INTERNATIONAL TAX
Cross-Border Tax Issues for Inbound Companies Mike Smith, Kyle Dawley, and Jill Boland
For many inbound companies, U.S. tax law can present a significant challenge. The decisions made today about global tax structure, financing of U.S. operations, and intercompany transactions can have far-reaching — and sometimes unintended — tax implications. Consider these strategies to help avoid typical pitfalls.
Tax structure (and restructure) opportunities To start, the tax structure of a U.S. company impacts: • Federal and state tax reporting requirements • Ability to claim certain deductions and foreign tax credits • Eligibility for relief under applicable income tax treaties • U.S. customers’ withholding and reporting obligations Therefore, business owners need to understand the ramifications under federal and applicable state income tax law of classifying a U.S. company as either a pass-through entity or a corporation.
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For example, a foreign company may form a U.S. entity that is classified either as a pass-through entity or corporate entity under U.S. tax law. A domestic pass-through entity with only one owner is considered disregarded as a separate entity for purposes of U.S. tax law and is treated as a branch of the foreign investor. When a foreign corporation has a U.S. branch, that corporation is subject to federal (and frequently state) income tax on the taxable income generated by the disregarded entity and must file a U.S. corporate income tax return. It is not uncommon for a domestic pass-through entity to have more than one owner creating a partnership. If a U.S. LLC is used, the LLC is treated as a partnership for all purposes of U.S. tax law and this structure may create an added complexity of the LLC being a hybrid entity if the foreign jurisdiction classifies the U.S. LLC as a corporation under its law. While the partnership is not itself subject to U.S. federal income tax at the entity level, it is required to annually file a U.S. partnership return on which it reports the taxable income generated during the tax year. A foreign corporate partner of a U.S. partnership is required to file its own U.S. federal income tax return and must include its distributive share of partnership income on that return. Foreign corporations that are considering an investment in a U.S. partnership may be well-advised to consider investing through
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The Washington CPA Spring 2021
a U.S. blocker company, rather than investing directly in a U.S. partnership or LLC. In such a structure, the U.S. blocker company, rather than the foreign investor, would be subject to the U.S. income tax return filing requirements as the direct partner in the partnership. Additionally, with a U.S. blocker company acting as the direct investor, a foreign corporation would not be subject to the new U.S. withholding and reporting requirements that arise when a foreign partner transfers an interest in a U.S. partnership (see discussion of Section 864(c)(8) below). Note that a foreign corporation may also choose to form a U.S. corporation as a subsidiary. The foreign corporation can incorporate an entity under state law. In such a case, the U.S. entity would be subject to tax on its taxable income and would need to file a federal corporate income tax return. One potential tax benefit available only to domestic corporations is the foreign-derived intangible income (FDII) deduction for corporations that sell goods and services to non-U.S. customers. Evaluate the supply chain of the domestic corporation’s revenue stream to help determine whether to form a U.S. corporate subsidiary.
Financing U.S. operations The capital structure a U.S. company adopts can significantly impact the taxation of its operating profits and the repatriation of such profits to its foreign parent. Federal income tax law generally favors debt over equity funding because: • Interest expense is tax deductible, whereas dividends are non-deductible • Interest payments typically attract lower withholding tax rates than dividends under most U.S. tax treaties • Repayments of principal under a debt instrument can be made tax-free Nevertheless, the compliance requirements for debt financing can be more onerous than equity funding, due to stringent documentation standards and a litany of interest expense deferral and disallowance rules, such as Section 163(j). The interest expense limitation under Section 163(j) can be a significant consideration for funding inbound U.S. investment. Generally, a U.S. taxpayer is not allowed to take deductions for a business interest expense to the extent the expense exceeds 30
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