Any financial executive who has attempted to find his or her way through the labyrinth of the Code’s international tax provisions likely knows that even the most trusted tax counselors often offer only inadequate guidance. Day-to-day operations are usually too vast—and their circumstances too involved—for an outside tax professional to assess them adequately. It is the financial executives (or the outside auditors) who know the operational details of a company and its transactions who must ultimately assess whether a company has exposure for underpaid international tax obligations. But these executives may not have enough of an international tax background to even realize there is a problem.
With the Obama administration planning to hire some 1,500 new international tax examiners, and current business conditions fraught with risk, an overlooked international tax exposure could very well put a medium-sized company’s very viability in peril. So it is only prudent for financial executives to do a checkup, of sorts, of their companies’ operations to ensure that there are no looming unidentified cross-border tax issues. This is especially true for companies large enough to have multinational operations but still small enough to be below the threshold of the Coordinated Examination Program that the IRS uses to audit large, publicly traded multinational corporations. With so many new international tax examiners on the IRS payroll, it is highly likely that many more medium-sized companies will find their transactions scrutinized by an international tax examiner.
A thorough review of every tax aspect of every cross-border transaction would consume hundreds of pages and require thousands of hours. Nevertheless, prudent CFOs and CEOs can exercise reasonable diligence to ensure that their business organizations have procedures in place to address some of the more common shortcomings in cross-border tax compliance. This item is intended to help CEOs and CFOs achieve that level of prudence. It addresses most of the routine tax compliance issues that larger medium- sized companies ($500 million or less in sales) are most likely to encounter, whether they are U.S. companies or the U.S. operations of foreign companies.
Particular attention is given to the type of international tax compliance traps that can blindside a CEO or CFO who has been lulled into a false sense that his or her foreign tax reporting obligations are under control; that false comfort sometimes comes to executives on the word of middle managers who simply do not know what they do not know. This article explains what should be contained in the “foreign” tab of what are often massive amounts of international tax detail and illustrates how executives or outside auditors may be signing off on information that can be catastrophically wrong.
For audit seniors and managers addressing the old Statement of Financial Accounting Standards (FAS) No. 109, Accounting for Income Taxes, and vetting tax positions for Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes (now mostly contained in FASB Accounting Standards Codification topic 740), as well as for tax specialists only somewhat familiar with international tax practice, completing the checkup should provide an early warning that there may be important international tax issues that require further investigation by an international tax specialist.
Restructurings, acquisitions, dispositions, and other major capital structure changes within cross-border operating groups are not addressed here. Those types of transactions are themselves fraught with traps and carry the risk of tax assessments large enough to put a company out of business, but they are well beyond the intended scope of this piece. Such inherently unique transactions demand the thorough evaluation of a tax professional well versed in international tax matters before they are undertaken.
For clarity, this checklist distinguishes between activities that mostly affect foreign- owned companies doing business in the United States (“inbound” activities) and activities affecting U.S. companies doing business overseas (“outbound” activities). Finally, it addresses activities that are likely to apply to both types of companies. Prudent managers and auditors should survey the entire list because many companies have activities across the spectrum of inbound and outbound transactions.
Inbound Entities and TransactionsIs the equity of the U.S. company sufficient to support the U.S. operation? If not, the IRS might take the view that the U.S. company’s interest payments are merely dividends. Interest deductions on capital purportedly “borrowed” from a foreign parent company would be denied, recharacterized as a dividend, and possibly subjected to U.S. withholding tax.
Does the U.S. company have any debts from (or any that are in any manner guaranteed or supported by) a foreign owner that might implicate the earnings-stripping interest limitation rules of Sec. 163(j)? If a company is thinly capitalized (i.e., with a modified debt-to-equity ratio determined by statute below 5:1) and it has debt payable to a related foreign person, a portion of the interest deduction on the company’s borrowed capital may be limited.
Even debt that is purportedly owed by the U.S. company to a U.S. or foreign bank but that is supported in any fashion by the creditworthiness of the foreign affiliated company will be considered to be a loan from the parent and thus subject to the interest limitation rules. For instance, if a parent company has a side letter to an unrelated lending bank that says its U.S. subsidiary will be provided with sufficient capital to pay the lender’s debt, the interest paid may be subject to Sec. 163(j).
Does the U.S. company have any debts from a bank guaranteed by a foreign parent or affiliate that implicates the intercompany pricing regime of Sec. 482? U.S. subsidiaries of foreign parent companies can often obtain better interest rates when the foreign parent company guarantees the creditworthiness of the U.S. borrower with a lender, either formally in the loan agreement or with “side letters” or “keepwell” agreements. On audit, international examiners may attempt to recharacterize these bank-to-subsidiary loans as though the parent company had borrowed from the lender at the parent company’s lower rate and then re-lent the money to the U.S. subsidiary at the subsidiary’s own higher rate of interest. If the loan interest is subject to U.S. withholding tax at the source, there can be substantial exposure for U.S. withholding tax on the higher amount of interest expense the auditor determines. Companies with large net operating losses are especially exposed to this risk; an IRS adjustment that increases the U.S. subsidiary’s interest expense has no current U.S. income tax effect (becaus e i t merely increases the loss), but it could net the international examiner additional tax revenue for underpaid withholding tax on the additional imputed interest.
Is the customs value for inventory items imported from overseas affiliates approximately equal to their cost as purchases in the inventory calculation shown on the U.S. business income tax return? If the customs value of imported merchandise differs from what is shown as the cost of inventory on the tax return, there can be exposure for tax or duties or both.
Is U.S. foreign tax withholding being properly computed on the full amount of royalties, dividends, interest, and other remittances due to the foreign parent company? Companies sometimes offset or “net” outbound payments with inbound payments and then pay withholding tax on the net amount so determined. But withholding tax has to be paid on the full amount the payer is liable to pay, not the cash amount for which payment is settled.
Occasionally there may be cash settlement of a liability owed to a foreign affiliate in one country through an affiliate in another country. Notwithstanding the flow of the cash, the U.S. withholding tax should be imposed on the payment as though 100% of it was paid to the country where the affiliate that was owed the funds is located. For example, interest owed to an affiliate in Brazil but settled through an intercompany account with a Dutch company should bear the full 30% U.S. withholding tax for the benefit of the ultimate Brazilian payee, not the zero withholding tax rate that would apply had the amount been owed to a Dutch company. The means by which the cash debt is settled is irrelevant for computing the proper U.S. withholding tax.
Outbound Entities and TransactionsHas the U.S. company evaluated any 10% or more foreign-organized affiliates to determine whether they might be controlled foreign corporations? If the U.S. company owns 10% or more of a foreign-organized corporation, the U.S. company should evaluate whether other U.S. shareholders that each own a 10% or greater interest collectively own an additional 40%. If they do, then the foreign affiliate might be subject to the antideferral regime of subpart F, which requires certain types of income earned overseas to be recognized currently (i.e., as though the income was an advanced dividend).
Has the U.S. company evaluated whether it owns 10% or more of foreignorganized affiliates or whether it has contributed more than $100,000 in U.S. or foreign currency to a foreign partnership? In that case, the U.S. company would be required to file Forms 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships. Failing to file the form can result in penalties.
Have investments in foreign companies been evaluated to determine whether the foreign company might be a passive foreign investment company (PFIC)? If the U.S. company owns shares of a foreign company, the foreign company may qualify as a PFIC if it has a high proportion of assets or income that is passive. For this purpose, cash is considered a passive asset, so newly formed companies are especially vulnerable. There can be substantial additional tax cost to the U.S. shareholder if the foreign companies are determined to be PFICs and they are not properly identified.
Have Forms 5471 and 8865 been filed with the tax return for each separate controlled foreign corporation (CFC) or foreign partnership (CFP)? Is there a means of capturing the details of transactions between a U.S. parent company and its CFCs/CFPs or among its CFCs? Foreign affiliate operations are often consolidated into national, regional, or simply a single foreign sub-consolidation to facilitate financial reporting efficiencies. But Forms 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, and 8865 are required for each separate legal entity, even if the companies are organized in the same country and even if a sub-consolidation of financial information for two or more separate foreign entities is available. The foreign legal entities must each be reported separately on their own separate Form 5471 or 8865, as the case may be. Failing to properly report the separate activities of the foreign affiliates can obfuscate transactions—between and among affiliates—generating income that is currently taxable to the U.S. owner. Moreover, the IRS imposes substantial tax penalties on any U.S. shareholder that fails to file the form.
International Tax Matters of Concern to Both Inbound and Outbound Entities
Are intercompany working capital accounts to the parent company and among other foreign affiliates cycled through and settled every 120 days? Buildups of intercompany payables to a foreign parent or affiliate, without regular and ongoing settlement (i.e., payment within 120 days), can cause the IRS to impute interest income to the creditor for U.S. tax purposes. The interest, in turn, can be subjected to U.S. withholding tax as interest.
For most companies, it is almost always better to maintain a policy among foreign affiliates whereby amounts unpaid within 120 days incur a stated market rate of interest. Without such a policy among international affiliated groups, interest that the IRS might impute to the taxable income of a U.S. company from receivables owed by its foreign affiliates has no offsetting tax deductible interest expense benefit on the affiliate’s books.
Have payees that receive payment at reduced or zero rates of withholding tax been adequately matched to documentation that supports the reduced rate? The payer is liable for withholding tax that it fails to withhold and, on audit, bears the burden of proof that the proper amount of tax has been withheld. A full review of the documentation requirements and the entire qualified intermediary tax regime would consume an article in itself; suffice it to say that prudent auditors and financial executives will periodically test to ensure that their accounts payable personnel are familiar with the panoply of foreign withholding tax rules and are maintaining the proper documentation for payments made overseas.
Have intercompany pricing issues been adequately addressed? The ultimate protection against IRS tax assessments on pricing issues is an advanced pricing agreement (APA) whereby the IRS abides by intercompany pricing it has already reviewed with the taxpayer and its representatives (usually an economist, accountant, or lawyer). But the protection is costly; even a very limited APA using simplified procedures that the IRS has adopted for smaller taxpayers can cost in the neighborhood of $50,000 in fees.
The next level of security from assessments caused by pricing issues is a pricing study whereby a professional firm (accountants or, more usually, economists) compiles and reviews the company’s intercompany pricing arrangements, analyzes them, and issues a report. This too is costly and has only a limited shelf life.
Companies that opt to venture into an IRS pricing audit without a professional well versed in the area do so at their own peril. Still, a company can greatly reduce the exposure for routine transactions—such as sales of merchandise, lending of funds, and payments for services—simply by finding comparable transactions with unrelated parties and ensuring that charges and costs for transactions among related companies are comparably priced. Where payments for “one-of-akind” royalties or services are to be determined, companies may find it worthwhile to obtain the advice of a pricing specialist for à la carte reviews of pricing.
Is interest expense due to foreign affiliates being deducted on a cash basis on the U.S. tax return? Interest accrued to foreign affiliates is usually deductible, but only on a cash basis for tax purposes. For most accrual-basis U.S. companies, there will be a difference between the amounts of interest they can deduct in the current year for the books and the amount they can deduct for tax purposes. Where there is no difference, it is very possible that taxable income may be understated on the income tax return.
In an environment where international tax examinations will play a larger role in tax audits, prudent financial executives and auditors will take the time to evaluate their current international tax compliance, assess any shortcomings, and correct them. Where there are—or have been—lapses, the stakeholders should consult with competent tax professionals and determine a proper course of action. But in no event should such shortcomings be ignored; the costs are simply too high.
EditorNotesJames Collins is a senior manager at Friedman LLP in New York, NY. For more information about this article, please contact Mr. Collins at firstname.lastname@example.org.