Don’t Get Caught in an Overseas Tax Trap

Smaller businesses keen on selling into the international markets should take a closer look at their own subsidiaries and the value-added tax in the countries in which they operate, a consultant says.

Now that the annual tax season has closed for most smaller businesses, it’s probably a good idea to consider how to extract some benefit out of the 2009 tax year.

One component of tax management that companies with less than $1 billion in revenue often overlook is international tax. Yet mismanaging international tax issues could be costly. Indeed, the estimated 27 million small businesses in the United States represent 97% of all the exporters of goods, according to the U.S. Small Business Administration. The USSBA defines such companies as those having fewer than 500 employees.

“There has been an explosion in cross-border expansion [regarding smaller businesses] driven by a weak dollar and the recession in the United States,” says Larry Harding, founder and president of High Street Partners, an international consultancy that focuses on small and midsize businesses. As a result of that expansion, companies can reduce their taxable income or save cash through tax strategies in a growing number of ways.

For example, Harding counsels executives to evaluate the tax implications of setting up a branch office rather than establishing an independent foreign subsidiary. From a tax perspective, if a branch office of a U.S. company is deemed a “permanent establishment” by local authorities, it could result in the company having a much higher tax liability on sales to local customers than if the in-country operation is structured as an independent subsidiary.

Harding says a tax authority’s decision to classify a business as a permanent establishment can be relatively subjective — local agencies need only conclude that a company operates a place of business within their borders. Further, the hurdle for that conclusion is often low — such as pointing to evidence of fixed office space, the presence of one or two employees in the office, or an activity that requires the company to have a steady presence in the locale. In the latter case, a contractor serving customers in a particular territory may qualify.

The profits generated by a branch that’s considered a permanent establishment are subject to the local country’s income taxes. Those taxable profits include the earnings generated by sales to local customers if the corporate parent of the branch is the same legal entity booking the sales.

For instance, consider an American company that employs one person in the United Kingdom who works in a branch office in London that’s deemed to be a permanent establishment. The employee sells a $1,000 industrial valve to a factory in Sheffield, England. The valve cost the U.S. corporation $700 to make, so all other things being equal, the company realizes a $300 taxable profit on the sale.

Because a permanent establishment triggers a local tax liability for the U.S. corporation, it must pay a 28% U.K. income tax on all the profits it generates locally, including the $300 made on the valve sale. In contrast, if the UK employee worked for a local subsidiary of the U.S. corporation rather than a branch, the subsidiary would be deemed as being the permanent establishment, but its taxable income would not include any of the earnings from the Sheffield sale made by the U.S. corporation.

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