Businesses are consistently evaluating how to stay competitive. Global expansion may be the answer for a business to reach new markets, meet current customer needs, reduce costs, or find talent. We’ve covered the basics of “What to Consider When Expanding Outside the U.S.” and, now, will look at why entity type is important.
Most business owners, at some point in time, have discussed with their legal and tax advisors the pros and cons of selecting their current business structure. As part of that discussion, we generally explain the differences between C corporations, S corporations, Limited Liability Companies, and Partnerships. A similar analysis will need to be made when structuring an investment outside the U.S. Each country will have its own type of investment vehicles that would need to be considered.
Some key starter questions:
- What type of entities can a non-resident establish in the jurisdiction?
- What is are the capital requirements for each option?
- What type of liability protection does the entity provide?
- What are the director requirements?
For example, many provinces in Canada have a residency requirement for directors. Therefore, if a U.S. company doesn’t plan to have a resident director, they will need to select a province that does not require a resident director for establishing an entity.
- What are the ownership requirements?
For example, a Mexican SRL entity requires a minimum of two owners. If this entity type is desired, there are simple workarounds, but having it set up in advance will save a lot of time and expense.
- What are the requirements for repatriating funds back to the U.S.?
- How long will it take to set-up the entity and how formal is the process?
- Which type of entities would be eligible for a U.S. check-the-box election?
Checking the Box
You may wonder why it would important for the entity to be eligible for U.S. “check-the-box” election, but it can play a significant role in structuring international investments.
The check-the-box election is a mechanism that allows a taxpayer to select how eligible foreign entities will be classified for the purpose of U.S. tax reporting. For example, if a foreign eligible entity is classified as a corporation under the default rules, an election can be made to treat the entity as a pass-through entity for U.S. tax reporting purposes. Similarly, if a foreign eligible entity defaults to a pass-through entity under the default rules, a check-the-box election can be made to treat the foreign entity as a corporation for U.S. tax purposes.
Impacts of the Tax Cuts and Jobs Act
Why is this so important? It’s because it may be the difference between avoiding double taxation or not. The 2017 Tax Cuts and Job Act (TCJA), overhauled the way foreign investments are taxed. Prior to the 2017 TCJA, there were opportunities to defer income offshore if properly structured. The TCJA has limited that ability by creating a new category of income called Global Intangible Low-Taxed Income or “GILTI.” US shareholders of foreign corporations that are subject to GILTI must include the foreign corporation’s earnings that are considered to be above a “routine” return in U.S. taxable income currently, eliminating the ability to defer.
The calculations are extremely complicated, but in general, routine earnings are considered to be a 10% return on the foreign company’s fixed assets.[i] The GILTI income is currently included in U.S. taxable income of the owner. C-corporations are allowed a partial deduction of the GILTI income, currently, 50% reduced to 37.5% for the year beginning after 2025. This deduction is only available to C-corporations[ii]. An additional benefit for C-corporations includes the ability to receive indirect foreign tax credits for income taxes paid by the foreign subsidiary. An individual is not eligible for indirect foreign tax credits, which is where the check-the-box election may provide a solution. By using the check-the-box election to classify a foreign corporation as a pass-through entity for US tax purposes, an individual shareholder would include their proportionate share of income in taxable income currently; however, they would also be able to claim as a foreign tax credit their proportional share of foreign taxes paid by the entity to offset US federal taxes.
The TCJA has created a highly complex regime for determining a U.S. taxpayers’ share of earnings from foreign investment, each taxpayer has their own unique set of circumstances. Clayton & McKervey helps business owners evaluate the structures available to them and assists with on-going monitoring as business continues to expand and change. Contact us to learn more.
[i] GILTI was enacted under IRC §951A. There are certain exceptions to the inclusion for foreign corporations meeting a high-tax definition.
[ii] Individuals are not eligible for the 50% deduction under IRC §250, however, there is an opportunity to make an election under IRC §962, Election By Individuals To Be Subject to Tax at Corporate Rates, that should be evaluated to determine if it would provide relief.