Creating a Foreign Sales and Marketing Organization
Now what happens if you want to expand your organization locally or you decide to go into a country with a more robust enterprise? There may now be a need to register in that country or even to form a subsidiary. Once that happens, how that organization is compensated becomes a main focus for foreign tax authorities.
Branch Versus Subsidiary
Costs: Set Up, Operation, and Exit
In looking at registering locally as a US company or forming a subsidiary, there are typically different associated costs. In many countries, the registration costs are quite similar, but the ongoing administrative requirements are different.
For example, many countries require local companies to perform a statutory audit even if the US parent isn’t required to conduct an audit or the subsidiary’s activities don’t seem substantial enough to warrant one. This can be a costly undertaking.
Exiting a country is also much easier when there isn’t a separate legal entity to wind up. Planning an exit strategy usually isn’t at the top of the list when first entering a country but having a plan in place and a flexible structure is important.
Sometimes, jurisdictional preferences or requirements may take the choice out of your hands. For example, there may be limitations on a US company’s business activities when they operate in branch form in certain countries. These specific local requirements need to be understood before becoming set on establishing a branch or subsidiary.
Having a subsidiary does provide some additional opportunities. For example, having a legal presence requires VAT registration. This can be beneficial because registering for VAT now allows a company to offset any VAT paid against VAT collected. However, income earned by an entity generally can’t be deferred because it’s now subject to US tax on a current basis under the GILTI rules.
In July 2020, the IRS published final regulations on the application of the high-tax exclusion from GILTI. Under the high-tax exclusion, taxpayers may make an election to exclude certain highly taxed income of a controlled foreign corporation when computing their GILTI. As such, income deferral may still be achieved in certain situations.
Typically, an entity’s income follows functions, assets, and risks. This means the more a company has, the more income it should earn. What the subsidiary is doing and who it’s doing it for will drive the amount of income and the form of compensation.
Finally, the issue of providing individuals with the authority to sign agreements can be revisited once a company has a taxable presence. While there may be some structuring needed to protect the US parent, local employees can be given authority to sign agreements.
Conducting Distribution Activities
Let’s say sales are booming outside the United States. The next step may be storing inventory, spare parts, and more locally to reduce lead time in getting the goods to customers.
One of the first considerations during this stage is deciding who’s going to own the inventory.
Most treaties offer exceptions to permanent establishment. For example, a company that owns inventory in a country—for the purpose of delivery, display, or further processing by another—won’t create a permanent establishment in that country. This makes it possible for a US company to own inventory in a foreign jurisdiction.
This can lead to other concerns, including a US company potentially being viewed as an importer under the local law. This could result in customs duties and VAT that could otherwise have been avoided.
There are opportunities to use free trade zones, customs-bonded warehouses, and other techniques to mitigate these costs.
Changes to Compensation
Once a company’s inventory is flowing through a foreign entity, its compensation may need to be changed. Something to consider is whether there’s enough of a difference in functions, assets, and risks than what the sales organization encounters. Even then, it depends. Sometimes a change is needed, but in other cases, it may not be warranted.
Spare Parts and Warranty Work
There are some additional questions to address and vet before expanding, such as:
- Who will perform the warranty work?
- Who will own the spare parts?
- Is the US company going to subcontract out to the local subsidiary?
Establishing Foreign Manufacturing
Finally, what if you want to manufacture locally? There are certainly opportunities and issues that this stage of the life cycle creates.
Defining the Customer
The first thing to figure out is the customer of this foreign manufacturer. Some questions that might help you determine this answer include the following:
- Will it sell its finished goods back to the US parent or a related foreign distributor?
- Will it have its own customers to which it will make sales?
These answers drive a lot of other questions. For example, if it’s purely a contract manufacturer, the financing of equipment may be much different than if it’s selling to its own customers.
Whether or not a foreign entity has to license intellectual property to manufacture will be based on how the entity operates. A contract manufacturer typically isn’t expected to license intellectual property while other types of manufacturers are expected to do so.
Overall Tax Strategy
All of these decisions have very different tax consequences that need to be fit into a company’s larger operational strategy.
For example, is the overall goal to maximize cash in the United States or is there the ability to leave cash offshore and invest those earnings in other foreign opportunities?
As previously mentioned, in the tax world, profits tend to follow functions, assets, and risks. If a manufacturer is performing other activities, then it’s expected to earn additional profits.
Because GILTI is calculated as the total active income earned by a foreign entity that exceeds 10% of the entity’s depreciable tangible property, significant GILTI generally isn’t expected to come from foreign manufacturing subsidiaries.
VAT remains a concern at this stage. Who the seller is will drive what the VAT consequences are. The owner of inventory during the manufacturing process can also be a driver to the extent the foreign entity is a contract manufacturer.