The US has some of the most complicated tax rules around the world. Minimizing the global effective tax rate while remaining compliant is always the goal for companies doing business globally. Here are some of the easy-to-miss complexities in US tax that business owners should know.
With high product consumption, the US imports enormous quantities of products from foreign countries. Many companies operate manufacturing centers in other countries and set up wholesale or distribution centers in the US. The US company usually buys the products from the foreign related party and sells to its customers in the US. In this case, the higher the cost paid to the foreign related party, the lower the profits that will remain in the US. Conversely, the lower the cost paid to the foreign related party, the more profits that will remain in the US. The price charged between related parties is called the transfer price. Because the transfer price can be manipulated to control the profits realized in a jurisdiction which, in turn, impacts the tax liability, there are rules requiring that the transfer price be at arms-length.
The arms-length principle requires the price of transactions between related parties should be in line with the price of transactions between independent parties. In the event of an IRS (Internal Revenue Service) audit, the agent may ask for the transfer pricing documentation to confirm that the price between related parties met the arm-length principle.
Foreign Tax Withholding
For US companies who make payments to foreign persons including entities and individuals, the US government has a right to tax a foreign person’s US sourced fixed determinable, annual, or periodical (FDAP) income. Common types of FDAP income include the rents, dividends, interest, royalties, and other personal services. The source of income depends on the type of income. For example, source of service income is the place where the personal service is performed, source of interest income is the residence of the payer, source of rental income is the location of the property.
A US payor must collect withholding tax and remit it to the IRS in the case it is applicable. If the tax is not properly withheld, the U.S. payor (withholding agent) will be liable for the cost of non-compliance, including withholding tax, interest, and penalty. The statutory rate of withholding is 30%. The statutory rate may be reduced or eliminated by claiming tax treaty benefits. Therefore, it is important for the US payor to understand the withholding taxes requirements and stay in compliance.
Federal & State Income Tax Filings
When selecting the type of legal entity that will be used to conduct business in the US, it is important to understand the differences in how any types are taxed. There are corporate entities and certain entities that can elect to be treated like corporations that file income tax returns and pay taxes at the corporate entity level. There are limited liabilities companies and partnerships that pass income to its owners who pay tax at the individual level. Pass through entities would require the business owner to obtain a US tax identification number and file tax returns in the US.
Besides paying Federal income taxes, the company will have state income tax compliance requirements. As the US has 50 states, each has its own tax rules and regulations. State income tax filing requirements are determined based on the “nexus,” or connection. Every state will set its own nexus threshold and once the threshold is met businesses are required to file state income taxes with that state. State income tax filings are not based on where the company is incorporated; therefore, reviewing the company’s state activities including employees, customers, inventory, fixed assets, and offices annually is highly recommended.
Sales & Use Tax
The US does not have a VAT (Value Added Tax) system, instead most states impose a sales/use tax system. Most states impose a sales/use tax on businesses when they exceed certain sales thresholds in the state. These taxes are on the gross sales price charged to customers. It is important for all businesses selling to US customers to understand when they are required to collect these taxes from their customers and remit them to the state(s).
Employees or Independent Contractors
The classification between employees and independent contractors may not be clear in the US. For employees, the employer is responsible for withholding and remitting the employers share of payroll taxes 6.2% of social security and Medicare tax of 1.45% along with the employees share of payroll taxes at the same rates. The employer is also responsible for issuing a W-2 form annually. Independent contractors are considered self-employed and, as such, are required to pay 15.3% of self-employment taxes. The payor is responsible for issuing a 1099 form to payees. As employees or independent contractors have different filing requirements, the taxpayer needs to review carefully. The IRS considers 20 factors when determining employment. The facts generally fall into three categories:
- Behavioral Control: Does the employer control (or have the right to control) what the worker does, and how the worker completes his/her job through instructions, training, or other means?
- Financial: Are the business aspects of the worker’s job controlled by the payer? This includes things like how the work is paid, whether expenses are reimbursed, and who provides tools and supplies.
- Relationship of the Parties: Are there written contracts or does the worker receive employee-type benefits? Will the relationship continue after the work is finished? Is the work performed a key aspect of the employer’s business?
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Understanding US tax requirements for your global business can be complex. Please contact us today to learn more.