DeutschCo has the choice of operating the distribution center as a U.S. subsidiary (“USSub”) or as a branch of DeutschCo in the U.S. There are several differences between the two types of organizations. Even if DeutschCo forms a limited liability company (“LLC”) in the U.S., DeutschCo will have to choose whether it will treat LLC as a USSub or branch for tax purposes under the entity classification regulations.
A USSub of DeutschCo would incur corporate income tax at rates ranging from fifteen to thirty-five percent. DeutschCo and USSub must allocate a proportional basis of DeutschCo’s general and administrative expenses to reduce USSUb’s income. Unless USSub runs afoul of the anti-treaty shopping provisions, USSub can deduct payments to DeutschCo for royalties, interest, and management fees, without incurring a withholding tax. USSub should incur a five percent withholding tax when repatriating a cash dividend to DeutschCo. DeutschCo should receive an indirect foreign tax credit on receipt of a dividend for USSUb’s share of U.S. income taxes paid. Because USSub is subject to U.S. taxation, DeutschCo will want to place all U.S. activities in USSub to avoid inadvertent treatment of DeutschCo as U.S. permanent establishment. A permanent establishment that earns effectively connected income in the U.S. would incur U.S. tax in addition to the U.S. tax that USSub would already be paying.
Under the treaty, a permanent establishment is a fixed place of business through which a foreign business conducts its local operations. If DeutschCo were to operate the distribution center and sales office as a branch, DeutschCo would obviously have a permanent establishment due to its fixed place of business, which this article will discuss later. But if DeutschCo operates in the U.S. through a USSub, a permanent establishment may inadvertently result from the activities of DeutschCo employees in the U.S. For example, because the treaty states that an office constitutes a permanent establishment, DeutschCo will want to avoid having any of its employees use the sale office at the U.S. distribution center. The treaty does exempt a mere warehouse, without any other type of activities, from treatment as a permanent establishment.
An inadvertent permanent establishment may also result from DeutschCo giving its DeutschCo employees operating in the U.S. the contracting authority on an agent. Under the agency test, a dependent agent of DeutschCo may constitute a permanent establishment if the agent has the authority of contract on behalf of DeutschCo in the U.S. and the agent “habitually exercises” that authority. Although the treaty does not define the phrase “habitually exercise”, the exercise of authority to negotiate and enter into contracts once or twice is probably habitual. The more the employee exercises this authority, the more likely the I.R.S. would deem it habitual. DeutschCo should not have an inadvertent permanent establishment from its employees’ involvement in the construction of the U.S. distribution center provided that the construction activity lasts less than one year. In addition to avoiding an inadvertent permanent establishment, DeutschCo should ensure that USSub does not have any transfer pricing exposure. Transfer pricing refers to the price that related corporations charge each other for tangible property, services, and loans. Transfer pricing receives substantial scrutiny from the I.R.S.’s international examiners, who may impose additional tax and a twenty to forty percent penalty if the prices are not at arm’s length. The best way to avoid a transfer pricing adjustment when audited and to avoid a penalty is to document the pricing practices as required by the regulations or to enter an advance pricing agreement. In our hypothetical, intercompany transactions could arise from the sale of goods, the transfer of technology, the provision of services, or constructive loans based on generous payment terms.
Assuming that the operations of DeutschCo’s U.S. branch constitute a permanent establishment, the effectively connected income generated would similarly incur federal tax at rates ranging from fifteen to thirty-five percent. The branch can take deductions appropriate to the taxed activities, which include general and administrative expenses calculated on a proportional basis between the branch and its DeutschCo headquarters, assuming that the branch can show it has benefited from these expenditures. A disadvantage is that the branch, as a non-corporate entity, cannot deduct payments for royalties, management fees, or interest to its DeutschCo headquarters.
In lieu of withholding on a dividend, the I.R.S. imposes a complex system of branch taxation on three separate tax bases:
- Profits from DeutschCo’s branch operations that are deemed repatriated from the U.S. under the branch profits tax rules;
- Interest deemed paid by the branch to foreign lenders; and
- Excess interest that is apportionable to effectively connected income of DeutschCo but not deemed paid by the branch.
The I.R.S. imposes the branch profit tax, the most relevant of the three, on a branch’s U.S. earnings that are deemed repatriated to Germany. The branch profits tax is designed to approximate the U.S. withholding tax imposed on a U.S. subsidiary for dividends to its foreign shareholders. Because the repatriation of branch profits does not involve actual remittances, DeutschCo would have to segregate its U.S. branch’s earnings from other earnings. More specifically, the branch profits tax applies to after-tax earnings that are effectively connected to DeutschCo’s U.S. operations to the extent DeutschCo does not reinvest those earnings in the U.S. The I.R.S. imposes the branch profits tax at a five percent treaty rate and is in addition to the regular U.S. corporate income tax on the effectively connected income.
Although DeutschCo’s branch will incur both U.S. taxes on the branch’s effectively connected income and German tax, DeutschCo can avoid double taxation with a foreign tax credit.
If DeutschCo expects the U.S. operations to lose money the first few years, a branch would permit the U.S. losses to reduce DeutschCo’s taxable income in Germany.
Learning Objectives in in the free webinar at March, 9th 2016 at 3 pm CET:
- Understand the basic requirements of the U.S. tax system
- Learn to properly structure investments to repatriate cash and minimize U.S. taxation while taking advantage of the German-U.S. Tax Treaty
- Avoid unpleasant surprises by understanding the compliance requirements
(From: German American Trade, Vol. 12 No. 5)