There are many strategies that internationally active U.S. companies can exercise to minimize their worldwide effective tax rates. One such strategy is to be diligent about charging out expenses to your foreign branches and foreign flow-through entities.
For illustration purposes, think of the very popular business structure of a U.S. company that has a “check the box” foreign entity of which the profit or loss, and the foreign tax credit, passes through directly to the U.S. tax return. Let’s also assume that the U.S. entity employs an individual who does all of the foreign entity accounting duties in the U.S. You may ask why does it matter if I charge the foreign entity for the accounting work provided by the U.S. person since all of the income and expenses end up on the U.S. tax return anyway? Not to mention I get a foreign tax credit for the taxes paid in the foreign jurisdiction. The answer is that it matters for several reasons with respect to utilizing the most effective and beneficial international tax strategy.
It’s true that those accounting expenses end up on the U.S. tax return whether you charge them to the foreign entity or not, but reducing the taxes paid in the foreign country by pushing down those expenses that belong in that foreign country has many benefits. First, this helps avoid a situation of having excess foreign tax credits that may potentially expire sometime in the future. Second, it could potentially reduce your worldwide effective tax rate. There are many real examples of companies with an overall taxable loss on the U.S. tax return, but the foreign entity is profitable. In this situation it is particularly important to make sure those expenses related to the foreign entity are pushed down in order to reduce the tax liability in the foreign country. This does not change the fact that there is a taxable loss reported on the U.S. tax return. Had those expenses not been pushed down, more taxes would have been paid in the foreign country while still reporting a U.S. taxable loss. Third, pushing down those expenses more clearly reflects the profit and loss situation in both the U.S. and the foreign country on a separate financial reporting basis.
When looking at the expenses reported by your U.S. company, consider the following:
- Are there any salaries and wages of U.S. persons who worked on the foreign financials, trial balance, or general ledger accounting? What percentage of their time was spent on this?
- Are there any travel related costs to go to the foreign country for business meetings, inspections, etc.?
- Are the worldwide sales staff and purchasing staff all in the U.S.?
- Are there any bank fees or other administrative charges related to the foreign country accounts?
- Were there any supplies, software expenses, repairs and maintenance expenses, or other services performed in the foreign country where the invoice was received in the U.S. and recorded on the U.S. books?
Initiating this international tax strategy may take some leg work by analyzing the different expense categories on your U.S. trial balance, but in the long run it’s a useful and beneficial exercise. Is your international tax strategy giving you the most benefit possible?