International business is practically mandatory for companies that expect to grow
and prosper in today’s global economy. If you ignore overseas opportunities to sell or
acquire goods, set up subsidiary companies
or develop partnerships, you’ll fall behind the
curve. However, entering the international
marketplace requires careful tax planning
and a knowledgeable group of advisers.
“There are many opportunities overseas,
but business owners must understand that
the international component adds a level of
complexity that they may not be used to,”
says Henry Grzes, associate director in international tax at SS&G Financial Services, Inc.
Smart Business spoke to Grzes about
international tax traps and opportunities.
What are the key drivers for businesses that
explore international opportunities today?
Twenty-five years ago, mainly large companies — the Fortune 500 crowd — pursued
international business. But with advances in
transportation, logistics and technology,
along with aggressive economic development in nations like China and India, small
businesses can just as easily take advantage
of overseas opportunities. Companies that
do not consider international endeavors are
leaving out a significant piece of the puzzle:
the global market, which is growing rapidly.
What tax risks do companies confront when
they enter the global arena?
Businesses that are new to the international game may revert to old tax habits and
assume that all’s well as long as they are paying the Internal Revenue Service. However,
every country has its own independent tax
structure. U.S. tax rules do not automatically
apply to other countries. You may realize
after the fact that the proper type of entity
was not formed or that an overseas business
was not capitalized properly. As a result, you
can lose the profit you expected to earn in the
foreign market. Additionally, when doing
business overseas in any capacity, you will
confront challenges with customs and transportation, not to mention the accounts
payable/receivable function. Before you
jump into an international deal of any kind,
you must perform due diligence.
What due diligence is necessary before conducting international business?
First, decide how you will pursue international business. Will you just test the waters
or commit to a formal overseas presence?
Will you acquire goods from foreign entities
or just sell to international customers?
Due diligence is critical when partners are
concerned. Because U.S. business owners
cannot easily travel to visit with potential
international associates, they rely on instinct
and may dive into a deal too quickly. It’s
always a good idea to include your accountant, attorney and banker in the due diligence
process to ensure you enter into agreements
with trustworthy foreign entities. When evaluating an opportunity, how will you know if
you are looking at records that properly
reflect the foreign company’s actual profit?
Again, rely on advisers who know their way
in the international arena.
What international tax opportunities might
business owners overlook?
One often-overlooked opportunity is the
ability to access start-up losses from your
international subsidiary to offset current U.S. income. Say you establish a Chinese subsidiary, and it is not profitable the first few
years. If a proper election is made, the
Chinese operation can be treated as a division of your U.S. company rather than a separate entity for U.S. tax purposes. You may be
able to apply those losses against your U.S.
income. Absent this election, the Chinese
company losses would be trapped in that foreign entity and would only be accessible
once that entity became profitable.
What common international tax traps can
U.S. companies confront?
When setting up a foreign subsidiary, be
sure to keep careful records that support
intercompany transactions between U.S. and
foreign entities. This is especially pertinent in
the following case: You set up a foreign manufacturing subsidiary that produces widgets
that you will buy to supply your U.S.-based
company. The U.S. tax rate on the profit from
the sales of those widgets is 35 percent; the
foreign tax rate is 10 percent on the profit
from the sale to the U.S. parent. The arms
length price if you were to purchase the widget from a third party is $5. Your U.S. company buys the widgets from your own foreign
company for $7.
By inflating the profit in your foreign subsidiary and depressing profit in your U.S. subsidiary, you take advantage of the lower tax
rate in that foreign country. However, you
must have support for this $7 price so the IRS
can verify that you paid a reasonable amount
compared to market average.
Will the IRS scrutinize the tax returns of companies that do business overseas?
With better training and technology to identify issues and the reporting of transactions,
the IRS is equipped to audit taxpayers and
issue penalties to companies that are not in
compliance with the various international
tax rules and regulations. Therefore, you
need to do your due diligence and enlist a
team of advisers with international experience. When you cross the U.S. borders, you
are playing by different rules.