When your company expands overseas, complex tax issues may arise. These include the need to
select the appropriate tax entity for both domestic and foreign purposes, charging the right prices for
intercompany transactions, and properly computing the foreign tax credit.
CB&H SPECIALIZES IN COMPLEX ISSUES TO ASSIST YOU
DOMESTICALLY AND ABROAD
The tax planning environment for a closely held company is significantly different from that for widely held
companies. With closely held companies, it is always desirable and often possible to completely eliminate
U.S. corporate-level taxation. Further, some planning techniques that reduce corporate tax may increase
the total tax burden of the closely held company. For valid business reasons, different stakeholders in the
entity may seek different forms of compensation. Finally, estate planning is generally not a consideration
for the management of widely held entities.
The key items for consideration include:
• Allowing losses to be passed through to individual owners in a way in which they will be
deductible.
• Eliminating corporate-level taxation, or alternatively, providing a mechanism by which the owners
can offset the company tax against their own tax liabilities.
• Adopting structures that permit flexibility in compensation and the ability to share profits for certain
stakeholders.
• Deferring current taxation of individual owners to the extent possible.
• Adopting structures that enhance the ability of owners to finance their retirement.
• Planning for continuity of the enterprise on death of one or more principals.
• Adopting structures that permit the transfer of ownership at death with reduced estate tax
consequences.
PRELUDE TO INTERNATIONAL TAX PLANNING
Expansion into foreign markets can take a variety of forms:
• Direct exporting. The simplest method to carry out foreign trade is direct exporting. With direct
exporting, the U.S. company sells and ships products directly to foreign customers, who send
payment directly to the U.S. company. No local activities are carried out, and no local people
(except for the customers) are involved. In today’s marketplace, the internet may be the way
to carry out direct exporting. A disadvantage of this method is the company’s distance from the
market, which affects reaction time.
• Franchisee/licensee. Another option is to have a foreign franchisee/licensee sell the U.S. company’s
product and remit a royalty back to the U.S. company. Under this scenario, the U.S. company
must analyze the local treatment of the arrangement to distinguish between payments for use
of know-how (royalty), payments for show-how (services), and payments for goods (property
transfers).
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• Acquisition of assets or shares. The advantage of acquiring a foreign company is that the U.S.
owner can acquire a full range of capabilities immediately. Because the entity has already been
established, the history of performance can be evaluated and reasonably projected. The cost
of the acquisition process is expensive because the U.S. owner’s employees incur travel and
per diem costs and outside accountants/lawyers are needed to gain comfort with in-country
requirements. If problems do occur, the U.S. owner bears all costs. Also, accounting issues are
handled differently in different countries and may require different presentation (and financial
impact) on U.S. financials.
• Joint venture. With a joint venture (partnership or corporation), a foreign partner’s skills can be
acquired to complement the U.S. partner’s technologies. Another advantage is that all U.S. partners
can bid for in-country work. The downside to this structure is the possible lack of control and that it
may be difficult to expand beyond one foreign country because of nationalistic tendencies. When
negotiating a joint venture via a partnership or corporation, valuing what both partners bring to the
table is difficult. The tendency is to assume a 50/ 50 relationship, but in reality it is hard to keep
both partners contributing equally. Also, it is difficult to get majority ownership in a foreign country
with a large partner. Because international business is affected by cultural differences, each party
should be sure to understand the company’s goals, important issues, and corporate sensitivities.
Documents are very formal (by-laws, shareholders’ agreement, business plans) and negotiations
lengthy. Business plans almost always understate the required investment, so be conservative
up-front.
• New subsidiary. The advantage of starting a new subsidiary is that there are low start-up costs,
and the U.S. owner has total control over planning and direction. In-country expertise, however,
will be needed, as well as the need to develop infrastructure. Another consideration is that as a
newcomer, the U.S. owner will be virtually unknown to the majority of the customer base.
• New branch. The advantages here are the same as starting a new subsidiary. Operating losses
can be consolidated in the U.S., and other tax considerations may also benefit the branch. As
with a subsidiary, however, a branch will need in-country expertise and marketing assistance to
develop a strong customer base. Another disadvantage is that sometimes a branch is not viewed
as an in-country company despite its physical presence. With both a subsidiary or a branch, staff
(management, technical, administrative) is needed who understand how to conduct business in
the foreign country as well as with the U.S. home office. Capable in-country managers are critical
as it is difficult to direct operations from the U.S.
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CB&H ISOLATES THE ISSUES FOR YOU
Faced with the tax issues of an employer that will be doing business in two jurisdictions, the most important
task for the U.S. accountant is to ask the right questions. More important than a basic understanding of
domestic tax law is an awareness of the sensitive issues the U.S. company may encounter in the foreign
jurisdiction.
KEY QUESTIONS
CB&H’S simple approach to your understanding the foreign tax landscape is to make a list of every
tax question imaginable that your U.S. company may encounter in going global. Here are sample
questions:
1. With respect to the proposed activities in the host jurisdiction, will such activities meet the definition
of commercial residency for tax purposes?
2. What are the local rates of taxation?
3. Are there preferential capital gains tax rates?
4. Are there penalties for accumulating earnings within the host country?
5. Are there taxes based on capital?
6. Are there local taxes, in addition to those at the national level?
7. What are the payment dates and filing dates for local and national tax returns?
8. What are the components of the tax calculation?
9. What depreciation methods are allowable?
10. Are there accelerated depreciation methods or expensing provisions that could be of benefit?
11. Are there business expenses that do not qualify for a tax deduction?
12. What are the allowable inventory methods?
13. How is interest expense treated for local tax purposes, i.e., cash method, accrual method? Are
there thin capitalization restrictions?
14. What are the carryback and carryforward periods with respect to net operating losses?
15. If a multi-tiered structure is established within the host country, how are dividends from domestic
sources treated for local tax purposes?
16. Are tax consolidations permissible within the host country?
17. What are the local tax consequences of capital repatriations, stock redemptions, liquidations, and
reorganizations?
18. What other non-income type taxes apply, i.e., VAT, property, payroll, stamp, realty, registration,
etc.?
19. Are there local tax incentives?
20. Are advance rulings required or possible within the jurisdiction for tax purposes?
21. What is the tax audit process with respect to a host country investment made from a foreign
jurisdiction?
In compiling and drilling through the list of questions, perhaps with legal counsel present, CB&H can
determine the relevant issues that require further investigation. The unimportant issues will be eliminated,
and at the end of this exercise, CB&H will have a complete list of issues to address with tax accountants
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on the other side of the world. In this way, CB&H will find the answers to the pertinent questions and thus
minimize your U.S. company’s tax burden in the foreign jurisdiction as well as assist you in achieving the
lowest legally possible worldwide tax rate.
U.S. OUTBOUND TAX ISSUES
Once the business considerations and foreign tax issues have been identified, the U.S. Internal Revenue
Code Statutory Outbound Provision must be factored into the international planning process. Only
after international business, foreign tax, and these U.S. statutory rules are evaluated together will the
international tax planning process be complete.
• The global economy lures businesses of all sizes and types. Special opportunities exist, and special
planning is required, when a closely held U.S. company – whether partnership, S corporation,
LLC, or C corporation – expands abroad. In particular, the use of hybrid or reverse hybrid entities
can allow for the minimization of tax liabilities in both the U.S. and the foreign country.
• Midsize closely held companies are becoming increasingly multinational, and the potential tax
effects can be considerable. Hybrid foreign and domestic entities provide opportunities for closely
held U.S. multinational companies to reduce overall taxation. Shareholders of a domestic S
corporation generally can eliminate the effect of all corporate-level taxation, both U.S. and foreign.
Hybrids can be used to disproportionately reward investors in and employees of subsidiaries
without running afoul of the “single class of stock” rules for S corporations. Hybrids also can be
effectively used to manage joint ventures while retaining tax benefits normally associated with
majority ownership.
STRUCTURAL ISSUES
Choice of commercial entity in both the U.S. and foreign jurisdiction is the most important tax planning
decision you will make. It significantly influences the income taxes that are ultimately paid. Domestically,
commercial activities are generally conducted in any of these formats:
• S corporation
• C corporation
• Limited Liability Company (LLC)
• Partnership
Domestic tax consequences can significantly differ among these structural choices. The chosen domestic
entity will, in turn, significantly influence the choices available in the international context. In foreign
jurisdictions, commercial operations are generally conducted in the following forms:
• Branch
• Partnership or joint venture
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• Corporation
COMPATIBILITY
The international entity selection must be compatible with the domestic parent in order to minimize the
overall tax burden. Compatibility is largely influenced by these issues:
• Will foreign operating losses be available as a benefit for U.S. income tax purposes?
• Should the profits from foreign operations be taxed in the U.S. on a current or deferred basis?
• What taxes paid to foreign jurisdictions are available as a foreign tax credit in the U.S. in order to
minimize the double-taxation burden?
CORPORATIONS, LLCs, AND PARTNERSHIPS
Ownership of an enterprise through a pass-through entity has the advantage for U.S. individuals of
eliminating entity-level taxation. An S corporation, noncorporate LLC, or partnership is not taxed at the
entity level. Rather, the shareholders, partners, or members include in their individual tax determination
their pro rata share of items of income, deduction, or credit of the S corporation, partnership, or LLC in the
current year. For purposes of determining foreign tax credits and the source of income, an S corporation
is treated as a partnership and its shareholders are treated as partners.
By contrast, shareholders of a C corporation pay tax only on dividends as received, and the C corporation
is subject to corporate income tax. Where an S corporation, partnership, or LLC holds its business activities
through a non-flow-through entity, the benefit of single-level taxation is lost. An S corporation, however,
may own a U.S. corporate subsidiary that may elect flow-through treatment as a qualified Subchapter S
subsidiary (QSSS). The QSSS election is available only for a domestic corporation 100%-owned by an
S corporation. Such a QSSS, however, may operate overseas, and often the use of a special-purpose
QSSS should be considered as an option. Some countries prohibit 100% ownership of a corporation by
a single person, which may effectively prohibit a QSSS. Use of a special-purpose sister corporation may
be considered in such circumstances, as well as where differing profit participation rights are to be given
those members working overseas. As discussed below, additional options are available for S corporations
that may accomplish the same goals with local entities. Because an S corporation may not have any non-
U.S. owners, the use of a hybrid in countries requiring some local ownership may be necessary.
Shareholders of an S corporation must receive allocations of income, deduction, etc., and distributions
strictly on a per-share basis, with no special allocations, under the single class of stock rules. This
limits how an S corporation may provide special rewards to certain classes of members. Partners of
partnerships and members of LLCs may benefit from non-pro rata special allocations.
All domestic entities can be classified either as transparent or veiled. The former category includes S
corporations, LLCs, and partnerships; the latter includes C corporations. The former are characterized
by having its owners face only one level of tax, whereas the latter category imposes both a corporate
and shareholder-level tax. These characteristics influence the availability of claiming credits for foreign
income taxes incurred in foreign jurisdictions, resulting from choosing the appropriate foreign entity. For
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you to maintain the integrity of a single-level tax, domestic transparent entities must operate abroad in
either branch or unincorporated partnership structures. This enables the domestic entity owners to claim
a foreign tax credit for the income taxes imposed in the foreign jurisdiction on the local entity. On the
other hand, veiled domestic entities can eliminate double taxation via the foreign tax credit for foreign
income taxes imposed on any type of foreign structure. When a domestic transparent entity chooses to
operate as either an incorporated joint venture or corporate subsidiary format, double taxation arises.
Although the benefits of both foreign loss pass-through and foreign tax credit access make branches
and unincorporated partnerships appear attractive for U.S. tax purposes, it is sometimes commercially
inefficient to operate a business in a foreign jurisdiction with such structures. This problem can be easily
overcome since 1997 through what is known as the “check-the-box” regulations.
Check-the-box regulations. Under these regulations, foreign corporations can be treated as:
• A branch, if wholly owned
• A partnership when more than a single owner is involved
Your treating a foreign corporation as a flow-through entity for U.S. tax purposes is done via an election
(Form 8832) and is made strictly for U.S. tax purposes. In the foreign jurisdiction, the foreign entity
retains its corporate identity. Similarly, foreign branches and unincorporated partnerships can be treated
as corporations for U.S. tax purposes via the same election process. This election giving the same entity
corporate characteristics in one jurisdiction and noncorporate characteristics in the other creates what is
known as a hybrid entity.
The U.S. income tax regulations contain a list of corporate entities by country for which no check-the-box
election can be made – rendering the foreign entity a corporation for U.S. tax purposes in all instances.
These regulations also indicate that if an entity has unlimited liability and no check-the-box election
is made, the foreign entity defaults to either a branch or an unincorporated partnership. On the other
hand, if the foreign entity has limited liability and no election is made, the foreign entity defaults to that of
corporate status.
Thus, hybrid entities can offer you the best of both worlds, i.e., flow-through treatment for U.S. purposes,
yet local corporate characteristics for foreign commercial and tax purposes.
FOREIGN TAX CREDIT ISSUES
International trade would be severely hampered if it were not for the foreign tax credit. Without the credit,
U.S. companies operating abroad would have to pay tax to both the U.S. and foreign government on the
same revenue from foreign sales.
There are two types of foreign tax credits, i.e., the direct and indirect.
DIRECT CREDIT- The direct foreign tax credit is simpler to compute. If your company pays a foreign
withholding tax of $15,000 and your U.S. income tax liability before the foreign tax credit is $60,000, you
pay tax of only $45,000 to the U.S. government. The direct foreign tax reduces your U.S. tax liability dollar
for dollar. The direct foreign tax credit gets its name from the fact that the foreign tax is imposed directly
on the U.S. taxpayer.
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The direct foreign tax credit is generally encountered as a withholding tax on remittances from foreign
jurisdictions as well as when a U.S. corporation conducts business abroad through an unincorporated
branch or partnership.
INDIRECT CREDIT - Suppose your U.S. corporation operates abroad through a foreign subsidiary.
Normally, income earned by the subsidiary is not taxable in the U.S. because it is earned by a foreign
corporation. In these situations, your .U.S. parent cannot credit the foreign income taxes paid by your
foreign subsidiary. When, however, your foreign subsidiary makes a dividend distribution to your U.S.
parent corporation, the dividend is generally taxable in the U.S. Your U.S. parent corporation is then
entitled to an indirect tax credit for the foreign taxes on the income that was earned by your foreign
subsidiary out of which the dividend distribution was made.
To qualify for the indirect tax credit, your domestic corporation must own at least 10% of a foreign
corporation’s voting stock. The indirect tax credit can also apply to complex multiple levels of foreign
subsidiaries when specified ownership thresholds are satisfied.
The foreign tax credit formula must be applied to different types of income, i.e., foreign tax credit limitation
baskets. These baskets are enumerated in Section 904(d) as follows:
• Passive income
• High withholding tax interest
• Financial services income
• Shipping income
• Dividends from each noncontrolled foreign corporation
• DISC dividends
• Foreign trade income
• Foreign sales corporation (FSC)
• General limitation income
The purpose for the multiple foreign tax credit limitation basket is to minimize your ability to average highly
taxed income with low-taxed income from foreign jurisdictions to take advantage of the foreign tax credit
limitation. Although the multiple foreign tax credit limitation baskets hinder a U.S. multinational’s ability to
maximize the foreign tax credit, a thorough review of the rules of each basket and exception can often
yield beneficial results by reducing the number of baskets that apply. Furthermore, a comprehensive
review of the components of the numerator of the foreign tax credit limitation can prove to be equally
beneficial.
CONTROLLED FOREIGN CORPORATIONS
To the extent your foreign subsidiary operates in a low-tax jurisdiction, it enjoys deferred U.S. taxes.
Concerned that U.S. corporate taxpayers would take advantage of this deferral technique, Congress
enacted Subpart F of the Code to discourage U.S. taxpayers from using foreign corporations to defer U.S.
taxes by accumulating certain types of income in foreign base companies located in low tax jurisdictions.
These provisions are primarily directed at two types of income:
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1. Passive income
2. Income derived from dealings with related corporations using a base company to shift income
away from related parties in a high tax jurisdiction
Both types of income are highly mobile from one taxing jurisdiction to another. Active business operations
conducted by a foreign corporation are not generally affected by these provisions. If a U.S. corporation
is required to include offshore earnings currently, the inclusion is treated as a dividend. Thus the U.S.
corporate parent is entitled to the indirect foreign tax credit as a form of relief against its U.S. tax liability.
This foreign tax credit on a Subpart F dividend is subject to all the limitations that would apply as if an
actual dividend were paid.
Subpart F contains a mechanism to prevent double taxation of the same earnings. Under the
dividendordering rule of Section 959, distributions are treated as being made first out of amounts previously
taxed under Subpart F. The unfortunate aspect of the Section 962 election, however, is that the electing
individual shareholder gets no exclusion under Section 959 for distributions of previously taxed income.
For this reason, the Section 962 election is rarely made. An important exception to Subpart F inclusions
is the high-tax exception. If the effective foreign tax rate on the income is 90% or more of the top relevant
U.S. tax rate (presently 90% of 38.6% for S corporations), no Subpart F inclusion is required. The benefit
of this exclusion may be lost, however, if losses of one entity reduce the tax bill of another.
HYBRID STRUCTURES
Losses of foreign operations can be passed through to owners of closely held businesses with fewer
obstacles than for widely held companies. Multi-tier hybrid structures can provide S corporation, LLC, or
partnership owners with access to the losses incurred in their foreign affiliates. Often, the passive activity
loss limitation rules will not apply to nonactive owners due to income of the U.S. operations. For actively
involved owners, various arguments are available to support the contention that the foreign activities are
not passive activities. Further, hybrid entities enable the U.S. owners to get current U.S. benefits while
preserving loss carryforwards locally.
Use of hybrids also will eliminate corporate-level tax for the owners. Foreign corporate-level taxes can flow
through an S corporation to be available as credits to the individual owners. Incremental corporatelevel
tax will occur only to the extent the foreign operations are subject to foreign tax at rates higher than
the owners’ average U.S. federal tax rates. Further, the ability to use credits may be enhanced by the
leveraging effects of double-dip structures, as well as the reduced local tax inherent in such structures.
Subpart F exposures can be reduced. Leveraging through double-dip structures tends to eliminate FPHCI.
While other forms of Subpart F income are eliminated, it is often at the cost of full inclusion of the income
in another form. Again, this may be beneficial where foreign taxes must be incurred in any event and such
taxes can be used as U.S. credits by the owners.
Finally, hybrid structures may provide additional ways the closely held business can provide for
management and family succession.
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LOSS PLANNING
Generally, losses of a hybrid (as defined above) will pass through to the members of the hybrid in the
jurisdiction in which the hybrid is treated as a flow-through entity or a non-entity. Utilization of such losses
may be limited under local rules (e.g., the passive activity loss rules in the U.S.), although such losses
may carry over for use in subsequent years.
A branch operation or a hybrid may be desirable where the operations are expected to incur losses.
This situation tends to arise in start-up operations where losses are expected during the initial years of
foreign operations. The ability to currently deduct these losses can be a significant benefit. Additionally,
an existing foreign operation may experience a period in which it incurs significant losses for a variety of
reasons.
PASSIVE ACTIVITY LOSSES
Owners not actively involved in the business face the passive activity loss restrictions of Section 469.
A passive activity is any trade or business activity in which the taxpayer does not materially participate.
A taxpayer materially participates if he meets one of seven tests, including participation for 500 or more
hours. Passive activity losses are limited to passive activity income. This limitation is applied by aggregating
all passive activities, whether or not related. A similar limitation applies to all credits, including foreign tax
credits, from passive activities.
Even owners actively participating in the U.S. business may face limitations. The material participation
test is applied separately to each activity. An S corporation, partnership, or LLC is allowed to group
together all activities in which it has an interest. Once so grouped, the owners of the entity must follow
such grouping.
DUAL CONSOLIDATED LOSS
Another provision also potentially prevents the offset of losses from a ULC against profits reported by the
member of the ULC or other affiliates in a consolidated return. Under the dual consolidated loss (DCL)
rules, losses of a dual resident corporation (DRC) are not allowed to offset income of a domestic affiliate
within a consolidated return. A DRC is any corporation considered resident of both the U.S. and another
country.
Any hybrid entity, including a branch or partnership ULC, is treated as a separate entity in determining
whether it is a DRC and for purposes of determining who is an affiliate. A DCL is a loss of a DRC that can
offset the income of any other person, including a successor in interest, in the other country. Deduction
of a DCL is permitted only if the U.S. consolidated return group makes an election under Reg. 1.1503-
2(g)(2). Under the election, the group must recapture the loss retroactively on certain triggering events,
including use of the loss by another entity, disposition, or failure to make an annual comprehensive
disclosure statement regarding the DRC.
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INTEREST STRIPPING AND DOUBLE DIP
The interest apportionment rules give rise to opportunities to shift income and get double deductions in
appropriate structures. Most jurisdictions impose limits on the amount of interest paid to affiliates that may
be deducted. Nonetheless, loans to foreign operations by U.S. owners generally will result in reductions
in foreign tax and also in improvements in foreign source taxable income. Further, under many U.S. tax
treaties, payments of interest are not subject to foreign withholding taxes. It is possible to further improve
the tax efficiency for a C corporation with appropriate structures, resulting in a “double dip” of interest
expense. Often, the use of a so-called “Double Dip: CV-BV,” a commonly used double-dip structure using
Dutch intermediary entities results in greater global tax efficiency wherein CV is a reverse hybrid (taxed
as a corporation in the U.S. and a partnership in the Netherlands).
The BV is a hybrid (branch in the U.S. and corporation in the Netherlands).
INCOME SHIFTING
It is often desirable to compensate stakeholders on differing bases. This is not permitted for S corporations
where the compensation is in the form of distributions, under the single class of stock rule. Traditionally,
this has been addressed through salary and bonus, an unsatisfactory solution where the desire is to link
the total compensation package to the performance of a business unit.
Hybrid entities can provide a solution for S corporations and others desiring to provide stakeholders
with a “piece of the action.” Since a multi-owner hybrid is treated as a partnership for U.S. tax purposes,
income shifting that occurs at the hybrid-entity level will be respected. The use of hybrids also can have
a significant impact on intercompany pricing issues. There is often tension between taxing authorities
as to appropriate prices. Where a U.S. company sells goods to its foreign corporate subsidiary, the IRS
often has an interest in keeping the sales price high, and the foreign taxing authorities in keeping it low.
If, however, the foreign subsidiary is a hybrid, the income of the subsidiary flows into the U.S. tax return.
There is less incentive for the IRS to make transfer pricing adjustments. In addition, the use of a hybrid
may eliminate any opportunity for an IRS adjustment. Section 482 limits the Service’s power to the
adjustment of income between related parties. Transactions between a hybrid branch and its owner are
not transactions at all, and involve only one taxpayer. This may eliminate any income or deduction that
might be adjusted. For example, interest charged by a taxpayer to its hybrid branch does not exist for
U.S. tax purposes.
FOREIGN CURRENCY ISSUES
Many foreign currency aspects of hybrids are substantially the same as those of separate entities, with
one exception noted below. Each qualified business unit (QBU) of a taxpayer or entity must maintain its
own books in its own functional currency. Income and expenses are maintained in this functional currency,
and the net result may be translated to another functional currency as needed. Special rules apply to
branch QBUs that have a functional currency different from their owners. These rules require recognition
of foreign exchange gain or loss on remittances from the branch or inter-branch transfers. Contrast this
to the rules for foreign subsidiary dividends, under which neither the subsidiary nor the owner recognizes
gain or loss on distributions of E&P.
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CONTINUITY
A key pair of concerns for closely held businesses is how to ensure continuity of the business in the event
of death or retirement and how to enable transfer of ownership between generations. Use of certain
foreign corporate structures can ease the difficulties of such planning.
As observed above, hybrids provide the opportunity to give locals a “piece of the action.” Hybrids also
provide the ability to retain local management following death or retirement of U.S. owners. The local
company may have as some of its officers or directors the U.S. management, but the shareholders will
be the S corporation itself and the local managers. Thus, on death or retirement, the non-local officers
and directors can be replaced by actions taken, generally, entirely on paper without external approvals.
Transfer of ownership by gift or bequest is easy if all of the ownership is within the S corporation. It is also
enhanced with hybrids if the ownership is outside corporate solution. The hybrid shares themselves can
be transferred much more easily than branch assets or partnership interests. Further, due to disparities
between U.S. and foreign estate and gift laws, often enhanced by the effects of treaties, there may be
opportunities to accomplish tax-free intergenerational transfers for certain classes of domiciliaries.
Ownership of the hybrid outside the S corporation may provide significant advantages in family planning,
but potentially at the cost of using losses and credits. As the enterprise expands overseas, the expansion
units may have little market value before they start making profits. The inception of the arrangement can
be an excellent time to transfer by gift part of the ownership of these potentially appreciating assets.
William
select the appropriate tax entity for both domestic and foreign purposes, charging the right prices for
intercompany transactions, and properly computing the foreign tax credit.
CB&H SPECIALIZES IN COMPLEX ISSUES TO ASSIST YOU
DOMESTICALLY AND ABROAD
The tax planning environment for a closely held company is significantly different from that for widely held
companies. With closely held companies, it is always desirable and often possible to completely eliminate
U.S. corporate-level taxation. Further, some planning techniques that reduce corporate tax may increase
the total tax burden of the closely held company. For valid business reasons, different stakeholders in the
entity may seek different forms of compensation. Finally, estate planning is generally not a consideration
for the management of widely held entities.
The key items for consideration include:
• Allowing losses to be passed through to individual owners in a way in which they will be
deductible.
• Eliminating corporate-level taxation, or alternatively, providing a mechanism by which the owners
can offset the company tax against their own tax liabilities.
• Adopting structures that permit flexibility in compensation and the ability to share profits for certain
stakeholders.
• Deferring current taxation of individual owners to the extent possible.
• Adopting structures that enhance the ability of owners to finance their retirement.
• Planning for continuity of the enterprise on death of one or more principals.
• Adopting structures that permit the transfer of ownership at death with reduced estate tax
consequences.
PRELUDE TO INTERNATIONAL TAX PLANNING
Expansion into foreign markets can take a variety of forms:
• Direct exporting. The simplest method to carry out foreign trade is direct exporting. With direct
exporting, the U.S. company sells and ships products directly to foreign customers, who send
payment directly to the U.S. company. No local activities are carried out, and no local people
(except for the customers) are involved. In today’s marketplace, the internet may be the way
to carry out direct exporting. A disadvantage of this method is the company’s distance from the
market, which affects reaction time.
• Franchisee/licensee. Another option is to have a foreign franchisee/licensee sell the U.S. company’s
product and remit a royalty back to the U.S. company. Under this scenario, the U.S. company
must analyze the local treatment of the arrangement to distinguish between payments for use
of know-how (royalty), payments for show-how (services), and payments for goods (property
transfers).
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• Acquisition of assets or shares. The advantage of acquiring a foreign company is that the U.S.
owner can acquire a full range of capabilities immediately. Because the entity has already been
established, the history of performance can be evaluated and reasonably projected. The cost
of the acquisition process is expensive because the U.S. owner’s employees incur travel and
per diem costs and outside accountants/lawyers are needed to gain comfort with in-country
requirements. If problems do occur, the U.S. owner bears all costs. Also, accounting issues are
handled differently in different countries and may require different presentation (and financial
impact) on U.S. financials.
• Joint venture. With a joint venture (partnership or corporation), a foreign partner’s skills can be
acquired to complement the U.S. partner’s technologies. Another advantage is that all U.S. partners
can bid for in-country work. The downside to this structure is the possible lack of control and that it
may be difficult to expand beyond one foreign country because of nationalistic tendencies. When
negotiating a joint venture via a partnership or corporation, valuing what both partners bring to the
table is difficult. The tendency is to assume a 50/ 50 relationship, but in reality it is hard to keep
both partners contributing equally. Also, it is difficult to get majority ownership in a foreign country
with a large partner. Because international business is affected by cultural differences, each party
should be sure to understand the company’s goals, important issues, and corporate sensitivities.
Documents are very formal (by-laws, shareholders’ agreement, business plans) and negotiations
lengthy. Business plans almost always understate the required investment, so be conservative
up-front.
• New subsidiary. The advantage of starting a new subsidiary is that there are low start-up costs,
and the U.S. owner has total control over planning and direction. In-country expertise, however,
will be needed, as well as the need to develop infrastructure. Another consideration is that as a
newcomer, the U.S. owner will be virtually unknown to the majority of the customer base.
• New branch. The advantages here are the same as starting a new subsidiary. Operating losses
can be consolidated in the U.S., and other tax considerations may also benefit the branch. As
with a subsidiary, however, a branch will need in-country expertise and marketing assistance to
develop a strong customer base. Another disadvantage is that sometimes a branch is not viewed
as an in-country company despite its physical presence. With both a subsidiary or a branch, staff
(management, technical, administrative) is needed who understand how to conduct business in
the foreign country as well as with the U.S. home office. Capable in-country managers are critical
as it is difficult to direct operations from the U.S.
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CB&H ISOLATES THE ISSUES FOR YOU
Faced with the tax issues of an employer that will be doing business in two jurisdictions, the most important
task for the U.S. accountant is to ask the right questions. More important than a basic understanding of
domestic tax law is an awareness of the sensitive issues the U.S. company may encounter in the foreign
jurisdiction.
KEY QUESTIONS
CB&H’S simple approach to your understanding the foreign tax landscape is to make a list of every
tax question imaginable that your U.S. company may encounter in going global. Here are sample
questions:
1. With respect to the proposed activities in the host jurisdiction, will such activities meet the definition
of commercial residency for tax purposes?
2. What are the local rates of taxation?
3. Are there preferential capital gains tax rates?
4. Are there penalties for accumulating earnings within the host country?
5. Are there taxes based on capital?
6. Are there local taxes, in addition to those at the national level?
7. What are the payment dates and filing dates for local and national tax returns?
8. What are the components of the tax calculation?
9. What depreciation methods are allowable?
10. Are there accelerated depreciation methods or expensing provisions that could be of benefit?
11. Are there business expenses that do not qualify for a tax deduction?
12. What are the allowable inventory methods?
13. How is interest expense treated for local tax purposes, i.e., cash method, accrual method? Are
there thin capitalization restrictions?
14. What are the carryback and carryforward periods with respect to net operating losses?
15. If a multi-tiered structure is established within the host country, how are dividends from domestic
sources treated for local tax purposes?
16. Are tax consolidations permissible within the host country?
17. What are the local tax consequences of capital repatriations, stock redemptions, liquidations, and
reorganizations?
18. What other non-income type taxes apply, i.e., VAT, property, payroll, stamp, realty, registration,
etc.?
19. Are there local tax incentives?
20. Are advance rulings required or possible within the jurisdiction for tax purposes?
21. What is the tax audit process with respect to a host country investment made from a foreign
jurisdiction?
In compiling and drilling through the list of questions, perhaps with legal counsel present, CB&H can
determine the relevant issues that require further investigation. The unimportant issues will be eliminated,
and at the end of this exercise, CB&H will have a complete list of issues to address with tax accountants
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on the other side of the world. In this way, CB&H will find the answers to the pertinent questions and thus
minimize your U.S. company’s tax burden in the foreign jurisdiction as well as assist you in achieving the
lowest legally possible worldwide tax rate.
U.S. OUTBOUND TAX ISSUES
Once the business considerations and foreign tax issues have been identified, the U.S. Internal Revenue
Code Statutory Outbound Provision must be factored into the international planning process. Only
after international business, foreign tax, and these U.S. statutory rules are evaluated together will the
international tax planning process be complete.
• The global economy lures businesses of all sizes and types. Special opportunities exist, and special
planning is required, when a closely held U.S. company – whether partnership, S corporation,
LLC, or C corporation – expands abroad. In particular, the use of hybrid or reverse hybrid entities
can allow for the minimization of tax liabilities in both the U.S. and the foreign country.
• Midsize closely held companies are becoming increasingly multinational, and the potential tax
effects can be considerable. Hybrid foreign and domestic entities provide opportunities for closely
held U.S. multinational companies to reduce overall taxation. Shareholders of a domestic S
corporation generally can eliminate the effect of all corporate-level taxation, both U.S. and foreign.
Hybrids can be used to disproportionately reward investors in and employees of subsidiaries
without running afoul of the “single class of stock” rules for S corporations. Hybrids also can be
effectively used to manage joint ventures while retaining tax benefits normally associated with
majority ownership.
STRUCTURAL ISSUES
Choice of commercial entity in both the U.S. and foreign jurisdiction is the most important tax planning
decision you will make. It significantly influences the income taxes that are ultimately paid. Domestically,
commercial activities are generally conducted in any of these formats:
• S corporation
• C corporation
• Limited Liability Company (LLC)
• Partnership
Domestic tax consequences can significantly differ among these structural choices. The chosen domestic
entity will, in turn, significantly influence the choices available in the international context. In foreign
jurisdictions, commercial operations are generally conducted in the following forms:
• Branch
• Partnership or joint venture
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• Corporation
COMPATIBILITY
The international entity selection must be compatible with the domestic parent in order to minimize the
overall tax burden. Compatibility is largely influenced by these issues:
• Will foreign operating losses be available as a benefit for U.S. income tax purposes?
• Should the profits from foreign operations be taxed in the U.S. on a current or deferred basis?
• What taxes paid to foreign jurisdictions are available as a foreign tax credit in the U.S. in order to
minimize the double-taxation burden?
CORPORATIONS, LLCs, AND PARTNERSHIPS
Ownership of an enterprise through a pass-through entity has the advantage for U.S. individuals of
eliminating entity-level taxation. An S corporation, noncorporate LLC, or partnership is not taxed at the
entity level. Rather, the shareholders, partners, or members include in their individual tax determination
their pro rata share of items of income, deduction, or credit of the S corporation, partnership, or LLC in the
current year. For purposes of determining foreign tax credits and the source of income, an S corporation
is treated as a partnership and its shareholders are treated as partners.
By contrast, shareholders of a C corporation pay tax only on dividends as received, and the C corporation
is subject to corporate income tax. Where an S corporation, partnership, or LLC holds its business activities
through a non-flow-through entity, the benefit of single-level taxation is lost. An S corporation, however,
may own a U.S. corporate subsidiary that may elect flow-through treatment as a qualified Subchapter S
subsidiary (QSSS). The QSSS election is available only for a domestic corporation 100%-owned by an
S corporation. Such a QSSS, however, may operate overseas, and often the use of a special-purpose
QSSS should be considered as an option. Some countries prohibit 100% ownership of a corporation by
a single person, which may effectively prohibit a QSSS. Use of a special-purpose sister corporation may
be considered in such circumstances, as well as where differing profit participation rights are to be given
those members working overseas. As discussed below, additional options are available for S corporations
that may accomplish the same goals with local entities. Because an S corporation may not have any non-
U.S. owners, the use of a hybrid in countries requiring some local ownership may be necessary.
Shareholders of an S corporation must receive allocations of income, deduction, etc., and distributions
strictly on a per-share basis, with no special allocations, under the single class of stock rules. This
limits how an S corporation may provide special rewards to certain classes of members. Partners of
partnerships and members of LLCs may benefit from non-pro rata special allocations.
All domestic entities can be classified either as transparent or veiled. The former category includes S
corporations, LLCs, and partnerships; the latter includes C corporations. The former are characterized
by having its owners face only one level of tax, whereas the latter category imposes both a corporate
and shareholder-level tax. These characteristics influence the availability of claiming credits for foreign
income taxes incurred in foreign jurisdictions, resulting from choosing the appropriate foreign entity. For
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you to maintain the integrity of a single-level tax, domestic transparent entities must operate abroad in
either branch or unincorporated partnership structures. This enables the domestic entity owners to claim
a foreign tax credit for the income taxes imposed in the foreign jurisdiction on the local entity. On the
other hand, veiled domestic entities can eliminate double taxation via the foreign tax credit for foreign
income taxes imposed on any type of foreign structure. When a domestic transparent entity chooses to
operate as either an incorporated joint venture or corporate subsidiary format, double taxation arises.
Although the benefits of both foreign loss pass-through and foreign tax credit access make branches
and unincorporated partnerships appear attractive for U.S. tax purposes, it is sometimes commercially
inefficient to operate a business in a foreign jurisdiction with such structures. This problem can be easily
overcome since 1997 through what is known as the “check-the-box” regulations.
Check-the-box regulations. Under these regulations, foreign corporations can be treated as:
• A branch, if wholly owned
• A partnership when more than a single owner is involved
Your treating a foreign corporation as a flow-through entity for U.S. tax purposes is done via an election
(Form 8832) and is made strictly for U.S. tax purposes. In the foreign jurisdiction, the foreign entity
retains its corporate identity. Similarly, foreign branches and unincorporated partnerships can be treated
as corporations for U.S. tax purposes via the same election process. This election giving the same entity
corporate characteristics in one jurisdiction and noncorporate characteristics in the other creates what is
known as a hybrid entity.
The U.S. income tax regulations contain a list of corporate entities by country for which no check-the-box
election can be made – rendering the foreign entity a corporation for U.S. tax purposes in all instances.
These regulations also indicate that if an entity has unlimited liability and no check-the-box election
is made, the foreign entity defaults to either a branch or an unincorporated partnership. On the other
hand, if the foreign entity has limited liability and no election is made, the foreign entity defaults to that of
corporate status.
Thus, hybrid entities can offer you the best of both worlds, i.e., flow-through treatment for U.S. purposes,
yet local corporate characteristics for foreign commercial and tax purposes.
FOREIGN TAX CREDIT ISSUES
International trade would be severely hampered if it were not for the foreign tax credit. Without the credit,
U.S. companies operating abroad would have to pay tax to both the U.S. and foreign government on the
same revenue from foreign sales.
There are two types of foreign tax credits, i.e., the direct and indirect.
DIRECT CREDIT- The direct foreign tax credit is simpler to compute. If your company pays a foreign
withholding tax of $15,000 and your U.S. income tax liability before the foreign tax credit is $60,000, you
pay tax of only $45,000 to the U.S. government. The direct foreign tax reduces your U.S. tax liability dollar
for dollar. The direct foreign tax credit gets its name from the fact that the foreign tax is imposed directly
on the U.S. taxpayer.
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The direct foreign tax credit is generally encountered as a withholding tax on remittances from foreign
jurisdictions as well as when a U.S. corporation conducts business abroad through an unincorporated
branch or partnership.
INDIRECT CREDIT - Suppose your U.S. corporation operates abroad through a foreign subsidiary.
Normally, income earned by the subsidiary is not taxable in the U.S. because it is earned by a foreign
corporation. In these situations, your .U.S. parent cannot credit the foreign income taxes paid by your
foreign subsidiary. When, however, your foreign subsidiary makes a dividend distribution to your U.S.
parent corporation, the dividend is generally taxable in the U.S. Your U.S. parent corporation is then
entitled to an indirect tax credit for the foreign taxes on the income that was earned by your foreign
subsidiary out of which the dividend distribution was made.
To qualify for the indirect tax credit, your domestic corporation must own at least 10% of a foreign
corporation’s voting stock. The indirect tax credit can also apply to complex multiple levels of foreign
subsidiaries when specified ownership thresholds are satisfied.
The foreign tax credit formula must be applied to different types of income, i.e., foreign tax credit limitation
baskets. These baskets are enumerated in Section 904(d) as follows:
• Passive income
• High withholding tax interest
• Financial services income
• Shipping income
• Dividends from each noncontrolled foreign corporation
• DISC dividends
• Foreign trade income
• Foreign sales corporation (FSC)
• General limitation income
The purpose for the multiple foreign tax credit limitation basket is to minimize your ability to average highly
taxed income with low-taxed income from foreign jurisdictions to take advantage of the foreign tax credit
limitation. Although the multiple foreign tax credit limitation baskets hinder a U.S. multinational’s ability to
maximize the foreign tax credit, a thorough review of the rules of each basket and exception can often
yield beneficial results by reducing the number of baskets that apply. Furthermore, a comprehensive
review of the components of the numerator of the foreign tax credit limitation can prove to be equally
beneficial.
CONTROLLED FOREIGN CORPORATIONS
To the extent your foreign subsidiary operates in a low-tax jurisdiction, it enjoys deferred U.S. taxes.
Concerned that U.S. corporate taxpayers would take advantage of this deferral technique, Congress
enacted Subpart F of the Code to discourage U.S. taxpayers from using foreign corporations to defer U.S.
taxes by accumulating certain types of income in foreign base companies located in low tax jurisdictions.
These provisions are primarily directed at two types of income:
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1. Passive income
2. Income derived from dealings with related corporations using a base company to shift income
away from related parties in a high tax jurisdiction
Both types of income are highly mobile from one taxing jurisdiction to another. Active business operations
conducted by a foreign corporation are not generally affected by these provisions. If a U.S. corporation
is required to include offshore earnings currently, the inclusion is treated as a dividend. Thus the U.S.
corporate parent is entitled to the indirect foreign tax credit as a form of relief against its U.S. tax liability.
This foreign tax credit on a Subpart F dividend is subject to all the limitations that would apply as if an
actual dividend were paid.
Subpart F contains a mechanism to prevent double taxation of the same earnings. Under the
dividendordering rule of Section 959, distributions are treated as being made first out of amounts previously
taxed under Subpart F. The unfortunate aspect of the Section 962 election, however, is that the electing
individual shareholder gets no exclusion under Section 959 for distributions of previously taxed income.
For this reason, the Section 962 election is rarely made. An important exception to Subpart F inclusions
is the high-tax exception. If the effective foreign tax rate on the income is 90% or more of the top relevant
U.S. tax rate (presently 90% of 38.6% for S corporations), no Subpart F inclusion is required. The benefit
of this exclusion may be lost, however, if losses of one entity reduce the tax bill of another.
HYBRID STRUCTURES
Losses of foreign operations can be passed through to owners of closely held businesses with fewer
obstacles than for widely held companies. Multi-tier hybrid structures can provide S corporation, LLC, or
partnership owners with access to the losses incurred in their foreign affiliates. Often, the passive activity
loss limitation rules will not apply to nonactive owners due to income of the U.S. operations. For actively
involved owners, various arguments are available to support the contention that the foreign activities are
not passive activities. Further, hybrid entities enable the U.S. owners to get current U.S. benefits while
preserving loss carryforwards locally.
Use of hybrids also will eliminate corporate-level tax for the owners. Foreign corporate-level taxes can flow
through an S corporation to be available as credits to the individual owners. Incremental corporatelevel
tax will occur only to the extent the foreign operations are subject to foreign tax at rates higher than
the owners’ average U.S. federal tax rates. Further, the ability to use credits may be enhanced by the
leveraging effects of double-dip structures, as well as the reduced local tax inherent in such structures.
Subpart F exposures can be reduced. Leveraging through double-dip structures tends to eliminate FPHCI.
While other forms of Subpart F income are eliminated, it is often at the cost of full inclusion of the income
in another form. Again, this may be beneficial where foreign taxes must be incurred in any event and such
taxes can be used as U.S. credits by the owners.
Finally, hybrid structures may provide additional ways the closely held business can provide for
management and family succession.
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LOSS PLANNING
Generally, losses of a hybrid (as defined above) will pass through to the members of the hybrid in the
jurisdiction in which the hybrid is treated as a flow-through entity or a non-entity. Utilization of such losses
may be limited under local rules (e.g., the passive activity loss rules in the U.S.), although such losses
may carry over for use in subsequent years.
A branch operation or a hybrid may be desirable where the operations are expected to incur losses.
This situation tends to arise in start-up operations where losses are expected during the initial years of
foreign operations. The ability to currently deduct these losses can be a significant benefit. Additionally,
an existing foreign operation may experience a period in which it incurs significant losses for a variety of
reasons.
PASSIVE ACTIVITY LOSSES
Owners not actively involved in the business face the passive activity loss restrictions of Section 469.
A passive activity is any trade or business activity in which the taxpayer does not materially participate.
A taxpayer materially participates if he meets one of seven tests, including participation for 500 or more
hours. Passive activity losses are limited to passive activity income. This limitation is applied by aggregating
all passive activities, whether or not related. A similar limitation applies to all credits, including foreign tax
credits, from passive activities.
Even owners actively participating in the U.S. business may face limitations. The material participation
test is applied separately to each activity. An S corporation, partnership, or LLC is allowed to group
together all activities in which it has an interest. Once so grouped, the owners of the entity must follow
such grouping.
DUAL CONSOLIDATED LOSS
Another provision also potentially prevents the offset of losses from a ULC against profits reported by the
member of the ULC or other affiliates in a consolidated return. Under the dual consolidated loss (DCL)
rules, losses of a dual resident corporation (DRC) are not allowed to offset income of a domestic affiliate
within a consolidated return. A DRC is any corporation considered resident of both the U.S. and another
country.
Any hybrid entity, including a branch or partnership ULC, is treated as a separate entity in determining
whether it is a DRC and for purposes of determining who is an affiliate. A DCL is a loss of a DRC that can
offset the income of any other person, including a successor in interest, in the other country. Deduction
of a DCL is permitted only if the U.S. consolidated return group makes an election under Reg. 1.1503-
2(g)(2). Under the election, the group must recapture the loss retroactively on certain triggering events,
including use of the loss by another entity, disposition, or failure to make an annual comprehensive
disclosure statement regarding the DRC.
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INTEREST STRIPPING AND DOUBLE DIP
The interest apportionment rules give rise to opportunities to shift income and get double deductions in
appropriate structures. Most jurisdictions impose limits on the amount of interest paid to affiliates that may
be deducted. Nonetheless, loans to foreign operations by U.S. owners generally will result in reductions
in foreign tax and also in improvements in foreign source taxable income. Further, under many U.S. tax
treaties, payments of interest are not subject to foreign withholding taxes. It is possible to further improve
the tax efficiency for a C corporation with appropriate structures, resulting in a “double dip” of interest
expense. Often, the use of a so-called “Double Dip: CV-BV,” a commonly used double-dip structure using
Dutch intermediary entities results in greater global tax efficiency wherein CV is a reverse hybrid (taxed
as a corporation in the U.S. and a partnership in the Netherlands).
The BV is a hybrid (branch in the U.S. and corporation in the Netherlands).
INCOME SHIFTING
It is often desirable to compensate stakeholders on differing bases. This is not permitted for S corporations
where the compensation is in the form of distributions, under the single class of stock rule. Traditionally,
this has been addressed through salary and bonus, an unsatisfactory solution where the desire is to link
the total compensation package to the performance of a business unit.
Hybrid entities can provide a solution for S corporations and others desiring to provide stakeholders
with a “piece of the action.” Since a multi-owner hybrid is treated as a partnership for U.S. tax purposes,
income shifting that occurs at the hybrid-entity level will be respected. The use of hybrids also can have
a significant impact on intercompany pricing issues. There is often tension between taxing authorities
as to appropriate prices. Where a U.S. company sells goods to its foreign corporate subsidiary, the IRS
often has an interest in keeping the sales price high, and the foreign taxing authorities in keeping it low.
If, however, the foreign subsidiary is a hybrid, the income of the subsidiary flows into the U.S. tax return.
There is less incentive for the IRS to make transfer pricing adjustments. In addition, the use of a hybrid
may eliminate any opportunity for an IRS adjustment. Section 482 limits the Service’s power to the
adjustment of income between related parties. Transactions between a hybrid branch and its owner are
not transactions at all, and involve only one taxpayer. This may eliminate any income or deduction that
might be adjusted. For example, interest charged by a taxpayer to its hybrid branch does not exist for
U.S. tax purposes.
FOREIGN CURRENCY ISSUES
Many foreign currency aspects of hybrids are substantially the same as those of separate entities, with
one exception noted below. Each qualified business unit (QBU) of a taxpayer or entity must maintain its
own books in its own functional currency. Income and expenses are maintained in this functional currency,
and the net result may be translated to another functional currency as needed. Special rules apply to
branch QBUs that have a functional currency different from their owners. These rules require recognition
of foreign exchange gain or loss on remittances from the branch or inter-branch transfers. Contrast this
to the rules for foreign subsidiary dividends, under which neither the subsidiary nor the owner recognizes
gain or loss on distributions of E&P.
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CONTINUITY
A key pair of concerns for closely held businesses is how to ensure continuity of the business in the event
of death or retirement and how to enable transfer of ownership between generations. Use of certain
foreign corporate structures can ease the difficulties of such planning.
As observed above, hybrids provide the opportunity to give locals a “piece of the action.” Hybrids also
provide the ability to retain local management following death or retirement of U.S. owners. The local
company may have as some of its officers or directors the U.S. management, but the shareholders will
be the S corporation itself and the local managers. Thus, on death or retirement, the non-local officers
and directors can be replaced by actions taken, generally, entirely on paper without external approvals.
Transfer of ownership by gift or bequest is easy if all of the ownership is within the S corporation. It is also
enhanced with hybrids if the ownership is outside corporate solution. The hybrid shares themselves can
be transferred much more easily than branch assets or partnership interests. Further, due to disparities
between U.S. and foreign estate and gift laws, often enhanced by the effects of treaties, there may be
opportunities to accomplish tax-free intergenerational transfers for certain classes of domiciliaries.
Ownership of the hybrid outside the S corporation may provide significant advantages in family planning,
but potentially at the cost of using losses and credits. As the enterprise expands overseas, the expansion
units may have little market value before they start making profits. The inception of the arrangement can
be an excellent time to transfer by gift part of the ownership of these potentially appreciating assets.
William
