US businesses are taxed on their worldwide income, and prior to the tax reform law passed in 2017—commonly referred to as the Tax Cuts and Jobs Act (TCJA)—earnings of foreign subsidiaries were generally deferred from US tax until repatriated to the United States.

That’s no longer the case. TCJA enacted various rules and regulations, including the global intangible low-taxed income (GILTI) tax. As a result, the opportunity to defer US tax through the use of foreign companies when selling outside the United States has been significantly limited. TCJA also created new opportunities, however.

In this article, we’ll discuss the international tax considerations for the five stages of a US manufacturer’s foreign operations:

1. Engaging in international sales
2. Using a salesperson in a foreign jurisdiction
3. Creating a foreign sales and marketing organization
4. Conducting distribution activities
5. Establishing foreign manufacturing

While not every company will follow these five steps, they represent a possible progression pathway for a US exporter increasing its foreign presence. With each change in business, there are tax opportunities and challenges to be taken into account. While some of these are particular to a certain activity, others exist regardless of activity type.

Engaging in International Sales

Typically, a US company’s first international expansion involves selling US-manufactured goods directly to a foreign customer. When initially selling outside the United States, there are three key opportunities to consider.

Creating an IC-DISC

An interest-charge domestic international sales corporation (IC-DISC) is a US domestic corporation that:

• Meets certain requirements under US tax law
• Has qualifying exports
• Makes a valid IC-DISC election

IC-DISC offers a significant federal income tax savings for making or distributing US products for export. It isn’t a tax shelter, but it creates permanent tax savings by transferring income from the exporter to the tax-exempt IC-DISC through an export sales commission.

The IC-DISC incentive is available to almost any US taxpayer, including:

• Individuals
• C corporations
• S corporations
• Partnerships
• Limited liability companies (LLCs)

FDII Deduction

For taxable years beginning after December 31, 2017, a US corporation may claim a foreign-derived intangible income (FDII) deduction on certain foreign-derived income. This income may include sales of intangible or tangible products—whether manufactured or purchased for resale by the corporation—to a foreign person for use outside the United States as well as income derived from a broad range of services.

The determination of the FDII deduction can involve a rather complex analysis. In short, 37.5% of FDII is deductible, which results in a 13.125% effective tax rate. The deduction is scheduled to decrease from 37.5% to 21.875% in 2026.

Other Considerations

Value-Added Tax

Unlike the US system in which everyone along the supply chain is exempt from sales tax until the end consumer, many foreign systems assess tax on all parties along the chain with the ability to take credits for any taxes paid.

While these types of taxes generally don’t result in a net cost, it can be a trap for the unwary if not appropriately applied. This is especially true when selling to individual consumers. In many cases, there isn’t a de minimis or certain volume of sales that are exempt—all are subject to tax. Therefore, the costs and administrative burden of value-added tax (VAT) need to be contemplated prior to making export sales.

Income Classification

While you may think that a transaction is the sale of an item, the tax laws in a foreign country could treat the transaction as a royalty. As a result, customers may be required to withhold income tax from their payment to you. In some cases, the tax result doesn’t always follow the commercial or legal terms of the agreement.

Using a Salesperson in a Foreign Jurisdiction

After a company reaches a certain level of foreign sales generated from the United States, they might look at putting some boots on the ground in the foreign location to increase penetration into the local market. This can open new opportunities and issues.

For the purpose of this article, assume there’s one person generating sales in the foreign location.

Independent Contractors Versus Employees

One of the first questions to ask is whether this person will be an independent contractor or an employee. Many countries have tests similar to the United States for determining whether someone is a contractor or an employee. The results are also the same as they are in the United States: liability for employment taxes.

Understanding whether someone is truly a contractor in a foreign country can help avoid a costly payroll tax issue in the future.

Salesperson Authority

The other key distinction between a contractor and an employee from an international tax perspective relates to the authority given to that person. If an independent contractor is used, then that individual can sign sales contracts on behalf of the US company without creating a permanent establishment or taxable presence in that country.

However, if that person were an employee, signing agreements on behalf of the US company would likely create a permanent establishment. Therefore, the distinction between the two is very important.

Taxable Presence for Non-Income Taxes

Whether or not someone creates a permanent establishment is typically governed by tax treaties between the two countries. However, a presence for non-income taxes—such as sales taxes—is governed by each country’s domestic laws. This means having an individual in a country generating sales, whether or not they sign agreements, can create a presence for sales taxes.

For example, if a company was previously able to avoid the administration of registering for, collecting, and remitting sales taxes when they were selling direct, having an individual in the foreign country may now make that unavoidable.

Payroll Reporting

Payments to a foreign person for services provided outside the United States are typically not subject to US reporting. This means there isn’t a Form 1099 filing requirement resulting from the relationship. However, there could be local reporting obligations.

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.

Jurisdictional Requirements

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.

Tax Considerations

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.

Compensation

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.

Individual Authority

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.

Inventory Ownership

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.

Customs Duties

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.

Intellectual Property

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?

GILTI

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

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.

Key Takeaways

While US companies may approach international expansion in different ways, it’s important to keep these three considerations in mind:

• Opportunities abound regardless of what phase of international business is being conducted.
• Conversely, there are many traps for the unwary along the way to expansion.
• Knowledge is power, and advance preparation allows companies to make smart business decisions.

We’re Here to Help

For more information about how to prepare to successfully conduct business internationally, contact your Moss Adams professional.

Special thanks to Ling Wei, a senior associate in International Tax Services, for her help with this article.