by James H. Barrett, Steven Hadjilogiou, and Sean Tevel
In certain situations, the acquisition of a business presents an opportunity for a buyer to structure a company’s operations into a more optimal tax structure. Many businesses, especially start-up businesses, have grown from the ground up. Tax planning in the early stages of a business generally will allow the business to be structured in a tax-efficient manner. However, in the real world, during the early stages of a business, allocating funds to tax planning is often not done. Thus, many businesses could benefit from proper tax planning. Furthermore, as tax law changes occur over the years, tax planning that was efficient may become inefficient. Finally, what is good for one business owner is not necessarily good for another. For example, tax planning for a nonresident of the U.S. is not the same as it is for a U.S. citizen business owner.
In an acquisition, especially an asset deal, the acquirer may be able to structure his or her affairs in a manner that is most beneficial to the business and its owner(s). Tax planning is unique to each particular business and to its owner. However, the general goal in any situation is to minimize the enterprise’s global effective tax rate. It is a basic tenet of U.S. federal tax law that as long as the transaction has adequate economic substance, taxpayers generally are free to structure their business transactions as they please, even if motivated by a goal of tax minimization.1 The tax planning that commonly has been used by multinational corporations and is statutorily permitted by the Internal Revenue Code (IRC),2 is equally available to closely held businesses. Such planning generally involves the allocation of profits that are generated outside of the U.S. to corporations that are created outside the U.S. Thus, the profit generated abroad is earned by an entity that is formed abroad and profit generated in the U.S. is allocated to an entity that is formed in the U.S. Certainly, a foreign business owner would not want to import into the U.S., and pay U.S. tax on, non-U.S. profits of his or her business.
Managing the tax exposure of an international business is a complex endeavor. A business that operates internationally should be aware of the tax effects of its cross-border transactions in the relevant countries in which the business operates, and in which its owners reside. Tax-efficient operations for international business can vary widely based on variables such as, among others, the business owners’ country of residence, the number of shareholders, the countries in which the business operates and the industry in which the business operates. For example, a U.S. citizen is taxable on his or her worldwide income, whereas, a nonresident is generally only taxable on his or her U.S. source income.
Some of the common inefficient tax structures that are frequently found in the real world include the incorrect choice of entity, needlessly importing profits into high-tax jurisdictions, mismatching intellectual property ownership with its jurisdiction of use, or not taking advantage of local tax minimization techniques. During the acquisition of a business, these inefficiencies can be corrected so that the purchaser does not have to suffer the same inefficiencies as the seller. Thus, an investor in a newly acquired business may have a very different tax reality than the previous owner did. More importantly, with proper planning a purchaser may significantly improve his or her tax position when compared to the previous owner.
Even in the case of stock deals, opportunities exist for the purchaser to improve upon the acquired entity’s tax position. At the very least, the purchaser should be fully aware of whether a target would operate in a tax-inefficient manner after the acquisition. For example, when a U.S. citizen purchases stock of an entity from a non-U.S. seller, the possibility exists that the buyer could have issues with the anti-deferral provisions known as Subpart F, or the Passive Foreign Investment Companies (PFICs) rules, or could simply have put himself or herself in an inefficient structure to receive dividends, especially if the foreign entity owns a U.S. corporation. Pre-acquisition, the buyer likely could have an opportunity to avoid such problems that would be much more difficult to solve after the acquisition.
Pre-acquisition planning generally involves a review of the target business’ operations and the design of a tax structure for that business which would be the most tax efficient and commercially reasonable from an operational perspective. Thereafter, the next step is to create a series of transactional steps to reorganize the business into the structure that is desired for the buyer. It is important to work with tax counsel in the local country jurisdictions in which the business operates to ensure the plan works from a U.S. and a foreign perspective. Sometimes these steps will not have a detrimental tax effect on the seller and, thus, should be readily agreeable to the seller. Conversely, in other situations, the restructuring may cause detrimental tax liabilities or be unacceptable from a business perspective, so that the seller would consider the proposal to be unacceptable. This article discusses some of the many issues that should be considered in the acquisition of a multinational enterprise.
Choice of Entity: Flow-through Compared to Corporate Deferral Structure
The initial consideration usually made is whether the business should operate in a flow-through or corporate deferral structure, or in some cases a combination of the two. A flow-through structure typically involves the use of partnerships, which includes limited liability companies (LLC) with more than one member, or as a sole proprietorship, which includes a single-member LLC. The advantage of the flow-through structure is that income earned by a flow-through entity is taxable to the entity’s members as if they had earned their portion of its income directly. Therefore, the income is not subject to double tax. In contrast a corporation is taxable on the income earned by it and its shareholders are subject to tax on dividends distributed by the corporation to them. For profits earned outside of the U.S., a flow-through structure owned by a U.S. tax resident may not be as tax efficient as a corporate structure when the profits are recognized in a jurisdiction with tax rates that are lower than U.S. tax rates. Because the U.S. imposes taxes on the worldwide income of its citizens and tax residents, the low-taxed non-U.S. income that flows through to a U.S. taxpayer would be subject to U.S. tax at the higher U.S. tax rates. For taxes paid to foreign governments, the U.S. generally provides a foreign tax credit, so that the taxpayer is not subject to double taxation on income earned abroad. For example, a U.S. taxpayer that operates a business through a flow-through structure in Ireland would be subject to Irish tax rates of approximately 12.5 percent. That income would be treated as earned directly by the U.S. taxpayer and subject to tax in the U.S. at a federal rate of approximately 39.6 percent plus state and local taxes. The U.S. should afford the taxpayer with a foreign tax credit for the taxes paid to the Irish government so that the aggregate amount of tax paid to the U.S. and Irish governments would amount to 39.6 percent.
On the other hand, many U.S. taxpayers operating active businesses outside of the U.S. choose to operate in corporate form, which is known as a corporate deferral structure. As the name suggests, this structure is utilized to defer paying the higher U.S. taxes on income earned abroad until such income is repatriated into the U.S. Because a foreign corporation is treated as a separate taxpayer, it is subject to the rates applicable in its country of incorporation and in the other countries where it does business. Thus, as an alternative to the previous example, if the U.S. taxpayer owned a foreign corporation that conducted an active business in Ireland, its tax rate would simply be 12.5 percent. The U.S. should not further impose tax on the income earned by the foreign corporation until such time as the income is repatriated. As discussed further below, the U.S. imposes two anti-deferral regimes, known as Subpart F and the Passive Foreign Investment Company rules, that potentially apply in certain cases to disqualify the deferral of the income by treating it as immediately taxable to the foreign corporation’s U.S. taxpayer shareholders. It is important to note that when the income is repatriated to a U.S. individual resident, he or she will not be entitled to a U.S. foreign tax credit for the taxes paid by the foreign corporation. In contrast, a U.S. corporate parent should be entitled to its share of the foreign subsidiary’s income taxes paid if it owns more than 10 percent of the voting stock of the foreign subsidiary. Finally, it should be noted that many jurisdictions in which foreign corporations are formed impose a withholding tax on dividends paid by the entity to its U.S. shareholders. The U.S. has entered into foreign tax treaties with many foreign jurisdictions that may reduce the tax rate that the foreign government may impose on the dividend withholding. Furthermore, the U.S. should allow a foreign tax credit to the shareholder for the amounts of tax paid on the foreign dividend withholding.
In the case where the purchaser is not a U.S. taxpayer, the choice between flow-through and deferral is also an important decision. Because the U.S. generally is considered a high-tax jurisdiction, foreign investors often choose to utilize a flow-through structure for their operations into the U.S. to avoid the double layer of taxation. Foreign investors generally are subject to similar considerations that U.S. investors face when choosing an entity type for their operations outside of the U.S.
Local Tax Minimization
In a deferral structure, opportunities exist to minimize the effective rate on non-U.S. sourced profits. The U.S. provides among the highest corporate tax rates in the world. Many countries, such as Ireland and Singapore, statutorily offer a low tax rate. Other countries, such as the Cayman Islands, do not impose tax. Finally, in some countries, such as the United Arab Emirates, free-trade zones exist that offer low- or zero-tax rates. Alternatively, some countries, such as Panama, impose a territorial tax system, which only imposes tax on income earned from within the country. As such, a company formed in one of the foregoing jurisdictions may operate outside that country without the imposition of tax. Finally, some countries, such as Singapore, the Netherlands and Switzerland, provide tax rulings, the terms of which are negotiated with the local tax authority, which generally provide for reduced tax rates from the country’s statutory rate.
For companies that operate in multiple international jurisdictions, it is advisable to select an appropriate international holding company that should allow the company to minimize withholding taxes in local jurisdictions. Such a company should allow, for example, the payment of a dividend from its German subsidiary to the holding company, which then can be contributed to its French subsidiary on a tax-free or minimal tax basis. In Europe, many of the countries may pay dividends to European parent companies pursuant to the so-called EU Parent Subsidiary directive. The better holding company jurisdictions are those that have wide treaty networks and do not impose tax on dividends received.
CFC Planning and potential PFIC Issues
When U.S. persons acquire multinational enterprises, they must be wary of the anti-deferral provisions in the Subpart F and PFIC rules. These rules can be viewed as imitating pass-through treatment and triggering immediate U.S. tax liability for U.S. owners on the income generated by their foreign businesses.
A foreign corporation that meets the definition of a controlled foreign corporation (CFC) is potentially subject to the Subpart F anti-deferral rules.3 For these purposes, a foreign corporation is a CFC for a tax year only if, on any date in that year, U.S. persons individually own at least 10 percent of the CFC’s voting stock (U.S. shareholders) and collectively own more than 50 percent of its stock in vote or value.4 A U.S. shareholder of a CFC is required to include his or her pro-rata share of Subpart F income in his or her gross income for the taxable year.5 Therefore, any U.S. person who acquires an interest in a CFC will lose deferral on Subpart F income earned by the CFC. Subpart F income is made up of what is known as Foreign Base Company (FBC) income derived by the CFC.6 FBC income is made up of several categories of income, which are primarily: FBC sales income, FBC services income, and foreign personal holding company income.7
FBC sales income is income derived by the CFC where the CFC purchases property from (or on behalf of) a related person, or sells property to (or on behalf of) a related person. Furthermore, the property must be manufactured, produced, grown, or extracted outside the CFC’s country of incorporation and the property must be sold outside the CFC’s country of incorporation.8 Thus, property manufactured, produced, constructed, grown, or extracted within the CFC’s home country is not FBC sales income regardless of who actually manufactures the product (same country manufacturing exception).9 Furthermore, property sold for use, consumption, or disposition within the country in which the CFC is created is also not FBC sales income (same country manufacturing exception).10 Finally, FBC sales income does not include income of a CFC derived in connection with the sale of personal property manufactured, produced, or constructed by such corporation from personal property which it has purchased (the manufacturing exception).11
FBC services income is income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services performed 1) for or on behalf of a related person; and 2) outside the country under the laws of which the CFC is created or organized.12 The Treasury Regulations include a nonexhaustive list of circumstances in which services are deemed to be performed for, or on behalf of, a related person. They are: 1) when a related person pays the CFC for the services; 2) when a related person is or was obligated to perform the services performed by the CFC; 3) when the services that were performed by the CFC were a condition or material term of a sale of property by a related person; and 4) when a related person contributed “substantial assistance” in the performance of the services by the CFC.13 Assistance will be substantial if the cost to the CFC of the assistance furnished by the related person equals or exceeds 80 percent of the total cost to the CFC of performing the services.14 There is no branch rule with regard to FBC services income.
Foreign Personal Holding Company income (FPHC income) generally is made up of dividends, interest, royalties, rents, annuities, and gains from the sale or exchange of property that gives rise to such types of income.15 Interest and dividends are excluded from treatment as FPHC income when they are received from a related person, which is a corporation created or organized in the same country as the CFC and using a substantial part of its assets organizing or conducting an active business in the same country as the CFC. Rents and royalties are excluded when they are derived in an active business and not paid by a related person, or when they are paid by a related person with regard to the use of property within the CFC’s country of organization.16 There is no branch rule for FPHC income and, therefore, electing to “check the box” on foreign businesses can be a useful planning tool. Effectively, by “checking the box,” the business becomes a disregarded entity for tax purposes and its income is treated as earned directly by the person or entity holding the foreign business.
Another anti-deferral regime that may apply in the case of a foreign corporation owned by a U.S. taxpayer is the Passive Foreign Investment Company regime (PFIC). A foreign corporation is considered a PFIC when, in any year while the foreign corporation has a U.S. tax resident shareholder, either 75 percent of its annual gross income is passive investment income or 50 percent or more of the corporation’s assets generate passive type income.17 Any U.S. person that has an interest in a PFIC is taxed at ordinary income rates on the gain from the disposition of their PFIC stock or upon receiving an “excess distribution” from the PFIC. In addition, the tax on the gain and any “excess distribution” is subject to a punitive interest charge that is designed to treat the U.S. person as if he or she had owed the tax over the period during which the U.S. person held the PFIC stock. Due to the tax burdens imposed by the PFIC rules, acquirers of foreign businesses should confirm the extent to which the business owns entities that may be treated as PFICs once the U.S. taxpayer acquirer purchases the enterprise.
Acquirers of international businesses should plan their sale structures and service contracts with Subpart F consequences in mind in order to avoid unnecessary FBC sales income or FBC services income when a related party transaction can be avoided. By engaging in proper Subpart F planning, many transactions that will accomplish the same objective in a commercial sense can still preserve the deferral of tax until the income is paid out to the U.S. owners.
Foreign Tax Credit Planning and Other Repatriation Planning
Repatriation planning involves minimizing local country taxes on operations, minimizing local country withholding taxes for subsidiaries, and maximizing the usefulness of U.S. foreign tax credits for repatriated income. The first step in repatriation planning often is the extent to which a U.S. parent should be investing in a foreign subsidiary by way of equity or a combination of equity and debt. As noted above, the U.S. permits a direct foreign tax credit for foreign income taxes imposed upon income earned by a taxpayer directly or through one or more entities that are flow-throughs from a U.S. federal income tax perspective. For U.S. corporate shareholders, there also is a deemed paid foreign tax credit under IRC §902 that applies when a dividend is declared by a foreign company to its U.S. parent. IRC §902 brings up foreign income taxes that shelter part or all of a U.S. corporation’s dividend income from U.S. taxes. U.S. foreign tax credits can help shelter Subpart F income and PFIC income. The U.S. foreign tax credit is subject to various limitations. The limitations frequently will cause a U.S. taxpayer to want to ensure that a sufficient portion of their worldwide earnings are deemed to be foreign earnings. At the same time, taxpayers often can maximize the usefulness of foreign tax credits by minimizing a given foreign subsidiary’s foreign earnings. Anti-abuse rules under the foreign tax credit rules apply in various areas including: 1) IRC §338 elections (which allow a stock sale to be treated as an asset sale); 2) loss generating foreign companies making check-the-box elections to be treated as flow-throughs before they are at a break even position (since inception); and 3) foreign tax credit splitting structures that split foreign income and foreign income taxes among foreign subsidiaries in a way that reduces U.S. taxes.18 Foreign tax credits are effected through various means including hybrid debt, hybrid entities, and deductible payments between entities that are disregarded from a U.S. tax perspective but regarded outside the U.S.19
Transfer Pricing Issues (Including Properly Documenting Intercompany Relationships)
Transfer pricing is another area that should be considered in the operation of an international enterprise. IRC §482 permits the IRS to examine dealings between controlled corporations and make allocations to place these dealings on the same basis for tax purposes as if they had taken place between independent and uncontrolled taxpayers.20 The standard that is applied when evaluating transactions between controlled taxpayers is the arm’s length standard.21 A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.22 However, because identical transactions can rarely be located, whether a transaction produces an arm’s length result generally will be determined by reference to the results of comparable transactions under comparable circumstances.23 The transfer pricing principles have a relatively broad reach. For example, IRC §482 was held to be applicable in transactions between entities commonly controlled in a 50/50 joint venture.24 Thus, transactions between controlled entities should be reviewed to ensure that the entities are conducting business on an arm’s length basis.
The Treasury Regulations provide a number of economic methods to value tangible and intangible property. Some of the more common economic theories used are the comparable uncontrolled price method, the cost plus method, the comparable profits method, and the profit split method.25 The economic valuation model that is used for a particular situation is decided under the best method rule, which provides, under the facts and circumstances, the most reliable measure of an arm’s length result.26 It generally is a best practice to value and document intercompany transactions as they occur. Maintaining contemporaneously documented evidence of a transfer price for intercompany transactions provides the added benefit that it limits a taxpayer’s exposure to the accuracy related penalty for substantial valuation misstatements under IRC §6662(e)(1)(B)(ii).
Intellectual Property Issues
Proper planning of the ownership and use of intellectual property is one of the most significant planning techniques to reduce a company’s global effective tax rate and is utilized by most Fortune 1000 companies. Intellectual property, which includes a company’s trademarks, copyrights, know-how, and trade secrets, generally constitutes the most valuable asset of any business. The acquisition of a multinational enterprise provides the opportunity for the acquirer to hold and manage its intellectual property that is geographically limited in scope to the U.S. in a U.S. entity and its foreign intellectual property outside of the U.S. through a foreign subsidiary. Future IP that is developed for use outside of the U.S. is developed by the foreign subsidiary and future U.S. IP is developed by the U.S. entity. As such, profits generated pursuant to the exploitation of the foreign IP is not taxed in the U.S.
Generally, the foreign subsidiary may be established in a low-tax jurisdiction paying tax at a top marginal rate of 12.5 percent or less (e.g., Ireland, Switzerland, or Singapore). Affiliated foreign subsidiaries of the international enterprise that are located in higher tax jurisdictions are required to license IP from the IP holding company in order to exploit the IP. The royalty payment by an operating subsidiary to the foreign subsidiary that owns the IP results in the recipient entity being subject to a relatively low rate of tax on the royalty. On the other hand, the payment of the royalty from a company operating in a high-tax jurisdiction offsets as a deduction a portion of the income tax in the high-tax jurisdictions. Thus, the overall effective tax rate for the group outside the U.S. is reduced.
Because IP is such a valuable asset to the business, care should be taken in drafting intercompany license agreements. IP counsel should be consulted to ensure that the intellectual property is properly maintained.
1 See Gregory v. Helvering, 293 U.S. 465 (1935); Rice’s Toyota World, Inc. v. Commissioner, 81 T.C. 184, 196 (1983), aff’d in part, rev’d in part and rem’d, 752 F.2d 89 (4th Cir. 1985).
2 All references are to the Internal Revenue Code of 1986, as amended, unless otherwise provided.
3 See I.R.C. §§951 and 957.
4 I.R.C. §§951(b) and 957(a).
5 I.R.C. §951(a). A U.S. shareholder is a U.S. person who owns 10 percent or more, by applying the rules of ownership of §958(b), of the total combined voting power of all classes of stock entitled to vote of a controlled foreign corporation.
6 I.R.C. §952(a).
7 I.R.C. §954(a).
8 I.R.C. §954(d)(1).
9 Treas. Reg. §1.954-3(a)(2).
10 Treas. Reg. §1.954-3(a)(3).
11 Treas. Reg. §1.954-3(a)(4).
12 I.R.C. §954(e)(1).
13 Treas. Reg. §1.954-4(b)(1).
14 Notice 2007-13.
15 I.R.C. §954(c).
16 I.R.C. §§954(c)(2)(A), 954(c)(3)
17 I.R.C. §1297(a).
18 See I.R.C. §909.
19 See TD 9577, 77 Fed. Reg. 8,127 (Feb. 14, 2012).
20 Achiro v. Commissioner, 77 T.C. 881 (1981).
21 See Treas. Reg. §1.482-1(b).
24 B. Forman Co., 54 TC 912 (1970).
25 Treas. Reg. §1.482-3(a).
26 Treas. Reg. §1.482-1(c).
Steven Hadjilogiou is an attorney at Baker & McKenzie law firm in Miami, who counsels with respect to international tax planning. His practice includes worldwide tax minimization, state and local tax planning, and partnership taxation. He is an adjunct professor at the University of Miami School of Law Tax LL.M. program.
James Barrett is a partner at Baker & McKenzie, LLP, in Miami, where he serves as the chair of the tax department. He is a co-chair of The Florida Bar Tax Section, Long Range Planning Committee, and practices in the area of U.S. federal income tax, focusing on outbound and inbound international tax planning.
Sean Tevel is a member of Baker & McKenzie’s tax practice group in Miami. His practice mainly focuses on international tax planning.
This column is submitted on behalf of the Tax Law Section, Michael Allen Lampert, chair, Michael D. Miller and Benjamin Jablow, editors.