It is perfectly legal to set up a subsidiary in a country with low corporate taxes (e.g., Ireland or British Virgin Islands) with the idea of letting earnings accumulate in this setting (and paying U.S. tax only when you repatriate same; this is "deferral"). The earnings of foreign corporations generally are not taxed in the U.S. until the foreign corporation repatriates them through the distribution of dividends. This can be an effective tax deferral technique provided Subpart F income can be avoided. We have considered the use of subsidiaries in low tax countries as a possible source of tax deferral.
Subpart F is an "anti-deferral" regime applied to Controlled Foreign Corporations ("CFCs"). A CFC is a foreign corporation in which U.S. persons own more than 50 percent of the corporation's stock (measured by vote or value; stock ownership includes direct ownership as well as stock owned indirectly or constructively; subsidiaries are CFCs). Subpart F income is income that is relatively movable from one taxing jurisdiction to another and that is subject to low rates of foreign tax.
When a CFC earns Subpart F income, the U. S. taxes the corporation's U.S. shareholders currently on their pro rata share thereof. Those shareholders are effectively treated as having received current income consisting of Subpart F income. Subpart F income of a CFC is limited by its current E&P (is deferred if the CFC has a deficit in E&P, until the CFC has positive E&P; IRC § 952). Earnings and profits ("E&P") of a CFC that have been included in the income of the U.S. shareholders are not taxed again when such earnings are actually distributed to the U.S. shareholders (IRC § 959).
Subpart F income consists of various types of income. The major category of Subpart F income applicable to most foreign corporations is "foreign base company income," which is defined to include:
- foreign personal holding company income (IRC § 954(c): passive income such as interest, dividends, annuities, net gains from sales of property that do not generate active income, net commodities gains, net foreign currency gains, certain rents and royalties, and income from personal service contracts.
- foreign base company sales income (IRC § 954(d)): income attributable to related-party purchases and sales of personal property made through a CFC if the country of the CFC's incorporation is neither the origin nor the destination of the goods and the CFC itself has not manufactured these goods.
- foreign base company services income (IRC § 954(e)): income from services performed by a CFC for or on behalf of a related party (parent or sibling corp.) where the services are performed outside the country of the CFC's incorporation. The regulations contain four specific situations where a CFC will be considered as performing services for, or on behalf of, a related party when the services were not directly provided to a related party, but the related party is involved with the services transactions. The four situations are as follows:
- The CFC is paid or reimbursed by, is released from an obligation to, or otherwise receives substantial financial benefit from, a related party for performing services;
- The CFC performs services which a related party is, or has been, obligated to perform;
- The CFC performs services in relation to property sold by a related party and the performance of such services constitutes a condition or material term of such sale; and
- The CFC receives substantial assistance furnished by a related party in the performance of the CFC's services.
The substantial assistance rule has caused the biggest problems to date for companies trying to avoid Subpart F income by causing services performed for unrelated parties to be treated as performed "for or on behalf of a related party." However, previous subjective tests (standard was met by shared personnel or "necessary assistance" - deemed to occur when the subsidiary relied on the direction, supervision, equipment, know-how or personnel of the parent in order to perform the services) have been recently replaced with a single objective test that requires that the assistance furnished by the related U.S. person equal or exceed 80% of the total cost to the CFC of performing the services. The new cost test may be applied either by demonstrating that the assistance provided by related U.S. parties was below the 80% threshold, or alternately, by showing that the cost of the services provided by the CFC exceeded 20% of the total cost.
When applicable, the Subpart F rules really only defeat the attempt at deferral; they do not result in any more tax (it would otherwise be paid when repatriated). The "loss" that is incurred in the event that income of a foreign subsidiary is characterized as Subpart F income is the cost of establishing and supporting the subsidiary. Nevertheless, this could be significant. Despite the relaxation and clarification of the "substantial assistance" rule, a company should only establish a C corp. subsidiary in a low tax country if it is confident that it can avoid Subpart F income.
Corporate U.S. shareholders are entitled to a foreign tax credit for their share of the foreign income taxes paid by a CFC with respect to E&P underlying a Subpart F inclusion (IRC § 960). To prevent avoidance of Subpart F, U.S. shareholders of a CFC must recharacterize gain on disposition of the CFC shares as a dividend (IRC § 1248).
EU Corporate Income Tax
In an area as diverse as the EU, corporate tax rates vary wildly. Ireland is at the low end (12.5%) and France is at the high end (34.5%). Though tax rates vary, tax systems are similar in that, in each, any company (regardless of entity type) with a "permanent establishment" ("PE") of business and which is earning income in the country will be subject to corporate income tax and VAT. A PE subjects a company to similar tax treatment to that of a legal entity in the particular country. Any regular business conduct will establish a PE (it does not take much - any office space will establish a PE).
EU Entity Choice
No European country has a business entity equivalent to a U.S. LLC. They have entities which are called equivalent to LLCs, but each is subject to the country's corporate income tax (they are somewhat equivalent for internal organizational purposes, but they are not equivalent for tax - they are not flow-through entities).
Disregarded Entity - Foreign Tax Credit
Despite the lack of flow-through entities, a wholly-owned subsidiary would be eligible for U.S. flow-through status. Regs. § 301.7701-2,-3. U.S. flow-through status (through the check-the box rules) would not change the fact that the subsidiary has already paid income tax, but members/shareholders may make use of the foreign tax paid credit. IRC § 702(a) and IRC § 1366(a)(1)A. The election (IRC § 901) of whether to deduct the foreign tax paid or to take the credit is made at the member/shareholder level. IRC § 703(b)(3) and IRC § 1363(c)(2)(b). The foreign tax paid credit would, of course, also be available to members/shareholders if the company did the business in the particular EU country directly (without a sub).
Disregarded entity status eliminates (i) the opportunity to do fiscal year deferral planning (having the sub's fiscal year end months before the parent's; parent only includes income in its fiscal year, which can be the next year), as the sub's fiscal year is the same as that of parent (as a disregarded entity), but also (ii) any chance that any of the subsidiary's income could be characterized as foreign base company services income (Subpart F; directly taxable to shareholders) under the controlled foreign corporation rules (IRC § 954).
Value Added Tax
The VAT in European countries (rates vary by country and goods/services) is ultimately paid by customers. Companies subject to VAT shift the burden of tax until it reaches the ultimate consumer. Companies must add the VAT to the sales price of their products/services, collect it from their customers, and in turn pay VAT to their own suppliers. The amount that companies must remit to the particular government is the excess of the total VAT collected during the tax period from their customers over the creditable VAT paid to their suppliers.