Businesses Coming to the US. What you don’t know can cost your company plenty!
Start-ups coming to the US from abroad, even if just to “test the waters” of doing business in the US, need to be wary of the complex US tax landscape – on a Federal and State level. Poor planning or lack of understanding of the laws, may cause an unsuspecting Start-up to cross the line and actually “start to do business” in the US. Then, failure to take simple actions like filing tax returns (even without profits) or collecting sales tax can result in huge tax liabilities!
In this new series Founders Who Scale will provide insights and smart guidance for foreign individual entrepreneurs seeking to tap US capital markets, and non-US based emerging growth companies seeking to leverage the massive US marketplace for growth opportunities.
Now let’s look at how non-US companies are subject to US Federal and State income taxes:
FORMS OF ENTERPRISE AND THEIR TAX IMPLICATIONS
How a foreign-based start-up structures its US operations will have an impact on how it will be taxed, and have a longer-term effect on profitability. There is a wide-range of business entity options, from flow-through entities / transparent entities like LLCs to opaque organizations like corporations.
Office location and activities to be undertaken in the US have tax implications as well. There are also further tax implications based on the start-up’s home country and whether it has a tax treaty status with the United States.
Typical business models that a foreign-based start-up might consider include the following:
A representative office is a structure that exists in a number of countries throughout the world. It frequently has a special / beneficial tax regime to enable a company to test the waters before it creates a legal entity in the country and expands its business operations. Unfortunately this model does not exist in the US except for very limited cases involving banks.
If a non US company is doing business in the US and has not created a legal entity in the US, then the NON US enterprise… whether it realizes it or not, is considered to have a branch in the US. The benefit of this structure include being able to use US losses against earnings of the parent company abroad; but frequently, detriments outweigh the benefits. For example, without a separate legal entity, such as an LLC or a Corporation, the parent company could be subject to direct US claims and liabilities. In addition, federal, state and local tax authorities could have access to the parent company’s global books and records.
How do you know if your business activity rises to the level of a “branch”?
It depends on whether there is a tax treaty between the home country of the parent and the US. Where there is no treaty, the threshold is fairly low. There is no bright line test. If the non-US enterprise is continuously and regularly transacting a substantial portion of its ordinary business in the US, during a substantial portion of the year, then it has a branch. It also has a branch if it has an independent or a dependent agent in the US.
Where there is a tax treaty between the home country of the parent company and the US, the threshold is a bit higher. Treaties include a concept called a “permanent establishment” (PE). The business profits earned by a non-US enterprise, will be subject to US tax, only if it does business in the US through a PE. A PE generally means a fixed place of business, through which the business is wholly or partly carried on. A PE is also created if the non-US enterprise has a dependent agent in the US.
In addition, the PE concept has exemptions for certain activities. It can conduct activities through an independent agent; it can maintain a stock of goods solely for display or for processing by another party. In addition, a PE is not created if the activities can meet the test of being preparatory or auxiliary to the business.
The branch must pay tax at up to 35%, as if it were a separate entity in the US. In addition, if it remits earnings, it will also have to pay branch profits tax, which is a tax designed to replicate the dividend withholding tax when paid from a US corporation to a foreign person. If the branch has been discovered by the tax authorities, and no tax returns were filed, the branch would need to pay tax on revenue with no deductions; and penalties may also apply. In addition, information returns are required, which carry with them $10,000 penalties, per omission for failure to file, even if no tax is due.
Limited Liability Companies (LLC)
An LLC can solve some of the problems associated with a branch; but in general it is not the best option for a non-US individual or a non-US enterprise because the shareholders are deemed to be partners doing business in the US. They must pay US tax on their share of the earnings of the US LLC.
In general, a corporation is a good structure for a non US individual or business wishing to set up a business in the US. The shareholders are not pulled into the US tax net by virtue of the activities of the corporation.
Profits earned by the US Corporation are usually taxed up to 35%. Beyond that the repatriation of profits (or a dividend distribution) by the US subsidiary to its foreign-based parent are subject to a withholding tax of 30%. Again US tax treaties can reduce the dividend withholding tax.
STATE TAX LIABILITIES
Warning: State income tax liabilities are not governed by US tax treaties, and vary by each state tax jurisdiction. Merely going to a trade show in certain states (like Texas) can create Nexus and therefore a duty to collect sales tax on all sales taking place with customers in the state, for a period of time.
Certainly maintenance of a place of business and having employees or agents, in the state would be enough to constitute doing business in a state, and therefore creating a potential tax liability. For a NON US enterprise, doing business in the US, the risk of falling into the State tax net could be immediate under certain circumstances.
In addition, if the US operations generate profits, State Income or Franchise taxes could be due. Once the State tax authorities have engaged with you and your business, the link, between state and the federal government will make it likely that your US operations will be noticed by the US federal government.
Remember that sales tax and employment tax are “trust fund” responsibilities and thus not only the Corporation would be liable for the tax or penalties but also the individuals, who are the “responsible party,” would be personally liable for any shortfall.
So non-US companies entering the US should be keenly aware of their home country tax treaty status and potential state nexus and taxability status for both sales tax and income tax when considering where to set up business in the US.
With the help of qualified US legal and tax experts, steps can be taken to minimize state tax exposure and penalties, even if a treaty applies to reduce / avoid any federal income tax liability.
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.