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.
When the permanent establishment is a branch of the legal entity booking the sale, the potential tax liability can be “a huge percentage levied against a large number,” notes Harding. More troubling, if local authorities determine that a so-called permanent establishment neglected to pay its proper share of taxes, it’s likely that the company would have to pay hefty fines and interest, as well as the unanticipated back taxes.
Indeed, in many cases it may be worth the extra expense and administrative headaches to set up a legally separate foreign subsidiary if the company sales volume in a particular country supports such a move, says Harding. But U.S. parent companies shouldn’t let the “tail wag the dog” and permit tax management to trump operational and business goals, he warns.
Harding also asserts that too many U.S. companies leave money on the table when it comes to the value-added tax, which in some countries is called a goods-and-services tax. A VAT is an indirect tax imposed by most jurisdictions outside of the United States that is levied at every transaction point in the supply chain that adds value, rather than just on the retail sale. The VAT, which can range from 15% to 30% of the transaction, is eventually paid by the final consumer. However, it is the responsibility of manufacturers, distributors, and sellers to collect VAT reimbursements from government agencies.
Unfortunately, many U.S. companies that are eligible to reclaim VATs have their reimbursement claims rejected because they either miss the filing deadlines or submit forms that are not properly filled out. What’s more, while some U.S. companies apply for VAT reimbursements linked to international companies, they miss the opportunity to collect reimbursements for such things as hotel stays that are related to business trips.
Regarding VAT and imports, Harding says: “Don’t be the importer of record for sales made overseas unless it is absolutely necessary.” It’s not easy for a U.S.-based company to reduce import duties or claim reimbursements. Also, convincing a customer to be the importer of record may take some deal-making finesse. But it’s likely worth the trouble, the consultant adds.
Witness the sale of a construction crane by an American company to a Brazilian outfit. If the Brazilian company is willing to be the importer of record, the American company pays no import duties or fees to get the crane into Brazil. There really is no monetary disadvantage to the Brazilian company, says Harding, since any VAT is reimbursed. Still, many sales executives want to close the deal and don’t want to complicate matters by suggesting that their customer take on the administrative job of being the importer of record. Nevertheless, if the foreign company is fully VAT-registered with its government and compiles with all filing rules, it’s generally easier for a local company to collect the reimbursement.