We proudly announce that the September-October 2015 edition of the EA Journal, NAEA’s flagship publication, features the latest article authored by our Principal Consultant, Tony Malik. The article discusses international tax laws applicable to U.S. businesses upon establishing a foreign subsidiary.

U.S. Tax Implications of Foreign Incorporations

Reprinted with permission from the EA Journal, National Association of Enrolled Agents.

Introduction

Growing businesses often explore and gradually expand into new markets. This expansion, depending on a particular business’s nature and ambitions, may be local, regional, or international in scope. The internationally expanding business, depending on its cross-border activity levels, may delve into foreign markets in one of several different ways including:

  • Domestically making sales to persons abroad
  • Licensing its products to a foreign business
  • Entering into a joint venture with a foreign partner
  • Establishing a foreign branch
  • Establishing a foreign subsidiaryThis article is an introduction to the U.S. tax implications of transfers effectuating outbound incorporations, i.e., establishing a foreign subsidiary. While this article assumes the U.S. business to be a regular corporation (i.e., C-corporation), it should be noted that the tax laws governing foreign incorporations are indiscriminately applied to all taxpayers regardless of type.
  • Each of the aforementioned market entry modes has unique advantages and disadvantages that need to be considered in light of the U.S. business’s entity type, functions and objectives. In practice, driven by myriad tax and nontax considerations, many businesses eventually establish foreign subsidiaries once they gain a foothold in a foreign market. A foreign subsidiary is a foreign corporation chartered abroad to locally conduct foreign operations.

 Tax Law’s Security Checkpoint

To the congressional mind, assets transferred across the U.S. border to form a foreign corporation acquire a fleeting character deserving scrutiny. The mechanism of this scrutiny, anatomized within IRC Sec. 367, vitiate the gain nonrecognition rules of IRC Sec. 351. Specifically, while IRC Sec. 351 covers the incorporation of a foreign business, IRC Sec. 367 limits its scope. Thus, as a matter of policy, the anti-nonrecognition rules of IRC Sec. 367 are designed to deter taxpayers from shifting potential income of U.S. impetus outside the U.S. taxing jurisdiction. As a matter of practice, the law requires a two-tiered assessment of outbound transfers, i.e., practitioners must first determine the applicability of IRC Sec. 351 followed by determining the applicability of IRC Sec. 367. To travel across the U.S. border tax-free, the transfer must meet the tests of the former and qualify for one of the uncontested exceptions to the general rule of the latter.

The general rule of IRC Sec. 367 denies gain nonrecognition any time an asset leaves the U.S. taxing jurisdiction. Interestingly, the language of the law denies this gain nonrecognition deductively, i.e., rather than directly addressing the transfer, the statute denies the transferee its corporate status for purposes of the transaction. This results in the annulment of IRC Sec. 351 thereby annulling gain nonrecognition. IRC Sec. 367, from the onset, quickly unfolds into an intricate legal constellation by cross-referencing numerous other code sections, superimposing exceptions upon exceptions and so on. For purposes of our discussion, we will limit ourselves to the major exception to the general rule, i.e., the foreign trade or business exception, along with the most common exceptions to this exception. Delving any deeper would require a science-grade telescope exceeding the length of this article.

Trade or Business Exception

It is useful to briefly consider the rationale of the general rule before meditating on any appurtenant exceptions. The general rule denying gain nonrecognition is in fact a very viable way of combating tax avoidance. Consider that in the absence of the general rule astute taxpayers could transfer appreciated assets across the U.S. border in a tax-free IRC Sec. 351 transaction and then arrange for a sale via the foreign subsidiary. The gain from this hypothetical sale would escape U.S. taxation even though the built-in gain, i.e., the appreciation in the asset’s value, would be U.S. source income. Keeping with this, one can see that IRC Sec. 367 operates as a backstop to this potential loophole. However, the law then necessarily has to extend exceptions to transactions lacking a tax avoidance motive. And thus the primary exception is made for transactions with a bona fide business purpose.

The major exception to the general rule of IRC Sec. 367 preserves the transferee’s corporate status whenever the transferred assets are legitimately meant for use in an active trade or business outside the U.S. This in turn extends gain nonrecognition to the transaction rendering it tax-free. The regulations impose a stringent four part test that must be met in order to qualify for the trade or business exception (Treas. Reg. Sec. 1.367(a)-2T). Very broadly, the four provisos that must be satisfied are as follows:

  1. A legitimate trade or business must exist. The law essentially provides that an enterprise meets the legal definition of a trade or business when it sufficiently and substantially constitutes the necessary business processes and procedures essential to independently conduct profit-oriented activities. In other words, the trade or business must be a reasonably complete and self-sustained operation – not simply a collection of functions that are ancillary to the conduct of a trade or business.
  2. The transferee must actively engage in the conduct of the trade or business. This proviso is satisfied when the employees and managers of the transferee conduct substantial operational and managerial activities in pursuit of the business. The law then articulates the role of independent contractors and “leased” personnel of related parties in this regard.
  3. The transferee’s active engagement in the trade or business must be outside the U.S. Needless to say that the trade or business itself must be located outside the U.S. Otherwise U.S. taxpayers could transfer appreciated assets abroad tax-free and subsequently continue operating a purely U.S. business through a foreign incorporated entity. Additionally, to prevent U.S. taxpayers from shifting gains outside the U.S. by executing circular transfers, this stipulation concomitantly requires the assets to remain outside the U.S. once transferred. Both requirements clearly subdue the income shifting potential of foreign incorporations.
  4. The transferred property must itself be used (or held for use) in the trade or business. This statute is in line with the jurisprudentially developed business purpose concept. This concept requires some sound business reason motivating the transaction in order for the prescribed tax treatment to follow. Tax avoidance is itself not a sound business purpose.

It is critical to note that the aforementioned outline is synoptic. The germane paragraphs of Treas. Reg. Sec. 1.367(a)-2T constantly articulate that each stipulation “must be determined under all the facts and circumstances.” The law clearly prohibits a priori assumptions in this area and tax practitioners must thus perform their due diligence in each case.

It should be pointed out that IRC Sec. 367(a) only applies to gains, i.e., loss recognition is not allowed in any event (Treas. Reg. Sec. 1.367(a)-1T(b)(3)(ii)). Again, as in the case of denying gain nonrecognition, it is useful to briefly consider the rationale for denying loss recognition on an outbound incorporating transfer. Consider that in the absence of loss nonrecognition, a U.S. taxpayer with high income could selectively transfer only loss property in an outbound incorporation thereby reducing its U.S. tax liability. Thus Congress’s principal objective in disallowing loss recognition is to prevent taxpayers from artificially reducing their U.S. tax liabilities by concluding potential loss stuffing transactions.

Exceptions to the Exception

Certain classes of assets embody key exceptions to the exception in the sense that the transfer of these assets triggers some sort of immediate gain (but not loss) recognition irrespective of whether the active trade or business exception is satisfied. One important class of such assets includes “tainted” assets which are treated as having been sold by the transferor when transferred abroad. The resultant gain is capital or ordinary depending on the asset’s economic relation to the transferor. IRC Sec. 367 lists the following as tainted assets:

  • Inventory
  • Installment obligations and unrealized accounts receivable
  • Foreign currency
  • Intangibles
  • Property leased by the transferor unless the transferee is the lessee

Note that each of the aforementioned assets presents the transferor with opportunities to manipulate the international source of income rules. For example, anticipated U.S. source income from installment obligations, accounts receivables or rental receipts from leasing personal properties would become reclassified as foreign source merely by transferring ownership of the underlying assets to a foreign person. Similarly, transferring inventory to a foreign subsidiary enables a multinational enterprise to arrange for the passage of title in a sale to take place outside the U.S. Since a sale is deemed to take place where title passes (Treas. Reg. Sec. 1.861-7(c)), U.S. taxpayers could conveniently avoid U.S. taxation by siphoning income to a foreign tax jurisdiction through a foreign corporation. Thus realizing the potential for abuse afforded by tainted assets, Congress imposes the deemed sale rule onto the transferor. It should be mentioned that, of all the aforementioned tainted assets, intangibles are separately taxed pursuant to special rules (IRC Sec. 367(d)).

Besides gain recognition on tainted assets, the law also requires recapture of certain previously claimed U.S. tax benefits to the extent gain is realized. While depreciable assets under Code Sections 1245 and 1250 yield the most common recapture potential, it should be mentioned that there are also certain industry-specific (e.g., mining, farming, oil & gas etc.) benefits that are required to be recaptured. Note that unlike tainted assets, assets yielding previously claimed tax benefits are not deemed sold to the transferee in an IRC Sec. 367 transaction. Rather the transferor is required to report the amounts of previously claimed U.S. tax benefits as ordinary income to the extent of realized gains – not recognized gains. This legal requirement of recapture therefore precludes taxpayers from enjoying a potential double tax benefit, i.e., transferring a previously depreciated U.S. situs asset in a foreign incorporation and consequently selling the then foreign situs asset free of U.S. depreciation recapture. Of course, there is no such recapture of previously claimed U.S. tax benefits in the case of transferred properties carrying realized losses. This is logical since not only does IRC Sec. 367 not apply to losses but this treatment is also consistent with domestic tax provisions addressing recapture. 

Conclusion

The incorporation of a foreign business by a U.S. taxpayer implicates a plethora of U.S. tax laws designed to prevent tax avoidance. Ultimately the taxation – or tax deferral – of outbound incorporating transfers depends on underlying economic factors such as the nature, character, destination and income potential of the transferred assets. When serving a globally expanding business client, tax practitioners must thus diligently obtain all the relevant facts and circumstances when turning to the law for guidance.

About the Author

        Tony Malik is Principal Consultant and owner of Point Square Consulting in Atlanta, Georgia. He specializes in international taxation (individuals and businesses). Tony practices a wide range of multijurisdictional tax issues spanning across compliance, planning and litigation. Tony can be reached at tony@pointsquaretax.com.

View the original print version of the article in PDF format: U.S. Tax Implications of Foreign Incorporations