Entering foreign markets - one step at a time.

Does a client have the urge to take his business overseas? A host of practical tax matters, such as using a foreign sales corporation, creating subsidiaries and branches, taking foreign tax credits, entering into a joint venture, and examining transfer pricing issues should be addressed Wore the first step outside U.S. borders is taken. This article discusses these and other matters for the first time would-be world wide entrepreneur.

A business that decides to look beyond U.S. borders to expand its markets faces a host of tax issues that were never before relevant (and thus, likely remained invisible) to the business's owners. These issues fall into two broad categories:

1. The Federal income tax rules applicable to foreign earnings.

2. The tax rules of foreign jurisdictions in which nexus is established.

This article will delve mainly into the first category, but will also comment briefly on certain aspects of non-U.S. taxation.

Background

Under Secs. 1 and 11, U.S. citizens and residents and corporations are subject to Federal income tax on their worldwide income, regardless of its source, type, place or means of payment. While Federal income tax ultimately will be incurred on the income of foreign subsidiaries, tax deferral is often possible. If the income in question has not been taxed by another jurisdiction, or has been taxed at a rate lower than the applicable Federal income tax rate, long-term deferral can provide a very meaningful financial benefit.

To prevent double taxation of income that has been taxed elsewhere, U.S. taxpayers may claim a foreign tax credit (FTC) under Sec. 901 (a) against their Federal income tax liability for foreign taxes incurred on foreign earnings. Generally, the FTC becomes available when the foreign earnings become subject to Federal income taxation.

Frequently, the first step in "going international" is exporting to foreign customers. Accordingly, this article first examines the tax aspects of export sales and then moves on to non-U.S. operations.

Exporting and Foreign Sales Corporations

Often, U.S. businesses first try international waters by exporting their products to customers located abroad. There are some helpful Federal income tax incentives in this regard.

Under Sec. 921, U.S. exporters that are regular (i.e., C) corporations can reduce their Federal income tax rate on profits from export sales by using a foreign sales corporation (FSC).(1) This is a permanent savings, not just a deferral; thus, using an FSC can provide a financial statement benefit, not just current tax savings.

Sec. 922(a)(1)(A) requires an FSC to be incorporated in be incorporated in a foreign jurisdiction, a prospect often daunting to U.S. businesses that have not previously experienced the complexities of establishing and running a foreign subsidiary. However, typically, an FSC is not a "foreign subsidiary" in the usual sense. The vast majority of FSCs rely on affiliates or an unrelated service provider to undertake the modest activities required. Thus, FSCs rarely have their own employees or significant assets.

In most cases, obtaining the FSC tax benefit is straightforward. While some planning is required, most companies find that the tax benefit far outweighs the effort. U.S. corporations that sell no more than $5 million of their products overseas (or that export more, but are satisfied to obtain tax savings on the most profitable $5 million of their sales) can elect "small FSC" status for the foreign subsidiary, as defined in Secs. 922(b) and 924(b)(2). While the small FSC still must be incorporated outside the U.S. (usually in Barbados or the U.S. Virgin Islands (USVI)), modest fees are paid for the provision of a local office and director, and no further activities outside the U.S. are required. Barbados and the USVI are by far the most common FSC locations, because they do not tax FSC income and have the service infrastructure and favorable local laws needed to successfully "operate" such an entity.

While the FSC benefit cannot be realized by exporters that operate in S corporation, partnership or other noncorporate forms, in some cases an FSC can be established by an individual retirement account set up by the business's owner. Such exporters may also benefit from using an interest-charge domestic international sales corporation to obtain tax deferral on up to $10 million of export sales.(2)

In almost all cases, a U.S. exporter will not become subject to foreign income tax solely as a result of exporting its products to customers outside the U.S.; however, those goods may be subject to import duties, which can often be reduced through careful planning. Most property produced in the U.S. is eligible for FSC benefits when exported, but there are some restrictions, and narrow rules apply that potentially restrict the export of computer software.(3) If title to exported goods passes outside the U.S., Sec. 863(b)(2) treats a portion of the exporter's profits as foreign-source income. Because these profits have not been subject to foreign tax and can be "mixed" with other, high-taxed foreign earnings for FTC purposes, foreign title passage can enhance the exporter's ability to fully use its FTCs, as is discussed below.

Using an FSC can reduce the foreign earnings that can be generated in this manner.

Establishing Foreign Operations

At some point, having personnel and facilities in another country is the only way to serve (and grow) a business's foreign markets effectively and efficiently. Often, this means establishing a distribution operation, rather than using (or continuing to use) independent distributors who may not have the desired level of commitment to the business's products or whose commissions may be too large.

What form will the distribution operation take? Generally, a business either can establish a local subsidiary or create a foreign branch of a U.S. corporation. A number of factors typically enter into this decision (e.g., taxation, market perceptions or expectations, financial statement disclosures in the foreign jurisdiction and liability exposure).

Establishing a Local Subsidiary

If the foreign operation is carried on through a locally incorporated foreign subsidiary, under Secs. 11(d) and 882(a), its earnings will be deferred from Federal income tax until repatriated to the U.S. The foreign subsidiary will be subject to local income taxation and, in many cases, value-added taxes, capital tax and other local charges. In addition, dividends and other payments made by the foreign subsidiary to its U.S. shareholder may be subject to foreign withholding tax.

Several rather complex sets of Federal income tax rules may also come into play if the foreign subsidiary earns significant amounts of passive income (e.g., bank account interest or dividends on portfolio stock investments),(4) has a high percentage of passive-income-producing assets (including cash),(5) lends money to a U.S. affiliate or makes certain other U.S. investments,(6) or deals with its U.S. shareholder or other affiliates in connection with business done outside its country of incorporation.(7) If applicable, these anti-abuse rules generally end deferral and treat part or all of the foreign subsidiary's income as if it had been distributed to the U.S. shareholders, making it currently taxable to them. The potential applicability of these rules must he carefully examined if tax deferral is a goal, especially if the foreign subsidiary is established in a tax haven or low-tax jurisdiction.

Manufacturing operations carried out through a foreign subsidiary generally will result in deferral of Federal income tax. A number of countries (e.g., Ireland and Singapore) offer special, low-tax regimes for manufacturers; the Federal income tax deferral benefit can be dramatic.

Establishing a Branch

Instead of incorporating a new foreign company to operate the foreign business, the enterprise could be carried on through a branch of an existing (or new) U.S. company. Deferral cannot be obtained in such a case; rather, the branch's results are included currently in the U.S. company's tax return in much the same way as are the results of a U.S. office or division; thus, the anti-abuse rules do not apply.

If the foreign branch is undertaking any significant activities in the foreign country in which it is operating, it will almost certainly become subject to foreign income (and perhaps other) tax on its income attributable to the branch operation. Many countries (e.g., the U.K.) impose the same income tax rate on branches as they do on subsidiaries, while others (e.g., Germany) have separate rates for branch operations. Similarly, some countries (e.g., Canada) impose withholding or other taxes on repatriations of branch earnings, while others do not. Further, in many countries, U.S. companies must register a branch operation before commencing activities there.

In some countries, it is possible to have a branch that is subject to no local income tax if its activities are restricted to those of a representative office supporting, but not actually undertaking, business activities. This might include, for example, investigating potential markets in the region or overseeing the activities of independent distributors that sell the company's products in the area; careful planning is required.

FTCs

As was discussed, the worldwide income of U.S. corporations, citizens and residents is subject to Federal income tax. Double taxation of foreign earnings is avoided by allowing an FTC for foreign income taxes incurred on foreign earnings. (While the U.S. is not alone in having a worldwide taxation/FTC system to avoid double taxation, many countries instead use a territorial system that does not tax profits arising outside the territory; thus, no credit mechanism is needed.)

An FTC is allowed under Sec. 901(a) for foreign income taxes incurred directly by a U.S. person, such as foreign taxes on foreign branch income or withholding taxes imposed on dividends received by a U.S. shareholder. Sec. 902(a) permits an FTC to a U.S. C corporation that owns 10% or more (by vote) of a foreign corporation for foreign income taxes incurred by the foreign subsidiary. The FTC becomes available when the subsidiary pays a dividend to its U.S. shareholders or, under Sec. 960(a), when a dividend is deemed to have been distributed to the shareholders under the anti-abuse rules.

The FTC mechanism is extremely complex. However, it is designed to result in the U.S. taxpayer incurring the higher of the U.S. or foreign income tax imposed on the foreign earnings. Thus, Sec. 904(a) limits the FTC to the Federal income tax that would otherwise be due on the U.S. taxpayer's foreign income. To a very great extent, the need to determine this FTC limitation makes the rules so complicated.

The FTC is determined on a worldwide, rather than on a country-by-country, basis. Income earned and taxes incurred in all foreign countries in which the U.S. taxpayer has operations (or subsidiaries paying dividends) are combined in computing the limitation, so that foreign taxes are "mixed" (or "blended") for FTC purposes. However, to the extent that foreign taxes are incurred on different categories of income, they are not blended, but are instead subject to separate limitations, under Sec. 904(d)(1). Thus, for example, while taxes attributable to general business income (including dividends from foreign subsidiaries engaged in an active business) are combined, they cannot be mixed with foreign taxes incurred on passive income or dividends from a foreign subsidiary no more than 50% owned by the U.S. person.

As a result of the limitation, if the foreign tax rate is higher than the U.S. rate, the taxpayer will have excess credits that are currently unusable, but may be carried back two years and forward five years under Sec. 904(c) if those years' limitations have not otherwise been reached. If the foreign tax rate is lower than the U.S. rate, additional Federal income tax will be payable on the foreign earnings; however, excess credits carried over from other years may become usable in the current year if the taxpayer has (or can) generate additional, low-taxed foreign earnings (in the same category). Passing title abroad on export sales can be important because the untaxed foreign income that results from foreign title passage can, in effect, bring down the rate incurred on other foreign income, allowing high-rate taxes to become fully creditable or use of excess credits from other years.

Significantly, according to Sec. 964(a) and (c), the FTC limitation is calculated using U.S. tax accounting principles, not the numbers set forth in foreign books of account or on foreign tax returns. Moreover, certain U.S.-incurred expenses (notably, a portion of the U.S. taxpayer's interest and research and development expenses) must be allocated against (and reduce) foreign taxable income for this purposes Thus, the effective foreign tax rate, for purposes of the FTC, will almost always be different from (and is frequently higher than) the foreign statutory rate, making it potentially more difficult in many cases to fully use FTCs. Careful, sophisticated planning is required.

Joint Ventures

U.S. companies entering a foreign market for the first time often take on a local partner to help ensure their success. From a tax standpoint, such joint ventures must be carefully structured to assure that the U.S. venturer obtains the overall tax results expected.

The use of joint ventures can raise issues of tax deferral and FTC use. As was noted earlier, for example, dividends from each foreign corporation 50% owned by a U.S. person fall into separate FTC limitations. Thus, taxes paid by such joint venture companies cannot be mixed with other foreign business income taxes for FTC limitation purposes.

If a U.S. company contributes a patent or other intangible asset to a foreign joint venture, significant Federal income tax problems may arise. Such situations demand special, expert analysis.

Transfer Pricing

At the risk of oversimplifying, U.S. and most foreign tax laws require commonly controlled parties to deal with each other at arm's length (i.e., on essentially the same terms as unrelated parties would adopt under the same circumstances).(9) At times, the methods favored by the IRS and foreign revenue authorities for arriving at an arm's-length price may differ. The IRS is also stricter than most taxing authorities in auditing transfer pricing, imposing substantial documentation requirements and harsh penalties under Sec. 6662(e) for erroneous pricing.

According to Sec. 482 and Regs. Sec. 1.482-2, transfer pricing rules apply to all transactions with related parties, including the sale of goods, the provision of services, the sale or licensing of intangibles and the lending or borrowing of money.

Keep in mind that, for example, a German tax authority will not look kindly on a U.S. corporation's sales to its German distribution subsidiary at an unrealistically high price so as to minimize its taxable income in Germany, a notoriously high-tax country. (This could also result in increased customs duties.) Further, Regs. Sec. 1.482-2(a) and -4 bar a U.S. corporation from making interest-free loans to a foreign subsidiary or undercharging a subsidiary that manufactures in a low-tax country for patents or other intangibles needed to make the product.

State Tax Issues

State taxation of foreign earnings also should be examined. Not all states tax foreign dividend income (or deemed dividends); a few tax earnings of USVI FSCs, but not Barbadian FSCs. Given the multitude of state and local tax rules, a multistate tax expert should be consulted.

U.S. Citizens Working Abroad

New foreign operations are often staffed by U.S. expatriates, at least initially. Special Federal income tax rules apply to such personnel, who are taxable on their worldwide income, even while they are living abroad. Under Sec. 911 (a) and (b), qualifying individuals can exclude from Federal income tax up to $70,000 a year in foreign earned income. On the other hand, most payments made to expatriates (e.g., relocation bonuses, cost-of-living allowances, reimbursements for school expenses for children, etc.) are subject to Federal income tax; as a result, an expatriate's total compensation is often much higher than his base salary, quickly consuming the $70,000 exclusion. Most expatriates will also be subject to foreign income taxes, which can be the most costly element of an overseas assignment. Although foreign taxes on non-excluded income are eligible for the FTC, foreign tax reduction planning is crucial to cost containment. Tax regimes applicable to foreign nationals vary widely from country to country; an expert should be consulted.

Conclusion

The tax aspects of"going international" are worth scrutinizing. The Federal income tax rules are complicated, as are the foreign laws. The importance of careful advance planning cannot be overstated--to minimize a business's overall global tax liability, and avoid adverse financial statement and cash-flow consequences.

RELATED ARTICLE: EXECUTIVE SUMMARY

* Use of a foreign sales corporation can result in lower tax rates, a permanent benefit, not a mere tax deferral.

* Anti-abuse rules generally end tax deferral for a foreign subsidiary by treating part or all of certain types of income as if it had been distributed to U.S. shareholders, making it currently taxable to them.

* Proper use of the foreign tax credit requires sophisticated tax planning.

Editor's note: Mr. Benson is a member of the AICPA Tax Division International Taxation Committee.