Industries: International Business
By: Goran Vukicievic
As multinational corporations expand their operations, they are often faced with executing transactions that involve multiple taxing jurisdictions. Without proper planning, cross-border movement of capital, products, services, and intellectual property can result in significant tax costs and corporate earnings erosion. When considering an international tax plan, tax efficiency, while important, should be considered in hand with the company's operational and treasury positions. A balance between treasury and tax is essential to achieving an efficient movement of capital between affiliates.
When considering the optimal corporate structure that addresses cash flow between foreign affiliates from a U.S. perspective, a U.S. multinational essentially has two options with respect to how the subsidiary entities can be set up. The first option is to operate through subsidiaries treated as disregarded entities (“DREs”) for U.S. tax purposes. The second alternative would be to utilize subsidiaries treated as corporations. Both are often set up with an ultimate foreign holding company that is held directly by the U.S. entity and is typically set up as a corporation for U.S. tax purposes so that the activity below is blocked and aggregated in that entity.
When that is the case, the company first needs to identify the ideal jurisdiction for the holding company. Organizing the holding company in a low- or no-tax country might seem like an obvious choice. However, the IRS would likely challenge the structure if there is no economic substance or business purpose to do so. In addition, there has to be a substantial operational presence in the country for the structure to be respected.
A few additional considerations should be taken into account when selecting the holding company location, such as:
Once the holding company is established, the subsidiary entities below it can either be set up (or acquired) as corporations or branch operations. Branch operations that are owned 100% are considered disregarded for U.S. tax purposes, as in they are treated as part of the operations of their owner, hence the name disregarded entity.
Taxation differs dramatically from a U.S. perspective when the subsidiaries are held as DREs. Some income tax treaties do not view DREs as entities that are eligible to avail themselves of the double-tax treaty. Because of this, a U.S. multinational should first consider the potential consequences of the lack of treaty benefits. From a U.S. tax perspective, DREs are really treated as branch operations, or divisions, of the entity which owns it. Therefore, payments such as dividends, interest, royalties, rents, and service fees between the disregarded entities typically do not produce taxable income for U.S. tax purposes under this structure. Thus, this structure can be favorable from a U.S. perspective to finance or license beween operating disregarded entities. This structure also tends to allow for efficient capital movement; however, it is essential to note that there is a potential for the U.S. parent to have to pick up taxable gain or loss when funds are moved between foreign entities if the holding company and disregarded entities use different functional currency. Other considerations include the treatment of the related foreign jurisdictions, since the DRE election is really only a U.S. tax concept.
In the next edition of the newsletter, we will expand on the second altenative, using corporate subsidiaries rather than DREs.