In today’s world, more and more U.S. businesses are operating globally in outlook and reach. Moreover, companies are “going international” earlier in their life cycles compared to 30, 20 or even 10 years ago. Once a U.S. company becomes a multinational organization, the complexity of its business operations typically rises dramatically. This rise in business complexity goes hand-in-hand with a significant increase in tax complexity.
The reasons for the increased complexity can be attributed to several factors including:
- more complex transactions requiring more analysis and understanding to appropriately apply tax law;
- the existence of international transactions brings into play a whole set of complex international tax provisions within the U.S. code; and
- the existence of cross-border transactions means that tax laws in multiple jurisdictions, often with differing taxing methods and positions, must be navigated.
These factors can lead to uncertainty, and potential exposure, with regard to a company’s tax liability.
For companies in various stages of their life cycle — from start up to mature — some of the same international tax issues occur with great regularity. The following top 10 list of international tax pitfalls is not all inclusive – some items could be taken off and some items added depending on the company – but it highlights how many common, and seemingly innocuous, business practices can lead to tax problems for the unwary.
Pitfall #1: Not clearing intercompany accounts payable/receivable
Many companies roll forward their intercompany balances between the U.S. and foreign subsidiaries from year to year.
Potential Issue: Internal Revenue Code (“IRC”) section 956 deemed dividend
If a net payable exists from the United States to a foreign subsidiary, and the payable remains outstanding beyond normal payment terms, the payable may be considered a loan from the foreign subsidiary to the U.S. company. This loan is viewed as a repatriation of money to the United States, and is treated as a deemed dividend subject to U.S. tax. This situation often occurs when intercompany transactions are managed through journal entries rather than through the Enterprise Resource Planning (“ERP”) system. Another common practice is for a parent company to provide a subsidiary with sufficient cash to meet its operating needs without a corresponding reduction to the foreign company’s accounts receivable. This results in the foreign company’s accounts receivable and accounts payable growing over time, which can trigger a Section 956 deemed dividend. A Section 956 deemed dividend may also be triggered if a U.S. company secures a loan using the stock of its foreign subsidiaries (this includes loans secured by “all the assets” of the U.S. corporation). The terms of the loan may, however, be structured to avoid triggering this deemed dividend.
Here’s an example that illustrates how improper management of intercompany balances can trigger a deemed dividend. Pursuant to its transfer pricing policy, a U.S. parent company is supposed to reimburse its foreign subsidiary on a “net cost plus” basis1 for sales and marketing services that benefit the U.S. parent. Let’s say the foreign subsidiary incurs $50,000 of local sales and marketing expenses on a monthly basis. The U.S. parent makes a payment of $150,000 each quarter to the foreign subsidiary to cover those expenses as they arise and no additional payments are made to the foreign subsidiary. During years 1 through 3, the foreign subsidiary generates no income. Although the mark-up owed may be quite small, assume 5% for purposes of this example, after 4 years, the foreign subsidiary has an intercompany receivable from the U.S. parent of $120,000. If in year 4, as a result of a sizable new contract, the foreign subsidiary generates a net income of $150,000, $120,000 of this income would be “deemed” distributed to the U.S. parent and subject to a 35 percent U.S. corporate tax. To make matters worse, the foreign subsidiary’s local tax authority may assert that additional tax is owed because its income for services rendered, and perhaps interest due on its intercompany balance, was understated in years 1-3.
Pitfall #2: Informal transfers of intangible property (“IP”)
When establishing a new subsidiary in a foreign jurisdiction, a U.S. parent company will often provide company know-how, processes, customer lists or other intangible property to its newly-formed subsidiary. These types of assets may have already been in use by an existing branch, which is subsequently incorporated.
Potential Issue: Transfer pricing adjustments increasing U.S. taxable income
While a U.S. corporation can contribute IP to a U.S. subsidiary without any tax consequences, transfers of IP to a foreign subsidiary result in a taxable transaction. Once intangible assets are made available to or are used by a foreign subsidiary, an “arm’s length” payment is required for their use.2 If no payment is made, there is a deemed transfer of IP out of the United States and a corresponding toll charge, which typically takes the form of a deemed royalty from the foreign subsidiary to the U.S. parent, may be imputed by the IRS and included in taxable income. This can lead to transfer pricing penalties and interest, administrative burdens and possibly double taxation.
A U.S. parent company decides to open an Asian manufacturing subsidiary to leverage lower costs of production in Asia. In the process of opening the subsidiary, U.S. engineers and plant managers travel to the new subsidiary to provide oversight, training, and information on U.S.-developed manufacturing techniques and processes. The foreign subsidiary is charged for the travel and expenses and salary costs of the U.S. personnel who provided this information. After a start-up period, the foreign subsidiary begins to earn a sizable profit relative to comparable manufacturing companies in its region. The U.S. transfer pricing rules require that the payment for IP be commensurate with the income attributable to the IP. If the information provided by the U.S. parent allows the foreign subsidiary to earn an above-normal return, a transfer of IP will be deemed and an arm’s length payment will be required. In most instances, the reimbursement of the U.S. parent’s costs (even with a mark-up) will not be sufficient.
Pitfall #3: Failure to charge for corporate headquarters services
Most U.S.-based corporations with international operations perform corporate functions and/or activities, such as accounting, IT, or human resources that benefit their operations worldwide. The costs associated with these activities often remain on the U.S. books.
Potential Issue: Transfer pricing – understated U.S. taxable income and overstated foreign taxable income
If foreign subsidiaries are profitable (and subject to tax overseas) while the U.S. business has losses, it is possible that the expenses incurred by the U.S. entity are supporting foreign operations. In addition, some tax jurisdictions treat the allocation of headquarters costs differently. Care must be taken to ensure deductibility of the charges in a foreign jurisdiction.
Pitfall#4: Lack of planning for withholding taxes
As U.S. companies establish their foreign distribution or licensing structure, foreign (or domestic) withholding taxes are frequently overlooked.
Potential Issue: Withholding tax liability
It is critical for companies that are anticipating the distribution of products overseas to plan for the potential tax treatment of the transactions in the various countries involved. Contractual terms, regardless of whether the transactions are labeled as sales or licenses, may have a significant impact on the applicable withholding tax, which typically ranges from 30 percent to 5 percent of the gross amount of the transaction. Furthermore, even if a withholding tax is inevitable, planning for withholding taxes may allow the company to pass that tax along to the end customer (which is common practice in certain countries). Instituting a standardized approach that anticipates potential withholding tax issues allows for increased certainty regarding the foreign (or U.S.) tax liability associated with transactions. Even if reduced withholding tax rates are available under treaty, failing to file the appropriate compliance forms may prohibit a company from benefiting from the reduced rates.
Pitfall #5: Failure to disclose foreign bank accounts
Potential Issue: U.S. information reporting of foreign activity
If aggregate foreign bank accounts total over $10,000, U.S. companies are required to furnish informational statements disclosing details regarding all foreign bank accounts held directly or indirectly if the U.S. company has direct or indirect control of the account and a financial interest in the account. These requirements are far-reaching and many U.S. corporations are not aware of the requirement to report accounts held by their subsidiaries or overseas offices. The potential penalties for failure to file these reports are as high as 50 percent of the balance of those accounts, and there may even be criminal penalties.
The IRS is aggressively pursuing the information reporting of foreign activity and has provided significant guidance regarding the various informational returns and disclosures that are required. Foreign bank account disclosures are considered one of the larger revenue generating opportunities for the IRS in audit examinations.
Pitfall #6: Lack of coordination between transfer pricing policies and customs reporting, VAT, etc.
Potential Issue: Underreporting for customs or VAT purposes and corresponding penalties
Transfer pricing policies directly impact the intercompany sales prices of products and services. Frequently, discrepancies arise between the prices that companies have implemented internally for transfer pricing purposes, and what is used or recorded for customs purposes. This is especially true when companies make year-end adjustments to their transfer prices in order to conform to the requirements of tax authorities. Significant issues can arise from a customs standpoint if the values are inconsistent. In addition, the transfer pricing rates applied for services rendered overseas are frequently subject to VAT or indirect taxes.
Pitfall #7: Inadvertent triggering of foreign income tax compliance requirements
Potential Issue: Foreign income tax liabilities and penalties
U.S. corporations that operate in multiple foreign jurisdictions are frequently caught unawares by tax filing requirements in the countries in which they operate. The employment of residents in foreign countries or the establishment of foreign offices is often mistaken as the sole threshold for requirements to file foreign tax returns. Although treaties between the United States and many foreign countries help limit the level of potential tax liability associated with operating in foreign countries, there are many countries the United States does not have an income tax treaty with. Furthermore, even when a treaty does exist, certain countries still require tax filings to obtain treaty benefits (and exemption from or reduced local tax).
Although many companies consider the probability of foreign countries discovering their activities as remote, and the potential for the tax authorities assessing a local tax liability as low, the existence of that liability may represent a substantial problem in the future. Risk from failure to file for local taxes may seem immaterial, especially when taking into account probability of discovery. But under certain circumstances, such as when companies are in diligence with the prospect of being acquired or are contemplating going public, a history of missed filings may represent a substantial tax liability that can directly impact the company’s financial valuation.
Pitfall #8: Poor or missing transfer pricing procedures or controls
Potential Issue: Transfer pricing penalties and adjustments
Many companies commission a transfer pricing planning study to establish a set of arm’s-length transfer pricing policies. Unfortunately, having arm’s-length policies is necessary, but not sufficient, to ensure that transfer pricing results are actually arm’s-length. Ensuring arm’s-length results also requires effective transfer pricing procedures and controls to ensure that transfer pricing policies have been properly implemented and are being followed. Proper monitoring of transfer pricing can prevent end-of-year adjustments that are difficult to manage.
The transfer pricing function cuts across many parts of the organization, including tax, finance, accounting, IT and operations. Without effective procedures and controls, intercompany transactions may be executed without knowledge of the tax department, and can have a material impact on tax liability. Common examples include the addition of a new product and the transfer of inventory.
Pitfall #9: Dated or incomplete transfer pricing documentation
Potential Issue: Transfer pricing penalties and adjustments
Many companies commission a transfer pricing study to cover certain intercompany transactions while leaving others undocumented. Similarly, companies will frequently use the same study for a number of years. Having proper documentation and intercompany pricing codified in intercompany agreements is the first line of defense in the event of a tax authority inquiry into transfer pricing. Failure to adequately document can lead to transfer pricing adjustments and penalties.
It is possible to leverage transfer pricing studies for a number of years; however, studies should, at a minimum, be refreshed annually to reflect current year data for the company and any comparables used, and to confirm that the relevant facts surrounding the intercompany transactions are unchanged. Changes in economic conditions, new intercompany transactions, or other changes in facts can have a material impact on transfer pricing results.
Pitfall #10: Sales to customers in foreign countries without registering for indirect taxes / value-added tax (VAT)
Potential Issue: VAT penalties and interest
Corporations operating in multiple foreign jurisdictions are often caught unaware of foreign VAT registration requirements. Many jurisdictions have a nil threshold; therefore a new supply chain, procurement policy or market could lead to a requirement to register for VAT. A registration could be required even without any physical presence in a country.
With VAT rates generally increasing globally (in Europe the rate can be as high as 25 percent), significant historic liabilities could accumulate, with this being exacerbated by strict penalties and interest.
For example, VAT registration may be required if the company acts as the importer of record, bringing goods into a country before delivery is made to the customer, procuring goods from an overseas supplier and making a local sale, or even the movement of inventory between two countries.
VAT liabilities are not just created by supplying goods, but also services. In fact, there may be a requirement for local subsidiaries to self-assess for local VAT on services procured from outside its jurisdiction (including management charges to a U.S. parent). Indeed, there may be a requirement to register and account for VAT on the sale of digital supplied services to private individuals where the customer is located.
An international supply chain can usually be structured to ensure that the liability to account for VAT falls upon the customer rather than the supplier. However, this often requires the supplier to obtain and retain satisfactory evidence (such as the customer’s VAT registration number), as well as ensure that the correct Incoterms (terms of trade) are used.