Businesses with Foreign Ownership Face Significant Tax and Regulatory Exposure

By John P. Barrack, Cherry, Bekaert & Holland, L.L.P. (CB&H)
Email: jbarrack@cbh.com

There are an increasing number of U.S. corporations with foreign ownership in our expanding global economy, and the U.S. government has instituted numerous tax laws and reporting requirements applicable to foreign-owned U.S. corporations. Some of the more common issues faced by U.S. corporations with foreign ownership include transfer pricing, non-deductible accrued expenses, interest limitations and withholding taxes.

Transfer Pricing
IRC §482 is a compliance code section that gives the IRS the authority to reallocate profits between related taxpayers in the event that the related parties (domestic or foreign) fail to determine an “arms-length” arrangement, transaction or price. The regulations under §482 provide standards the IRS can use to determine what is “arms-length” under the appropriate or “best method” when contemporaneous records are not kept by the taxpayer showing how the intercompany pricing of a transaction was determined. Therefore, it is very important for U.S. corporations to develop and maintain proper transfer pricing documentation, which must be completed each year before the U.S. income tax returns are filed to meet the contemporaneous documentation standard.

Accrued Expense Limitations
Under the related party rules of IRC §267, U.S. corporations with foreign ownership are generally unable to deduct several types of accrued expenses owed to their foreign affiliates until the expense is actually paid. This requirement is applied to any fixed, determinable, annual or periodic (FDAP) expenses, such as interest, rent, royalties and other non-effectively connected FDAP income. The foreign recipient is deemed to be on the cash basis so, under the matching principal, some of the U.S. corporation’s accrued expenses are not deductible until paid. One exception to the general rule allows a U.S. corporation to deduct certain accrued FDAP expenses to the extent a tax treaty reduces the rate of withholding on that income.

Accrued Interest Expense
One type of FDAP is accrued interest expense. Interest owed to a related foreign affiliate can only be deducted when paid [Reg. §1.267(a)(3)].

In November 1994, the Tax Court in Tate & Lyle Inc. and Subsidiaries v. Commissioner [103 TC 656 (1994)] ruled that that a U.S. company could deduct accrued interest; however, this decision was overturned by the Third Circuit Court of Appeals [87 F3d 99 (1996)]. Later, in 2003, the Tax Court in Square D Company v. Commissioner [121 TC 168 (2003)], reversed its earlier decision in Tate & Lyle, concluding that accrued interest is non-deductible until paid. The Square D decision was affirmed in February 2006 by the Seventh Circuit Court of Appeals [438 F3d 739 (2006)].

Other Interest Expense Limitations
Foreign-owned U.S. subsidiaries with large amounts of debt can have a competitive advantage when compared to U.S.-owned counterparts. Interest expense lowers U.S. taxable income and positive earnings can be repatriated overseas as a tax-free repayment of debt. To combat perceived abuses and to supplement the IRC §267 limitations on accrued interest, the Internal Revenue Code includes additional interest expense limitations. Old and brief, IRC §385 empowers the IRS with the authority to prescribe regulations necessary to determine whether an interest in a corporation is to be treated as stock or indebtedness, and which factors are to be taken into account in a particular factual situation to determine whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists.

The IRS can use IRC §385 to propose a reallocation of equity and debt (along with the associated interest) to the extent the IRS deems the taxpayer’s debt/equity ratio to be unreasonable. Since no regulations were ever finalized under §385, this debt-to-equity standard was hard to enforce, which resulted in Congress adopting more stringent mathematical requirements in the IRC §163(j) earnings stripping regulations.

Under IRC §163(j) if a 1.5 to 1 debt/equity safe harbor is not met, then U.S. taxpayers can only deduct disqualified interest expense to the extent of 50 percent of the corporation’s adjusted taxable income. If interest expense is non-deductible under IRC §163(j), then the interest is not permanently non-deductible. Instead, it is simply deferred until the debt/equity safe-harbor is met or the U.S. corporation has sufficient taxable income to deduct the interest under the 50 percent of adjusted taxable income threshold.

Withholding Tax Issues
The U.S. government generally imposes a 30 percent tax on U.S.-source income received by foreign recipients (IRC §§1441 and 1442). This tax is required to be withheld and remitted to the U.S. government by the U.S. payor at the time of payment. Tax treaties between the U.S. and most developed countries can reduce or even eliminate the 30 percent withholding tax in certain instances.

Items of income paid from a U.S. company to its foreign parent or affiliates are often subject to withholding taxes. Income items and the amount withheld are reported on U.S. tax forms 1042, 1042S and 1042T. These are calendar year forms, regardless of the fiscal year end of the U.S. or foreign corporation, and are due March 15 each year. Of course, the due dates can be extended if necessary.

Claiming Tax Treaty Benefit
Foreign income recipients wishing to take advantage of lower withholding rates afforded by a U.S. tax treaty must provide treaty qualification evidence to the U.S. subsidiary prior to the U.S. subsidiary making a payment. A U.S. payor must posses a signed representation by the intended recipient evidencing treaty qualification. In addition, a Form W-8 BEN is required to be on hand at time of payment to qualify for treaty benefit and reduced withholding.

The foreign recipient must also submit a Form 1120-F as a transmittal document, with a Form 8833 treaty benefit election form attached, as a further representation by the recipient of treaty benefit qualification if payments exceed minimum thresholds or other filing criteria is met.

Other Reporting Requirements
Transfers to and from a foreign-related party are required to be reported under IRC §6038 and §6038A. Generally domestic corporations with a 25 percent or greater foreign shareholder are required to furnish a Form 5472, which requires general information about the foreign shareholder and related foreign affiliates, as well as details regarding monetary transactions between the U.S. corporation and the foreign related party.

Information regarding controlled foreign corporations (CFC) is reported on Form 5471. U.S. citizens and residents who are officers, directors or shareholders in certain foreign corporations are required to complete the form. The Form 5471 requires detailed financial information about the CFC, including income statement, balance sheet, earnings and profits, and any reorganization information.

Both the Forms 5471 and 5472 are remitted with the income tax return of the U.S. taxpayer with another copy filed separately with the IRS.

Conclusion
As the U.S. economy continues to grow and become more global, there are an increasing number of U.S. corporations with foreign affiliations. Taxpayers must be vigilant to ensure compliance with the Internal Revenue Code, and to properly account for income and expense items related to a foreign parent.

John is a Tax Partner with CB&H and a member of the Firm’s Private Business Group.