From an economic standpoint, the past several years have been brutal. But hope is growing that better days are coming, along with increased interest by foreign investors in pursuing opportunities in the United States. These prospects present challenging business and tax decisions at the federal and state levels. Failure to appreciate this reality can result in costly mistakes.
Any foreign business that chooses to invest should thoroughly evaluate all available options prior to investing. To assist with these decisions, here is a brief overview of aspects of international income taxation, state taxation, and legal and non-legal business issues concerning inbound U.S. investment. U.S. International Taxation
Several levels of tax issues must be considered when choosing a business structure.
Taxation of the Business Enterprise
Threshold decisions have tax ramifications that may be unknown to foreign-based investors. For example, deciding whether to operate as a branch of a foreign corporation or as a U.S. corporation has different tax consequences. If a foreign corporation invests through a branch and a tax treaty applies, the business profits of that branch will typically be subject to U.S. income tax only if such activities create a permanent establishment (PE) as defined by the treaty.
If no treaty exists, then American taxation of a foreign corporation’s operations is determined under this nation’s tax law. If a foreign corporation’s U.S. operations constitute a trade or business with effectively connected income, then the net business income that is U.S.-sourced and not Fixed, Determinable, Annual, or Periodical Income (FDAP, such as interest, dividends, or royalties) is subject to tax at the regular graduated income tax rates. Whether a foreign company has such a business depends on the facts and the degree of contacts and activities in the United States. Generally, sales into the United States alone will not create such a trade or business, but full manufacturing and distribution of products in the United States likely will.
A foreign business could also invest in this country through a U.S. corporation or holding company structure. Investing through an American corporation will likely require transfer pricing analyses of transactions between related companies and may provide tax planning opportunities.
Repatriation of Income
Foreign businesses should evaluate how the United States taxes distributions from the earnings of American corporations and branches of foreign corporations. Repatriating funds to a foreign parent can create withholding and other tax liabilities. Sometimes treaty provisions may apply to limit or eliminate these types of taxes.
Taxation of Employees
If a foreign company chooses to hire foreign employees in its U.S. operations, American rules for determining tax residence apply, subject to any applicable tax treaty. The United States taxes residents — an individual with lawful permanent resident status (a green card holder) or sufficient physical presence in the States for a certain period of time — on worldwide income. An individual may be a dual resident and subject to tax in America and a foreign country. But a treaty may eliminate this double taxation under a “tie-breaker” clause, which limits a taxpayer’s residence to one country by evaluating the strength of the taxpayer’s connections to both countries. Under a treaty’s Savings Clause, however, the United States may reserve the right to tax residents on their worldwide income regardless of residency status in the other country. In such a case, the treaty generally allows a foreign tax credit to help mitigate double taxation.
For non-U.S. residents, there is a limited exception to tax on income from services performed in the United States. If the exception does not apply, such income is typically taxed at graduated income tax rates. A treaty may limit a non-resident’s exposure to U.S. income tax. Proper planning may allow an employee to avoid resident tax status by limiting that employee’s presence in the United States.
State Issues
State tax considerations present potential exposure and planning opportunities. A state’s taxing jurisdiction may be limited, however, based on the degree of activities that the business conducts within that state. A business that merely wants to sell goods manufactured outside the United States to American customers may be able to avoid many state taxes. With proper planning, a business that wants to manufacture goods or provide services in the United States will likely pay state taxes where it invests but may be able to avoid or reduce the taxes paid to states where it only sells or distributes products. Tax credits and incentives may also be available to reduce taxes. Key state tax concepts to consider when determining where and how much to invest, as well as how to distribute goods or provide services to customers, are the types of state taxes, nexus, and apportionment.
Most states have their own taxes based on net income, gross receipts, or capital of in-state taxpayers. To be subject to any of these taxes, a taxpayer must have “nexus” with a state, which is a certain level of connection or activities in the state. Once nexus is established, a state may usually tax only activities that are fairly attributable to that state, determined by apportioning the taxpayer’s taxable base. The tax base is apportioned using a formula based typically on the sales, property, and payroll of the taxpayer in the taxing state versus the total sales, property, and payroll of the taxpayer everywhere. State apportionment formulas vary, and it is possible to be taxed on more or less than 100 percent of the taxpayer’s tax base.
Planning Opportunities
Taxpayers may avoid state taxes by avoiding nexus with states; planning investment and distribution methods based on state apportionment rules, tax rates, and credits; and negotiating tax abatements and other incentives with state authorities. Common strategies for taxpayers with manufacturing operations include avoiding investment in states that weigh the property or payroll factors heavily, which likely increases the taxable base and taxes in those states; avoiding nexus with states with a single sales apportionment factor if most of the taxpayer’s sales occur in that state; and relying on Public Law 86-272, which is a federal statute that prevents a state from imposing income taxes on the sale of tangible personal property if the taxpayer’s activities within the state are limited to soliciting sales, and the contracts are approved and orders filled from outside the state.
Tax Credits, Economic Incentives, and Other State Tax Issues
Once a foreign company has determined how it will invest in the United States, it must decide where to invest. U.S. states compete ferociously for foreign direct investment, and the incentive packages they offer can be lucrative. A foreign company should investigate the availability of economic incentives and tax credits, such as those based on the value of annual investment in property or equipment, payroll, or research and development in a state. States may also provide credits for specific taxpayer activities, like automotive or battery-cell manufacturing.
Property taxes may apply to both personal and real property used in business operations. Many states are willing to partially or fully abate property taxes for a period of time to attract new manufacturing businesses, and will negotiate a reduction based on the amount of investment or economic value a new business will provide to the community.
Sales and use taxes generally apply to consumer sales. Many states do not tax a sale if it is made to a final manufacturer that includes the product in the final consumer good. A taxpayer may avoid sales and use taxes if it does not have sufficient presence in a taxing state.
Other Considerations
In addition to tax issues, foreign investors will meet other challenges, such as legal, business, cultural, strategic, and otherwise. Whenever possible, these factors and appropriate strategies should be carefully considered before investing. Here are some examples to consider:
Legal Considerations
Product liability: this refers to the statutes and case law that permit recovery for injuries allegedly caused by unreasonable conduct of a manufacturer and/or product seller, or by product defects. Companies must have an understanding of product liability laws wherever they manufacture, distribute, or sell goods. These laws vary across states.
Intellectual property: ownership, access, and transfer of interests in advanced engineering, technology, and other intellectual property rights often serve as the cornerstone to investors’ market penetration strategies.
Employment: the ability to attract and retain qualified employees is essential. Moreover, the ability of employees to organize in a new manufacturing facility may increase costs, reduce work force flexibility in terms of employee numbers, and even affect the location of manufacturing activities.
Environmental: the decision to build a new manufacturing facility on an unused “greenfield” site, or reuse an old, possibly contaminated “brownfield” industrial site is important. A greenfield acquisition will likely cost more. But states may offer a company developing a brownfield incentive to clean up the land. Still, there is a risk that a company may assume liability for any remaining past environmental damage.
Contracts: long-term supply agreements, while desirable, have become detailed and sophisticated. A supplier should understand what the contract provides and plan accordingly. The terms and conditions set forth correlative rights and duties, among other things.
Regulatory: our national and state governments regulate many industries. The automotive industry, for example, is heavily regulated by the Department of Transportation (NHTSA), the Environmental Protection Agency (EPA), and several other federal and state agencies.
Non-Legal Considerations
Establishing a strong relationship with a customer can be important to facilitating product development, increasing manufacturing efficiency, and reducing production costs.
The availability of local, skilled employees is essential to the success of any business. Issues relating to the availability of local talent include educational opportunities for employees, cost of living, and personal income taxes.
States also typically offer non-tax incentives, which may include funds to cover land acquisition costs, site-preparation costs, construction costs, and other costs to make the manufacturing facility operational.
Challenges associated with currency fluctuations may arise. Various financial arrangements (such as swaps) can help companies deal with short-term distortions in currency values. Companies can take other measures to adjust to long-term currency fluctuations.
Political Considerations
The government will likely become more proactive, as evidenced by its enforcement of safety and environmental regulations and protectionist trade policies. Government actions and policies may increasingly affect competition.
“Opportunities Should Abound”
Why is all of this preparation important and necessary before investing in the United States? Because this nation is steeped in legal procedure. Failure to act accordingly can have undesirable — yet avoidable — consequences.
The challenge for any multinational company is to operate as consistently, efficiently, and seamlessly as possible. Investing outside your country creates a learning curve where you must adjust to cultural workplace differences, and your new work force must accept a new management style. For successful integration, get everyone on the same page as soon as possible. The most effective way to streamline efforts, avoid costly mistakes, and maximize opportunities is to develop legal, financial, and economic strategies.
As the recovery continues, opportunities should abound, especially for investors with innovative technology and business plans that adapt to emerging trends. But so, too, may risk. Foreign investors should proceed as knowledgeably as possible. As the old adage goes, an ounce of prevention is worth a pound of cure.
