Marcum LLP
2017 Year-End Tax Guide

 

Foreign Tax Credits and Various Operating Structures

Foreign Tax Credits and Various Operating Structures
 

U.S. Companies considering international expansion need to consider many issues before commencing operations in a foreign location.

For U.S. companies undergoing international expansion, there are a number of important issues to consider prior to commencing operations in a foreign jurisdiction. A principal consideration is the type of foreign entity through which the U.S. company will be conducting its activities in foreign markets, as this could materially impact overall taxation.

DIRECT FOREIGN TAX CREDIT
In general, foreign income taxes are imposed on business activities conducted in foreign jurisdictions.
Where the U.S. company does not have a foreign subsidiary corporation set up, the U.S. company is directly responsible for any tax liability arising in such country. As such, the U.S. company will pay the foreign income tax directly and either:

  1. Receive a foreign tax credit against its U.S. federal income tax liability assessed on such foreign source income, or
  2. Claim it as a business deduction.

Usually, it is more advantageous for taxpayers to claim a foreign tax credit, as it reduces the U.S. federal income tax liability, dollar-for-dollar. The total amount of foreign tax credit allowed is limited to the U.S. federal income tax liability on the foreign source income earned.

In the case of a U.S. company classified as a pass-through entity for U.S. tax purposes, such as an S corporation, the shareholders would claim a credit for their distributive share of the foreign taxes paid directly by the S corporation. This would also be the case if the S corporation were operating in the foreign country through a foreign entity that is disregarded or considered a pass-through for
U.S. federal income tax purposes.

INDIRECT FOREIGN TAX CREDIT
In general, a U.S. company classified as a C corporation that owns 10% or more of the voting stock of a foreign corporation from which it receives dividends in any taxable year will be deemed to have paid the same proportion of such foreign corporation's foreign income taxes, otherwise known as "indirect (or "deemed paid") foreign tax credits." Conversely, in the case of a U.S. parent S corporation, indirect foreign tax credits are not available since S corporations are pass-through entities. As such, where an S corporation owns 100% of the voting stock of a foreign corporation, the 10% ownership requirement mentioned above would be met. However, the S corporation would not be able to claim any indirect foreign tax credits for foreign taxes paid by the foreign corporation since the U.S. parent is not a C corporation.

ORDINARY VS. QUALIFIED DIVIDENDS
Generally, dividend distributions are included in the U.S. shareholder recipient's gross income and subject to U.S. tax. Dividends are generally characterized as either a qualified dividend or an ordinary dividend. A qualified dividend is a distribution of cash or property made from either a U.S. corporation or a qualified foreign corporation. A "qualified foreign corporation" is generally defined as a corporation organized in a treaty partner country eligible for benefits under such treaty. Qualified dividends are taxed at preferential rates which could be as high as 23.8% (i.e., 20% capital gains rate plus 3.8% net investment income tax), while ordinary dividends are taxed at ordinary rates, which could be as high as 39.6%.

Below are four hypothetical scenarios illustrating the mechanics of the above rules. These scenarios have assumed the U.S. entity is an S corporation with individual shareholders taxed at the highest progressive individual tax rate unless otherwise noted below:

Scenario 1
S Corporation with Foreign Disregarded/Pass-Through Entity with Foreign Tax Rate of 34%.
Foreign Source Taxable Income $1,000,000
Foreign Income Taxes (34%) $340,000
U.S. Individual Federal Income Taxes (39.6%) $396,000
Less Direct Foreign Tax Credit ($340,000)
Total U.S. and Foreign Taxes $396,000
   
U.S. Effective Tax Rate 39.60%


Scenario 2
S Corporation with Foreign Corporation in a Non-Treaty Partner Country (Ordinary Dividends) with Foreign Tax Rate of 34%
Foreign Source Taxable Income $1,000,000
Foreign Income Taxes (34%) $340,000
Foreign Corporation Profits Available for Distribution $660,000
U.S. Individual Federal Income Taxes – Ordinary Dividends (39.6%) $261,360
Total U.S. and Foreign Taxes $601,360
   
U.S. Effective Tax Rate 61.40%


Scenario 3
S Corporation with Foreign Corporation in a Treaty Partner Country (Qualified Dividends) with Foreign Tax Rate of 34%
Foreign Source Taxable Income $1,000,000
Foreign Income Taxes (34%) $340,000
Foreign Corporation Profits Available for Distribution $660,000
U.S. Individual Federal Income Taxes – Qualified Dividends (23.8%) $157,080
Total U.S. and Foreign Taxes $497,080
   
U.S. Effective Tax Rate 49.70%


Scenario 4
S Corporation with Foreign Corporation in a Treaty Partner Country (Qualified Dividends) with Foreign Tax Rate of 21%
Foreign Source Taxable Income $1,000,000
Foreign Income Taxes (21%) $210,000
Foreign Corporation Profits Available for Distribution $790,000
U.S. Individual Federal Income Taxes – Qualified Dividends (23.8%) $188,020
Total U.S. and Foreign Taxes $398,020
   
U.S. Effective Tax Rate 39.80%

As illustrated above, where the foreign country's income tax rate is lower than 21% and such jurisdiction is a treaty partner of the U.S., it is more advantageous to set up a foreign corporate subsidiary, as there would be no tax cost of deferral since the effective tax rate on repatriated profits would approximate the U.S. individual rate. As illustrated in Scenario 4 above, the effective tax rate is 39.8%, which essentially results in the same tax impact had the U.S. company operated in the foreign country either directly or through a foreign disregarded / pass-through entity. However, to the extent the foreign country's income tax rate is higher than 21%, it is more tax efficient to structure the foreign operations using a disregarded / pass-through entity if profits are repatriated to the U.S. on a regular basis.

In light of the above discussion, the tax classification of foreign entities for U.S. federal income tax purposes is a significant aspect of any expansion plan which should be considered in conjunction with the foreign income tax rate to determine the optimal means of structuring a U.S. company's operations abroad. Notwithstanding, tax reform proposals in the U.S. could significantly alter this analysis. As such, it is important to monitor such proposals to assess the overall tax impact on operating structure alternatives.



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