Remember the warning from old war movies about Incoming? Businesses
that are incoming or inbound to the U.S. present new and interesting
problems for practitioners. While this newsletter does not purport to
be all-inclusive on this issue, it focuses on some of the threshold
questions to ask if a foreign entity approaches you for advice about
entering the U.S. market.
First, the foreign business needs to decide if it can use an unrelated U.S. independent sales agent to promote the product or service. In some situations, items like beer or simple machinery can be purchased abroad and sold in this country by a U.S. agent. In such situations, the foreign producer has no active U.S. source income from the sale, because sales take place outside the U.S. and the company has no activities here.
Foreign business contemplating entry into the U.S. market is often faced with two broad choices. One is to sell directly in the U.S.; the second is to form a U.S. subsidiary and let that subsidiary conduct all operations in the U.S. The consequences of this choice are profound, and to understand them requires understanding the concept of EFFECTIVELY CONNECTED (U.S.) INCOME (ECI), which can best be thought of as income connected to a trade or business conducted in the U.S.
Foreign company engaged in business in the U.S. is taxed much like a U.S. corporation on its ECI. Other forms of inactive income, say from investments, are subject to withholding by the payor at the IRC mandated 30% rate or lower treaty rate if there is an income tax treaty between the recipient's country and the U.S. Having the parent corporation become subject to filing a U.S. corporate income tax return is not attractive to many foreign manufacturers.
Foreign corporation that engages in a U.S. trade or business may also become subject to another complex set of rules known as the branch profits tax which is intended to tax the corporation on an amount that is roughly comparable to a deemed dividend that would be paid to the corporation, as if it had conducted the activity through a subsidiary. Also, if the foreign corporation directly enters the U.S. market, a host of state and local tax issues can arise.
The second option -- forming a U.S. domestic corporation -- is often the choice of many foreign manufacturers since the parent usually does not have ECI and does not have to file a U.S. domestic corporate income tax return. While forming a U.S. domestic subsidiary usually relieves the foreign manufacturer of some headaches, there are other problems. How should the foreign parent price the product to the U.S. subsidiary? Setting the price high or low will determine profitability, and this ability to affect profitability in the U.S. or the foreign country is called transfer pricing.
In the past two decades, the U.S. has been more aggressive in pursuing manufacturers it believes are unreasonably setting prices. Since IRS challenges to transfer pricing often involve protracted litigation, the IRS has adopted a system calledAdvance Pricing Arrangements APAs) that may eliminate some of these delays. Generally, APAs involve larger U.S. manufacturers but the APA route is open to foreign manufacturers entering the U.S. market. Deciding if a domestic or foreign manufacturer should apply for an APA is inherently difficult and is made more so by the requirement that if the foreign company has a comparable process in their country, authorities in that country need to be notified.
The choice between entering the U.S. directly or using the subsidiary approach must also be evaluated in light of applicable tax treaties. Since tax treaties, generally, take precedence over the Internal Revenue Code, treaties can greatly alter the rules set up in the Code.
What if the foreign parent exercises substantial control over its U.S. subsidiary? In that case, the U.S. subsidiary may be considered dependent on the foreign parent for U.S. tax purposes. In that situation, the courts may find that, because of the degree of control, the foreign parent has ECI in the U.S., and the desired goal of having the foreign parent not be subject to U.S. tax reporting will be lost.
Assuming a foreign entity decides to have a U.S. subsidiary, in what state should they incorporate? Often Delaware is the first choice, because corporate and business laws in that state are well developed.
What about the proposed name of the U.S. subsidiary? Is it available both in Delaware and other states where business offices may be functioning? Zoning, office space, and compliance with city, county, and state laws have to be addressed. Immigration is another factor to consider. The workers and their dependents need appropriate visas to stay in the U.S. Importantly, at the grassroots level, there is the blending of foreign bosses with U.S. workers.
Much of what is written on this subject comes from the large law and accounting firms and is oriented toward "what we did for General Motors or Microsoft." Most of the literature in this area addresses the problems of major U.S. companies dealing with outbound issues. As the U.S. market becomes more international, smaller U.S. professional firms will be asked about theinbound issues. Keep us in mind for help on this, as well as domestic issues.
By Tax and Business Professionals, Inc.
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