You’ve read a lot of articles touting the ease of starting a company in the United States, and you’re finally ready to proceed. You even have the certificate of incorporation ready. But what if you also have a company based in your country? Should you bother linking it to your new company in the U.S., and if so, how should you go about it? That’s what a lot of our startup clients with software development offices in their home countries wonder when launching a company in the U.S. to attract investors. How can you make separate legal entities work well together? Read on and find out.
If you haven’t yet incorporated an American company (AmCo) and are considering your options, you might want to check out our guide on the subject.
Why Link the Companies?
The answer is simple – to provide a basis for transferring money one way or the other. This can be done with the aim of financing one of the entities to cover its expenses, saving on taxes, or both. Without a documented basis for a money transfer, banks may block the transfer or impose restrictions. When the companies are linked either as a parent-subsidiary or through an agreement, a bank is much less likely to restrict money flows between the companies.
Once a documented basis for money transfers is established, you can direct the money flows between the related companies to suit your needs. For example, if you are in the software development business, and your developers work for the foreign company (FoCo) while the U.S. company serves as the sales office, you can finance the FoCo using the sales revenue that the U.S. company generates. Linking the related companies also allows for tax optimization because you can transfer money from a high-tax jurisdiction (expense) to a lower-tax jurisdiction (income) and pay taxes in the latter.
Ways to Link a U.S. and Foreign Company
Let’s first establish what options you have for linking an AmCo and FoCo. In this article, we assume that the AmCo will generate most of the revenue and finance the FoCo, which, in turn, will develop software back in the foreign country (FC) with its own office and staff.
Now let’s consider each of those options in detail.
Subsidiaries, Branches, and Representative Offices
A common way for an AmCo founded by a foreign tax resident to access its home market is by making the FoCo a subsidiary of the AmCo or by setting up a branch or representative office in the FC. A potential consequence of this arrangement is that the AmCo’s founders will be subject to the FC’s rules on controlled foreign companies (CFCs). A CFC is any foreign company that satisfies two conditions:
- it is not a tax resident of the FC; and
- it is controlled by tax residents of the FC.
Since, in our example, the AmCo’s founders are tax residents of their FC, the AmCo may be considered a CFC under the FC’s law. CFC laws often impose certain obligations on the founders and provide for liability for failing to fulfill them.
Alternative: Linking Companies with an Agreement
If the AmCo’s and FoCo’s primary focus is software development or other IT-related business, another way to formalize their affiliation is through parallel coexistence based on a hybrid license and service agreement.
Under this agreement, the AmCo, which has exclusive rights to the IP used in the business, procures IT services from the FoCo. The FoCo, in turn, can get a simple, non-exclusive license from the AmCo to use the IP for a fee. This can be useful if the product will also be sold in the FC market. This arrangement also allows the FoCo to use the income from selling its services for its own business needs in the FC.
Using a linking agreement also reduces (though doesn’t eliminate completely) the risk that the AmCo will be deemed a CFC by the FC’s tax authorities. Some CFC laws consider such an arrangement to be between “interdependent persons,” and any transactions between them “controlled transactions.” Under the general rules, taxpayers must notify tax authorities of any controlled transactions conducted in the course of the calendar year. However, CFC rules often contain minimum thresholds for the value of controlled transactions subject to reporting, which may be set at a fairly high level. If the transaction value between the AmCo and FoCo doesn’t reach that threshold, the transactions don’t have to be reported.
Possible U.S. Tax Implications of Linking the Companies
Having considered the FC’s perspective on the various forms of linking a FoCo and AmCo, we now turn to implications of U.S. regulation CFCs.
(1) Application of U.S. Regulations on CFCs
Under the U.S. tax law, a CFC is a foreign corporation where over 50% of the total combined voting power of voting stock or total value of the stock is owned by U.S. shareholders on any day during the taxable year. The terms “foreign corporation,” “stock,” and “U.S. shareholder” are defined in the law and include not just the FC equivalents of corporations, but also other types of legal entities and forms of asset ownership.
A U.S. shareholder is a U.S. person owning 10% or more voting stock in a FoCo (in companies without shares, the concept of voting stock usually means the power to appoint senior executives). A U.S. person, aside from U.S. citizens or residents, also includes partnerships and corporations incorporated and paying federal taxes in the United States.
In the arrangement where the FoCo is the AmCo’s subsidiary, it will most likely be considered a CFC under U.S. law because the AmCo is a U.S. person and thus a U.S. shareholder of the FoCo. The same isn’t true for a linking agreement structure, however, because in our example the FoCo is neither owned nor controlled by U.S. shareholders, thus falling outside the scope of the U.S. CFC laws.
(2) Tax Implications for the AmCo
The U.S. law on CFCs is quite extensive and covers many different situations. In this article, we only touch on its key aspects.
The AmCo will have to include the following sources of the FoCo’s income in its taxable income (Subpart F income):
- insurance income;
- foreign base company income (FBCI). This includes: (1) foreign personal holding company income, which mainly includes passive income, e.g. dividends, interest, royalties, and income from foreign currency transactions; (2) foreign base company sales income, which includes income from buying or selling personal property manufactured outside the CFC’s country of incorporation and sold (transferred) for use outside that country; and (3) foreign base company services income, which includes income from performing services for a related person located outside the CFC’s country of incorporation.
- bribes, kickbacks, and other illegal payments made by the CFC, as well as international boycott income; and
- income received in blacklisted countries.
These sources of income don’t have to be included in the AmCo’s taxable income (in full or in part) in the following cases:
- if the sum of such income is less than the lesser of: (1) 5% of the CFC’s gross income; and (2) $1 million; or
- if gross insurance income or FBCI was subject to an effective rate of income tax imposed by a foreign country greater than 90% of the maximum rate of corporate tax in the United States.
Taxable income also doesn’t include previously taxed income (e.g. dividends paid by the CFC to a controlling person) or effectively connected income received in the United States (if it is not subject to an applicable double taxation treaty).
(3) Liability of the AmCo
If it fails to report the CFC’s income, the AmCo could be fined $10,000-$50,000 per year, depending on how long it waits to file the report. This could also result in curtailed tax benefits for the AmCo’s other sources of income and even criminal charges.
From the standpoint of both U.S. and FC law, linking the AmCo and FoCo through an agreement (provided they have the same founders) significantly alleviates the tax reporting burden as compared to setting them up as parent and subsidiary companies (i.e. a vertical corporate structure).
If you wish to link your companies in your home country and the United States with a contract that’s tailor-made to fit the needs of your business, consider purchasing our linking agreement service package.