The world of U.S. tax surrounding foreign income and the reporting of foreign assets is extremely complex. Unfortunately, many domestic CPAs and tax attorneys do not understand the full set of requirements behind the United States’ international tax system to help their clients implement plans to lower their U.S. tax due and reporting requirements.
The Orange County business tax lawyers here at Evolution Tax & Legal has serviced the likes of large fortune 500 companies, to small solely owned businesses, and individual investors with their international tax planning, global tax strategy, and reporting needs.
We’ve put together the items you should be taking into consideration when planning to mitigate your tax burden when operating a business in a foreign country.
International Tax Planning Strategies
There are two segments of international tax planning that you should be aware of—that around outbound operations (i.e. U.S. company operating offshore) and inbound operations (foreign companies operating in the U.S.). Each of these segments have their own unique corporate tax planning considerations.
Outbound Business Tax Planning
Outbound business tax planning considers the tax impact of cross border transactions for U.S.-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 U.S. 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 foreign earnings.
Tax planning is not a static exercise because the facts surrounding international business are ever-changing. Thus, a business must respond with a tax planning strategy 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 the 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, an aggressive tax planning framework needs to be operated. Generally, this framework should consider the following objectives–
(1) Establish the factual foundation for planning;
(2) Reduce U.S. tax;
(3) Reduce local country tax;
(4) Utilize foreign tax credits;
(5) Facilitate the movement of cash among foreign affiliates; and
(6) Provide for efficient repatriation of cash from foreign affiliates to the U.S. affiliated group.
How to Reduce U.S. Taxes for Outbound Business Operations
There are several techniques that are available at a tax professional’s disposal, and we will only be able to scratch the surface of what is available out there.
Utilization of Offshore Losses. One primary technique surrounds the utilization of unrealized losses or ongoing losses incurred by a business to offset U.S. 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 U.S. imposes tax on worldwide income of a U.S. corporation, structuring foreign loss operations as a branch of a U.S. corporation or a flow-through entity owned by a U.S. corporation may reduce U.S. taxable income. Below are considerations and tax issues associated with the utilization of offshore losses to offset U.S. taxable income.
i. 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 U.S. 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 in a foreign country.
ii. 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 U.S. corporation recently purchased a foreign corporation and made an election on the purchase to step-up the basis in the assets of the foreign target corporation.
Captive Insurance Companies
Another strategy commonly used to reduce U.S. 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 U.S. 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 levels, the 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 U.S. Assets to a Foreign Corporation
Another method commonly used to reduce U.S. 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 U.S. 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 U.S. because the future income earned by the asset is generally not subject to U.S. tax. There are various exceptions to this general rule.
What Are the Tax Obligations and Reporting Requirements of a Foreign Person or Business With Inbound Operations?
At its core, the U.S. tax framework governing the taxation of income earned by non-U.S. persons is straightforward. The key to understanding international taxation 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.
Not all non-U.S. persons operate in the United States with sufficient regularity and continuity to create a U.S. trade or business. 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.
In addition to the federal income tax, there are various other tax obligations and reporting requirements a foreign person or business with inbound operations to the US needs to consider.
1. State Income Taxes
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.
2. State Gross Receipts 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 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.
3. State Franchise Taxes
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.
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.
4. State and Local 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.
5. State and Local Sales Tax
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.
6. Use Tax
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.
7. Federal and State Employment Taxes
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.