by
Mike Smith, Kyle Dawley, and Jill Boland
| Apr 23, 2021
For many inbound companies, U.S. tax law can present a significant
challenge. The decisions made today about global tax structure,
financing of U.S. operations, and intercompany transactions
can have far-reaching — and sometimes unintended — tax
implications. Consider these strategies to help avoid typical
pitfalls.
Tax structure (and restructure) opportunities
To start, the tax structure of a U.S. company impacts:
- Federal and state tax reporting requirements
- Ability to claim certain deductions and foreign tax credits
- Eligibility for relief under applicable income tax treaties
- U.S. customers’ withholding and reporting obligations
Therefore, business owners need
to understand the ramifications
under federal and applicable state
income tax law of classifying a U.S.
company as either a pass-through
entity or a corporation.
For example, a foreign company
may form a U.S. entity that is
classified either as a pass-through
entity or corporate entity under
U.S. tax law. A domestic pass-through entity with only one owner
is considered disregarded as a separate entity for purposes of
U.S. tax law and is treated as a branch of the foreign investor.
When a foreign corporation has a U.S. branch, that corporation
is subject to federal (and frequently state) income tax on the
taxable income generated by the disregarded entity and must
file a U.S. corporate income tax return.
It is not uncommon for a domestic pass-through entity to have
more than one owner creating a partnership. If a U.S. LLC is used,
the LLC is treated as a partnership for all purposes of U.S. tax
law and this structure may create an added complexity of the
LLC being a hybrid entity if the foreign jurisdiction classifies the
U.S. LLC as a corporation under its law. While the partnership is
not itself subject to U.S. federal income tax at the entity level,
it is required to annually file a U.S. partnership return on which
it reports the taxable income generated during the tax year. A
foreign corporate partner of a U.S. partnership is required to
file its own U.S. federal income tax return and must include its
distributive share of partnership income on that return.
Foreign corporations that are considering an investment in a U.S.
partnership may be well-advised to consider investing through
a U.S. blocker company, rather than investing directly in a U.S.
partnership or LLC. In such a structure, the U.S. blocker company,
rather than the foreign investor, would be subject to the U.S.
income tax return filing requirements as the direct partner in the
partnership. Additionally, with a U.S. blocker company acting as
the direct investor, a foreign corporation would not be subject to
the new U.S. withholding and reporting requirements that arise
when a foreign partner transfers an interest in a U.S. partnership
(see discussion of Section 864(c)(8) below).
Note that a foreign corporation may also choose to form a
U.S. corporation as a subsidiary. The foreign corporation can
incorporate an entity under state law. In such a case, the U.S.
entity would be subject to tax on its taxable income and would
need to file a federal corporate
income tax return.
One potential tax benefit available
only to domestic corporations is the
foreign-derived intangible income
(FDII) deduction for corporations that
sell goods and services to non-U.S.
customers. Evaluate the supply
chain of the domestic corporation’s
revenue stream to help determine
whether to form a U.S. corporate subsidiary.
Financing U.S. operations
The capital structure a U.S. company adopts can significantly
impact the taxation of its operating profits and the repatriation
of such profits to its foreign parent. Federal income tax law
generally favors debt over equity funding because:
- Interest expense is tax deductible, whereas dividends are
non-deductible
- Interest payments typically attract lower withholding tax
rates than dividends under most U.S. tax treaties
- Repayments of principal under a debt instrument can be
made tax-free
Nevertheless, the compliance requirements for debt financing
can be more onerous than equity funding, due to stringent
documentation standards and a litany of interest expense
deferral and disallowance rules, such as Section 163(j).
The interest expense limitation under Section 163(j) can be a
significant consideration for funding inbound U.S. investment.
Generally, a U.S. taxpayer is not allowed to take deductions for a
business interest expense to the extent the expense exceeds 30
percent of the taxpayer’s adjusted taxable income, which closely
approximates earnings before interest, taxes, depreciation, and
amortization (EBITDA). Any disallowed excess interest expense
is carried forward to the next taxable year.
Potential pitfalls
Pitfalls can’t always be avoided, but with proper planning you
should not be blindsided by unexpected U.S. tax liabilities.
Section 267A
The Tax Cuts and Jobs Act (TCJA) added the anti-hybrid rules
under Section 267A creating a level of complexity. Section 267A
restricts the deductibility of expenses paid by a U.S. taxpayer to
a related party when the related party is a hybrid entity. A foreign
entity is considered a hybrid entity when its tax classification (for
U.S. tax purposes) differs from its tax classification for purposes
of the tax law of the country in which it is formed. Therefore,
you must understand the local and U.S. tax classifications not
only of the U.S. company, but of all related parties with which
that U.S. company transacts business.
BEAT
The base erosion and anti-abuse tax (BEAT), which was also
added to the federal income tax code under the TCJA, functions
as an alternative minimum tax on U.S. corporations that meet
certain U.S. gross receipts thresholds for related companies.
The BEAT provision requires applicable taxpayers to add back
deductions that qualify as base erosion payments, which results
in additional federal income tax liability.
Section 864(c)(8)
Foreign corporations with an interest in a U.S. partnership
should also be aware of Section 864(c)(8), which could impose
withholding tax on the transfer of the partnership interest.
While there are several exceptions under this provision, you
must disclose the transaction, as well as any such exceptions
claimed by the foreign corporation, no later than 20 days after
the transaction is effected. As noted above, foreign investors in
a U.S. partnership may choose to structure their U.S. partnership
investments through a U.S. blocker corporation.
Inadequate transfer pricing
In the area of transfer pricing, federal income tax law grants the
IRS authority to reallocate income and deductions between
controlled taxpayers (e.g., a foreign corporation and its U.S.
subsidiary) if transactions between such parties are not priced
at arm’s length. These adjustments can bring increased U.S.
federal income tax liabilities, plus interest and penalties, without
corresponding tax reductions in the foreign jurisdiction.
To protect against such exposure, U.S. taxpayers should
conduct transfer pricing studies that benchmark pricing on
intercompany transactions against pricing on comparable
third-party transactions. Your transfer pricing policy should
be updated frequently, applied consistently, and comply with
documentation standards mandated by federal tax law.
COVID-19 impact
The Coronavirus Aid, Relief, and Economic Security (CARES)
Act provided significant relief to U.S. taxpayers, which included
a temporary increase of the limitation on deductible business
interest expense under Section 163(j) to 50 percent rather than
30 percent. Additionally, the CARES Act allows a five-year
carryback of net operating losses that were generated in a
taxable year beginning after December 31, 2017, and before
January 1, 2020.
Federal and state tax law changes are inevitable, as evidenced
by TCJA and COVID-19. Change is again likely with 2021 seeing
a change in federal administration. U.S. taxpayers will need
to monitor and model the variable of tax rate changes and
other temporary provisions that may occur with a new political
landscape.
Mike Smith and Kyle Dawley are principals with CLA in
Charlotte and Minneapolis offices, respectively. Jill Boland
is a director with CLA in Oak Brook.
This article appears in the spring 2021 issue of the Washington CPA magazine. Read more here.
Learn more about the latest developments
affecting the international tax landscape at the
2021 International Tax Conference on May 27.
Find details about sessions and speakers,
including Kyle Dawley, at wscpa.org/intc.