This article will provide a general overview of the U.S. tax and employee benefits considerations in structuring an entity to conduct the foreign aspects of a business (“Foreign Operations”).
- U.S. Tax Considerations
Principal among the U.S. tax considerations are whether Foreign Operations are expected to generate taxable income or loss and whether any such income would be subject to a local country income tax at a rate at or below the U.S. statutory rate of 35%.1 An additional consideration is whether earnings from the Foreign Operations are intended to be repatriated to the United States or whether the earnings will remain with a foreign entity that conducts the Foreign Operations to expand such Foreign Operations. These considerations will determine a number of structuring issues, such as what type of entity to utilize and how to finance the newly formed entity.
- Choice of Entity
A U.S. corporation (e.g., through a branch) or a foreign or domestic flow through entity can be utilized to conduct the Foreign Operations. If such entities are used, any income, gain, loss, deduction or credit will be subject to current U.S. taxation and, thus, the subsequent repatriation of any previously taxed earnings will not result in additional U.S. tax.2 Any foreign income taxes would be permitted as a foreign tax credit in the year paid or accrued (a “Direct Credit”).
Alternatively, if a foreign corporation (which does not have a U.S. tax presence or is not a flow through entity) conducts the Foreign Operations, any income or gain properly attributed to that entity will be taxed only when actually or deemed repatriated to the United States (subject to certain anti-deferral rules). Likewise, losses, if any, generated by the Foreign Operations would not be available to offset non-foreign income earned by a U.S. taxpayer. Any foreign income taxes paid by the foreign corporation would be permitted as a tax credit against U.S. tax only at the time of an actual or deemed repatriation of the foreign earnings (an “Indirect Credit”) to a U.S. corporate shareholder (subject to various limitations).
A foreign holding company (“Foreign Holding Entity”) may also be utilized to either conduct Foreign Operations or hold interests in entities that conduct Foreign Operations. A Foreign Holding Entity is most often utilized where Foreign Operations are expected to generate income subject to a low local country tax rate and such income is intended to be utilized to expand foreign operations rather than be repatriated to the United States. Therefore, a Foreign Holding Entity should generally be organized in a low or zero tax jurisdiction and, preferably, one that 19 has a favorable tax treaty for the Foreign Operations country and the United States. In addition, a Foreign Holding Entity, treated as a foreign corporation, may also help to facilitate the timing and utilization of any foreign tax credits.3
- Anti-Deferral Rules
Under Subpart F of the Internal Revenue Code,4 a “U.S. Shareholder” of a “controlled foreign corporation” must include in gross income its pro rata portion of any “subpart F income” whether or not such income is distributed to its U.S. Shareholder.5 Accordingly, if Foreign Operations are conducted by a foreign corporation, income earned by such Foreign Operations may constitute subpart F income.
- Financing the Newly Formed Entity
The capitalization of an entity conducting Foreign Operations with debt (whether from a related party or a third party lender) versus equity will depend on a number of tax considerations including: (i) whether the Foreign Operations’ earnings are intended to be repatriated to the United States or redeployed outside the United States; (ii) whether any distributions will be subject to a local country withholding tax; (iii) whether an interest deduction provides a local country tax benefit; and (iv) whether the Foreign Operations are expected to generate foreign taxes.
- Other Tax Considerations
The above summary provides only a high level overview of tax considerations in structuring an entity to conduct Foreign Operations. There are a multitude of other activities which may affect the ultimate decision on how to best structure such an entity for U.S. purposes, such as (i) whether there will be a transfer or use of U.S. owned intellectual property by a foreign entity, (ii) the nature of any related party transactions and whether a transfer pricing study is necessary, (iii) withholding rates in the country of organization, and (iv) the applicability of any income tax treaty between the United States and the country of organization. Furthermore, the current U.S. taxation of foreign earnings may be subject to modification under legislative proposals and should be closely monitored.
- Employee Benefits Aspects of Employee Transfers from the United States to Foreign Operations
Historic U.S. employees are often utilized when a U.S. business is setting up an entity to conduct Foreign Operations. This section will provide an overview on ways of dealing with the requirements of internationally mobile employees and their benefits. 20
- Considerations Based on Employment Type
Where the employee(s) in question are on a short-term assignment (i.e., up to 5 years) or secondment, a typical approach is for those employees to be retained in the U.S. benefits structure where permissible under foreign law. This would include participation in equity plans, pension plans, social security and welfare plans. An important aspect of the process is assuring that the U.S. plans are drafted appropriately to permit continued coverage of such individuals while on assignment without inadvertently covering other employees whom the employer would like to exclude. Further, retaining U.S. citizens on assignment on a U.S. payroll effectively implements the typical approach to the provision of benefits to such individuals. When a U.S. citizen on assignment must be localized, retention of such individual in all U.S. plans (e.g., a 401(k) plan) may be administratively impracticable, and alternative benefits or additional compensation must sometimes be provided.
Alternatively, you may have an employee who is a “globalist” (i.e., employed on a series of short-term assignments without any expectation of a return to the United States). If these employees are truly international, then they will normally warrant an international approach to both pay and benefits involving off-shore benefit arrangements.
- Developing an International Employee Benefits Policy
By definition, the management of international employee benefits is inherently complex because it requires an understanding of legislation and practice in multiple jurisdictions. It also requires consideration of local culture and market conditions. Therefore, the benefits policy should be developed in consultation with the business or human resources managers in the various local jurisdictions where the company has operations. The first step in establishing a workable policy is to define its objectives. Key considerations to take into account in doing so are outlined below.
- Identify each market of operation and the employees working in them
The first consideration in establishing a benefits policy is to identify the relevant labor market to which it will apply. It is important to recognize that a company will compete for different segments of the labor market in different jurisdictions. For example, if the entire workforce is sales and marketing staff, it will only be competing in that segment. In another location the local employer could be competing for employees in the production segment of the workforce. 21
- Identify the intended market position with respect to remuneration for each market
In general, a company with “competitive” pay or benefits is providing total remuneration to employees at or near the market average. Many companies seek to set their pay and benefits at this level, although some will pay below, with additional elements contingent on individual or group performance.
- Identify the elements of remuneration considered to be employee benefits
It should be recognized that not all benefits will be relevant in each country. For example, in the United States the provision of medical insurance is an important part of the employee benefit package; in the United Kingdom this is not the case for most employees, because there is almost universal healthcare coverage provided under the National Health Service which is funded by compulsory employer and employee contributions. Therefore, the best way to assess whether a form of benefit is relevant is to consider it on a country-by-country basis. If it is relevant it then becomes a question of whether some or all of the employees should be covered.
- Consider if there is any requirement for consistency across the business locations
Developing an international benefits policy requires consideration of whether it is desirable to achieve the same level of consistency in pay practices across borders. The approach to benefit design and delivery may be consistent without necessarily providing that benefits should be the same in different jurisdictions. One approach is to simply target a competitive level of benefits by reference to the local labor markets and tailor benefits accordingly. Another approach is to adopt an above-market position in all countries to attract the best staff and facilitate the movement of employees along lines that transcend local market conditions.
- Recognize the need for compliance with local legislation
Although legislation in different countries may contain common themes, the details are often different. It is therefore possible to encounter situations where the laws of the parent company’s home jurisdiction will conflict with the laws governing a subsidiary’s jurisdiction. This is a frequent problem in relation to secondments and when a company wishes to establish a benefit policy in multiple jurisdictions..