When there is a transition of power, changes can also be expected to the tax system. Frazier & Deeter international tax experts discuss these potential changes and how the different US tax structure could affect companies seeking to expand into the US.
Dave Kim | National Practice Leader, International Tax
Mike Whitacre | Tax Partner
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Untangling the Technical: US Tax for Non-US Companies: Potential Changes Under Biden
This transcript was assembled by hand and may contain some errors.
It has been edited for readability.
Adelle Starr Hello, everyone, welcome to Untangling the Technical, Frazier & Deeter’s podcast, in which we take a look at complicated topics to break them down for people navigating today’s ever-changing tax environment.
This is Adelle Starr, and today, we’re excited to have two of our tax partners here to talk about the US tax regime so that companies seeking to expand into the US can understand some of the changes that are likely to happen in the US tax system.
First, let me welcome Dave Kim to the podcast. Dave is the leader of Frazier & Deeter’s International Tax practice. He’s an attorney who works with multinational businesses to arrive at global tax strategies and solutions. Dave, welcome to the podcast.
Dave Kim Thank you.
Adelle Excellent, we also have Mike Whitacre. Mike is a Partner in Frazier & Deeter’s Tax practice, and he works with both US and cross-border companies regarding tax planning and compliance. Mike, welcome to the podcast.
Mike Whitacre Thanks, Adelle.
Adelle Well, let’s dive right in. Dave, what are some of the aspects of the US tax structure that foreign companies need to be aware of?
Dave That can be a very broad topic, and I’m going to try to stay very high level, but one of the things that you want to focus on about clients and investors is what is the headline tax rate. Typically, if you’re going to come into the US, very often that will be the corporate rate for C-corporations, which is currently 21%. The individual rate, which is less applicable, is currently 37%, so those are some of the things that would be top of mind.
The other thing is, are there any applicable withholding taxes, payments that distributions that may come out of the US back to the investors home country, whether that be in the form of dividends or interest payments or royalties or other types that may be US withholding and what the applicable rate there. Now, the statutory rate for the US is 30%, which is relatively a very high rate, and that’s normally on a gross basis. That’s very keen for foreign investors, which can be reduced by various bilateral treaties that the US has with the countries around the world. We’re in an interesting time, and the fact that with the new administration having just come into place, that they’re on the campaign trail, as well as subsequent to having been in office, have been discussing various tax reforms.
One of the key reforms that they mention is raising the current 21% that I previously mentioned, and US corporations to 28%, that’s a significant increase. Now, it’s not up to 35% where it was pre 2017 US Tax Reform Act, but 28% is something that even US businesses are absolutely concerned about and modeling out the effects of that. Mike, I want to talk to you and see what you’ve been hearing.
Mike Sure. I think the conventional wisdom, for whatever that’s worth right now, is 25%, because I think there’s some feeling that there’s not going to be enough support in the Congress to get it up to 28% but we’ll see what’s happening there. But picking up on the different rate structures and going back to what you were talking about earlier, just some of the things to be aware of for these companies coming into the US, is companies really need to be aware of what their activities are in the US and are they creating a taxable presence in the US and we refer to that as a permanent establishment in treaty parlance.
So, I see a lot of companies before they actually come over and set up a US entity, are hiring contractors in the US a lot of times to do sales and things like that. So, I would just caution people to make sure you’re aware of what you’re doing in the US and how the US tax is in that. A lot of these things result in having to file some forms and the forms themselves are often not that complicated. But just forewarning to companies listening to this, is if you don’t file those forms, the way the US tax authorities work is they have pretty high penalties if you miss filing certain forms and they use that as kind of a club. So, just warning people listening out there to be aware of what you should be filing because if you miss it, the penalties can be fairly substantial. We’re talking $10,000-$25,000 penalties.
Obviously, if you missed those for a couple of years, it can be fairly substantial. Just going back, jumping back to the earlier part about some of the things to be aware of. But, you know, then going back to what Dave was talking about, about the tax rates, I think where this is going is that if the tax rates going up, it’s going to put a premium on transfer pricing and for those of you listening to this that aren’t familiar with it, it’s a documentation of what you’re doing in each country and usually you’re with the US, you’re trying to minimize the amount of income in the US because of the US tax rate.
It looks like going forward it’s going to be higher, but we encourage people that look at what your foreign home headquarters company is doing versus what the US is doing. Arrange that properly and document it properly to protect yourself. There’s been a little bit less of an issue with that since the tax rate dropped to 21% but it looks like it’s going back up. I think it’s something that people really need to pay attention to.
Adelle You’ve mentioned this may happen, that might happen, it’s not really clear. Could you just for our listeners who may not be familiar with how US tax laws are implemented, what has to happen in order for there to be a change to the tax regime in the US?
Dave Great question. Again, keeping this very high level, in the US where tax legislation is started in Congress, right? Typically, the US House introduces a bill although the Senate can as well, but typically the House introduces tax legislation, requires a majority. So, 200 or more than 218 votes or 218 votes to pass that legislation. Then, it goes to the Senate, and the Senate also has to pass legislation as well. Now, in normal times, what that requires is 60 votes in the Senate and the Senate is made up of 100 senators. Then, once the tax legislation passes, it goes to the president for his signature or veto. So, that’s very broadly how tax bills work themselves through the system.
The current environment that we are in politically, is that 2020 elections resulted in the Democratic majority in the House narrowly. Now, we’ve got an even finer line between the Democratic majority leader in the House and the Senate can’t be any closer, it’s 50 Democratic senators and 50 Republican senators. The tiebreaker goes to the Vice President, there needs to be a partnering and a collaboration between our politicians to try to pass legislation. The current political environment that might speak to this as well isn’t fostering that collaboration and hasn’t been for a while.
There was some legislation that was recently passed, and because this can get complicated very quickly, is that there is a process that’s significant major bills in the last four administrations have passed the Tax Reform Act that under the Trump administration was passed under this process, that it’s called Budget Reconciliation. Under the Budget Reconciliation rules, a simple majority, so that’s 50 plus one can pass legislation, and the recent COVID Relief Act, that $1.9 trillion act, that was done under budget reconciliation and in fact, it was passed 51-50 with Vice President Harris casting the tie breaking vote.
Mike To the audience here, we’re kind of in uncharted territory politically in the US. Traditionally, that reconciliation was only used once a year, but it looks like they may be able to do that more frequently, which means to Dave’s point, that they can get things through with just the margin that the Democrats have now in the House and the Senate, as long as they don’t lose any of their own people. But that’s the wild card in all of this, is there are moderate Democrats in both chambers and they may lose some of them if they push things too far and in even with reconciliation, may not be able to get what they want.
That’s why, kind of going back to my earlier comment, you may see a 25% corporate tax rate instead of a 28%, because some of the moderate Democrats are not willing to support the higher corporate tax rate. It’s definitely a much different political environment and it’s very narrow, so I think that makes it very volatile and unable to tell exactly what’s going to come out of all this. But, I think everyone thinks for sure the corporate tax rates are definitely going up. It’s just a question of how much, depending on the political support the Democrats can keep together.
Dave Thanks, Mike. I don’t think anyone in this political environment really expects 28. I’ve absolutely heard 28.5% is the number, and even at 25, that’s going to make a significant difference. The current OECD average, not including the US, if you combine that and average it and its combined rates, for our purposes the federal and state rate together, is slightly north of 23%. We’re already north of that. When you look at 21% plus the state rate, we’ll call it 4%, so over 25. We’re above that. If you’re paying 28 and you’re talking about 30 to 33%. Got people talking about this race to the bottom in terms of countries trying to lower their rates to attract foreign direct investment. So, there’s a broader context there.
Then to complicate things even more is that there is a global minimum tax discussion that the US has just started. The Biden Administration and Treasury Secretary Yellen have all publicly supported and said that they’d be willing to start talking about that, which wasn’t the case part of the administration. So, we got to take that in the context of globally and not just what the US environment is. One last point on the congressional point, part of the reason why you need 60 votes is really the ability for senators or any individual senators, more specifically to filibuster and hold up legislation. There’s been discussions about getting rid of the filibuster and there doesn’t seem to be an appetite for that. Senator Joe Manchin, who is a Democratic senator, has publicly said that he will not support getting rid of the filibuster. Himself and all 50 senators plus want to get rid of the filibuster. He could block that, and really, there’s no real effort to get rid of that as well.
To Mike’s point, I think the rate’s going to go up, it’s a matter of when and by how much. I think it will go up and then what’s the process? If the filibuster is still going to be around, it’s going to be a bipartisan approach, require that 60 vote Senate approval, or is it going to be that secondary budget reconciliation process? I think those are issues that are important
Mike Beyond the rate itself, one of the things that came out of the prior tax changes under the Trump Administration was they tried to simplify and make it easier for US headquartered multinationals to operate, which was a major change in the way the US operated. But again, beyond the actual tax rate change, this is what the Biden Administration is proposing, undoing a lot of those regimes that were put in by the Trump Administration, and you’ll be back into the more restrictive aspects of being a US based multinational.
Now, people listening to this foreign inbound companies come to the US might say, “Why does that matter to me?” The reason I’m pointing this out is if you’re doing that, you probably don’t want to use your US subsidiary to hold other foreign country’s subsidiaries. You probably want to hold those out of your home country. But that’s just something needs to be looked at, that would generally be a reason to really look at that and not put subsidiary of other foreign subsidiaries under your US entity. Just a point to be aware of beyond the normal tax rate changes.
Dave I think that’s a great point. In fact, you and I both have clients that have exactly that structure where you’ve got a foreign parent that has a US subsidiary that has foreign subsidiaries underneath what we call a sandwich structure. You’re absolutely right, this is not the point of this podcast so I don’t get into it too much, but the proposed legislation that we’re discussing, we talked about the headline rate going from 21 to either 28 or 25 or something north of 21. The other significant legislation is what we call guilty, and currently that’s a tax favorable rate at 10.5% on really any income earned by foreign subsidiaries of US headquartered companies. That rate there’s a lot of discussion about that rate going to 21.
There’s also other proposals by Wyden and by other members of the administration that says, whatever the headline rate is in the US, that corporate rate, we’re going to tie that guilty rate to that. So, if it goes up to 25, we’re going up the guilty rate to 25. Again, that significantly would increase the economic expense potentially of you having a US subsidiary and then having other investments outside the US held by that US subsidiary. So, it’s a very good point. I do want to take one second because I think it’s an important point that Mike brought up in the fact of this taxable presence in the US. When inbound foreign investors are looking to come to the US, one of the preliminary points that you’re going to want to address, is what do you want to do with the US and does that create a taxable process?
Mike mentioned permanent establishment, which is treaty based and a higher standard of having that taxable presence. But that requires that there’s a treaty between the US and the inbound country. So, if you are a Hong Kong investor, for example, you’re not going to get the benefit of a higher threshold. You’ll be kicked into the lower threshold of what we call a US trade or business, and so it doesn’t take as much to have a US trade or business as you would at a firm establishment. So, just a point of reference that there are several countries that we don’t have a treaty with. The first thing is, do you have a taxable process? Should you work as a permanent establishment, i.e. get US branch that’s taxable? Or do you go and operate the US and corporate form and the filing obligations for each of those? Whether that’s an 1120 for here in the US or US subsidiary, or 1120-F or some other forms that you have to file.
To Mike’s point, if those are missed, not only the penalty for missing those forms, but the actual tax implications. Meaning that if you’re a foreign investor that has a tax presence across the US, you file your level 20 F, or you don’t file your level 20 F, for example, and the US then asserts taxation on the profits that you earn. That may be taxed at a gross basis, where you lose otherwise available deductions, business deductions to you. So, sometimes not only is there a potential Failure to File penalty, but there may be an actual tax cost in terms of how you are taxed if you don’t file those forms as well.
Adelle That’s pretty interesting. Let me ask you, you’ve been talking about things that apply to any foreign companies that are coming into the US, doing business in the U.S. Are there any special things that you wanted to point out about companies that are coming from the UK?
Dave Thanks, Adelle, for that. I think that the UK is also going through some changes, and that might be the understatement of the year with Brexit happening. Recently, what’s very interesting is that you can’t just pass legislation where they’re headline corporate rate is going to go from 19%, which is relatively low and purposefully so, to 25% in 2023. That can take a lot of international tax practitioners, including myself, by surprise.
So, when I spoke to Malcolm Joy, our managing partner out of our UK firm, and he gave me the heads up on that, that really surprised me because the UK for the last five, seven years has been really aggressive in making themselves stand out as a country where they attract foreign direct investment and really headquarter companies. So, their rate was historically one of the highest rates in the OECD and they came down to 19%. They introduced legislation around IP and patents and, again, a lot of favorable or tax friendly legislation that was introduced there. There’s slowly been this claw back where the UK was early adopters in terms of taxation that’s passed several years ago, and that was part of the OECD’s BEPS initiative or at least was discussed as part of that.
Again, I feel like this is now reversing course, and this headline rate going from 19% to 25% is something that’s significant. Then, you’ve got to compare that rate to what we just discussed in terms of the US rate being 21%, potentially going up to 25%. And then you may be agnostic because you’ve got somewhat of an equalization not considering the state tax rates or if it goes up to 28%, what then happens? From both the US and a UK headquarter company perspective.
Mike Just picking up on what Dave’s saying, we do extensive amounts of UK companies coming into the US because as Dave mentioned, we have a London office under the 19% rate and you compare that to a current US tax rate of like 21%+, as Dave mentioned earlier, state tax, income tax. You’re probably talking about a 26% US rate versus 19%, so it’s fairly substantial. Seven percentage points to motivate people to structure their transfer pricing to try to keep profits high in the UK to benefit that lower rate. But even with the UK rate going to 25% in 2023, if the US rate goes up to 25% and then you add, let’s say another 5% or 6% on for state, you’re still at a 5% or 6% differential.
That difference is probably not going to change much, even with the UK rate going up, it’s probably going to be five or six points lower than the US, so just something to think about there and back to what I said earlier about getting your transfer pricing organized and getting it documented properly to minimize your taxes. The other thing that’s great about the UK, and Dave mentioned treaties before, with the UK/US treaty provides 0% withholding on royalties, 0% on interest and with the right ownership structure 0% on dividends. That’s a great benefit for UK companies coming into the US that you need to look at. The other thing that’s going on from my understanding, I’m not a UK R&D credit specialist, but I think there’s some limitations being put on the UK R&D benefits going forward. The US has great R&D credit benefits, but they’re changing those a little bit, too.
So, I would just say as a point of reference, if you’re a UK company coming into the US and a lot of our clients have IP R&D because they’re tech or tech enabled businesses, look at that aspect of it to make sure you are structured properly from an R&D credit benefit aspect in the two different countries.
Dave Mike, great points. I want to pick up on the first thing that you mentioned, the applicable withholding rate under the treaty between the US and the UK, I do want to point out that that 0% withholding on dividends is one of only a handful of countries that we have that 0% rate with. It really is something that UK based companies should look at and again, with the proper ownership and holding period requirements, that 0% is rather unique. The R&D point is interesting, there is some pressure, I have been talking to Malcolm about potentially some changes there.
In the US, if nothing gets done on the R&D side, then starting in 2022 R&D expenses will be forced to be amortized over a five-year period. Which is something that’s completely new for this kind of capitalization or amortization of that expense over a five-year period. It’s definitely something if you’re a IP heavy or technology base or a biotech company in the UK that may have a significant impact on you if there is no movement on that.
Again, what I’m hearing in terms of congressional and political will around this topic is that people want to get something done. Long lasting influence on this, Mike’s mentioned this a couple of times and I do think it’s really important because it gets brought up a lot and we’re not 100% sure if people understand transfer pricing, is that that is something that is absolutely critical. It’s something that’s on the radar of just about every country, every OECD country most certainly.
The US, it’s really the first, maybe the second item being requested under audit, and I think the same is the case in the UK. But, the importance of that being is, number one, you’ve got to deal with transfer pricing. What that is, is just making sure that if you have a related party, i.e. a UK company that has a US subsidiary and you have any intercompany transaction between those two companies, transfer pricing is in plain. To Mike’s point, you can proactively plan around your transfer pricing so that your business and your actual economic arrangement with your US subsidiary, is one such that the profit is being allocated to one jurisdiction or the other. To Mike’s point, given where the rates are that profits may be more profit allocated to the UK, which is something that absolutely a person can do for you.
So, I do want to point out that that is absolutely something that Frazier & Deeter and specifically the head of our Transfer Pricing practice happens to sit in the UK as well, Malcolm Joy. That’s absolutely a consideration that should be front and center as you’re thinking about your investments in the US.
Adelle Dave and Mike, we wanted to thank both of you for taking the time to be on the podcast today. And for our listeners, please subscribe to our podcast so you don’t miss the next edition of Untangling the Technical.