America, the land of opportunity – so long as you aren’t American!
- by Jimmy Sexton
- March 29th, 2016
Recently I met with a foreign (non-U.S.) company (“Clueless”) seeking tax advice regarding selling products (“widgets”) in the U.S. The CEO was very excited about this new endeavor and eager to get started. He shared with me that in an effort to be proactive they had already formed a U.S. subsidiary (“Clueless U.S.”) to sell their products through.
In the back of my mind I was thinking, why in the hell would you form a U.S. subsidiary and be subject to U.S. tax if all you plan to do is sell products in the U.S.? But I needed more information to determine whether a U.S. subsidiary was needed; maybe there was a reason I wasn’t aware of.
For purposes of brevity, I will summarize the fact pattern so we can get to the point of this article. Clueless is incorporated and operates out of a jurisdiction (“Country A”) that has a comprehensive double tax agreement (“DTA”) with the U.S. Clueless manufactures widgets and sells them throughout the world. The highest corporate tax rate in Country A is 10% and the highest corporate tax rate in the U.S. is 39%, a difference of 29%.
Clueless wanted to start selling their widgets in the U.S. To that end, they found a U.S. distributor (“Distributor”) eager to sell their widgets. Clueless’ plan was to sell their widgets to Clueless U.S. at an arm’s length price, of course. Clueless U.S. would then sell and deliver the widgets to Distributor. Clueless felt it was important for Clueless U.S. to keep a large supply of widgets in the U.S. so the Distributor’s demand could be quickly met.
I asked the CEO, “Do you like paying more tax than you need to?” The CEO immediately quipped, “Of course not!” Today was going to be the CEO’s lucky day, because fortunately they came to see me before commencing U.S. operations. Here is why.
The U.S. can only tax a foreign business if that foreign business has what is known as a “permanent establishment” in the U.S. A permanent establishment is generally a place of management such as a branch, an office, a factory, or a workshop. A mine, oil or gas well, a quarry, or any other place of extraction of natural resources would also fall into the category of “permanent establishment.” What many companies don’t realize, however, is that several DTAs with the U.S. have specific exemptions from certain types of facilities being considered a permanent establishment. In this case of the DTA between Country A and the U.S. stated that “the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery” is specifically exempted from the definition of a permanent establishment.
What did this mean for Clueless? It meant a HUGE tax savings! Why you ask? Let’s analyze this a bit. Under Clueless’ original plan, Clueless U.S. was going to purchase inventory from Clueless for purposes of storing it, selling it, and delivering it to the Distributor. This creates two completely unnecessary side effects; a potential transfer pricing issue and U.S. corporate income tax on profits from Clueless U.S.
Issue 1: Related companies are required to do business with one another at arm’s length. In this instance, Clueless U.S. would have to pay Clueless an arm’s length price for widgets, i.e. the price that Clueless would sell widgets to an unrelated 3rd party. Because Clueless and Clueless U.S. are related, a potential transfer pricing issue arises. If Country A’s revenue department or the IRS disagreed that the price charged by Clueless to Clueless U.S. wasn’t arm’s length they could readjust price, which could have big tax implications.
Issue 2: Clueless U.S. would have profits on the difference between the purchase price and sale price of the widgets. Given the sales projections this would land Clueless U.S. in the 34% tax bracket in the U.S.
Remember, pursuant to the DTA between Country A and the U.S. “the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery” is exempted from the definition of a permanent establishment. What does this mean for Clueless?
It means that Clueless doesn’t need Clueless U.S. at all. Clueless can sell directly to Distributor and still maintain a storage facility in the U.S. to ensure timely delivery to the Distributor without being considered to have a permanent establishment in the U.S. By structuring its business this way it avoids the transfer pricing issue because the Distributor is an unrelated 3rd party, and U.S. income tax is avoided altogether.
And viola! I just saved Clueless the cost of a transfer pricing study and 24% U.S. corporate income tax on U.S. profits.
Over the years I have become quite familiar with fact patterns similar to this. The solution outlined in this article is relevant to almost any foreign company selling products to the U.S.; especially those who sell online and simply deliver products to the U.S.
Unfortunately, most companies think that in order to sell in the U.S. you need a U.S. company – absolutely not true! In fact, from the fact pattern above you can see that there are substantial advantages – especially from a tax standpoint – to doing business with the U.S. from outside the U.S. Foreign businesses selling to the U.S. can often do so with far less tax than U.S. companies selling in the U.S.
When will the U.S. wake up and realize that their corporate tax policies are killing their competitiveness? For now, however, foreign sellers can often exploit the massive U.S. market without having to pay a dime of U.S. income tax.
If you are foreign business wanting to access the U.S. market, and need some tax advice, give us a call–we can help.