Too often we run across owners of a business or a web-based site who think that just because they set up their company outside the U.S. they do not need to pay U.S. tax (or file U.S. corporate income tax returns). When they learn they must, the IRS imposes steep penalties, interest and even criminal penalties.
Inbound transactions involve foreign persons or companies investing or doing business in the U.S. The U.S. imposes a tax on foreign persons on most nonbusiness investment income that originates from the U.S. and income that is connected with U.S. businesses or branches.
Nonbusiness investment income will be subject to a U.S. withholding tax, rather than the U.S. income tax. This withholding tax can be much more severe than the income tax, as there are no deductions or credits against the withholding tax. The withholding rate can range from zero to a whopping 35 percent, depending on the type of income and whether the income is being paid out to a resident of a country in which the U.S. has negotiated a bilateral tax treaty.
Income that is effectively connected with a U.S. business is subject to federal tax just like any other U.S. business. The income may also be subject to the U.S. withholding tax when it is removed from the U.S.
Foreign businesses that operate a U.S. branch or office may be subject to the U.S. branch profits tax in lieu of the U.S. withholding tax. This tax mimics the tax imposed on foreign companies that receive income from U.S. subsidiaries. The branch profits tax differs from the U.S. withholding tax in that it is based on an estimation of the U.S. branch's assets to determine what income accrued to the foreign owner.
With inbound transactions, the emphasis is usually on how the foreign company can structure its investment or business affairs so that it generates income that is not subject to tax in the U.S. This will usually be decided by what activities are carried out in the U.S. For example, a foreign software company may opt to locate its design, manufacture, support and/or distribution activities outside of the U.S., using an agent or third parties in the U.S., or through a wholly owned subsidiary.
If the investment or business cannot be structured so that it is not subject to U.S. tax, the focus shifts to how the funds can be removed from the U.S. in a tax-advantaged manner. There are a number of ways to remove funds from the U.S.
For example, earnings from a U.S. subsidiary may be removed from the U.S. by paying interest to the foreign parent company. The U.S. subsidiary may be able to deduct this interest payment thereby eliminating its U.S. tax liability. Moreover, the U.S. subsidiary may not have to withhold any or a portion of the interest payment under current law or applicable treaties. The interest may even be paid to a foreign country that does not impose a tax on the interest income. This is often referred to as "interest stripping."
Similarly, earnings of a U.S. subsidiary may be removed from the U.S. by paying a royalty to the foreign parent company. This royalty may be for the use of the parent's foreign-owned intellectual or intangible property, such as computer software, trademarks or patents. The U.S. subsidiary may be able to deduct this royalty payment and thereby reduce its U.S. tax liability and it may be able to reduce the amount of U.S. withholding tax that applies by having the payment made to a country that has a favorable bilateral tax treaty with the U.S.
The foreign parent company, depending on the laws of its state, may not be subject to tax on the income in its own country. Companies often set up foreign intellectual property holding companies for this very purpose.
The laws involved in structuring inbound transactions can be complex, yet many of the solutions need not be. The tax savings from properly structuring inbound transactions are usually more than sufficient to cover the cost of planning the transactions. With proper planning, individuals can accumulate wealth faster than they otherwise would and businesses can obtain a financial advantage over others who fail to properly structure their transactions.
Montage Services provides international and domestic tax consulting and advisory services primarily for corporations. To inquire about a particular tax issue or seek consulting services, contact Scott Wentz, managing director, at (415) 963-4016 or scott@montage-services.com.
