How To Plan for Global Tax Minimization
May 3, 2024
Expanding business operations globally allows companies access to new markets, more efficient manufacturing options, new technologies, a larger workforce and new sources of inventory. At the same time, global expansion increases the level and complexity of taxation. Therefore, a well-thought-out global tax management strategy will be imperative to the success of your global business activities.
Tax Implications of Expanding Your Business Globally
Without proper international tax planning, a company’s worldwide tax liability along with its compliance obligations can double or triple, making the business less competitive than before. With proper tax planning a company is able to reduce its worldwide effective tax rate as it expands overseas.
What Is Global Tax Minimization?
Global tax minimization is the process that companies follow to fully comply with the tax law in each country in which they operate in such a manner that their worldwide income tax liability is reduced to the lowest possible amount. Every global tax minimization plan is unique to the company that adopts it. There are some common features among the plans adopted by U.S.-based companies.
Successful companies can structure their operations to take advantage of the highly complex U.S. international tax rules. They accomplish this through:
- Adopting transfer pricing policies designed to maximize profits in low-tax countries and minimize profits reported in high-tax countries
- Planning their activities to access the benefits of income tax treaties
- Work with local country tax advisors to reduce local country taxes
Choosing the Right Business Structure
Global tax minimization starts with careful thought when designing the right business structure. There are many factors that influence business structure design, including if the company is:
- Publicly held, private equity-owned or closely held
- Classified as a pass-through or a corporation for U.S. tax purposes (the classification may be different for foreign tax purposes)
- Expanding primarily into treaty countries or non-treaty countries, or both
- Keeping its cash offshore (e.g., for foreign expansion) or repatriating its cash (perhaps to service debt, pay dividends or expand domestically)
- Owned by individuals with a particular exit strategy
Every cross-border structure is unique, but there are some common themes:
Pass-through structures are designed so that all income, expense, gain or loss from the foreign operations flow currently into the U.S. income tax return. These structures tend to be favored by companies that are pass-through in the U.S. and by U.S. corporations that are expanding into high-tax countries. These structures plan for the efficient use of foreign tax credits for income taxes paid to foreign countries. It is important to carefully study the local country’s taxes to determine whether they qualify for credit against U.S. income tax.
The Treasury Department recently published new regulations that make it much more difficult for a foreign tax to qualify as a credit against U.S. income tax. U.S. corporations with foreign pass-through structures can use the foreign derived intangible income (FDII) deduction to lower their U.S. effective tax rate. FDII is income from the use of U.S.-based intellectual property and other non-physical assets in creating an export of goods or services. The deduction has the effect of lowering the tax rate on qualifying export income to 13.125%.
U.S. blocker corporations for U.S. individual taxpayers and partnerships began following the Tax Cuts and Jobs Act of 2017, when the corporate income tax rate was reduced from 35% to 21%. This made the corporate tax rate significantly less than the maximum individual tax rate of 37%.
Example:
If a U.S. individual owns the shares of a controlled foreign corporation (CFC), directly or through a partnership, there is a good chance that some or all the CFC’s income will be reported currently on the individual’s U.S. tax return. The individual becomes subject to U.S. tax immediately on that income at the 37% rate even if the cash stays offshore in the CFC.
If the CFC paid foreign income tax on the same income, the individual may not claim the tax as a credit against the U.S. tax liability. The result is immediate double taxation with no relief. To avoid this result, some individuals choose to form U.S. blocker corporations to hold the shares of their CFCs. The blocker corporation may be allowed to claim the foreign income tax as a credit against the U.S. corporate tax on the same income.
Even if a foreign tax credit does not completely offset the U.S. tax liability, the income is subject to the 21% corporate tax rate rather than the 37% individual tax rate. When the income is later distributed up through the blocker to the individual as a dividend, it is exempt from further tax at the corporate level and subject to tax at the individual level at the 20% capital gains tax rate.
Controlled foreign corporation (CFC) structures are designed to maximize the benefit of the global intangible low-taxed income (GILTI) regime and the corporate deduction for foreign source dividends. CFC structures tend to be most efficient when the U.S. parent company is classified as a corporation and is expanding into low-tax countries. Foreign earnings in a CFC structure run a tax onslaught in the U.S. These earnings are taxed as follows for U.S. taxpayer corporations:
- CFC income is classified as subpart F income is taxed currently in the U.S. at 21%. The U.S. corporation may be able to claim a foreign tax credit for foreign income taxes paid or accrued on the subpart F income. This income includes passive income like dividends, interest, rents and royalties, and certain types of portable income from related party sales or services.
- CFC income that is classified as GILTI is taxed in the U.S. at a rate as low as 10.5% through 2025 and as high as 16.406% thereafter. The U.S. corporation may be able to claim a partial foreign tax credit for foreign income taxes paid or accrued on the GILTI income. GILTI is equal to all the income of the CFC less the subpart income (already taxed) and less 10% of the CFC’s investment in tangible business assets. If the local income is subject to a high local effective tax rate (18.9% or higher), it is excluded from GILTI.
- CFC income that is not subpart F and not GILTI is generally not subject to tax in the U.S. This is because in the year that it is earned, and it escapes U.S. tax when it is distributed up to the U.S. parent corporation as a dividend. The U.S. corporations receive a deduction for dividends received from certain foreign corporations, including CFCs.
Transfer Pricing
When related parties transact with each other, they can set the price at a level that achieves the lowest tax liability for both of the parties combined. Many companies engage economic and legal experts to determine and document the price. The stakes are high because the tax benefit from getting it right can be huge. The penalties for getting it wrong or not properly documenting the price can be quite large.
Example:
Company A manufactures smartphones in Ireland. Its wholly-owned subsidiary, Company B, sells the smartphones in Germany. The corporate tax rate in Ireland is 12.5%, and the corporate tax rate in Germany is 29.9%. In the absence of any legal restrictions, Company B would agree to purchase the smartphones from Company A at a very high price because the two companies have the same owners.
This will maximize taxable income in low-tax Ireland and minimize taxable income in high-tax Germany. However, Ireland and Germany both have transfer pricing rules that require Company A and Company B to use an arm’s-length transfer price and to document their method of determining the price. Determining the arm’s-length price is a very complex process, and the rules allow for quite a bit of subjectivity.
Understanding International Tax Treaties
Close to 70 countries have tax treaties with the U.S. for the purpose of reducing exposure to double taxation, which can drive a company’s effective tax rate to 50% or higher. Tax treaties provide rules for which country has the primary right to tax certain income. This is done by providing an exemption from tax or a tax credit along with reduced withholding tax rates.
U.S. tax treaties have a limitation on benefits (LOB) article that is highly complex and makes it difficult for companies to qualify for treaty benefits. There are also reporting rules that must be followed, and some countries require a residency certificate before extending treaty benefits.
Many countries do not have a tax treaty with the U.S., including all South American and many Latin American countries. Doing business in a non-treaty country requires even more careful tax planning.
Local Country Tax Planning
Many countries use their tax rules to attract businesses and revenue to their country and away from others. There have been a variety of initiatives in recent years to reduce competition for tax revenue such as the base erosion and profits shifting (BEPS) initiative and Pillar One and Pillar Two. These efforts have had varying degrees of effectiveness.
Finding the Right Tax Advisor
U.S.-based multinational businesses should consider engaging a local country tax advisor to assist in minimizing local country income taxes. Local tax advisors have specialized knowledge unique to their own countries on:
- Holiday tax rates
- Tax breakdowns based on employment
- Local tax credits and incentives and if a transfer pricing study is required to secure those incentives
- Products taxed differently, such as digital services or services that are performed outside the country
It’s recommended to consult with a U.S. tax advisor who is a member of a worldwide accounting and advisory firm alliance to find the best foreign tax advisor.
Your Guide Forward
Expanding a business globally can be risky but can also have huge rewards. Reach out to a Cherry Bekaert International Tax team member to learn more about the rewards of a global tax minimization plan during expansion. The planning is a highly complex process but can be achieved with the proper planning and international tax structuring, as well as the right tax professionals.