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S corporations in the international setting.

S corporations offer significant tax savings by eliminating a second level of tax on corporate earnings. Although generally used for U.S. operations, there are numerous opportunities for their use in foreign operations. Key issues facing S corporations with foreign operations are (1) avoiding inadvertent termination of S status by owning 80% or more of a foreign subsidiary, and (2) obtaining a foreign tax credit (FTC) for foreign taxes by structuring foreign operations to allow a flowthrough of foreign taxes. With planning, S corporation benefits can effectively be made available to foreign investors.

Corporations frequently begin doing business abroad by exporting U.S. goods or services and do not require a foreign presence. As foreign operations expand, however, a corporation may wish to establish a foreign branch or subsidiary. The choice between a branch and a subsidiary will be influenced by foreign law, business considerations, and U.S. and foreign tax considerations.

Export activities not involving a foreign presence usually do not have foreign tax consequences. U.S. taxation of these activities will not differ significantly from U.S. taxation of domestic activities. If possible, S corporations should ensure that title to exported goods passes outside the United States so the export sales income may be considered foreign source. If a foreign presence is later established, the additional foreign-source export income, to the extent it is not heavily taxed by a foreign government, will often increase the U.S. FTC and offset U. S. tax on other foreign income.

Use of a foreign sales corporation (FSC) or an interest-charge domestic international sales corporation (IC-DISC) generally is not beneficial to S corporations. Use of an FSC will result in double taxation because the S shareholders are not eligible for the special FSC dividends received deduction under Sec. 245(c). An IC-DISC, which permits deferral of tax on a part of export income but imposes an interest charge on the deferral, generally is not beneficial because the interest is not deductible to the S shareholders.

An S corporation that requires a presence in a foreign country may conduct its business through a branch in that country, rather than through a separate legal entity, by registering to do business in the foreign country. Most foreign countries will recognize S corporations as separate legal entities for both business purposes (such as limited liability) and tax purposes, even though they are treated as flowthrough entities for U.S. tax purposes.

The earnings of a foreign branch generally will be taxed at the prevailing corporate rates in the foreign country, although some countries have special rules that apply to foreign corporations. Income attributable to a branch is ordinarily reduced by allocable branch expenses. The allocation of expenses may produce a more or less favorable result than taxation of a subsidiary incorporated in the foreign country. Foreign tax law may also be modified by an income tax treaty between the foreign country and the United States. In addition to a tax on current earnings, a foreign country may impose a tax when after-tax branch earnings are repatriated to the United States. This tax is comparable to a foreign withholding tax on dividends, which is imposed on repatriation of earnings from a subsidiary.

S shareholders will be subject to current U.S. tax on their pro rata share of branch profits and may deduct their pro rata share of branch losses subject to the normal restrictions on loss deductions. Shareholders may elect to receive an FTC for foreign taxes paid or accrued by the foreign branch rather than deduct them. The FTC generally is more advantageous since, within certain limitations, it offers a dollar-for-dollar reduction in U.S. taxes.

Note that C corporations with branch operations are subject to the dual consolidated loss rules of Sec. 1503(d), which may limit the use of foreign losses. It is unlikely these rules would apply to an S corporation with a foreign branch.

If an S corporation wishes to conduct foreign operations through a branch but does not want to expose itself to legal liability in a foreign country, its shareholders may form a separate S corporation to conduct foreign operations in branch form. This structure will not alter U.S. taxation; income, loss and foreign taxes will pass through to the shareholders of the new S corporation in the same way as they pass through to the shareholders of the original one. It may, however, affect foreign taxation of foreign branch earnings. Because the foreign operations will be separated from the domestic operations, indirect expenses, such as head office expenses, cannot be allocated against the foreign income to the new S corporation. However, the original S corporation may be able to charge the new one for administrative and other services it renders, subject to a foreign transfer pricing adjustment (if the charges are not at arm's length). It may be possible to fund the new S corporation with proportionately more debt than the original one, which would create a large interest expense and reduce foreign taxes.

It may be desirable, for business reasons, for an S corporation to establish a presence in a foreign country through a foreign subsidiary. (The S corporation must own less than 80% of the subsidiary's shares to avoid termination of S status (Sec. 1361(b)).) From a U.S. tax perspective, this generally is undesirable; ordinarily the S shareholders will not receive an FTC for foreign taxes paid by the subsidiary. Although U.S. tax on a foreign subsidiary's earnings may frequently be deferred until earnings are repatriated, the practical benefit of deferral is limited because foreign taxes often are higher than U.S. taxes. If a foreign presence is required, conducting foreign operations through a foreign entity treated as a partnership for U.S. tax purposes is generally preferable.

The second principal difference between foreign taxation of a branch and of a subsidiary is that dividends paid by a subsidiary generally will be subject to a foreign withholding tax. The rate is often reduced to 15% or 5% under U.S. income tax treaties, and an IFTC for the withholding tax is usually available. The withholding tax will not always result in a higher tax on subsidiary earnings; branch earnings may be taxed at a higher rate or may be subject to an additional tax when deemed repatriated.

Special rules apply under Secs. 367 and 1491 to transfers of appreciated property to a foreign corporation and may require recognition of gain for U.S. tax purposes, even though the transfer normally would qualify for nonrecognition treatment. Using an S corporation would avoid this problem.

Many foreign countries allow substantial flexibility in creating a limited liability company (LLC), and it is frequency possible to structure the entity so it is treated as a partnership for U.S. tax purposes and a corporation for foreign law purposes. This enables an S corporation and its shareholders to achieve a flowthrough of income, loss and foreign taxes (and FTC benefits). The foreign country will tax the entity as a separate corporation, rather than taxing the S corporation on income and loss allocated to a foreign branch. This allows greater flexibility than a branch structure in determining, for example, the extent to which the subsidiary is financed by debt.

A foreign entity will be treated as a corporation for U.S. tax purposes if it lacks two of the four corporate characteristics: continuity of life, centralized management, limited liability and free transferability of interests; see Regs. Sec. 301.7701-2. A foreign LLC for which U.S. partnership status is desired should be structured to clearly lack both continuity of life and free transferability of interests. An entity lacks continuity of life if a provision in its charter calls for its dissolution in the event of a shareholder's death or insolvency. To lack free transferability, a transfer by any shareholder of stock in the entity must be prohibited unless the consent of all other shareholders is obtained. Local law must also be consulted and should be consistent with changes to the charter. The IRS will refuse to recognize an entity's lack of free transferability if a single shareholder indirectly controls all of the entity's stock. Thus, the S corporation should consider an additional shareholder for the foreign entity.

Note that transfers of appreciated property to a foreign partnership (including a foreign corporation treated as a partnership for U.S. tax purposes) are subject to an excise tax under Sec. 1491 equal to 35 % of any nonrecognized gain. The transferor can avoid the excise tax by making an election that subjects the foreign partnership to certain restrictions, and the election may require recognition of some (or all) of the gain.

It is also possible to conduct foreign operations through a foreign partnership. In general, U.S. taxation will be similar to the taxation of a foreign branch, with a flowthrough of income and foreign taxes. Foreign taxation will vary depending on the foreign country in which the partnership operates.

A corporation with foreign branch assets that elects to be treated as an S corporation is treated, for purposes of the foreign loss recapture rules, as if it disposed of the branch assets (Sec. 1372(b)). Under these rules, gain is recognized to the extent of certain prior year losses. Termination of an S election also may trigger foreign loss recapture.

One way in which an S corporation can obtain capital from a foreign investor, and allow the foreign investor to participate in the profits generated by the S corporation's business, is for the foreign investor to become a partner in a partnership to which the S corporation's business operations are contributed.

A business purpose will be required for this transaction or the partnership may be viewed as a device for avoiding the S eligibility rules, in which case the foreign investor could be treated as an S shareholder, resulting in termination of S status.

Note that a disproportionate distribution to the foreign partner shortly after the partnership's creation may constitute a "disguised sale," causing a deemed taxable event for the S shareholders.

If the partnership is engaged in U.S. business, its foreign partners are also considered to be engaged in U.S. business under Sec. 875(l) and are subject to U.S. tax on partnership income effectively connected with that business. The partnership must withhold on the earnings of foreign partners. A foreign individual who holds, at death, an interest in a partnership doing business in the United States will be subject to U.S. estate tax. A foreign corporation that is a partner in a partnership doing business in the United States is subject to the branch tax (Sec. 884), an additional tax on interest and dividends deemed paid by a branch or partnership, unless limited by an income tax treaty.

S corporations usually are considered in a domestic tax planning context. In spite of the strict eligibility requirements, proper advance planning can make an S corporation a preferred entity for foreign operations as well.
COPYRIGHT 1993 American Institute of CPA's
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Article Details
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Author:Elliott, Richard
Publication:The Tax Adviser
Date:Apr 1, 1993
Previous Article:Tax consequences in partnership debt restructuring.
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