Tax and accounting aspects of global expansion.

• Author: Larkins, Ernest R.

For clients desiring to do business worldwide, a host of tax and accounting considerations await. This article presents an overview of a number of these issues, including the foreign tax credit, use of foreign sales corporations, joint ventures, passive foreign investment companies, controlled foreign corporations and branches and foreign currency and transfer-pricing issues.

American companies wishing to expand beyond U.S. markets are faced with many tax and accounting issues and decisions that differ from those confronted in a purely domestic environment. An organizational form must be selected for conducting business abroad; the tax consequences of global operations vary significantly depending on the business form selected. In addition, the accounting aspects of international operations have reporting, control and behavioral implications. This article examines several important tax and accounting dimensions for U.S. companies venturing into the global marketplace.

Tax Issues

Business considerations (e.g., market penetration and risk management) often suggest the organizational form or structure for doing business abroad. However, because each organizational form involves different tax issues, this decision should not be made without considering the tax consequences. The foreign tax credit (FTC) effect is a central issue, regardless of the organizational form selected.

Regs. Sec. 1.11-(a) taxes U.S. domestic corporations on their worldwide income. Thus, any tax paid to a foreign country results in double taxation on the same income. To mitigate this effect, Sec. 901 allows a company to claim an FTC on its U.S. tax return for income tax paid or accrued to foreign countries. However, Sec. 904(a) limits the FTC to the U.S. tax imposed on foreign income.

Example: 1: D Corp. (a U.S. multinational) has $1,000 of foreign income on which it pays $400 of foreign tax (a 40% foreign tax rate). Before considering the FTC limit, D can claim a credit on its U.S. tax return for the $400 paid. However, if the effective U.S. tax rate is 35%, D is allowed a credit of only $350 (i.e., the U.S. tax on the foreign income); the additional $50 of foreign income tax paid is an "excess credit" and indicates that both the U.S. and the foreign country are effectively taxing some portion of the foreign income. If, instead, the U.S. tax rate is 42%, D can take a full $400 FTC. D will have an "excess limit" of $20; no portion of the foreign income is subject to double taxation.

In effect, the FTC allows the company to credit foreign tax against the U.S. tax on the foreign income; no credit can be taken against the U.S. tax on the company's domestic income. Thus, companies conducting business in high-tax (low-tax) foreign countries often have excess FTCs (limits). If those companies can conduct international business so that some profits are taxed at low foreign rates, while others are taxed at high foreign rates, the hightaxed income can be averaged with the low-taxed income, minimizing double taxation and resulting in a lower overall effective tax rate. This is a major objective of international tax planning.

Exporting

Export sales generally attract no foreign tax. For a multinational corporation with excess FTCs from other international activities (e.g., a foreign sales branch in a high-tax country), an export sale is effectively taxed at only half of the normal U.S. tax rate.

Example: 2: The facts are the same as in Example 1; the U.S. tax rate is 35%. D paid $400 on $1,000 of foreign income; the FTC completely offset the U.S. tax otherwise due. D later made an export sale that generated $200 of net income. If the product sold is U.S.-manufactured and the sale occurred outside the U.S., half of the income is deemed foreign-source income for FTC purposes. D's total $1,100 of foreign income is taxed a total of $400 by the foreign country, but the FTC limit is now $385 ($1,100 x 0.35).

How much additional tax was paid on the $200 of export income? At a 35% U.S. tax rate, $70 of U.S. tax results. However, the export sale also allowed D to increase its FTC from $350 to $385. Thus, the net increase in tax from the export sale is $35 (i.e., $70 U.S. tax -- $35 FTC increase); the export sale is effectively taxed at only 17.5% ($35 net tax increase/$200 income), half the normal U.S. rate.

FSCs: When a U.S. company does not have excess FTCs, export sales can be made through a foreign sales corporation (FSC), defined in Sec. 922. Most FSCs operate as commission agents and are located in the U.S. Virgin Islands or Barbados. Although the FSC requirements appear complex, the proliferation of FSC management companies means that most U.S. exporters can establish and maintain such entities at a modest annual cost (around $10,000). A less costly and simpler alternative, the "small FSC" (defined in Sec. 922(b)), provides tax benefits to businesses with up to $5 million in annual foreign trading gross receipts, under Sec. 924(b) (2).

For most products exported, the FSC tax benefit is 15%. For example, if a U.S. company normally pays U.S. tax at a 35% rate, the use of an FSC results in an effective tax rate of only 29.75% (0.35 x 0.85) on export profits. For high-volume, low-profit items such as grain, the FSC benefit can range between 15% and 30%. The FSC tax benefit can reach as high as 65% when the U.S. company uses marginal costing techniques under Sec. 925(b)(2) to seek or maintain a foreign market.(1) Sec. 927(d)(2)(B) allows FSCs to group transactions in strategic ways or to unbundle transactions to obtain significant tax savings.(2)

Sec. 927(a) permits most products manufactured in the U.S. to qualify for the FSC tax benefit if sold for use or consumption abroad. Section 1171 of the Taxpayer Relief Act of 1997 (TRA '97) added computer software to the list of items that qualify. Notable exceptions for which no benefits are allowed under Sec. 927(a)(2) include manufacturing and marketing intangibles, primary oil and gas products and unprocessed softwood timber.

In summary, U.S. companies with excess FTCs from foreign operations (e.g., a manufacturing plant in Germany) generally should conduct their export operations without an FSC. Such export sales are effectively taxed at half the normal U.S. rate. U.S. companies without excess FTCs can use an FSC to reduce their U.S. tax bill on export sales by 15% or more.

Licensing Arrangements

Royalty income from licensing agreements with distributors and producers in other countries are subject to U.S. tax; in addition, many foreign countries impose a flat withholding tax on such income. For example, French law requires that 33 1/3% be withheld on royalties paid to nonresidents.(3) U.S. treaties generally reduce the withholding percentage, but the actual withholding sometimes varies, depending on the type of property rights licensed. Under the U.S.-France income tax treaty, copyright and film royalties (and certain broadcasting royalties) are exempt from withholding; all other royalties are subject to 5% withholding.(4)

Because both the U.S. and a foreign country often tax the same royalty income stream, an FTC is allowed on the U.S. tax return for the withholding tax; such withholding is subject to the limit discussed earlier. When royalty income is exempt from foreign withholding tax (whether due to host country law or treaty) and the U.S. recipient has excess FTCs from other international activities, they can shield the U.S. tax otherwise due on the royalty income (much as the excess FTC shielded half the U.S. tax on the export income in Example 2). Thus, royalty income from foreign licensing agreements often is taxed at very low effective rates.

Joint Ventures

A joint venture (JV) often involves two...