This article originally appeared in the August 2013 issue of Smart Business Philadelphia magazine.
It used to be that only very large companies were doing business overseas. As more small and midsize companies enter the international marketplace, they must learn how to navigate tax laws related to conducting business in foreign countries.
"These tax laws are often broad and complex, and companies need to know how to minimize their combined taxes," says Richard J. Nelson, CPA, director of Tax Strategies at Kreischer Miller.
Smart Business spoke with Nelson about what companies need to consider and how to manage the tax implications of doing business overseas.
What do companies need to consider in terms of taxes related to international business?
The first, and most important, decision is what to do regarding profits and cash from overseas operations. Are you planning to bring profits back to the United States right away or will you seek a deferral strategy that will leave cash and profits overseas for the time being? The answer to that question determines how overseas operations are structured.
A deferral structure is preferable when you want to keep profits offshore for a significant time and the foreign tax rate is lower than the U.S. tax rate. In order to defer U.S. tax, the foreign entity must be treated as a corporation for U.S. tax purposes. The goal is to move as much income as possible to this entity, and to defer U.S. tax until earnings are brought back here.
What problems do companies encounter with the deferral strategy?
Some pitfalls include matching of foreign tax credits, Subpart F rules and transfer pricing rules.
Proper planning is needed to ensure foreign taxes paid are credited to offset U.S. taxes. Subpart F rules, if applicable, make foreign profits taxable in the U.S., even if the earnings are not repatriated. Poor planning in these two areas could result in paying a higher overall effective tax rate on the same income.
Transfer pricing rules are designed to ensure that the transfer of goods from the U.S. company to the foreign company are priced fairly so the U.S. collects its fair share of taxes on the profit. If the Internal Revenue Service challenges your pricing, you could face significant penalties.
Does a non-deferral strategy pose pitfalls as well?
In a non-deferral strategy, the tax implications are not nearly as complicated. Generally, the foreign company is established as a ‘pass through’ entity, or you can check a box to have it treated as a disregarded entity or pass through entity. With this structure, the U.S. taxes the income of the foreign corporation and foreign tax credits are available to offset any U.S. tax on current profits. There are no additional U.S. taxes when the money is repatriated.
Under this scenario, you don’t need to be concerned about transfer pricing rules, at least from a U.S. perspective, or Subpart F rules. This structure provides the most flexibility and is well suited to U.S. companies that are S corporations with overseas operations.
Are there tax incentives for a U.S. company doing business overseas?
If you are selling products overseas that are manufactured in the U.S., you may be able to take advantage of an Interest-Charge Domestic International Sales Corporation (IC-DISC). You set up a separate corporation that makes an IC-DISC election and is, by law, exempt from federal income tax. A commission agreement is entered into between the related exporter and the IC-DISC. The related exporter pays the commission to the IC-DISC, which gets a 35 percent tax deduction. The IC-DISC then pays the commission to its shareholders, who are individuals, as a qualified dividend, which is taxed at 20 percent. The overall savings is 15 percent.
Can companies manage the various tax scenarios internally?
Because of the many complexities involved in doing business internationally, there is a lot of expertise required in planning a strategy to minimize the company’s overall effective tax rate. Seeking competent advice is crucial to avoid the many pitfalls that you may encounter when venturing overseas. ●