Ready to go global? Ask yourself these tax questions first.
This article was first published by TechCrunch.
For many U.S. tech companies, international expansion is not so much a question of if they will start operating abroad, but rather when.
If you’re a leader at one of these companies, you’ve likely investigated the appeal of opening an international sales office, creating a subsidiary overseas, or hiring employees who reside in another country. Doing so can help with growth as much as it can alleviate constraints.
“Setting up legal entities in foreign jurisdictions can allow companies to sign contracts in certain jurisdictions, be closer to clients and prospects, or hire the best talent,” explains Alex Castelli, Managing Partner of the Emerging Markets industry practice at CohnReznick. “But it also means tax questions both locally in the new market and here in the U.S.”
No matter your intentions for international expansion, it’s critical you know the tax implications and possible benefits. Here are a few tax-related questions to consider before putting money down on that office in London, Brussels, Delhi, or beyond.
When choosing an entity type for your business abroad, understanding the U.S. tax law is critical. Generally speaking, maintaining flexibility in your tax treatment is the goal.
Under IRS rules, certain entities can elect to be either fiscally transparent such as partnerships or opaque such as a corporation. Your decision can affect how partners or shareholders are taxed on income in the U.S. and abroad.
Then, there are a number of questions on a decision tree that can help identify the right structure. For instance:
- Will the local entity be earning revenue from third parties, or will it simply be contracting with its U.S. entity to provide services?
- Will it be repatriating any money to the U.S.? Or will it not be generating any cash to send back?
- What are the local taxes and tax rates? Are there any taxes on royalty or dividend payments back to the U.S.?
- Is the U.S. entity set up as a partnership or a corporation for U.S. tax purposes?
Reviewing these details on a country-by-country basis can help determine the best structure to achieve your goals and gain U.S. tax efficiency.
When setting up a local entity in another country, payroll taxes and income taxes are typically the first tax items to consider. Before identifying the right location for a workforce or international expansion, it’s very common for companies to research local corporate income tax rates, which can occur at the country, provincial, and city level depending on the location.
And while research is good, and general corporate tax rates are helpful for determining structure, the topline rates are usually not comprehensive enough. For tech companies especially, there are a couple foreign taxes of which to be mindful — even if you’re not setting up shop in foreign jurisdictions. Those taxes are called the Value-Added Tax (VAT) and Goods and Services Tax (GST) taxes.
Similar to sales tax requirements here in the U.S., VAT tax requirements in foreign jurisdictions are very complicated. Each jurisdiction has its own set of rules, regulations, and exemptions. VAT taxes also require registration and administration for varying rules, which can be extremely burdensome.
Unfortunately, avoiding dealing with foreign taxes or pleading ignorance will not make your tax exposure go away. But it’s not all bad — in fact, looking more closely at VAT taxes can help you to save on costs.
Below are some examples of real tech companies whose tax situation changed due to VAT taxes:
Company A: A U.S.-based digital marketing SaaS company that had clients in 20 jurisdictions including the EU, Asia, and South America
What they discovered: “After researching the tax reporting requirements, the company determined B2B digital sales were subject to VAT withholding in some, but not all, of their jurisdictions,” says Asael Meir, Technology Practice leader and Partner at CohnReznick. “Therefore, in order to avoid costly penalties, we had the company pragmatically register in some of those countries that had VAT withholding requirements, while managing the risks of limited filing in several jurisdictions.”
Company B: A U.S.-based fintech company that was selling to customers in the U.K., in addition to hosting a live training event in London with an entrance fee
What they discovered: “The company failed to collect and remit the VAT tax on the entrance fee,” explains Yoli Martinez-Nadal, Technology Tax Partner at CohnReznick. “Subsequently, the HM Revenue & Custom (IRS equivalent in the U.K.) contacted them to inquire about the live training event and their U.K. operations. The U.K. authority assessed the VAT tax. Hefty interest and penalties were applied, leading the company’s tax bill to almost double. Unfortunately, there was very little room for requesting an abatement of the penalty as it originated from an inquiry from the U.K. tax enforcement. The situation could have been prevented with proper tax planning prior to the event which would have resulted in the tax being properly collected from the event attendees and remitted to the authorities with no tax cost to the company.”
Doing business overseas can also significantly increase the complexity of your U.S. tax returns. The IRS requires owners of foreign corporations to report financial statements of the entity, recast income based on U.S. tax principles, and calculate U.S. tax charges. One of these is the well-named GILTI charge, which is short for Global Intangible Low Taxed Income.
You don’t want to be guilty of misunderstanding GILTI.
“It’s also important to ensure your benefits are captured in your tax strategy so you can minimize what you owe in the U.S. This requires understanding foreign tax credits as well as the Foreign Derived Intangible Income Deduction (FDII),” explains Shaune Scutellaro, Technology Tax Partner at CohnReznick. “For U.S.-based technology companies with a significant number of foreign customers, the FDII benefit can cut the tax rate on deemed foreign exports by about a third. Knowing the actual location of your multi-national customers is extremely important”.
Finally, having foreign entities and foreign bank accounts means that a late-filed return or missed filing can have significant consequences. Certain late filed foreign forms come with a penalty of $25,000 per missed filing, and the penalty for missing foreign bank account reporting forms can be even higher. Even if your company is generating losses and doesn’t have any U.S. corporate income tax due, missing a tax filing can be a big deal. Errors, even when they are made in good faith, are subject to penalties, and an abatement, if available, can be difficult, timely and costly.
Transfer pricing describes instances when your company enters into transactions with related parties under common control or common ownership. This is especially critical when you are dealing with cross-border transactions with different tax systems. A carefully planned transfer pricing strategy is necessary and sometimes required in some jurisdictions. You want to avoid double taxation and closely manage your global tax effective rate. In the cross-border setting, transfer pricing is used as a tool to plan pricing transactions between related parties. Different countries want a piece of the pie.
Transfer pricing is both an art and a science.
When you are planning for transfer pricing, your focus should be with intercompany transactions and the economics of the transaction. You’ll want to consider the acceptable method for transfer pricing cost, cost sharing, profit split, the tax rates on the relative countries. The goal is to minimize the tax burden from the global operation and maintain or reduce your overall effective tax rate. Without proper planning you may be in a situation in which you may be double taxed or in a situation in which you have “trap” losses in one jurisdiction and large amounts of income in another.
For example, a U.S.-based cybersecurity company with subsidiaries in India and Europe had losses in Europe but the U.S. parent and India subsidiary had income. After reviewing their operation and intercompany transaction, the company was able to shift some of the income from the U.S. to Europe entity to balance the overall tax effective rate of the company. Strategies like these are critical to ensuring your expansion abroad benefits your entire company on the whole.
“While the tax rules may be overwhelming and onerous, as your business evolves and the need for international expansion becomes clear, understanding the opportunities and potential pitfalls of your tax strategy will improve your efficiency and expansion timeline”, states Scutellaro. Ultimately, avoiding costly obstacles and clearing the path for the next level of your business to reach a larger client base and business ecosystem.
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