AROUND THE GLOBE: Tax & Compliance Issues on International Projects

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1 Copyright 2015 by the Construction Financial Management Association (CFMA). All rights reserved. This article first appeared in CFMA Building Profits (a member-only benefit) and is reprinted with permission. BY CLINT W. BRASIER, JOHN E. COLWELL & JOHN M. KELLEHER AROUND THE GLOBE: Tax & Compliance Issues on International Projects While the specific issues will vary depending on the size and nature of a project and the country in which the work is located, some general areas of concern recur consistently. This article covers some of the more common structural, tax, and compliance issues that CFMs should consider when contemplating expanding outside their home country s borders. Although the tax regulations and reporting requirements cited here are specific to U.S. companies, many of the general principles could apply to Canadian companies as well. Foreign Operations Structure A contractor expanding into a new jurisdiction must answer a number of fundamental questions early in the process: How should the business be structured legally? Which accounting method will it use? What are the licensing and regulatory requirements? The first forays into international business can be challenging for CFMs in medium- to large-sized companies that do not yet have significant cross-border experience. Even large and experienced international contractors can benefit from a periodic review of their tax and compliance practices. The most critical questions, however, revolve around how to structure the foreign operation in a way that allows it to return profits with the fewest tax consequences. The answers largely depend on why the contractor is choosing to engage in international work. One of the most common reasons for a foreign expansion is to meet the needs of an existing customer (e.g., a retailer entering a new market, or a manufacturer that needs

2 ...three general areas of concern significantly affect a contractor s tax position: tax treaties and permanent establishment rules, branch vs. separate entity, and bringing home profits infrastructure to support a new source of materials). In this situation, the contractor must ask: What will happen when this project is complete? Is this a one-time opportunity, or is the company likely to expand further in this jurisdiction? In other cases, the expansion is the result of a strategic decision to expand the company s geographic footprint. The impetus might be a specific large-scale opportunity or the forecasted growth of a target market in another country. Once the company s strategic rationale and long-term vision for the expansion are understood, management can begin addressing some more specific questions regarding how to structure the operation for the most favorable tax treatment. Critical Structural Issues When establishing operations in a foreign jurisdiction, three general areas of concern significantly affect a contractor s tax position: Tax treaties and permanent establishment rules Branch vs. separate entity Bringing home profits Tax Treaties & Permanent Establishment Rules A tax treaty is an agreement between two jurisdictions that determines which one has the right to tax the income earned by a resident of the other jurisdiction. The specifics of these treaties vary from one country to another, so any discussion of their effects should be taken as general guidance only. The U.S. has tax treaties with approximately 60 foreign countries. IRS Publication 901 provides an overview of the major provisions of these various treaties. 1 However, the absence of a tax treaty introduces significant uncertainty into the situation, since any profits made in a foreign country could be subject to income taxes in both jurisdictions. For example, the lack of such a treaty between the U.S. and Brazil has been characterized by the Center for Strategic and International Studies as a major disincentive for U.S. corporations interested in operating or investing in Brazil, and was undoubtedly a significant concern for U.S. contractors bidding on infrastructure projects to support the 2014 World Cup and the 2016 Olympic Summer Games in Rio de Janeiro. 2 On the other hand, a tax treaty has been in effect between the U.S. and Japan since 1973, a key point of interest to companies looking at projects related to the 2020 Olympic Summer Games in Tokyo. Most tax treaties are based on a model developed by the Organisation for Economic Co-operation and Development (OECD). 3 In general, the OECD model limits the ability of a foreign jurisdiction to tax the business profits of a resident of the other country to those situations where a permanent establishment (PE) is created. Foreign companies are not typically required to pay income tax in the host country unless they create a PE in that country. What constitutes a PE is a critical point and is generally explained in the treaty. Many treaties state that a particular threshold must be defined before a construction site is considered a PE. For example, the U.S.-Canada Income Tax Convention specifies that a building site or construction or installation project constitutes a permanent establishment if, but only if, it lasts more than 12 months. 4 Because treaties are reciprocal, the same standard applies to a Canadian company engaging in work in the U.S. A project s duration may not be the only provision that could trigger the PE provisions and subject a company to another country s income tax requirements. Contractors should consult with their legal and accounting professionals for a final determination of how the relevant tax treaties will apply in each case. Branch vs. Separate Entity Tax treaties and their PE provisions directly impact a major structural decision a company must face when entering a new jurisdiction: Should it operate as a branch of the U.S. business, or should it establish the foreign operation as a separate corporate entity? Because it is merely a continuation of the U.S. company in a foreign jurisdiction, setting up a branch is usually simpler in terms of the legal and administrative processes involved. Bear in mind, however, that even though it is not a separate CFMA Building Profits November/December 2015

3 Around the Globe Tax & Compliance Issues entity, a branch could still be subject to the host country s income tax filing requirements if it creates a PE. In choosing between a branch and separate corporate entity, liability protection will also play an important role. The laws governing corporate liability vary greatly from country to country, so consult with qualified legal counsel from the host jurisdiction if this is a concern. Focus on Cash Flow Perhaps the most significant factor affecting this decision centers on cash flow. In many countries, payments that local businesses make to a nonresident entity (e.g., the branch office of a U.S. construction company) may be subject to special withholding rules. For example, if the host country requires 15% withholding on payments made to nonresidents and the contractor pay request is for $100,000, then the owner would pay the contractor $85,000 and remit $15,000 to the taxing authority as a withholding amount. The withheld funds could be recovered eventually if claimed as a prepayment of income tax, but the withholding rates often exceed the expected margin most contractors can expect to make on a typical project. This could cause unforeseen cash flow problems unless it is factored into the company s initial financial projections and bidding formulas. In some jurisdictions, filing an exemption request may alleviate these withholding requirements. In any case, the issue must be considered as part of the initial structural decisions and cash flow projections. Using a separate legal entity in the foreign jurisdiction could resolve this withholding issue, though this approach would create a PE. Bringing Home Profits If the foreign operation is structured as a branch of the U.S. company, then the profits or losses that branch generates are subject to U.S. income taxes and reported on the company s U.S. income tax return. If the company is also required to file a return in the foreign country, then any taxes it pays there generally can be credited against its U.S. tax liability. On the other hand, if the company chooses to establish a separate corporate entity in the host country, then it must choose how to handle the profits or losses the foreign operation creates and the changes in equity that result. As a domestic entity in the foreign jurisdiction, the new entity will be subject to that country s income tax regulations. But the U.S. parent corporation must also determine how the income of the foreign subsidiary is handled for U.S. income tax purposes. Corporation vs. Pass-Through Entity In general, for U.S. tax purposes, a U.S. company could elect to treat its foreign entity as a corporation or pass-through entity. However, Treas. Reg (b)(8) identifies certain types of foreign entities that are per se corporations, which are required to be treated as corporations for U.S. income tax purposes. That means the foreign entity s income or losses are not taxable in the U.S. until they flow through to the U.S. parent in the form of dividends. Even if other options are available, identifying as a corporation could be favorable if a long-term presence is desired, especially if the foreign income tax rate is lower than the U.S. rate. This would allow the foreign subsidiary to grow equity faster. However, the U.S. parent may not be able to deduct any losses incurred in the foreign jurisdiction on its U.S. return. Moreover, if the foreign subsidiary were to shut down in a net loss position, the unrecovered investment that the U.S. parent has in the foreign subsidiary would likely be converted into a capital loss, which may or may not be deductible subject to certain limitations. If the foreign corporate structure is not listed within the per se regulations, then it could be regarded as an eligible entity, which means the company could elect to treat its foreign operation as a branch or pass-through entity for U.S. tax purposes. Even if it s not listed within the per se regulations, the subsidiary could still be subject to the foreign jurisdiction s income taxes, but its income and losses could flow through to the U.S. parent and be reported on its U.S. income tax return. A U.S. income tax credit could then be claimed for the taxes paid to the foreign jurisdiction. When a risk of losses on foreign operations is possible, the pass-through structure could be desirable since it would allow the U.S. parent to deduct these losses when incurred. Note, however, that the option is available only if the foreign entity s structure is not included on the Treasury s list of per se corporations. Sales, Use & Value Added Taxes Virtually every country imposes some form of sales and use tax on transactions within its borders. The U.S. differs from most countries in that sales tax generally is imposed just once, upon the end user.

4 For example, a contractor that installs personal property as part of real property typically is deemed to be the end user for sales tax purposes and would pay sales tax on the materials that are installed. Most other countries take a different approach, instead employing some form of Value Added Tax (VAT). In a VAT system, sales taxes are still ultimately borne by the end consumer but are collected at every stage of production. Most Canadian companies recognize the VAT concept through the Canadian goods and services tax (GST), but U.S. CFMs might be unfamiliar with VAT compliance. In a VAT or GST system, sales tax is collected based on the value of the product or service as it is sold. Before remitting the tax to the jurisdiction, the producers deduct credits for the taxes they had paid to their own suppliers, so they actually pay VAT only on the value added. Even if a contractor does not create a permanent establishment in a foreign jurisdiction for income tax purposes, it will probably still need to register (and comply) with the host country s VAT requirements. Without a VAT registration, a contractor that is assessed a tax by the local VAT authority will not be able to claim a credit for the VAT it paid to its suppliers. VAT rates vary, but typically cost the contractor a significant amount. Foreign jurisdictions also vary in the way taxes are applied to equipment and supplies that are imported from another country as well as how the VAT is applied to tangible personal property and equipment used in fulfilling a contract. Contractors will need to weigh the tax consequences of importing equipment or materials against the costs of acquiring them locally. Payroll Taxes & Employee Issues When a tax treaty is in effect between the U.S. and a host country, it will directly affect employee payroll tax requirements. Most treaties specify that an employee who works in a jurisdiction for fewer than 183 days during a 12-month period is not subject to host country income taxes. This treaty provision will be important to PMs who might only travel to the jobsite on a monthly basis for project oversight. If the company has a permanent establishment in the country, then that exemption might not apply. Moreover, in a country where no tax treaty exists, employees likely will be liable for income tax from day one. Employees and employers also might be required to pay into any payroll-based national social welfare programs and other benefit plans. Some countries have totalization agreements with the U.S. that exempt employees from participating in these programs as long as they (or their employer) provide certification of coverage under another country s system. For employees on long-term assignment (e.g., onsite PMs and superintendents), the company might also need to establish a payroll equalization agreement with its employees. Such agreements keep employees in the same financial position as if they had continued their roles in the U.S. Depending on local conditions, this equalization could result in either an increase or decrease in pay. It also helps the employee comply with any new required tax filings. Compliance Issues A contractor could also face tax compliance issues stemming from a foreign project. Many countries require that certain tax filings be prepared by a certified or chartered accountant licensed in that jurisdiction, so establishing a relationship with such a professional is an important early step. Depending on the size of the project or entity, some countries also require a statutory audit be prepared to support the tax return. A company engaged in a foreign project must also comply with a number of U.S.-based filing requirements. IRS enforcement of these requirements has increased over the past decade due to an increase in cases of offshore tax avoidance. Depending on the structure used for the foreign operations, U.S. income tax reporting requirements could include: Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations; Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships; or Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities. Failure to file these required forms can result in a $10,000 per year penalty, even if no income tax is actually due. A U.S. company also must file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, to report capital contributions to the foreign entity as well as any transfers of tangible or intangible property. CFMA Building Profits November/December 2015

5 Around the Globe Tax & Compliance Issues An often-overlooked U.S. reporting requirement is the Report of Foreign Bank and Financial Accounts (FBAR). This filing is a nonincome tax report that is not filed with the IRS. Instead, it must be filed electronically with the U.S. Department of the Treasury s Financial Crimes Enforcement Network (FinCEN) by June 30 of every year using FinCEN Form 114. The FBAR is mandatory for any U.S. corporation or individual that maintains foreign bank accounts that exceeded $10,000 at any time during the year. The FBAR filing requirement also applies to every individual who has signature authority over the foreign bank account. The penalties for failing to comply can be severe and include criminal penalties if FinCEN determines the violation was willful. 5 Going Global Balancing Risk & Opportunity Bidding and managing construction projects in foreign jurisdictions can open up a wealth of opportunities for contractors with sufficient size and resources to handle the challenges. In addition, the ability to follow customers as they expand into new markets or broaden their global supply chains can help strengthen valuable relationships and create additional revenues. However, these opportunities must be balanced against the potential regulatory compliance risks and associated costs. By researching the specifics of the country in which the work is located and consulting with experienced professionals in the jurisdiction, CFMs can help mitigate these risks and improve the potential for a financially successful and operationally efficient foreign expansion. n Endnotes 1. Income-Tax-Treaties---A-to-Z. 2. csis.org/publication/brazilian-presidents-october-visit-right-timebrazil-us-tax-treaty Foreign-Bank-and-Financial-Accounts-FBAR. CLINT W. BRASIER, CPA, is a Senior Manager in the Construction Real Estate Services Group at Crowe Horwath LLP in Franklin, TN. He serves national and regional construction clients in industries ranging from general construction, specialty trade, Heavy/Highway, and architectural and engineering. Clint has more than 14 years of experience assisting clients with federal and state income tax compliance, income tax structure/method analysis, and selection, and state and local tax issues affecting contractors. Phone: clint.brasier@crowehorwath.com JOHN E. COLWELL, CPA, is Tax Partner in the Construction Services Group at Crowe Horwath LLP in Franklin, TN. With more than 36 years of experience, he is a past author for CFMA Building Profits and a frequent CFMA presenter. He is a member of CFMA s Tax & Legislative Affairs Committee and its Publications Advisory Group. John also belongs to the AICPA and Tennessee Society of CPAs. John holds a BS in Accounting and Masters in Tax Accounting from the University of Alabama. Phone: john.colwell@crowehorwath.com JOHN M. KELLEHER, CPA, is an International Tax Partner at Crowe Horwath LLP in its Oak Brook, IL office. He leads the International Tax Services for the Crowe s Metro Region. He currently leads the firm s export incentives practice and acts as the firm s resource regarding compliance with the Foreign Account Tax Compliance Act (FATCA). With more than 20 years of international tax experience, John has partnered with clients to understand and minimize the tax cost of operating a global business. John has presented at various professional meetings and forums such as NACUBO, ICOFA, and NASC. Phone: john.kelleher@crowehorwath.com