If you’re considering doing business overseas, make sure you’ve done the proper planning before you jump in, or the result could be disaster.
No matter the size of your company, if you fail to get everything in order, you could find yourself in very deep trouble both with the IRS and with the local tax authorities in the country in which you are doing business, says Barry Wen, tax senior manager at Burr Pilger Mayer.
“Too many companies think that unless they are a large, multinational company, they don’t need to worry about the international tax issues, but any company with a presence in a foreign country needs to be aware of the tax planning opportunities and compliance requirements,” Wen says. “The IRS has become more aggressive in seeking revenue, and targeting foreign operations is an easy way to do that because many taxpayers are not aware of all federal requirements.”
Smart Business spoke with Wen about what you need to consider before expanding internationally.
What does a business owner need to think about before making the jump into another country?
The first thing to consider is what kind of entity you want to have overseas. Do you want to have a corporation, a partnership or a disregarded entity? You really need to determine what your long-term plan is, have proper projections and budgets and identify both the U.S. and foreign tax issues and compliance requirements. Other questions you want to ask yourself are: How should I report foreign income or losses? Is there any relief from the foreign tax withholding? Should I make the check-the-box election?
What should companies be aware of regarding the income anti-deferral rules?
Generally speaking, a foreign corporation is not subject to U.S. tax on its foreign earnings until it is repatriated to the U.S. However, the anti-deferral rules restrict the deferral of tax on certain foreign income for certain U.S. owners of certain foreign corporations. For example, there are no deferrals if the foreign income could have easily been earned in the U.S. or there are hidden distributions such as investment in U.S. property. Therefore, you have to very closely watch your related parties’ transactions in different countries.
Why is it important to have proper transfer pricing documentation?
The IRS’s transfer pricing rules are designed to ensure that prices charged by related entities for goods or services net the same results as what would have been realized if unrelated entities were involved in that same transaction under the same circumstances. These transactions need to be well documented because the IRS and more than 70 other foreign tax authorities want to make sure that your intercompany transactions are arm’s length in nature, so you cannot shift income among different entities of the same group or from one country to another. Therefore, you need to have contemporaneous documentation, including a functional and economic analysis to support your transfer pricing policies. Without such documentation, many countries’ tax authorities, including the IRS, may make transfer pricing income adjustments and impose penalties. U.S. penalties can range from 20 percent to 40 percent of the adjustment amount.
On the other hand, a fiscally responsible and well-tested transfer pricing study could contribute to long-term sustainability of your effective tax rate and provide planning opportunities for future expansion. It also became more important after the adoption of the FIN48 by most entities because of the potential uncertain tax positions of your foreign operations.
What forms are critical for U.S. corporations to file when doing business overseas?
Depending on the type of your foreign operations, many forms may be required to disclose with the IRS. The most common one is Form 5471, which requires certain U.S. owners to disclose their foreign corporation’s operations, and it must be filed annually. Depending on which category filer the taxpayer may be, there are different schedules that need to be filed. Because it requires detailed foreign financial information, it usually takes time to get it right. So it’s recommended to start planning right after the year-end and work with your overseas staff to get that as soon as possible. If you are required to file the form but fail to do so, the IRS would assess a $10,000 penalty on each occurrence.
Another common and important form is the Report of Foreign Bank and Financial Accounts (FBAR) form TD F 90-22.1. The form requires you to disclose your financial accounts in foreign countries if the aggregate value exceeds $10,000 at any time during the calendar year. Please be aware that you may have filing requirements not only if you own, directly or indirectly, those accounts, but also if you just have signature authority. Similar to Form 5471, failing to file a required FBAR is costly.
What do U.S. taxpayers need to be aware of on a personal level when working overseas?
First of all, don’t think that just because you’re working overseas you don’t need to file a U.S. tax return. As a U.S. taxpayer, your worldwide incomes are still subject to the U.S. tax. How you report the foreign source earned income depends on whether you qualify for a special foreign earned income exclusion rule and whether you want to make such election. If you do, you may exclude certain foreign earned income from U.S. tax, but the related foreign tax credit must be reduced accordingly. Therefore, you need to compare and take the most beneficial way of filing.
Additionally, because you stay and work in a foreign country, don’t overlook the potential local tax authorities’ filing requirements and withholding rules. You may have a foreign tax liability because you performed services there.
Barry Wen is tax senior manager at Burr Pilger Mayer. Reach him at (408) 961-6316 or BWen@bpmcpa.com.