Setting up your business overseas is one of the most exciting things that many of us will do in our business career.

Not only are we, as business Founders or C Suite executives, moving with the business – but the idea that we are taking our business proposition to a new foreign market is a thrill and a bit daunting in many respects.

Establishing my business in Singapore in March 2004 was a completely foreign experience in so many respects. There were many logistical challenges to deal with including adjusting to a new business environment, a new regulatory regime and building a totally new market for our product and services.

For most of you setting up or moving a business you will be pre-occupied with establishing revenue earning operations.

This means that often tax and other planning is left until you arrive.

This, of course, is way too late.

This article covers some issues to address ahead of time.

Expecting The Unexpected

Make sure you really examine how to manage a number of common risks as you expand into your new markets including:

• The real financial cost of expansion (it will take longer and cost a lot more to break even)

• The cultural divide between domestic and foreign markets (get a copy of the book The Culture Map by Erin Meyer) which is to say that the way people understand communication and make decisions is often a major reason why the business will not succeed in the new location

• Regulatory differentials between domestic and foreign markets (expect the approach of the regulator in your new country to be vastly different from your home country)

• Download a copy of my book ‘Expatland’ from our Expatland website 

Setting Up Business

Planning your overseas expansion generally requires you working with your accountants in both countries for between six and twelve months before you head overseas.

One of the key things to understand is that if a subsidiary or a branch pays tax overseas there is some form of tax credit when profits are remitted to the parent company.

Sometimes the best country to pay tax in is where the majority of shareholders live. 

This is so that shareholders might be able to get a credit for tax paid by the company.

Foreign tax paid at the company level is generally not something that shareholders in another country get a tax credit for.

You need to spend some time thinking about the best form of business structure also. 

In my experience, while the main forms of business entities can vary from country to country, those countries with English common law regimes, generally have similar types of structures.

Many countries have structures that provide limited liability to owners but are treated as ‘flow-through’ vehicles for tax purposes, so only the owners are taxed. A classic example is a US LLC (limited liability company).

Other Tax Issues To Consider

Your focus should be on the key issues to consider on departure such as:

Issue 1: How does the foreign country tax system work?

In a number of countries, the US being a prime example, there can often be three levels of tax. For example, in New York, there is federal tax, state tax and city tax to contend with. In other countries like Hong Kong, foreign income is exempt from tax.

Issue 2: Transfer pricing issues

What transfer-pricing issues will you have to deal with. Having prices above or below market value for transactions between related companies is a major tax risk in the present global environment.

As an example, recently a prospective client in the global travel business told us that they had a ‘back office’ for their IT department in San Francisco. 

They then told us that their previous accountant had told them they did not have to worry about filing a US tax return – because the branch was not charging any expenses back to Australia and they were just covering their direct costs!

Great news, they thought, until we had to tell them that it was totally incorrect.

Upon a review of the facts of the case, it actually turned out that they had a ‘permanent establishment’ in the US. This gave them a US tax filing obligation.

The previous accountant also completely missed that transfer pricing rules demand that a market price be charged by the San Francisco office to the head office for the services being provided to head office.

Our client had no idea about these issues.

This is one of the challenges we regularly face when dealing with clients coming to us from domestic-only focused firms.

Firms that focus only on single country tax systems with little or no expertise in international tax, nonetheless, often seek to advise clients going overseas. 

Rather than admitting ‘they don’t know what they don’t know’ and looking to work with a specialist firm to get some outside help, they try to do it in-house.

Usually, this leads to expensive mistakes.

Issue 3: Using debt or equity to fund the foreign expansion

In using capital to start your foreign business, one of the key issues to consider is how to get money into your foreign business operation and then how to get profits out.

Many people are tempted to take the view that lending money into the foreign business is easier because it can be ‘repaid’ with little or no complexity. 

The general thinking being that money that goes in as a loan can come out as a loan, right? 

Well, it is not always that simple.

Many foreign countries have rules that require the payment of interest on inter-company loans.

Issue 4: How to send profits to the home country

Having considered how to fund your foreign business and make it profitable, the next question to think about is how profits can be remitted to your home country.

There are a number of techniques that can be used to send profits home. These include dividends, interest, or royalty payments. 

Other techniques include management fees and head office recharge. 

One of the issues to consider here, includes the likely imposition of a foreign withholding tax on payments out of the country. 

Planning profit repatriation is a key issue to consider.

Issue 5: Review your intercompany pricing model don’t assume

Many businesses – especially large American businesses adopt a ‘one size fits all’ approach.

Rather than take a country-by-country approach to looking at how to price transactions between group companies, larger businesses just assume they can apply a Group Policy across the board.

That is not acceptable in most advanced tax regimes.

Consider the real-life case study that I dealt with recently.

CabinetMaker Inc (not their real name)

‘We don’t do things that way’ was what the US-based CFO told me when I suggested they get an arm’s-length review of their ‘global transfer pricing model’ by an Australian transfer pricing specialist.

‘CabinetMaker Inc’, was supplying IT products and services from the US to Australia.

They decided that the Australian company would, ‘just like all other overseas subsidiaries’, receive an 8 per cent payment from the US office for the services it provided the US office from Australia.

A couple of months before, the CFO had called me following a referral from a US client.

Given we have a US–Australia tax specialisation, they called us to see if we would prepare their Australian income tax return for their sole Australian company.

The company in Australia had a ‘representative office’ function.

Its purpose was to source leads in the Australian market and then refer those leads to the US office to complete the sales process and the forming of the business relationship.

The US company was being very careful that what it did in Australia did not give it a ‘taxable presence’.

All reasonably standard stuff they thought.

When I asked how they arrived at the 8 per cent, they mentioned that they had a pricing model in Chicago.

They said that the ‘Chicago model’ was used globally to justify how 8 per cent was ‘payment enough’ for sourcing sales in Australia.

I persisted with a few questions, as follows:

So, with three questions, I could see that CabinetMaker Inc. was relying on a home country pricing model developed with no understanding of the Australian market.

A fatal mistake to make when you are a new company expanding abroad.

I attempted to acquaint them with the realities of doing business away from the US.

They were in another country now and they had to adapt to the differences in the market.

Needless to say, when the CFO hit me with the comment, ‘I will take it to the Board of Directors and come back to you’, I heard nothing more from them.

The aftermath to the above is that recently a story broke in the Australian media that the company, a subsidiary of a US tech company, was being audited by the Australian Taxation Office.

The media reports noted that their transfer pricing practices were suspect.

The global giant failed to adapt its pricing model between group companies and did not want to listen to advice.

They did not want to unlearn what they thought they knew.

They persisted in trying to apply an overseas model without adapting to their new surroundings. 

As a result, their business practices were found wanting in Australia and abroad.

The above mistake is reasonably common; that is, companies expanding abroad believe they can bring their own way of doing business with them. 

Nine times out of ten that is incorrect.

When companies expand to a new country, it pays to go back to first principles, get proper advice and assume nothing. 

Adapting to your new surroundings is essential.

We understand that business owners and entrepreneurs require specific advice from experienced professional advisers in multiple jurisdictions and that a migration tax plan has to be prepared for a company – just as it does for an individual.

Examples Of Unintended Arrival

Example 1 

A foreign company establishes a branch in the arrival country.

This occurs when senior directors of a foreign company remain directors of the foreign company and they change their personal tax residence.

As is commonly the case, the directors continue to ‘run the foreign company’ from their new location. They often do this without realising that they have unwittingly brought the foreign company into the purview of their arrival country.

This triggers tax filing and other reporting obligations.

Example 2

Shareholders leave their home country to live abroad, and while they may not be directors of the foreign company, they remain nonetheless individual shareholders.

In this instance, many tax regimes will demand that tax be paid on the earnings of the foreign company as the profit belongs to the shareholders now living in their new country.

This tax exposure would arise by the ‘controlled foreign corporation’ legislation that many countries have.

If one or both of these unintended actions has occurred, then there is a need to value the assets of the company and understand the value of the shares in any foreign company.

Often, the ‘starting cost base’ of the company assets is relevant because that is the basis upon which future capital gains are calculated. 

Most clients miss this step unless properly advised.

Companies that ‘arrive’ on an unintentional basis now have two tax returns to do one in their home country and one in their arrival country!

Planned Arrivals

When we have an opportunity to work with clients ahead of their departure, we can plan how best to ‘move the company’.

Taking your business abroad is an exciting time for most people. Full of challenges and new opportunities, it is often a make-or-break time for a corporate group.

My view is that if you undertake a proper tax planning exercise covering some or all of the above issues before you leave, then the thrill of setting up your business overseas will not be overshadowed by unintended tax and business issues.

This article relates to foreign business founders with an active business, who are moving to the US. There is a risk that foreign earnings may be double taxed when your organisation is taxed as a US entity. This is due to the application of US attribution rules (Controlled Foreign Corporation (CFC) rules) and Passive Foreign Investment Company (PFIC) rules.

To avoid being double taxed and ensure that foreign tax credits can be appropriately applied, it may be advisable to make a check-the-box election. This election essentially means that foreign corporations are choosing to elect their US tax status at the point in time that the US tax system becomes ‘relevant’ to them.

This check-the-box system is a tax regime that doesn’t just impact organisations that are set up in the US. It can also impact Australian businesses and global businesses when the foreign founder of the corporation moves to the US.

When does the US tax system become ‘relevant’ to a foreign corporation:

The US tax system is considered to be ‘relevant’ to a foreign corporation when one of the following applies:

a) the foreign corporation derives US sourced income;

b) the foreign corporation is required to file an income tax return in the US; or

c) the owner of a foreign corporation becomes a US tax resident (ie a US Person).

Why might a check-the-box election be made?

The most basic reason for making the check-the-box election is to ensure that the owner of the corporation in the US is properly credited with the foreign tax payments. A check-the-box election will avoid the attribution of income under CFC rules or the loss of long term capital gains tax rate discounts when shares are transferred in a passive foreign investment company (PFIC).

When will a foreign corporation be a CFC?

When US shareholders own more than 50% of the shares, either directly or indirectly, then the foreign corporation will be considered to be a controlled foreign corporation (CFC). To be considered a ‘US shareholder’ the person must own more than 10% of the voting rights or stock value of the foreign company.

When is a foreign corporation a PFIC?

A passive foreign investment company (PFIC) exists when one of the following two conditions are satisfied:

1. Passive investments generate at least 75% of a corporation’s gross income (as opposed to regular business activities); or
2. At least 50% of the corporation’s assets create passive income. Passive income includes interest, dividends and capital gains.

What is a foreign eligible entity?

A foreign eligible entity is defined by whether a member has limited liability or not. This is a default classification under the check-the-box regulations. When all members of the corporation have limited liability the US taxes the foreign eligible entity as a corporation. When at least one member does not have limited liability the entity is not a foreign eligible entity.

An eligible entity may make a check-the-box election to opt out of the default classifications.

Warning on making an election after default classification has been made

It is important to make your election prior to the default classification being applied. This is because making a later election will change the organisation’s classification. Such a change in classification can trigger a liquidation event.

When you should make a check-the-box election:

To ensure the check-the-box election is made appropriately you should consider making the election when you meet all of the following conditions:

1. you own a foreign corporation
2. the US tax system is relevant for your corporation
3. you need to apply foreign tax credits against your US corporate tax regime
4. you wish to avoid applying the CFC or PFIC rules.

Author: Matthew Marcarian

Hua Wang Bank case – the drama continues

Is Australia’s most important corporate residency case in 40 years heading to the High Court? We are watching with interest. The taxpayer has appealed to the High Court from the decision made by the Full Federal Court in Bywater Investments Limited v Commissioner of Taxation [2015] FCAFC 176 on appeal from the decision in Hua Wang Bank Berhad v Commissioner of Taxation [2014] FCA 1392.

What makes the Bywater/Hua Wang case so compelling is that the Federal Court came down so strongly on the side of the Commissioner in agreeing with his argument for a ‘substance over form’ approach.

What was the case about?

The question was whether five overseas-incorporated companies had their central management and control in Australia and therefore were Australian residents for tax purposes. The amount of tax in dispute, before interest and penalties, was over AUD 14M.

What was decided?

Justice Perram was damning in his conclusions. He referred to the activities of the foreign companies as a ‘crooked pantomime’ designed as window dressing to conceal the control of the Australian resident. Overseas directors were ‘puppets who did not exercise any independent judgment in the discharge of their offices’ but instead merely carried into effect the wishes of the Australian resident in a mechanical fashion.

Apart from the overwhelming findings of fact and there was also resounding condemnation by the judge of the taxpayer’s ‘disgraceful’ behaviour in trying to conceal his ownership of the foreign companies. The ATO was able to obtain documents from the Cayman Islands that proved otherwise.

At a technical level the case highlighted ‘two principles’ relating to the issues that have never once waivered over the past 40 years in Australian tax law; being that

1. a company is resident where its real business is carried on, and its real business is carried on where the central management and control abides; and
2. the question of where a company is resident is one of fact and degree.

Implications for clients

The case is an object lesson to Australian companies or entrepreneurs seeking to expand overseas and who intend to use ‘nominee directors’.

This case dramatically illustrates how important it is for clients to ensure that any overseas companies are run by overseas directors with sufficient operational experience and independence to be able to carry on and supervise the business of the company. If strings are pulled from Australia there is a risk that those overseas companies will be considered resident in Australia, with the result that Australian tax may apply. A second set of rules, the Controlled Foreign Corporation rules may also apply to foreign company that aer controlled by Australian residents even if they are controlled and managed outside Australia, if the income derived is passive in nature or considered to be tainted income.

CST Tax Advisors is able to assist clients with advice in these complex areas.