One of the first and most important decisions a U.S. company must make when considering foreign business activities is the form in which the activities should be operated.  This decision is important from a tax standpoint, because the form chosen will determine both the timing and the extent to which the foreign earnings will be subject to U.S. tax.  The decision may also determine whether the foreign business activities will be subject to foreign income taxes.  The following is a discussion of the various forms of conducting business activity overseas. 

EXPORTING

The easiest and most common way for a U.S. manufacturer to take advantage of foreign markets is through the export of products from the United States.  The primary advantage of this form of conducting business overseas is that it eliminates the need to invest substantial capital abroad.  Export operations are frequently conducted directed by either export managers located in the United States or through the use of independent sales agents located in the foreign markets.  In either case, the exporting company usually will not have sufficient operations in the foreign country to become subject to income tax in that country.  Any profit earned on export sales is subject to immediate taxation in the United States unless remittance of the income is blocked by exchange control restrictions in the foreign country.  In this event, the U.S. taxpayer may elect to defer recognition of the income for U.S. tax purposes until the funds can be effectively converted to U.S. dollars and remitted.

LICENSING

Direct exporting requires little or no contact or knowledge of another country.  If business reasons dictate more presence in or knowledge of a foreign market, a licensing agreement may be the best approach for the U.S. company to penetrate the foreign market.  A licensing arrangement generally permits an independent foreign business to use patents or trademarks of a U.S. company for the purpose of manufacturing the product in a certain foreign market.  In return for the license, the U.S. company generally receives royalty income.  The income derived by a U.S. company from a licensing arrangement is currently taxable in the United States unless the blocked income exception applies.

The character of the license determines whether the U.S. company is subject to foreign income taxes.  If the U.S. company receives royalty income, the foreign company may impose a withholding tax on the income.  The determination of whether a U.S. company is subject to tax in a foreign country as a result of a licensing agreement depends on the tax law of that country and its application to the agreement. 

If an income tax treaty exists between the U.S. and the foreign country, the U.S. company will not be subject to income tax in the foreign country unless it has a permanent establishment there.  If there is a permanent establishment in the foreign country, then the income that is effectively connected with that permanent establishment will be subject to income tax in the foreign country.  Generally, royalty income is not attributable to a permanent establishment and is subject only to withholding tax. 

FOREIGN BRANCH

If the U.S. company anticipates a profitable market for its products, it may not be willing to license its technology to an unrelated party.  For this reason, a U.S. business may want to conduct its business abroad through a foreign branch.  The taxation in the foreign country of the branch will be determined under the tax laws of the foreign country in which it is located or under the applicable income tax treaty. 

The income or loss generated by the foreign branch of a U.S. company is generally included currently in the determination of U.S. taxable income of the U.S. company, unless the blocked income rules apply.  The use of the branch may, therefore, be advantageous if tax losses are anticipated.  Frequently, U.S. companies will consider the use of a foreign branch when first expanding into a new foreign market, since tax losses are likely to occur during the startup phase.  Note that the advantage of utilizing tax losses generated by foreign branches has been limited by the overall and separate limitation loss rules of Internal Revenue Code (IRC) Section 904(f), the consolidated return foreign-loss limitations of IRC Sec. 1503(d) and the provisions of IRC Sec. 367(a)(3).   

FOREIGN CORPORATION

The establishment of a foreign corporation usually indicates a U.S. company’s intention to make a permanent investment in a foreign country.  The primary tax advantage to a U.S. company of using a foreign corporation is that the income earned by the foreign corporation is not subject to current U.S. tax.  Foreign corporations, except for certain qualifying corporations located in Mexico or Canada, are not included in the U.S. consolidated income tax return.  Thus, the income of the foreign corporation is not taxable in the United States until the income is “repatriated” to the U.S. in the form of a dividend, interest or other payment. 

In certain situations, however, income of a foreign corporation must be currently included, in whole or in part, in U.S. taxable income.  Such situations generally occur if the foreign corporation is controlled by U.S. shareholders.  The requirement to include such income currently is usually found in Subpart F of the IRC dealing with controlled foreign corporations or the foreign personal holding company provisions.

SUMMARY

One of the most important decisions that must be made when engaging in international business activities is the form in which the activities will be conducted.  In addition to the tax implications discussed above, the economic, political and social environments in the foreign country must also be carefully considered in making a decision.