Feb 16, 2017, 07.57 PM | Source: Moneycontrol.com
The following article is an initiative of KNAV and is intended to create awareness among the readers.
Three tiers of taxation
There are three tiers of taxation in the US - Federal, State and Local (cities and counties); which are generally determined by applying a tax rate on taxable income. While federal income taxes are based on seven brackets ranging from 10% to 39.5%, states and cities/counties have either a flat or a progressive tax structure. In addition to income tax, certain states also have franchise tax (generally based on the net worth of the company) and gross receipts tax (based on gross revenues of the company and not the income). Certain states like Alaska, South Dakota and Wyoming, have no income (tax?) at all. This three-tier system of taxation can lead to a significantly high tax cost for a business entity.
Various corporate structures
When beginning a business, organizations must decide on the form of business entity to be established, as this determines taxability. The most common forms of business are sole proprietorship, partnership, corporation, S-corporation and Limited Liability Company. Various legal and tax aspects need consideration when selecting a business structure.
Standard corporations or C-corporations are subject to double taxation, if the company makes a profit. They are taxed at the corporate level, and any dividends paid onto the individual shareholders are also taxed under personal income tax.
S-corporations on the other hand are not taxed at the corporate level. The profits or losses of S-corporations flow through and are reported on the shareholder's individual tax returns. Taxes, if any on the share of profits received from an S-corporation are borne directly by the shareholder. However, one of the criteria for S-corporation eligibility is that all the shareholders should be non-corporate US persons and hence this option is generally not available in case of investments into the US from foreign jurisdictions.
A Limited Liability Company is a business structure allowed by state statute. Limited Liability Companies are generally treated as pass-through entities by the IRS, unless specifically elected to be treated as C corporations for tax.
Consolidated tax returns
Consolidated tax returns are the overall tax returns filed by business conglomerates on behalf of smaller subsidiary firms. The election to file a consolidated return is available to certain groups of US domestic corporations called ‘includable corporations’ that are connected through stock ownership with a common parent. The benefit of filing a consolidated return, apart from making it a centralized and efficient process, is the treatment of the consolidated group as a single taxable entity for purposes of computing tax. Unused tax attributes such as tax losses and credits of an affiliate may be used to offset the income and tax liability of other affiliated group members.
Modes of acquisition
When it comes to acquisition, there are primarily two methods, namely asset acquisition and stock acquisition. Asset acquisition is when a purchaser buys specified assets of a business, and specified liabilities. The merit of this method from the legal standpoint is that the buyer can lay more focus on specific assets and limit the liabilities. From a tax standpoint, the buyer gets a stepped-up tax, (basis the assets acquired, including intangibles which may be generated on account of acquisition which are eligible for tax amortization over a period of 15 years), but loses the carry-over tax attributes of the target company. However, from a seller’s point, it is important to note that the asset sale is subject to double taxation if the target is a C-corporation but LLCs and S-corporations are subject to pass through taxation, in which there is no double taxation.
On the other hand, a stock purchase is when the buyer purchases shares of the target company. The stock sale is subject to a single levy of tax. The buyer does not get a step-up in tax basis the assets but is entitled to carry-over tax attributes of the target company.
Additionally, in the US there are section 338 provisions wherein under certain cases; the acquirer can elect to treat stock acquisitions as asset acquisitions for tax purposes.
Hence, the acquirer needs to carefully weigh the pros and cons of each of the two methods before concluding on the mode of acquisition.
Section 382 and 383 limitations
Section 382 and 383 of the Internal Revenue Code places annual limitation on the amount of net operating losses and tax credits which a corporation can offset post change of control.
Net operating losses and credits are key tax attributes which the acquirer looks at in the process of acquisition and hence it comes extremely important to review the availability of these attributes post change of control. The availability or non-availability of these attributes can have a significant bearing on valuation and negotiations.
Selecting appropriate acquisition vehicles:
The businesses may expand in the US either organically or through acquisitions. In case you wish to opt for the latter, one of the key considerations is using an acquisition vehicle. A particular type of entity may be better suited for a transaction because of its potential tax treatment. In general, there may be 3 types of entities which may be considered as acquisition vehicles: (i) local US holding company (ii) foreign parent company and (iii) non-resident intermediate holding company. Each of the structures has its own pros and cons, an evaluation of which is extremely important. Amongst others, a couple of aspects which need to be considered are (a) method of acquisition to be opted and (b) quality of tax treaty with parent company or intermediate holding company jurisdiction and anti-treaty shopping provisions existing in most US treaties (Limitation of Benefits clause) and under the US domestic rules on conduit entities.
Funding US subsidiaries
For Indian companies, obtaining funding from external financing sources may be difficult for their US subsidiary. Thus, most of them finance the subsidiary internally through a combination of debt and equity or by providing corporate guarantee against third party debts provided to the US subsidiary. However, it is important to be mindful of various tax considerations arising on account of debt and equity funding, some of which are highlighted below.
As per recently issued IRC 385 regulations, certain debt issued by US corporations may be recharacterized as equity under certain conditions. The regulations specifically state that a debt shall be recast into equity if such debt is issued by the corporation to a related corporate shareholder/other members of the expanded controlled group, subject to certain exceptions. These regulations also have introduced documentation requirements that impose discipline on related-party lending transactions by requiring timely documentation and financial analysis, similar to the documentation and analysis that is created when debt is issued to third parties.
Additionally, the US has stringent thin capitalization rules also called earnings-stripping rules. These rules are applicable in case of debt issued to foreign related corporations or debts guaranteed by a foreign related party. In such a case, if the debt-equity ratio of an entity exceeds 1.5:1, earnings-stripping rules become applicable and it limits the deductibility of interest paid or accrued in situations where all or a portion of such interest is exempt from US taxes.
FDAP Income and US-India Tax Treaty
For an Indian company in the US, if the income is generated by direct operations with US trade or business, then the income earned will be subject to federal corporate tax and state income tax.
However, if an Indian business earns Fixed, Determinable, Annual or Periodic (‘FDAP’) income which is not ‘effectively connected’ with a US trade or business, such income is generally subject to a 30% withholding tax, unless reduced or eliminated by the tax treaty. In this context, a review of the India-US tax treaty shall be extremely important if direct investment from India into US is contemplated.
Certain key benefits in the US-India tax treaty in this context are (i) withholding @ 15% on dividend payments (ii) withholding @ 10% and 15% on interest payments to banks/financial institutions and others respectively and (iii) characterization of fees for technical services (‘FTS’) earned from India as foreign source income through protocol to tax treaty entitling US entity for foreign tax credit on taxes withheld in India on FTS.
Complexities of multi-state taxation
It is common knowledge that every business decision will most likely have a tax implication, especially for companies operating across multiple states. Two major concerns that such enterprises face are nexus and the apportionment rules. Simply put, nexus is defined as the right for the state to tax a business which has a physical or economic presence in a state. The nexus is generally determined by the presence of any of the three factors: payroll, sales and property (owned or rented) in the state. Now firms with a nexus in multiple states will apportion or divide their profits by determining how much income each state can tax, based on apportionment rules. These apportionment rules are extremely complex and need careful attention both at the time of setting up and after commencement of operations.
The US is known for its advanced manufacturing and R&D capabilities, attracting the best from around the world. One of the reasons is the many tax incentives offered, especially for innovation.
There are various deductions and credits available at federal and state levels. Though the benefits at a federal level are standard irrespective of the location of your business, state level deductions and credits can play a vital role in selecting the right location. The benefits are not just restricted to income tax but also expand to payroll taxes, sales tax and property taxes.
In addition to deductions, grants and credits stated in law, it has also been seen that the businesses have been able to negotiate with states for better incentives. Thus, selecting the right state can help save significant dollars on taxes.
To conclude, the US offers immense business opportunities to both established businesses and new-age investors. Keeping in mind that the US is still the largest consumer market on earth, with a staggering GDP of over $18 trillion; it is a market opportunity that no business can ignore, and therefore a whole lot of Indian businesses too are looking at tapping the opportunities therein. With a bit of caution and understanding, the shift will be profitable for both. In fact, according to a report by CII in 2015, India-based companies were responsible for creating 91,000 jobs and $15 billion in investments across the US. As the partnership between the two nations grows, so will the business, but Indian companies must always remain vigilant with respect to tax provisions in US while acknowledging these as one of the major decision drivers.
The above article is authored by Shishir Lagu, National Lead Partner, US inbound tax & regulatory services - KNAV.