Posted by Thomas G Kinsella, ATP

Cross-Border Tax Issues For Inbound Businesses

Cross-Border Tax Issues For Inbound Businesses

For many inbound businesses, U.S. tax laws can be a daunting task. The decisions you make today regarding your overall tax structure, financing operations in the United States, and business-to-business transactions can have significant and sometimes undesirable tax implications. Consider these strategies to avoid typical mistakes.

Tax structure and restructuring opportunities 

For starters, the tax structure of your business in the United States affects:

  • Eligibility for exemption under applicable tax treaties

  • Federal and state tax reporting requirements

  • Possibility of claiming certain foreign credits and tax deductions

  • U.S. customer withholding and reporting requirements.

Therefore, you should understand the ramifications of applicable federal and state tax laws when classifying your U.S. corporation as either a corporation or a pass-through entity.

For example, a foreign corporation may be a U.S. entity classified as a pass-through entity or a corporation under U.S. tax law. A sole proprietorship pass-through entity is considered to be disregarded as a separate entity under U.S. tax law and is treated as a subsidiary of the foreign investor. When a foreign company has a branch in the United States, that company is subject to federal and, in some instances, state income tax on the taxable profit generated by the disregarded entity and must file a U.S. tax return.

It is not unusual for a local pass-through entity to have more than one owner. If a United States LLC is used, the LLC is treated as a multi-functional partnership under U.S. tax law. This structure may create additional complexity for the LLC to be a hybrid entity if the foreign corporation's jurisdiction classifies the U.S. LLC as a corporation under its laws. Although the business itself is not subject to income tax at the U.S. federal entity level, you must file an annual U.S. partnership return showing the taxable income generated in the fiscal year. A foreign company that is a partner of a U.S. partnership must file its U.S. federal income tax return and also include its share of the distribution of the partnership's income in that return.

Foreign companies considering investing in a U.S. corporation might be wise to consider investing through a U.S. corporation rather than investing directly in a U.S. corporation or LLC. In such a composition, the U.S. blocker company, instead of the foreign investor, would be subject to U.S. tax reporting requirements as a direct partner of the partnership. Additionally, if a U.S. blocker company acts as a direct investor, a foreign company would not be subjected to the new U.S. reporting and withholding requirements that arise when a foreign partner transfers interest in a partnership.

Keep in mind that a foreign company can also choose to set up a U.S. company as a subsidiary. The foreign company may constitute an entity under state law. If so, the U.S. entity would be subject to its taxable income tax and would have to file a federal income tax return.

A potential tax benefit available only to domestic businesses is the Foreign-Derived Intangible Income Deduction (FDII) for businesses that sell goods and provide services to customers outside of the United States. 

Funding of U.S. operations

The capital structure adopted by your U.S corporation can have a significant impact on the taxation of your operating profits and the repatriation of those profits to your foreign parent company. Federal income tax law usually favors debt over equity financing because:

  • Interest expense is deductible, while dividends are not deductible.

  • Interest payments generally attract lower withholding rates than dividends under most U.S. tax treaties.

  • Principal repayments of a debt security may be tax-exempt.

However, compliance requirements for debt financing can be more demanding than equity financing due to strict documentation standards and a litany of deferred interest charges and rejection rules, such as Section 163 (j).

The interest expense limiting under Section 163(j) may be an important aspect of financing investments received in the United States. In general, a U.S. taxpayer cannot deduct a business interest expense as long as the expense surpasses 30% of the taxpayer's adjusted taxable income, which is very close to earnings before interest, taxes, depreciation, and amortization. Any excessive interest expense that is not authorized is carried forward to the following year.

Potential risks

Pitfalls can't always be avoided, but you shouldn't be surprised by unforeseen tax liabilities in the United States with the right planning.

Chapter 267A

The TCJA added anti-hybrid rules to Section 267A, creating a level of complexity. Section 267A limits the deductibility of expenses paid by a U.S. taxpayer to an affiliated party where the affiliated party is a hybrid entity. A foreign entity is deemed a hybrid entity when its tax classification differs from its tax classification for tax purposes in the country in which it is incorporated. Therefore, it is necessary to understand the local and U.S. tax classifications of the U.S. company and all affiliated parties with which the U.S. company operates.

Base Erosion and Abuse Tax (BEAT)

BEAT, which was added to the Federal Income Tax Code under the TCJA, serves as an alternative minimum tax for U.S. businesses that meet certain limits on gross income in the United States for related companies. The BEAT provision requires affected taxpayers to add deductions that are considered base erosion payments, resulting in additional federal tax debt.

Section 864(c)(8)

Foreign companies interested in a partnership in the United States should also be aware of Section 864 (c)(8), which may impose withholding tax on the transfer of interest. Although there are several exceptions under this provision, you must disclose the transaction, along with any exceptions requested by the foreign company, no later than 20 days after the transaction. As mentioned above, foreign investors in a U.S. partnership can choose to structure their U.S. partnerships through a U.S. blocker company.

Inadequate transfer pricing

When it comes to transfer pricing, federal income tax law gives the IRS the power to redistribute income and deductions among controlled taxpayers (for example, a foreign corporation and its U.S. subsidiary) if the transactions between these parties are not valued at market conditions. These adjustments can increase U.S. federal tax obligations, plus interest and fines, without an appropriate tax reduction in a foreign jurisdiction.

To protect from such exposure, U.S. taxpayers should conduct transfer pricing studies by comparing the prices of intragroup transactions with comparable transactions with third parties. Your transfer pricing policy should be frequently updated, applied consistently, and comply with the documentation standards required by federal tax law.



Thomas G Kinsella, ATP
Contact Member