the financial management functions of the individual or business. This is because financial personnel of a business seek to access and redeploy excess cash among related affiliates to maximize the return from capital.
To effectively manage continual planning, a planning framework needs to be operated by. Generally, this framework should consider the following objectives–
- Establish the factual foundation for planning;
- Reduce U.S. tax;
- Reduce local country tax;
- Utilize foreign tax credits;
- Facilitate the movement of cash among foreign affiliates; and
- Provide for efficient repatriation of cash from foreign affiliates to the U.S. affiliated group.
I. Establishing the Factual Foundation
The outset of every tax planning engagement relies upon building a sound factual foundation from which to plan upon. Without this, your advisor is “flying blind” and will not be able to properly plan for your business operations. Even worse, without a sound factual foundation, an advisor could miss planning for potential pitfalls in a business’s operations thereby leaving a company exposed to potentially punitive US tax regimes and assessments.
In order to establish a sound factual foundation, your advisor will review the corporate structure and existing transactions that impact the effective tax rate. Once established, your advisor will also have to understand how capital is moved in the enterprise to best meet the needs of the business. Obtaining this knowledge requires the advisor to work hand-in-hand with their client to properly understand the organization and operations of the business.
II. Reduction of US Taxable Income
Once a sound factual basis is established, the first objective an advisor considers is to reduce an individuals or businesses US taxable income. There are several techniques that are available at an advisor’s disposal, and we will only be able to scratch the surface of what is available out there. You’ll see that this is a constant trend throughout this article.
The first set of techniques we will discuss surrounding the utilization of unrealized losses or ongoing losses incurred by a business to offset US taxable income.
- Utilizing Foreign Losses to Reduce US Taxable Income
In planning for cross-border operations, one important focus is the ability to obtain a deduction in the United States for built-in losses offshore and loss operations conducted in foreign countries.
Because the US imposes tax on worldwide income of a US corporation, structuring foreign loss operations as a branch of a US corporation or a flow through entity owned by a US corporation may reduce US taxable income. Below are considerations and issues associated with the utilization of offshore losses to offset US taxable income.
- Losses Derived Through Branch Operations
A simple technique to utilize losses incurred offshore is to structure offshore operations as a branch. A branch is a flow-through entity for US tax purposes, so any income or loss incurred by the branch flow up to its ultimate parent where it is reported. This technique is commonly used when a business is starting up operations overseas.
- Limitation on Branch Losses–Dual Consolidated Losses
One major consideration in using this technique are the rules better known as the dual consolidated loss (DCL) regulations. These regulations limit the ability to claim the loss from a branch from both a US perspective and a foreign country perspective.
Specifically, these regulations apply to the situation in which a branch incurs a net taxable loss for the year. Generally, a loss incurred by a branch is not allowed to offset income of a member of an affiliated group unless the parent US corporation can demonstrate there is no ability to use the DCL to offset income that is not immediately subjected to US tax.
However, a US corporation can make an election to get around this limitation, better known as a “domestic use election” (DUE). If made, the US corporation must certify that the loss has not been used and will not be used to offset income not immediately taxable for a period of 5-years. If the loss is utilized during this period, then the US corporation is required to recapture the DCL with interest attached.
- Inbound liquidations of Loss-Generating Businesses
Another method to utilize foreign losses is to liquidate a foreign subsidiary that is expected to incur significant losses in the future and thereafter utilize those losses.
One situation in which it may be beneficial for a U.S. corporation to liquidate a foreign corporation is when the US corporation recently purchased a foreign corporation and made an election (e.g. an IRC 338 election) on the purchase to step-up the basis in the assets of the foreign target corporation.
Foreign Tax Credit Limitations: What is important to note in this type of inbound liquidation, is the limited the ability to claim foreign tax credits from the branch. This limits the US purchaser’s ability to claim foreign tax credits for a portion of the foreign taxes paid by the target attributable to the difference between the foreign taxable income and the U.S. earnings and profits.
Income Recognition on Liquidation – IRC 367(b): In the event that the foreign entity is a subsidiary and liquidated, the US shareholders of the foreign subsidiary are required to include income equal to its “all earnings and profits amount”.
The “all earnings and profits amount” is the amount of net positive earnings and profits of the liquidated subsidiary and is treated as a deemed dividend. However, if the foreign subsidiary has a deficit in earnings, the deficit cannot be used to offset the earnings and profits of the US parent unless the deficit relates to a US trade or business.
If an liquidation of a foreign subsidiary immediately follows an IRC 338 election basis step up election, then this will limit the amount recognized—after purchase, there will be limited “earnings and profits” of the foreign subsidiary subject to this income recognition principle.
Impact of DCLs: These types of transactions are still subject to the DCL regulations outlined above. Thus, these regulations can potentially limit the ability of a US parent to claim a deduction of losses against US taxable income if they apply. As we mentioned above, a DUE can be used to offset US income in this scenario if it so applies.
Foreign Currency Issues: What also needs to be accounted for in these transactions are potential foreign currency gain or loss exchange issues between a US taxpayer and its branches. In this scenario, gain or loss may be recognized on certain transactions between a branch and its US owner, or among branches of the same US owner. Of these transactions, a liquidation, incorporation, or sale of a branch operation also may result in a taxable remittance for these purposes.
- Captive Insurance Companies
Another strategy commonly used to reduce US taxable income is the formation of a “captive insurance company”. This strategy is only applicable for companies who are willing to commit the capital necessary to operate one.
A “captive insurance company” is generally considered to be an insurance company owned by a single shareholder (or a small group of shareholders) that insures only its shareholder(s) and its affiliates. In a typical captive arrangement, a corporation purchases insurance from a commonly controlled brother/sister insurance affiliate.
If utilized, the “captive insurance company” applies insurance tax accounting rules in calculating its taxable income and the insured will deduct the premiums paid to the insurance subsidiary. The premiums paid to an insurance subsidiary may be deductible by the insurance subsidiary’s owner or its affiliates. The insurance subsidiary itself would include the premium income in income but be allowed to offset its premium income with loss reserves, including discounted unpaid loss reserves.
- State and Local Tax Planning
State income tax is another important component of lowering a company’s US taxable income. The normal starting point for state taxable income is that defined by the federal government, subject to a number of adjustments and modifications. Accordingly, in the absence of a specific state modification, federal taxable income (or lack thereof) will determine the calculation of state taxable income.
At the state and local tax level, income of a controlled foreign corporation is generally treated as dividend income as opposed to an income inclusion calculated for federal tax purposes. This could qualify such deemed dividends for a dividend received deduction.
- Transfer of US Assets to a Foreign Corporation
Another method commonly used to reduce US taxable income is to shift the location of certain income producing assets overseas.
In evaluating the manner in which assets are transferred to a foreign corporation, the tax consequences surrounding the transfers will depend on a number of factors, including the types of assets being transferred (tangible or intangible property, and the manner in which the transfer is effected (i.e., contribution, license, or sale).
Generally, no income or loss is recognized on a transfer to a foreign corporation so long as the transferor(s) have “control” of the corporation immediately after the transfer. However, this is not the case when a US person makes a non-taxable transfer to a foreign corporation. Instead, the transaction is taxable as if the property had been sold for its fair market value. This rule reflects a policy of taxing the built-in gain in the asset as it leaves the US, because the future income earned by the asset is generally not subject to US tax. There are various exceptions to this general rule.
Exception for Assets Used in Active Trade or Business. An exception exists for assets used in an active trade or business outside the United States. This exception is full of requirements and nuances and requires special attention of an tax professional to determine it applicability.
Tainted Assets: The foreign business asset exception does not apply to certain “tainted” property. Tainted assets are ineligible for tax-free treatment even if the transfer meets the active trade or business exception. The following kinds of property are considered “tainted”:
- Inventory or other property held primarily for sale to customers;
- Installment obligations, accounts receivables, or similar property, but only to the extent that the principal amount has not been included previously in taxable income;
- Nonfunctional currency and other property that gives rise to foreign currency gain or loss; and
- Certain tangible property in which the transferor is a lessor at the time of the transfer
Intangibles: If intangible property, as defined below, is transferred to a foreign corporation in a non-taxable exchange, generally it is treated as if the US person sold the intangible for a continuing deemed annual royalty. This treatment applies regardless of whether the property is to be used in the United States, in connection with goods to be sold or consumed in the United States, or in connection with a trade or business outside the United States.
Because of this treatment, the right to use intangible assets is often transferred to a foreign corporation through a license. The license of property is treated as merely granting the right to use the property and is not treated as a sale. In addition, a license allows the subsidiary to deduct such license payments.
Another common method many taxpayers have utilized (or at least attempted to) is to move their corporation or operations from the US to a foreign country with a lower tax rate. This is better known as a “corporate inversion”.
To curb these attempts, the US promulgated anti-inversion rules treating inverted foreign corporations as domestic corporations. These are a nuanced set of rules that require the advice and consultation of a professional advisor.
III. Foreign Tax Reduction
After considering the reduction of US taxes, the next step in the process is to consider techniques that lower the overall foreign tax due on international operations. Once again, there are many techniques that can be utilized to reduce foreign taxes but we will only be able to scratch the surface in this discussion.
- Local Country Tax Incentives
The tax rate of a foreign country, and the incentives they are willing to offer a business, is a major consideration of whether a US based company will place their operations in said foreign country. Generally, foreign countries will grant US companies incentives in the form of temporary tax breaks, rebates, etc. in exchange for specific capital investments into their country. The incentives provided vary on the level of capital investment and industry the US corporation is involved in. Obtaining these incentives is done through a negotiation process with the foreign country’s government.
- Reduction of Withholding Taxes
Another consideration is the reduction of a company’s overall withholding tax obligations on payments from its foreign subsidiaries. These withholding taxes are levied upon repatriation payments such as dividends, rents, royalties, and interest.
When considering the burden of withholding payments, it is important to consider the owner of the foreign subsidiary and the applicable country’s tax treaty with the US. Some tax treaties provide more favorable withholding rates than others. For example, the following U.S. income tax treaties provide for the elimination of the withholding tax on certain dividends by the foreign treaty partner: Australia, Belgium, Finland, Denmark, Japan, Mexico, Netherlands, Sweden, United Kingdom, Luxembourg, and Germany
Additionally, the Netherlands and Luxembourg are countries in which a holding company is often organized. Both countries benefit from the application of the European Union (EU) parent-subsidiary directive which provides for a zero withholding tax rate for dividends between corporations where both corporations are organized in the. Further, both the Netherlands and Luxembourg grant a participation exemption, thereby allowing dividends received from a foreign operating subsidiary to be exempt from Dutch or Luxembourg tax. In addition, neither the Netherlands nor Luxembourg imposes a capital tax on the contribution of an operating subsidiary or on the disposition of stock by the operating company.
In contrast to European countries, the United States has fewer income tax treaties with Asian countries. Investments in Asia, particularly India, are often made through a Mauritius holding company because of the robust treaty network Mauritius has with Asian countries.
In addition to holding companies for Europe and Asia, a U.S. parent corporation may consider using a Canadian subsidiary to act as a North American holding company including those organized in Latin America. The use of a Canadian corporation as a holding company for owning an interest in Latin American controlled foreign corporations (CFCs) may provide for a lower amount of withholding tax than if the subsidiary were owned directly from the United States. Canada has executed income tax treaties with Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, and Venezuela.
- Financing Cross Border Investments
Financing can be a crucial tool in reducing foreign taxes. Financing transactions should be structured to achieve the following objectives:
- Obtain a U.S. tax deduction for initial funding (subject to foreign tax credit considerations);
- Obtain a local country tax deduction for interest expense in a high taxed country;
- Ensure that interest income derived by a foreign financing affiliate is subject to little or no withholding tax;
- Ensure a low rate of tax in the financing affiliate’s taxing jurisdiction; and
- Ensure no immediate U.S. taxation under subpart F.
- Controlled Foreign Corporations Engaged in Active Business Operations
In order to effectively plan for the use of controlled foreign corporations (CFC), an understanding of the foreign dividend received deduction, the Subpart F regime, Global Intangible Low Taxed Income (GILTI), Foreign Derived Intangible Income (FDII), and Base Erosion and Anti-Abuse Tax applies in the context of operations conducted through CFCs. You can obtain an understanding of these rules in Series 203 and Series 204, where we provide an overview of such rules.
- Tax Effective Planning for the Manufacturing Supply Chain
This section will focus on common structures that are not subject to the foreign base company sales (FBCSI) and services (FBCSVI) rules as part of the Subpart F regime. Although there is no single structure that will fit the needs of every U.S. multinational corporation, there are several tax-efficient structures that should be considered.
Unrelated Party Purchase and Sales: A U.S. parent corporation can avoid recognizing FBCSI by having it’s CFC engage solely in unrelated transactions. For example, assume a US parent corporation organizes a CFC in Hong Kong. The CFC purchases products from third parties and resells such products directly to third parties. The CFC will not recognize FBCSI.
Same Country Manufacturing Exception: An exception to FBSCI applies to CFC purchases or sales of products manufactured in the CFC’s country of incorporation.
Products Purchased by Local Country Sales Affiliate: An exception applies to the recognition of FBSCI in the case a US parent corporation wishes to use two, separate sales affiliate subsidiaries to sell products. This exception applies so long as each sales affiliate purchases goods from unrelated parties and sell them to unrelated parties. Assume an US corporate parent organizes a Mexican subsidiary CFC1, which purchases products from unrelated manufactures in Mexico. The US parent also owns 100% of the stock of CFC2, organized in the Australia, which operates as a marketing agent for the sale of the products sold by CFC1 to customers in the Australia. Income derived by CFC1 will not be treated as FBSCI, for the reasons discussed above, provided it buys the products directly from the Mexican manufactures and sells the products directly to the customers in Australia. In addition, CFC1 must pay a sales commission to CFC2 to compensate CFC 2 for its marketing services.
Low-Tax Controlled Foreign Corporation Operating Through Branches: If a US multinational corporation wishes to use multiple locations outside the CFC’s country of incorporation to sell finished goods, FBCSI can be avoided provided the CFC purchases and sells to unrelated parties.
High Tax Distributors: A US multinational corporation may also want to utilize multiple locations to sell finished goods that the CFC manufactures. In such cases, even though the CFC would generally be able to avoid FBCSI, because it is the manufacturer, a portion of the income can be characterized as FBCSI. Thus, in such cases care must be taken to ensure that no tax rate disparity exists between the manufacturing location and the sales location.
Global Service Businesses and FBSCVI. CFCs can avoid FBSCVI by executing global services contracts with third parties and thereafter subcontract the services to related parties, so long as an US related party does not exceed 80% of the total cost of the services performed under the contract.
From this rule allows a planning opportunity involving the use of a centralized holding company to execute global contracts to provide services throughout the world. After executed, the services can be subcontracted with related persons. Thus, a CFC can engage in performing global contracts with third parties without generating FBSCVI so long as US related parties do not perform more than 80% of the contracts cost.
Additionally, a contract can be executed with a unrelated third party, and thereafter subcontract the work to entities disregarded with respect to the CFC without incurring FBSCVI. Thus, the use of branches to provide services on behalf of the CFC is a viable option from a subpart F perspective; however, it may be less than optimal from a foreign tax credit perspective.
IV. Utilizing Foreign Tax Credits
To effectively reduce the effective tax rate of a US company, it must plan to make the efficient use of foreign tax credits. This can be with respect to foreign taxes paid by itself or its subsidiaries. A discussion of the foreign tax credit and its related limitations is beyond the scope of this article but is addressed in Series 204: US Based Companies with Foreign Operations; Part 2: Dual Taxation Relief and Other Incentive Provisions.
Foreign tax credit planning must consider the following issues:
- Whether the foreign tax paid qualifies for the foreign tax credit.
- Whether the corporation is subject to foreign tax credit limitations.
- Whether foreign subsidiaries and affiliates are structured to allow access to foreign taxes paid for purposes of calculating the foreign tax credit.
- Whether a foreign subsidiary or affiliate has enough cash to repatriate to a US parent to allow the utilization of foreign taxes paid on its foreign earnings.
There are various techniques that professional use to maximize the amount of the foreign tax credit a US corporation is entitles too. Once again, we will only be able to scratch the surface of the general techniques used to maximize the use of the foreign tax credit in this article.
A key focus on foreign tax credit planning is maximizing the amount of foreign-source taxable income in each separate limitation category, particularly the default category — the general limitation basket. This requires a comprehensive approach which requires careful consideration of the following:
- Identify the character of the income (e.g. gain from the sale of property, service fees, dividends, interest, rent, or royalty);
- Determine the source of the income (US or foreign);
- Determine whether the income is characterized as GILTI, foreign branch income, passive income, or general limitation income; and
- Identify transaction or structuring options that increase the amount of foreign-source general limitation income.
Utilization of CFC Look-Thru Rule: If properly structured, payments subject to the look-through rules can be used to increase the capacity of an US affiliated group to claim foreign tax credits with respect to general limitation income. For example, a royalty paid from a high taxed CFC to a US affiliate will be subject to zero withholding tax under many U.S. income tax treaties. Thus, if the royalty expense is factually related to the CFC’s general limitation income it will be taxable as general limitation income to the U.S. affiliate thereby providing an increase in foreign tax credit capacity.
Increasing Foreign Source Income (FSI) via Dividends. The utilization of actual or deemed dividends from a controlled subsidiary can increase the FSI income of the US recipient, and thereby increasing their foreign tax credit limitation with respect to the category of income the payment relates to. Some transactions that fall under this technique includes–
- Increasing dividends from CFCs as they are sourced to residence of payor; and
- Utilize deemed dividend transactions through intercompany transactions and certain dispositions of CFC stock, such as—
- Deemed Redemption Transaction: Transfer of property to a common parent in exchange for a foreign subsidiary.
- IRC 1248 Deemed Dividend Transaction: Sale of stock of an CFC that is in a position earnings & profits position.
- IRC 956 Deemed Dividend Transaction: A loan from a CFC in a positive earnings & profits position to a US parent.
Increasing FSI via Interest: Interest income is treated as being from sources within the United States if the interest is paid or accrued on obligations of the United States, domestic corporations, or non-corporate residents. Contrariwise, any interest that is not treated as derived from sources within the United States is treated as derived from sources outside the United States. Thus, a US corporation will engage in lending funds to a CFC to increase its foreign source income.
Royalties to Increase FSI: Royalties and income from the use of intangible such as patents, copyrights, and other intellectual property are sourced to the “place of consumption”. Thus, these intangibles will be licensed to a foreign affiliate for foreign use in exchange for a royalty to increase the US parents foreign source income.
V. Facilitating the Movement of Cash Among Foreign Affiliates
In order to facilitate movement of cash among foreign affiliates, the structure of the US multinational company must be reviewed in order to determine where efficiencies can be gained to avoid over withholding on the movement of cash amongst such affiliates. Once analyzed, and plan will need to be created and implemented to create the tax efficient movement of cash.
Restructuring Controlled Foreign Corporation Corporations. Reasons for restructuring the organization of CFCs may include post-acquisition integration of a business, obtaining consolidation or tax loss offsets for local country purposes, increasing financial leverage in cross-border operations for treasury, financial and tax purposes, reduction of withholding taxes, utilization of losses and combination of corporate entities to increase operating, treasury, and managerial efficiencies. Such restructuring will involve numerous US tax issues that must be addressed to assure that the desired efficiencies are achieved from both a tax and operations perspective.
Creating a Holding Company. The creation of a holding company may provide a local country tax benefit by allowing for consolidation of subsidiaries for purposes of offsetting losses and deficits, as well as potential withholding tax benefits, while facilitating the movement of cash between affiliates. However, a US multinational corporation must consider potentially punitive provisions that would apply to such transaction, particularly in the case of the transfer of stock to a foreign corporation.
When transferring stock to a foreign corporation, these potentially punitive provisions causing an income inclusion can be avoided through a tax free asset reorganization. This includes an actual merger under local foreign law or a contribution of a subsidiary’s stock to the holding company followed by an immediate liquidation of the subsidiary.
Sale of Foreign Subsidiary Stock to Holding Company. A sale of a foreign subsidiary’s stock to a holding company can be used to increase leverage of a foreign subsidiary and reduce local tax. This commonly occurs in the case of a sale of foreign subsidiary stock to a holding corporation in exchange for debt.
Its important to note that this type of transaction has its own potential for income inclusion as a “deemed dividend”. This however can be avoided through tax free reorganizations, inbound liquidations, and spin-offs. Each one of these alternatives has its own consequences that should be analyzed independently.
Breaking it Down to Two Holding Company Alternatives. Broadly speaking there are two different alternatives for structuring CFC-to-CFC and facilitation the movement of cash. The first structure is the use of a single holding company that operates through subsidiaries that are treated as disregarded entities for U.S. tax purposes. The second option also involves the use of a single holding company, however, in this case, the subsidiaries are treated as corporations for U.S. tax purposes.
If a single holding company that operates through disregarded entities is used, the country of choice is especially important. The country chosen to house the holding company should aim to have—
- A participation exemption for dividend income from lower tier-subsidiaries.
- Capital gain exclusions on the sale of lower-tier stock; and
- Provide the holding company the ability to obtain an low-effective tax rate on related party financing.
Under this structure, payments between disregarded entities, such as dividends, interest, rents, royalties, and service fees, generally do not produce taxable income for U.S. tax purposes. However, if the holding company and the disregarded entities use a different functional, the movement of cash from a disregarded entity to the holding company or between disregarded entities is likely to result in a foreign currency exchange gain or loss.
A holding company with subsidiaries regarded as separate entities for both US and foreign tax purposes can be used. This structure provides an exception to recognition under the Subpart F regime for dividends, interest, rents, and royalties paid between controlled foreign corporations. This facilitates the movement of cash between foreign affiliates while still maintaining deferral.
The need to facilitate the remittance of cash to the United States must be balanced against the effect of such repatriation on the effective tax rate of the enterprise. In addition, repatriation cannot be viewed as a single transaction, but rather it is a corporate objective that impacts both the corporate structure as well as operational transactions.
To take this comprehensive approach, the Global STEPS methodology divides repatriation into three categories: annual, structural, and situational.
Annual Repatriation Transactions. Annual transactions represent transactions that are executed as part of the day to day operations of funding the business. This includes facilitating deductible payments such as rents, royalties, interests, services, management fees, and guarantees fees from a foreign subsidiary to the US parent. Some other strategies utilized to facilitate the annual repatriation of cash include–
- Requiring controlled foreign subsidiaries to fund stock obligations;
- Execution of a “cost sharing arrangement” between a US parent and foreign subsidiary;
- Repatriation of a foreign subsidiary’s income that has already been subject to tax in the US; and
- Sale of receivables from a US parent to a foreign subsidiary
Structural Repatriation Transactions. Structural payments are those that are dependent on a corporate or financing structure allowing efficient repatriation of cash that is accumulated from offshore operations. Commonly used techniques include—
- A foreign subsidiary’s repayment of debt to a US parent;
- Return of capital contributions in a non-taxable manner; and
- Loans from a foreign subsidiary to a US parent;
Situational Repatriation Transactions. Situational transactions represent a single restructuring transaction to repatriate cash when the circumstances permit. These techniques commonly include–
- Related party sale of a foreign subsidiary to a holding company;
- A related party sale of a foreign subsidiary to a holding company, followed by a liquidation of the foreign subsidiary sold; and
- A holding company’s purchase of another branch’s assets from the US parent.