Choice of entity for expansion of operations into a foreign country: when expanding into a foreign country, tax-savings decisions are affected by many factors, including the choice of entity. This article describes how that choice is involved in managing global tax strategies.

• Author: Godfrey, Howard

EXECUTIVE SUMMARY

* When flowthrough treatment is desired, a U.S. business may expand into a foreign country with a branch office or plant.

* A foreign partnership is advantageous when foreign operations are expected to generate flowthrough losses to a U.S. partner, and foreign taxes are high.

* A foreign corporate entity is preferred if the foreign tax rate is low or nonexistent, and the objective is to defer payment of U.S. taxes on foreign earnings.

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The U.S. has a global income tax system that applies to taxable income of U.S. businesses (1) earned in the U.S. and throughout the world. U.S. businesses with operations in a foreign country may be subject to foreign income taxes as well. Thus, U.S. businesses with foreign income are potentially subject to double taxation. (2)

When expanding into a foreign country, many factors affect tax-saving strategies. These include the company's goals, the nature and location of the foreign business activity, the foreign country's income tax rate, the type of entity used for foreign operations, the profitability of foreign operations and the U.S. owner's need to receive periodic transfers of funds.

This article describes how a U.S. taxpayer's goal of managing its global tax liability affects its choice of entity when expanding into a foreign country. The application of the tax law is illustrated by considering the entity choices available to "A," a hypothetical U.S. manufacturer. (3) Exhibit 1 on p. 396 contains the income statement for A, based on the following facts.

Example 1: A currently manufactures and sells 100,000 units per year, with a selling price of $50 and a manufacturing cost of $25 per unit. Administrative and selling expenses are $15 per unit; A's Federal tax rate is 34%. (4) There is no state income tax. (5) A has determined that it can double its business by expanding into a foreign country. If it does so, A's per-unit production costs and other operating costs (including selling and distribution) for the additional production be unchanged.

The motivation for expansion is to increase profits through increased sales. Additional benefits, including lower manufacturing costs from offshore manufacturing, lower shipping costs and lower local income taxes on foreign profits, may also lead to international expansion.

No Taxable Foreign Presence

In the simplest case, a U.S. company may choose to sell its product in a foreign country, while minimizing its exposure to that nation's income taxes. One purpose of U.S. tax treaties with many foreign countries is to clarify which country may impose a tax on business activities, thus reducing the amount of double taxation. Under the U.S. Model Income Tax Convention, (6) a U.S. company will be subject to income tax by a foreign country only if it has earnings from a permanent establishment (PE) in the foreign country. Article 5(6), Permanent Establishment, of the model convention provides:

An enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent, or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business as independent agents.

The term PE does not include the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise.

A U.S. company may delegate foreign sales activity to an independent sales agent in the foreign country and limit its distribution activities to storing, displaying and shipping the products. In this situation, the U.S. company generally will not have a PE creating a taxable presence in the foreign country as a result of its sales activities, assuming the company is operating in a country with which the U.S. has an income tax treaty in force. (7)

Example 2: A, from Example 1, expands its manufacturing capacity in the U.S. and sells its product in the foreign country. A minimizes its business activities in the foreign country and is not deemed to have a PE there. Financially, this expansion will result in A doubling its taxable income (from $1 million to $2 million) and its U.S. income tax (from $340,000 to $680,000). A would not incur income taxes in the foreign country.

Of course, foreign laws may vary, and A should carefully consider the foreign country's laws regarding a PE. A complete analysis in this situation would consider other taxes, fees and charges, including the VAT (none of which are covered in this article).

Choice of Entity for Foreign Expansion

In some cases, a U.S. business needs a substantial presence in a foreign country, even if that means operating through a PE that is subject to foreign income taxes.

One choice is to organize a wholly owned branch office (8) in the foreign country. A foreign branch is not a separate entity, but instead provides flowthrough of income and losses for U.S. tax purposes. A "branch" also means a foreign entity with a single owner (9) that the company has elected under the check-the-box regulations (a CTB election) to be treated as a disregarded entity (DE), by filing Form 8832, Choice of Entity Classification. (10)

A second option is a partnership, which may be organized in the U.S. (a domestic partnership) or in a foreign country (a foreign partnership) and may include foreign partners. A partnership is a flowthrough entity. It may provide needed capital for expansion. In addition, a foreign partner may provide expertise on the foreign business climate and operating practices. This option also includes a foreign entity with two or more owners, for which an election on Form 8832 is made.

A third option is to organize or purchase a foreign corporation. This may permit reporting foreign earnings on the U.S. income tax return to be deferred, because it is not a flowthrough entity.

Foreign Branch or Other Wholly Owned Flowthrough Entity

When a U.S. business expands into a foreign country with a branch office or plant, in some cases it is necessary to organize the wholly owned local entity under local law. Under the CTB regulations (Kegs. Sec. 301.7701-2 and -3), a taxpayer generally can select the U.S. tax classification of a foreign entity. However, there is no choice if the foreign entity is a per se corporation, (11) because it will be treated as a C corporation for U.S. income tax purposes.

A foreign entity may be disregarded (i.e., treated like a branch) for U.S. tax purposes as a result of an election under the CTB regulations, while being treated as a corporation under foreign tax law (a "hybrid" entity). Operating results of a branch or DE are reported on the owner's income tax return. Foreign earnings may be subject to both U.S. and foreign income tax.

Example 3: A, from Example 1, organizes F, which is a branch or other flowthrough entity operating in a foreign country with a 34% income tax rate. F manufactures 100,000 units at a cost of $25 per unit and sells them for $50 per unit. F has net income before taxes in the foreign country of $10 per unit. F will have taxable income of $1 million and will owe $340,000 in foreign income taxes, leaving after-tax income of $660,000. A will have global taxable income of $2 million and total U.S. income tax of $680,000 (before credits), because its taxable income will include U.S. operations and...