Estimating marginal tax rates when entering foreign markets.

• Author: Larkins, Ernest R.
• Position: Part 2

EXECUTIVE SUMMARY

* In choosing the most appropriate form for marketing products and services abroad, alternatives include branch operations and hybrid entities, joint ventures, subsidiaries and CFCs.

* Transferring employees abroad can increase their income and Social Security tax liabilities; it also increases the MTRs of U.S. employers that reimburse employees for those taxes.

* Before establishing business operations abroad, a U.S. company should consider the MTR of its remittance strategy.

This two-part article discusses key decisions that U.S. companies face when entering foreign markets and the potential effect on marginal tax rates (MTRs). Part II focuses on how various organizational alternatives, transferring employees and different methods of remitting profits back to the U.S. company influence MTRs.

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This two-part article addresses how establishing business operations in foreign jurisdictions raises tax issues having a potentially significant effect on the marginal tax rate (MTR). Part I, in the September 2004 issue, covered the ramifications of selecting a particular foreign business locale and conducting business through exporting and licensing arrangements. Part II, below, analyzes (1) organizational alternatives for conducting business in foreign countries, such as branch operations, joint ventures and subsidiaries; (2) transferring employees; and (3) the manner of remitting profits back to the U.S. taxpayer.

Organizational Alternatives

Branch Operations

Conducting foreign business through a branch has both advantages and disadvantages. During the early years, foreign branches may experience net losses while a U.S. corporation tries to establish a market. On the other hand, the corporation can deduct these losses against domestic income, which provides an immediate Lax benefit and reduces its MTR from foreign operations.

However, Sec. 904(f) requires the taxpayer to recapture losses via the foreign tax credit (FTC) when foreign operations turn profitable. Briefly, the unrecaptured overall foreign loss recharacterizes some of the U.S. corporation's foreign-source income as U.S.-source income, reducing the FTC limit and potentially decreasing the FTC. Also, foreign branches with positive earnings trigger host country income tax and, in some jurisdictions, host country branch profits tax. (15)

One impediment to conducting business abroad through branches is unlimited liability. Branches are mere extensions of the corporate form, not separate entities. Thus, they can expose a U.S. corporation to legal liability from host country claimants.

To allow deductible losses to flow through while limiting legal exposure, U.S. companies sometimes establish a "hybrid entity" in the foreign host country, such as a limited liability company (LLC), and make a check-the-box election to treat the LLC as a branch under U.S. law, achieving the best of both regimes. (16) For example, U.S. companies often use a Societe a Responsabilite Limitee (SARL) or Gellschaft mit beschrankter Haftung (GmbH) as a hybrid entity. When profitable, such hybrid entities pay the host country's corporate income tax and may incur withholding taxes when remitting profits, both of which affect the MTR.

Joint Ventures

Joint ventures are global strategic alliances in which a U.S. company makes a direct investment abroad, but permits a foreign investor to hold an equity interest. In some cases, the U.S. and foreign investors own equal shares--a 50-50 joint venture--but not always. For tax purposes, joint ventures are classified as follows:

1. Partnerships;

2. Minority corporate joint ventures, in which the U.S. investor owns at least 10%, but no more than 50%; or

3. Majority corporate joint ventures, in which the U.S. investor owns more than 50%.

Because the majority corporate joint venture tax issues resemble those involving subsidiaries (discussed below), this section discusses only the first two types.

Partnerships: When established as a partnership, a U.S. joint venturer includes its share of partnership profits and gains on its U.S. tax return and deducts its share of losses. If the host country treats the entity as a partnership, legal liability becomes an issue, as with the foreign branch. However, organizing a SARL, GmbH or similar LLC and checking the box to be treated as a partnership under Regs. Sec. 301.7701-2 can secure legal liability protection while retaining the benefits of the partnership form. As was mentioned, checking the box subjects a company to the host country's corporate income tax (and possibly, withholding taxes when remitting profits).

Minority corporate joint ventures: Unlike partnerships, minority corporate joint ventures allow U.S. owners to defer the U.S. residual tax on foreign earnings from low-tax jurisdictions. (17) U.S. residual tax deferrals provide a significant tax benefit. For example, deferring $100 of residual tax for 10 years at a 10% discount rate results in a tax payment of $39 in present-value terms, a 61% savings.

Establishing a minority corporate joint venture sometimes created FTC problems. For tax years beginning before 2003, U.S. taxpayers had to include dividends from each 10-50 foreign corporation in separate baskets, which restricted cross-crediting. They could not apply excess limits (or credits) in these baskets against excess credits (or limits) in other...