Estimating marginal tax rates when entering foreign markets.

• Author: Larkins, Ernest R.
• Position: Part 1

EXECUTIVE SUMMARY

* U.S. companies entering foreign markets should consider a host country's tax laws and income tax rates, treaties with the U.S. and the overall interaction between national tax systems.

* U.S. taxpayers need to determine the best business form or arrangement for marketing their products or services abroad.

* Exporting and licensing are relatively low-risk means of penetrating foreign markets.

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Beginning and expanding business operations in foreign jurisdictions raises myriad tax issues having a potentially significant effect on the marginal tax rate (MTR), as this two-part article discusses. Part I covers issues involved in choosing a particular country and certain business arrangements, such as exporting and licensing, for doing business abroad.

Four major decisions confront domestic companies "going global" for the first time and U.S. multinationals expanding into new geographical areas:

1. Where should a company base new operations or otherwise conduct business?

2. What organizational structure or contractual arrangement should the company use to conduct business abroad?

3. Which U.S. employees (if any) must be transferred to assure success?

4. How will the company remit profits to the U.S. from its foreign subsidiaries?

   Each question involves significant tax issues that affect the marginal tax rate (MTR). For U.S. companies, the MTR on foreign profits equals the present value of worldwide taxes arising from foreign business activities, divided by foreign profits. This definition characterizes foreign profits as incremental or marginal income (over and above domestic profits) and focuses attention on key decisions.

   This two-part article examines the tax implications of these issues and provides guidance on estimating MTRs when entering foreign markets. Part I covers the effects of selecting a particular foreign business locale and conducting business through exporting and licensing arrangements. Part II, in the September 2004 issue, will examine (1) organizational alternatives for conducting business in foreign countries, such as branch operations, joint ventures and subsidiaries; (2) the effect of transferring employees; and (3) the manner of remitting profits back to the U.S. taxpayer.

   Selecting a Country

   Choosing a country in which to conduct foreign business activities is not straightforward; a country's economic, political, cultural and regulatory environment can affect a U.S. company's risk adjusted rate of return. For example, hyperinflation, the threat of expropriation, cultural mores against buying from nonresident companies and internal laws limiting foreign ownership of local entities, restrict opportunities for conducting business abroad in countries with such characteristics, even if the tax laws are otherwise favorable.

   In fact, taxation rarely drives choice of location. (1) However, once a U.S. company decides to invest abroad, tax planning becomes a major factor in selecting the best entry approach. To properly evaluate the tax factors, U.S. companies entering foreign markets should consider the host country's tax laws and income tax rates, the interaction between national tax systems and income tax treaties between the host country and the U.S. (2)

   Combined Tax Rates

   An important aspect of a country's tax structure is its income tax rate. (3) Because many countries impose more than one tax on profits, separate rates have to be combined to obtain a single pre-remittance "combined tax rate." Determining a foreign host country's combined rate requires consideration of its national income tax, applicable surtaxes, local or provincial income taxes and deductibility. Relying solely on a country's national income tax rate, without considering these other components, can significantly understate MTRs (as explained below) and lead to less-informed, suboptimal decisions. The examples below illustrate how to combine tax rates in three host countries:

   * Brazil has a 15% income tax rate, a 10% nondeductible surcharge based on profits and a 9% nondeductible social contribution tax, resulting in a combined rate of 34% (15% + 10% + 9%). (4)

   * Germany has a 25% corporate tax on profits, a nondeductible 5.5% solidarity levy imposed on the corporate tax and a deductible trade tax imposed on profits. The trade tax varies by location; typically, it is 18% in large cities. Thus, the combined rate in such cities is 39.6% ((25% (1 - 18%)) + (5.5% (25%) (1 - 18%)) + 18%). (5)

   * Korea has a 27% corporate income tax and a nondeductible 10% surcharge on the income tax; thus, its combined rate is 29.7% (27% + (10% X 27%)). (6)

   Interaction Between Tax Systems

   U.S. companies conducting business abroad directly are subject to income tax in two countries on their business profits--the U.S. and the host country. To encourage foreign commerce and mitigate the effect of double taxation, the U.S. permits a foreign tax credit (FTC). U.S. businesses can claim an FTC for the lesser of:

1. Foreign income taxes paid or accrued under Sec. 901(a) (7) or

2. Foreign-source income / Worldwide income x U.S. tax on worldwide income, per Sec. 904(a).

   Basically, the FTC can be viewed as the lesser of two components:

1. Foreign-source...