Entering foreign markets - one step at a time.

• Author: Benson, David M.

Does a client have the urge to take his business overseas? A host of practical tax matters, such as using a foreign sales corporation, creating subsidiaries and branches, taking foreign tax credits, entering into a joint venture, and examining transfer pricing issues should be addressed Wore the first step outside U.S. borders is taken. This article discusses these and other matters for the first time would-be world wide entrepreneur.

A business that decides to look beyond U.S. borders to expand its markets faces a host of tax issues that were never before relevant (and thus, likely remained invisible) to the business's owners. These issues fall into two broad categories:

1. The Federal income tax rules applicable to foreign earnings.

2. The tax rules of foreign jurisdictions in which nexus is established.

This article will delve mainly into the first category, but will also comment briefly on certain aspects of non-U.S. taxation.

Background

Under Secs. 1 and 11, U.S. citizens and residents and corporations are subject to Federal income tax on their worldwide income, regardless of its source, type, place or means of payment. While Federal income tax ultimately will be incurred on the income of foreign subsidiaries, tax deferral is often possible. If the income in question has not been taxed by another jurisdiction, or has been taxed at a rate lower than the applicable Federal income tax rate, long-term deferral can provide a very meaningful financial benefit.

To prevent double taxation of income that has been taxed elsewhere, U.S. taxpayers may claim a foreign tax credit (FTC) under Sec. 901 (a) against their Federal income tax liability for foreign taxes incurred on foreign earnings. Generally, the FTC becomes available when the foreign earnings become subject to Federal income taxation.

Frequently, the first step in "going international" is exporting to foreign customers. Accordingly, this article first examines the tax aspects of export sales and then moves on to non-U.S. operations.

Exporting and Foreign Sales Corporations

Often, U.S. businesses first try international waters by exporting their products to customers located abroad. There are some helpful Federal income tax incentives in this regard.

Under Sec. 921, U.S. exporters that are regular (i.e., C) corporations can reduce their Federal income tax rate on profits from export sales by using a foreign sales corporation (FSC).(1) This is a permanent savings, not just a deferral; thus, using an FSC can provide a financial statement benefit, not just current tax savings.

Sec. 922(a)(1)(A) requires an FSC to be incorporated in be incorporated in a foreign jurisdiction, a prospect often daunting to U.S. businesses that have not previously experienced the complexities of establishing and running a foreign subsidiary. However, typically, an FSC is not a "foreign subsidiary" in the usual sense. The vast majority of FSCs rely on affiliates or an unrelated service provider to undertake the modest activities required. Thus, FSCs rarely have their own employees or significant assets.

In most cases, obtaining the FSC tax benefit is straightforward. While some planning is required, most companies find that the tax benefit far outweighs the effort. U.S. corporations that sell no more than $5 million of their products overseas (or that export more, but are satisfied to obtain tax savings on the most profitable $5 million of their sales) can elect "small FSC" status for the foreign subsidiary, as defined in Secs. 922(b) and 924(b)(2). While the small FSC still must be incorporated outside the U.S. (usually in Barbados or the U.S. Virgin Islands (USVI)), modest fees are paid for the provision of a local office and director, and no further activities outside the U.S. are...