With a one-year extension of the production tax credit (PTC) included in the American Taxpayer Relief Act, signed into law by President Obama in January, U.S. wind energy companies breathed a collective sigh of relief. Nonetheless, in addition to beneficial federal policy, wind companies need consistency in the implementation of that policy.
Unfortunately, this latest extension of the PTC has done nothing to eliminate the “boom and bust” nature of U.S. wind energy development. So how can U.S. wind energy companies mitigate the uncertainty that will likely arise if 2013 begins to wane without another extension of the PTC? One option is for companies to increase their business opportunities by expanding abroad, and one region that has potential for wind energy firms is Latin America.
Numerous studies have shown that wind power is expected to play a greater role in meeting Latin America’s growing demand for electricity. Increasing demand means opportunities for U.S.-based manufacturers and service providers to supply the equipment and services needed to meet that demand. Expansion into new markets must be planned carefully, with a focus on identifying and managing the potential costs of such an expansion. One such cost is the U.S. and foreign tax exposure arising from the sale of goods or services by a U.S. company to foreign customers.
There are various ways to expand into a foreign market. One way is for a manufacturer or service provider to test the waters by selling directly to a single customer in a foreign market. Another way is for the manufacturer or service provider to set up a local subsidiary to sell its products or services to a range of customers in the local market, using local employees.
Regardless of the scenario, the U.S. company’s tax-related goals should include minimizing U.S. and local-country taxes on the income earned from its activities in the foreign country and maximizing the number of credits from the payment of foreign taxes that can be used to offset U.S. taxes on its foreign income.
Deferral, foreign tax credits and sourcing
There are three key concepts in the U.S. tax rules that impact the aforementioned goals: deferral, foreign tax credits and sourcing.
Deferral. The U.S. system of taxation is referred to as worldwide taxation. Under this system, U.S. companies are taxed on their income earned anywhere in the world. This means that income earned by a U.S. company operating directly in a foreign country is included in the U.S. company’s taxable income in the year it is earned, even if that income is not brought back to the U.S.
Income earned by foreign subsidiaries, however, may be excluded from the U.S. parent company’s taxable income until it is repatriated, such as in the form of a dividend paid by the foreign subsidiary to the U.S. parent company. This benefit is referred to as “deferral.” In general, deferral is available for active business income earned by foreign subsidiaries. It is not usually available for more movable types of income, such as investment income (e.g., interest, dividends) and income from certain sales and services involving related persons.
Foreign tax credits. In a system of worldwide taxation, income earned by a U.S. company in a foreign country is usually taxed twice – first in the foreign country and then in the U.S. To alleviate this situation, U.S. tax rules allow U.S. companies to claim credits for foreign income taxes paid on income earned in foreign countries against their U.S. tax liability on the same income.
An important factor in determining the number of foreign tax credits a U.S. company can claim is the amount of income earned by the foreign company that, under U.S. tax rules, is characterized as being from foreign sources. (It should be noted, however, that not all income earned by a U.S. company outside the U.S. is treated as being from foreign sources; some of the income may be characterized as being from U.S. sources.)
Sourcing. Increasing a U.S. company’s income that is characterized as “foreign source” for U.S. tax purposes can increase the amount of the U.S. company’s foreign tax credits. Conversely, decreasing the amount of its foreign-source income will usually decrease the number of its foreign tax credits.
Although it may seem counterintuitive, with proper planning, it is possible to shift portions of income earned by a U.S. company from activities in a foreign country from one category to another without increasing the amount of income that is subject to tax in that foreign country. For example, U.S. tax rules prescribe that income from the sale of goods is “foreign source,” in whole or in part, if title to the goods passes to the buyer outside the U.S. Similarly, income from the performance of services is foreign source to the extent the services are performed outside the U.S.
A U.S. company can increase the amount of its foreign-source income by negotiating with its customers so that they take title to the goods outside the U.S. or by increasing the time its employees physically perform services outside the U.S.
Numerous studies have shown that wind power is expected to play a greater role in meeting Latin America’s growing demand for electricity.
There are several strategies a U.S. company can employ to minimize U.S. and local-country taxes on the income earned from its activities in the foreign country and maximize the number of credits from the payment of foreign taxes that can be used to offset U.S. taxes on its foreign income.
Avoid a taxable presence. A U.S. company’s initial entry into a foreign market may be limited to a single sales or services contract. In this situation, the simplest approach may be to operate directly from the U.S., without setting up a local subsidiary. In this scenario, the primary goal is to avoid triggering a local tax on the income earned in the foreign country. Although this will depend on both the specific facts of the transaction and the local laws involved, in many Latin American countries, local taxes are triggered on income from sales and services only if a U.S. corporation establishes a taxable presence.
In general, a taxable presence is created if the U.S. corporation conducts business activities from a fixed location in the country. It does not matter whether the U.S. corporation owns or rents the location or uses another person’s space free of charge. The key factor is whether the space is at the disposal of the U.S. corporation.
For example, renting a local office where the U.S. company’s employees will work while visiting the local country will create a taxable presence. In contrast, regular visits by the U.S. company’s sales personnel to a customer’s local office to take orders will probably not create a taxable presence unless the customer provides the sales personnel with a dedicated space in its office from which they conduct additional business activities.
Many countries in Latin America also have rules governing the creation of a taxable presence in certain situations. Activities that are preparatory or auxiliary to the U.S. corporation’s business – for example, conducting market research, seeking new business opportunities, or renting space in a warehouse for the temporary storage of goods being delivered to a local customer – will probably not create a taxable presence.
A taxable presence may be created, however, if an employee has the authority to conclude contracts in the name of the U.S. company and habitually exercises that authority in the foreign country. U.S. companies that engage in construction projects may be considered to have a taxable presence in a local country if the project lasts more than a specified number of days.
Maximize income from foreign sources. If it is not possible to avoid a taxable presence in a local country, the fall-back position is to maximize the U.S. foreign tax credits that can be used to reduce the amount of U.S. taxes paid by the U.S. company on the income earned in the foreign country. This requires maximizing the amount of such income that is treated as being from foreign sources under U.S. tax rules. As previously mentioned, this can be done by ensuring that customers take title to the goods outside the U.S. or by increasing the time the company’s employees physically perform services outside the U.S.
Form a foreign subsidiary. Depending on the volume of actual or expected business activity in a foreign country, a U.S. company may want to consider conducting those activities through a wholly- or majority-owned foreign subsidiary. The primary reason that U.S. companies operate in foreign markets through foreign subsidiaries is to benefit from deferral. By setting up a foreign subsidiary to sell goods in the local market or to provide services to local customers, a U.S. parent corporation is not taxed on the income from those transactions unless and until the income is repatriated to the U.S. This gives the U.S. parent corporation more flexibility in determining how and when to repatriate the earnings.
For example, in the absence of deferral, a U.S. parent company would likely have its foreign subsidiary distribute those earnings annually as a dividend so that the U.S. parent has the cash needed to pay the U.S. tax liability on those earnings. With deferral, those earnings can remain with the foreign subsidiary for its use in expanding the U.S. parent’s business outside the U.S. The ability to control when earnings are repatriated is also an important factor in managing the costs associated with currency exchange rates and local country withholding taxes.
It is important to recognize that, despite the benefits of deferral for U.S. tax purposes, creating a deferral structure is not cost-free. The U.S. parent will incur costs associated with creating and maintaining a local entity, including legal and administrative costs and those necessary to meet capital requirements. If the foreign subsidiary has employees, it will also incur employment-related costs.
More significantly, the creation of a foreign subsidiary automatically results in a taxable presence in the local country. Under U.S. tax rules, however, foreign tax credits may be available for foreign income taxes paid by the foreign subsidiary on its earnings when those earnings are repatriated to the U.S. parent company in the form of dividends.
Finally, as previously mentioned, not all of the income earned by a foreign subsidiary is eligible for deferral. Income ineligible for deferral includes investment income, such as interest and dividends, that exceeds a specified amount, as well as income from certain sales and services involving related persons. Sales income is not eligible for deferral if it is earned by a foreign subsidiary from the sale of goods that were purchased from the U.S. parent and sold to customers outside the country in which the foreign subsidiary was formed. Services income is not eligible for deferral if it was received for services performed by the foreign subsidiary using the technical expertise and assistance of employees of the U.S. parent corporation.
Form a foreign subsidiary after a taxable presence has been established. Many U.S. companies that expand abroad incur losses in the early years. For these companies, operating directly from the U.S., rather than through a foreign subsidiary, can be desirable because losses from the foreign operation can be used to reduce taxable income earned in the U.S.
However, claiming such losses on a U.S. tax return can be a double-edged sword. Foreign losses can also reduce income in the foreign-source category under U.S. tax rules. As noted, this can reduce the number of the U.S. corporation’s foreign tax credits. More significantly, once the foreign operations become profitable, the U.S. parent may decide to transfer those operations to a foreign subsidiary in order to take advantage of deferral. However, the U.S. parent corporation may incur U.S. – and, possibly foreign – income tax on any gains from the appreciated property transferred to the foreign subsidiary.
By planning ahead and keeping these strategies in mind, wind energy companies can be more prepared to expand abroad, especially in markets in Latin America. w
Spotlight: Latin America
Selling Abroad Requires Careful Tax Planning
By Kelly Kogan
Expansion into new markets must be planned, with a focus on identifying and managing the potential costs of such an initiative.
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