This is the final part of our US expansion blog series addressing the top ten challenges that UK and European companies face after establishing an initial US presence. This Part 5 focuses on US tax structuring and tax compliance.
Part 1 addressed various challenges relating to employees. Part 2 covered contracting with large companies and protecting key intellectual property. Part 3 addressed securing US investment. Part 4 focused on management of US litigation risk.
Because the US is a federal jurisdiction, it is particularly complex from a tax standpoint. Companies face corporate income tax at the federal and state level, may be required to collect sales tax at the state and local level, and can be subject to a variety of other taxes, such as employment-related taxes, real property tax and personal property tax. We find that, for emerging companies, tax accountants can provide US tax support most cost-effectively, since they can both provide the relevant advice and handle the tax compliance (tax return filing).
Inter-Company Arrangements. For tax reasons, your US subsidiary needs to work with its non-US parent on an arm’s length basis, supported by written inter-company agreements. This is required by both the US tax authority (the US Internal Revenue Service, or IRS) and your home country tax authority (HMRC in the UK). The structuring of this relationship depends on the manner in which you would prefer to operate from a commercial standpoint and the tax advice that you receive. For example, in selling your services or products in the United States, it is common for the US subsidiary to act as a sales agent or distributor. We find that many of our software as a service (SAAS) clients determine that the limited risk distributor model works well for them. In that model, the US subsidiary (the limited risk distributor) enters into the contracts with its US customers and then turns to its non-US parent for everything that it needs to support the contract – trademark, core intellectual property, head office services, customer care and the like. The parent also takes the main commercial risk (hence the “limited risk” reference). The subsidiary receives the revenue from the contracts, and then compensates the parent on an arm’s length basis for everything that the parent provides; after those expenses, the subsidiary is left with revenue and profit appropriate for the activities and risk that the subsidiary incurs. The subsidiary payments to the parent may be subject to US withholding tax, in which case the levels will be typically reduced (sometimes even to zero, depending on the character of the payment) pursuant to the tax treaty between the US and the parent’s home country.
In some cases, the subsidiary may also provide services to the parent for which it needs to be compensated. This is clearly the case in the sales agent model (where the subsidiary finds the potential clients and the parent company contracts directly with them) but it may also be true where the subsidiary is performing other services for the group. Take care if your US subsidiary is developing IP for the group – you will want careful guidance on how that should be handled, and clarity as to the ultimate ownership of the IP.
Transfer Pricing. In any case, whatever model you use, it will need to be supported by one or more inter-company agreements that set out the arrangements, the services, and the charges. The charges, which are referred to as “transfer pricing,” need to be set with appropriate tax accounting support. We suggest that US (rather than parent home country) tax accountants do this work, because the sensitivities tend to be more on the IRS side. This is partly because US corporate income tax levels (34% at the federal level, and frequently totalling more than 40% once state taxes are taken into account) are generally higher than in most other countries, so the IRS is motivated to ensure that the subsidiary receives an appropriate allocation of the profit.
Transfer pricing studies can be very expensive, but it is possible for early stage companies to get size-appropriate advice that can be supplemented as revenues grow and the business becomes profitable. We recommend that you put these arrangements in place in the very beginning – it is more problematic for the parent to start charging for IP and services in, say, Year 4 that it has provided to its US subsidiary for free in Years 1 through 3 (when the US subsidiary was losing money).
Capitalization. You will also need advice on how best to capitalize your US subsidiary. Parent companies frequently lend money to their subsidiaries for working capital. While some element of debt makes sense, the IRS will recharacterize all of the debt as equity if the debt:equity ratio is too high. Again, tax accountants can provide this advice cost-effectively.
Your US subsidiary needs to sort out its tax compliance from the very beginning. It will be subject to tax registration at the federal, state and local levels, and is likely to need to file a variety of corporate income tax and other tax returns. In addition, if it is selling products and has “nexus” with a state (such as an office), it probably also will be required to collect sales tax from residents of that state. Some states – including New York – treat software as a service as prewritten software subject to sales tax.
Of course, your US subsidiary also will be obligated to pay employment taxes and withhold income and employment taxes from its employees, although it may use a third party service to handle this.
Failure to collect and pay over sales tax and employment tax can lead to personal as well as corporate liability.
Tax accounting firms should be able to handle this on a federal and 50-state basis. Those accustomed to working with emerging companies also should be able to do this cost-effectively. It is important to address tax compliance issues at the very beginning of your subsidiary’s operations – it can be very costly to fix tax compliance errors. For example, there is a mandatory federal filing if certain inter-company arrangements (of the kind described above) are required, and the failure to file that form in a timely way generates an automatic $10,000 fine.
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Want to learn more about how best to pursue US expansion or US investment? Feel free to get in touch with Robert Mollen.
Post produced in partnership with Robert Mollen at Fried Frank Technology.