International business is no longer the province of large corporations. In cities as diverse as San Francisco or Los Angeles, or even smaller cities in California, more and more small businesses can embrace international trade. At Safe Harbor LLP, we advise businesses on international tax issues, and form one of the top CPA firms in San Francisco for International tax. In this blog post, we will examine some issues on International tax, especially the so-called IC-DISC (Domestic International Sales Corporation).
Planning to Prevent International Tax Surprises: the Global Position
Not long ago, international business was the domain of large corporations. Today, the Internet, advances in freight and logistics, and other developments have made global markets accessible to even the smallest businesses.
But just because some barriers have been lowered doesn’t mean doing business internationally is easy. In fact, it’s a complex process that requires a company to establish the necessary infrastructure, develop an understanding of foreign cultures, and prepare for a new tax environment. Careful tax planning can help you set up your international business in a manner that minimizes worldwide taxes and maximizes cash flow. Let’s take a closer look at some of the issues you should consider.
Structuring Your Corporation for International Tax Advantages
There are many ways to do business abroad, including direct exporting, a joint venture with a foreign partner, acquiring a foreign company, or establishing a new foreign subsidiary or division. The right strategy depends on several factors, including the laws of the country in which you wish to do business and the level of control you seek.
The structure of your global operations also has significant tax implications. Suppose, for example, that your business operates as an S corporation. Without careful planning, you may find yourself subject to double taxation on foreign income, paying corporate-level taxes in the foreign country and individual-level taxes in the United States.
You can minimize or eliminate double taxation by setting up a hybrid structure — that is, one that’s treated as a taxable entity in one country and a pass-through entity in another — and filing the appropriate elections. These structures allow foreign corporate-level taxes to flow through to the individual owners as credits against U.S. income tax. There may still be double taxation, however, to the extent that the foreign tax rates are higher than an owner’s U.S. income tax rate.
Corporate structure also affects a company’s ability to take advantage of foreign losses or to defer U.S. taxes on foreign income. For example, if a foreign operation is structured as a hybrid entity or as a branch or division, the owners may enjoy significant tax benefits by deducting foreign losses (subject to passive activity loss rules and other restrictions).
On the other hand, if you’re doing business in a country with low taxes, operating through a foreign subsidiary may allow you to defer U.S. taxes on foreign income (subject to limitations). For some companies, an interest charge–domestic international sales corporation (IC-DISC) can provide similar benefits at a low cost.
Income Tax Withholding and Credits
It’s critical to understand a foreign country’s income tax laws, regulations and procedures. It’s particularly important to consider withholding taxes. If your company doesn’t have a physical presence in a country, the country may impose significant withholding taxes on your company’s gross income.
Many countries have treaties with the United States that provide for low or no withholding taxes on cross-border payments, but there may be exceptions. For example, some countries may not extend international treaty rights to certain types of entities, such as limited liability companies (LLCs).
The availability of foreign tax credits is crucial to avoiding taxation of income by both the foreign country and the United States. Withholding taxes paid to another country generally entitle your company to a dollar-for-dollar direct credit against U.S. tax liability.
But if you operate through a foreign subsidiary, it’s a bit more complicated. The subsidiary pays corporate-level taxes on foreign income, which becomes taxable in the United States when it’s distributed to the parent. The parent can claim an indirect tax credit for foreign taxes paid, subject to certain ownership requirements and limitations on the amount of the credit for certain types of income.
Indirect Taxes and International Tax Issues
Don’t overlook indirect taxes, such as customs duties and value-added tax (VAT). Duties vary substantially from country to country and even from product to product. And there may be opportunities to minimize duties by categorizing products in a certain way or by unbundling products and reassembling the components after they’re imported.
A VAT is similar to sales tax, except it’s imposed on the amount of value added at each level of the production process. Generally, the seller is responsible for collecting and remitting the tax, offset by any VAT the seller has paid to others.
More than 140 countries have VATs, and the rules vary dramatically from country to country. VAT rates generally fall between 15% and 25%. In some countries, VAT registration is required even if you don’t have a physical presence there. Where registration isn’t required, voluntary registration may provide advantages, including quicker refunds of excess tax payments.
If goods will be stored in inventory for an extended period of time, consider using a bonded warehouse to defer customs duties and VAT.
Doing business abroad requires you to learn a new business language, and we’ve introduced just a few important terms. With the help of a tax advisor, you can translate these concepts into international business success.
