Tips on Tax Laws in the US
By Aaron N. Wise, Attorney at Law © 2009
• Claiming Tax Treaty Benefits. Foreign companies and individuals that claim the benefits of particular provisions of a tax treaty to override provisions in domestic U.S. federal income tax law, must disclose the treaty-based provision in a federal income tax return. This applies whether or not the foreign party was otherwise required to file a U.S. federal income tax return. Non-compliance can involve potentially very large penalties.
• No Applicable Income Tax Treaty. There will be situations where no applicable income tax treaty exists between the foreign party’s home country and the USA. In that situation (1) the foreign party should avoid acts and activities that will cause it to be doing business in the USA for US federal income tax purposes; and doing business in any particular U.S. state for purposes of its income tax; and (2) creative, advance tax planning will often be required.
• Branch, LLC or Corporation. When the foreign company decides to have its own U.S. operation, it must also decide whether it should function as a U.S. branch of the foreign company or as a separate U.S. legal entity (like a corporation or LLC) organized in one of the states in the U.S.A. If you expect the early years of the U.S. operation to show losses, you might give consideration to operating a branch. This may be advantageous from a foreign income tax standpoint. However, the U.S. imposes a branch profits tax on the deemed repatriated earnings of the branch. This, in effect, equalizes the tax treatment of a U.S. branch and a U.S. subsidiary corporation or LLC. Based on this author’s experience, if you intend to market your products or services in the United States, the formation of an American corporation is in many if not most cases the route to select. Operating through a “branch” is too risky from several standpoints, including liability. And, the LLC (limited liability company) has several important drawbacks, particularly for a foreign-owned one.
• Taxation of “Corporations”: U.S. Federal Income Tax. A corporation formed under the laws of a U.S. state is subject to U.S. federal income tax on its worldwide income. The tax is levied on its net taxable income, which is essentially its gross income minus allowable deductions. A corporation's taxable income and federal income tax are computed essentially as follows:
book gross income
+/- adjustments and deductions
= taxable income
x applicable corporate tax rate
= amount of tax
- applicable credits
= final tax liability.
The annual accounting period selected by a U.S. corporation is its taxable year generally, and is normally the same as its financial year.
• Alternative Minimum Tax. To the extent that its application results in a higher tax than the regular corporate tax, an alternative minimum tax ("AMT") is imposed in lieu of the regular corporate tax. Certain so-called “tax preference” items are added back to the corporation's taxable income to arrive at the corporation's alternative minimum taxable income. The AMT is intended to assure that all U.S. corporations with substantial economic income pay federal income tax notwithstanding exclusions, deductions and credits otherwise available by law. The AMT makes for additional complexity and more record keeping. Corporations with relatively low gross receipts may be exempt from AMT for its initial year or possibly initial years of operation.
• Consolidated Tax Returns. A group of U.S. companies consisting of a U.S. parent company and its at least 80% owned U.S. corporations may be taxed on their consolidated income, by filing a consolidated federal income tax return. In such cases, dividends paid by the U.S. affiliated companies to their U.S. parent company are exempt from U.S. federal income tax.
• Transfer Pricing. The American tax authorities are concerned that profits between the foreign parent company and its U.S. subsidiary or affiliate may be shifted from the U.S. to the foreign country. This would be the case whenever the parent company invoices the subsidiary at a higher price than would be charged a third party. Under Internal Revenue Code (" IRC") Section 482, the government has the right to change the prices charged by the foreign parent company to the U.S. affiliate, if it believes that they do not reflect the proper amount. That is the amount which would be charged in an "arms length" transaction between unrelated parties. As an exporter this normally means that you must be able to prove to the tax authorities that the price you charge to your branch, subsidiary or affiliate in the United States is the same as you charge an unrelated third party. Other charges such as interest on loans, license fees, royalties and management and other service fees between related parties are also included in IRC Section 482 must be carefully conceived to avoid tax problems. Provisions more or less paralleling IRC Section 482 are found in many US income tax treaties.
A foreign company can also encounter U.S. customs problems when it invoices a related party at too low a price.
• Interest, Royalties and Service Fees between Related Companies. Royalty and interest payments from a U.S. resident payor to a foreign payee will, as a rule, be subject to a flat 30% U.S. withholding tax. Tax treaties to which the U.S. is a party either reduce the rate or eliminate the withholding tax. Normally a U.S. corporation can deduct these from its income as business expenses. Under U.S. federal income tax rules, a corporation's ability to deduct interest paid to a related party can, under certain circumstances, be substantially curtailed if the related corporation is not subject to U.S. income tax on the interest income. As remarked above, similar potential problems exist for royalty and service fee payments between related parties.
• Debt/Equity Ratio. Care must be taken to assure that a proper and acceptable relationship between debt and equity for foreign-owned U.S. corporations is maintained. If the tax authorities can establish that the debt is too high in relation to the stockholders' equity, they can treat the interest payments as dividends and can as well consider the principal repayments as dividends. The result of this determination has the effect of increasing the taxable income of the U.S. corporation by the disallowance of the interest expense and application of income and/or withholding tax on both the interest and principal repayments.
• Real Estate (Immovable Property). Many years ago, it was possible for a foreign individual or company to escape all U.S. taxes when real property was sold in the United States at a profit. One reason for this was that some tax treaties exempted such transactions. Several years back, that was changed. If a foreign company or individual sells real property located in the United States, a U.S. withholding of 10% of the sales price applies. The seller has to effect the withholding and pay the money to the IRS. The purpose is to assure that the income tax due on the gain from the sale will be collected.
• Accumulated Earnings Tax (“AET”). This is a penalty tax applicable if the authorities believe that the U.S. corporation is not sufficiently distributing its earnings to its shareholders (thus avoiding their being taxed on dividends), but rather keeping the funds in the business beyond its reasonable needs. At this writing, the AET is 15% of the corporation’s accumulated taxable income.
• Dividends. Shareholders are normally subject to U.S. income tax on dividends. Non-U.S. shareholders are subject to U.S. withholding tax on dividends received from a U.S. company (normal rate 30%) which may be reduced by the applicable income tax treaty (if any).
• Net Operating Loss Carryback/Carryforward. If the U.S. branch or corporation has an operating loss in any year, this loss can be offset against prior income as well as any future income. Generally, it can be carried back first to the two years preceding the loss year, then forward to the twenty years following the loss year. The taxpayer can, by filing an election, waive the entire carryback period whereupon the NOL can only be carried forward.
• Financial Statements. There are differences between a financial statement prepared on the basis of generally accepted accounting principles and tax returns prepared in accordance with the U.S. Internal Revenue Code. Some items that may cause these differences are depreciation, foreign exchange gain or loss, and intangible drilling costs. Reserves for future expenses and other contingencies are not allowed for income tax purposes, nor are valuation reserves. A reserve fund for bad debts, however, is permitted, both in the financial statements and the income tax returns.
vThe affairs of a company are considered private and, therefore, there is normally no requirement to publish its financial statements, unless the shares of the company are publicly held and are thereby subject to the rules and regulations of the U.S. Securities and Exchange Commission.
• State Corporate Income Tax; New York City Corporate Tax. Nearly all U.S. states have an income tax on corporations, normally applicable to income attributable to that particular state. The rates range per state from around 1% to around 10%. For corporations conducting business in New York City, there is a corporate tax calculated by one of several methods, the top rate being at this writing 8.85%. The paid taxes can be deducted on the corporation’s U.S. federal income tax return.
• Payroll Taxes; Voluntary Expenses. Most companies pay certain payroll-type taxes, which, as a rough rule of thumb, will total around 10% of their employees’ salaries and wages. In addition, they may incur voluntary expenses for medical care, disability insurance, life insurance and retirement plans of their employees. In total these costs will probably range roughly from around 15% to 25% of salary and wage payments.
• State Sales and Use Taxes. Many states and municipalities collect “sales taxes” on retail sales and “use taxes”, with different rates in effect from one location to the next. Each tax authority establishes which goods and services are subject to sales tax and use tax, and establishes the procedures to be used for registration, collection and payment of the taxes due. If the company is not doing business in a particular U.S. state, it is usually not obligated to collect sales tax on sales within that state. On the other hand, if the state laws consider your activity as doing business in the state and your company sells and delivers a product to the final user within the state, you must collect the sales tax from your buyer, file the required tax returns and pay the tax to the state or municipal tax authority. This can be quite cumbersome if the company is doing business in many states.
Generally, non-exempted tangible person property purchased outside of the buyer’s home U.S. state (e.g., the one in which it is doing business) and brought back into it, on which the out-of-state seller has not collected sales tax at least equal to the home state’s use tax, is subject to the home state use tax. Typically, out-of-state purchases of tangible personal property intended for resale by the buyer are exempt from home state use tax, whereas if it is for use or consumption by the buyer, it will apply (but subject to the preceding sentence and absent some other exemption)