Plan Your Journey To The US Market
When a foreign business expands into the U.S. market, it must make several decisions regarding operating in the U.S. These tax considerations are an important component in this decision due to the high corporate income tax rates in the U.S. However, although tax considerations are important, there are also a variety of nontax (e.g., legal, business, regulatory) considerations to take into account when making a decision regarding the business form of U.S. operations.
The determination of how a company will be taxed must be based on the nature and scale of the business operation. The choice must be based on the nature and scale of the business operation. In United States, some business entities can elect their classification as either corporation, partnership or an entity disregarded from its owner. Each type of business has its own advantages and disadvantages.
From a U.S. tax perspective, whether to operate as a branch or a corporate subsidiary may have important U.S. tax implications to the foreign owner. Branch operation activities are taxed in the United States as a division of its owner while a corporate subsidiary is a standalone entity taxed on its activities in the United States.
Operating a U.S. business through a partnership (or an LLC taxed as a partnership) causes its partners to be engaged in the U.S. trade or business conducted by the partnership. The foreign partners will be taxable on the share of the partnership effectively connected income and required to file a U.S. tax return since there is no tax at the partnership level.
Tax Treaties and Permanent Establishment
Tax treaties provide that business profits are taxed in the United States only if the foreign company’s operations in the U.S. rise to the level of a permanent establishment (PE). Activities considered auxiliary and preparatory do not give rise to PE. The tax treaties reduce or eliminate the withholding tax on U.S. source “fixed, determinable, annual or periodic income” (FDAP). A U.S. subsidiary can trigger a U.S. PE for a parent company if the U.S. subsidiary acts as an agent of the non-U.S. supplier in the U.S. by having authority to negotiate and conclude contracts in the name of the non-U.S. supplier and regularly exercises that authority.
When a foreign entity does not have any U.S. effectively connected income or PE, it is a common practice for a foreign corporation to file a “protective” tax return to receive the benefit of the deductions and credits if it is later determined that the foreign corporation was subject to U.S. tax. Without a protective return filed, following a later determination that a U.S. trade or business exists, the foreign taxpayer loses the ability to claim deductions and credits, and is therefore taxed at graduated U.S. rates on the basis of its gross rather than net income.
Transfer Pricing Rules
The transfer pricing regulations allow the IRS to make allocations to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the evasion of taxes. Controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances under “arm’s length” standard. Treasury regulations require taxpayers to keep contemporaneous documentation to support the arm’s length prices. The documentation must be submitted to the IRS within 30 days of the request.
Capitalization of U.S. Investment
To distinguish between debt and equity, there is no single factor controlling, but the IRS has used a “substance over form” concept since there is no bright-line test. The regulations list a couple of factors that would be considered for a debt instrument to be classified as pure debt. In case a debt instrument is re-characterized as equity, all the interest payments will be re-characterized as dividends and therefore nondeductible.
U.S. earnings stripping rules limit the interest deduction to an amount not in excess of 50 percent of EBITDA. This limitation of deduction does not apply when debt to-equity ratio does not exceed 1.5 to 1.
The deduction for accrued interest to a foreign related party is deferred until the interest is actually paid.
State Taxation and Sales Taxes
The term “tax nexus” suggests that a business has enough connection to a state that it is subject to state taxation. Nexus, or a business connection for the employer, can occur when the employer has a business location, sales transactions, or employees performing services in a state.
Some states have adopted rules mandating that nexus is created for income tax by having a sufficient economic presence in the state. This “economic nexus” concept has not been adopted by all states, and rules are different for the states that have adopted it. Businesses would have nexus if they generate sales in these states without local physical presence. Some states offer several local credits and incentives based on different criteria so it is important to be informed before deciding the location of the U.S. business.
The United States does not have federal sales taxes or VAT but most states and municipalities impose sales taxes. Sales taxes are imposed on sales of tangible property but some states impose sales taxes on services, software sales and software as a service (SAAS). The responsibility to collect sales taxes is on the seller. A foreign distributor should consider sales taxes when title to products passes in the U.S. A resale certificate should be obtained from the purchaser, wholesale transactions are tax exempt.
Foreign employees may be considered resident aliens and taxed on their worldwide income if their physical presence in the United States meets the substantial presence test (more than 183 days during the current year or the sum of the days calculated on a weighted average, spent in the U.S. during the most recent three-year period equals or exceeds 183 days). The foreign employees’ presence in the U.S. may trigger U.S .taxation for the foreign employer when there is no tax treaty with the investor’s country, or when the employees’ activity would fail the exemptions of tax treaty provision on permanent establishment. It is advisable to have the foreign employees on the payroll of the U.S. company to avoid taxation for the employer.
A foreign employer has the responsibility to withhold and remit the income and social security taxes from the wages of the foreign employees working in the United States. A company must register for payroll taxes with the state where the employee is domiciled and the state where the employee performs the services. Most foreign companies entering the U.S. use professional employer organizations (PEOs) to manage their U.S. payroll and HR.
Temporary worker visas are for persons who want to enter the United States for employment lasting a fixed period of time, and are not considered permanent or indefinite. These visas require the prospective employer to first file a petition with U.S. Citizenship and Immigration Services (USCIS). An approved petition is required to apply for a work visa. U.S. immigration law provides foreign nationals with a variety of ways to become lawful permanent residents (get a Green Card) through employment in the United States.
A qualified U.S. immigration attorney should be consulted to ensure proper and timely filings in accordance with U.S. Immigration Laws.
U.S. Withholding Regime
Passive income that originates from sources within the United States and is not effectively connected with a U.S. business is generally subject to a 30% tax rate. The 30% tax is a gross basis tax that is generally withheld at the source. Passive income subject to the 30% tax includes interest, dividends, rents, salaries, and other non-periodic income (referred to as FDAP income - “fixed, determinable, annual or periodic income”). Income that is effectively connected with a U.S. business is subject to tax at the applicable graduated rates in effect for the person receiving the income, but (with certain exceptions, such as withholding on effectively connected income by partnerships) withholding is not required. The withholding regime is generally designed to place the burden of collecting this U.S. tax on the person from whom the IRS can most readily collect such tax. The 30% withholding is applicable unless an exemption or reduced withholding rate applies under an applicable treaty.
It is important that a foreign business use U.S. advisors to get informed before starting U.S. operations, from selecting the best business structure, complying with all tax and payroll reporting and disclosure requirements, preparing a solid transfer pricing that would meet the IRS’s standards, and understanding the tax treaty with the investor’s country.
Partner with Wiss
When conducting business in foreign countries, having the right tax strategies in place can help you maintain your competitive edge. Our International Tax team understands that each client has unique needs and we aim to work together to help keep you one step ahead of the ever-changing regulations in the international market. In conjunction with our technical expertise, our tax team is also fluent in multiple languages and through our alliance with LEA Global, we have access to the most knowledgeable teams of international business advisors. Your company's ultimate success in the U.S. market is obtained by making the right decisions on establishing cross-border operations. Partnering with Wiss' International Tax team will ensure your that your specific needs are met while allowing you to focus on the growth of your business. View this article for a more extensive guide.