An entity organized in Germany (hereinafter, “GermanCo”) with some level of involvement or operation in the United States may be impacted by various sections of the United States Internal Revenue Code of 1986, as amended (the “Code”). Below is a high level discussion of several of the applicable Code sections.
Effectively Connected Income
Even though GermanCo is organized in Germany, i.e. not a U.S. resident entity, U.S. law will still tax GermanCo under the U.S. tax system on any income effectively connected to its U.S. trade or business.
GermanCo must determine whether its involvement in the United States rises to the level of a U.S. trade or business, as contemplated by Section 882 of the Code. This determination is fact-based, and generally, if GermanCo performs “considerable, continuous, and regular” economic activity in the United States, domestic law will tax that activity in the same way it would tax the activity of a U.S. resident entity. Domestic law operates to impute the activities of agents to GermanCo, if such agent is acting on behalf of GermanCo, however, the rules become very complicated and arcane depending on whether the agent is “dependent on” versus “independent of” the GermanCo. Passive investments normally do not rise to the level of a U.S. trade or business.
After reaching a determination that GermanCo is engaged in a U.S. trade or business, the Code will tax only that income of GermanCo that is “effectively connected” to its U.S. trade or business. Section 864 of the Code dictates that income, gain or loss is considered effectively connected if it is either (1) derived from the assets used or held for use in GermanCo’s U.S. trade or business or (2) the activities of the U.S. trade or business were a “material factor” in GermanCo’s realization of such income, gain or loss. Certain other income items, although earned abroad, will be taxed under the Code if GermanCo has an office or other fixed place of business in the United States.
If GermanCo qualifies for special treatment under the tax treaty between the U.S. and Germany, applicable tax treaty rules may supplant the rules described above. The treaty rules vary slightly from the U.S. domestic rules, as the concepts of “business profits” and “permanent establishment” replace the concepts of “U.S. trade or business” and “effectively connected” income described above.
Thin Capitalization and Restrictions on “Earnings Strippings”
Many operating company group structures rely on the use of both GermanCo and U.S. corporations to separate the income earned by the GermanCo from the income earned by any U.S. entity. Generally, operations are structured this way because a U.S. entity is subject to U.S. taxation of its worldwide income, regardless of source, while GermanCo will only be subject to U.S. taxation of its U.S. source income. In this type of structure it is common to see loans, and corresponding interest payments, flowing between the U.S. company and GermanCo, which are related companies. To the extent the U.S. entity is making deductible interest payments to GermanCo, it will be able to move that much more income out of the purview of United States taxation. This arrangement is commonly called “earnings stripping,” and rightfully so, it has sparked the interest of the U.S. government.
Section 163(j) of the Code is applicable if (1) a domestic corporation’s debt-to-equity ratio exceeds 1.5:1, as of the end of the taxable year (i.e. it is “thinly capitalized”) and (2) the domestic corporation makes interest payments to a related person exempt from U.S. taxation (i.e. a foreign corporation). Section 163(j) denies the domestic corporation’s deduction for interest payments to the extent the total interest deduction would exceed 50% of the corporation’s income (before deducting the interest). In effect, the U.S. government restrains a thinly capitalized corporation’s ability to strip earnings.
Under Code section 482, the IRS can re-allocate income among "controlled" entities, such as a foreign parent and U.S. distributor, to properly reflect income. The prices charged between such related parties (“transfer prices”) are required to be arm's length prices.
Current regulations impose substantial penalties for understatements of U.S. tax due to transfer pricing adjustments – 20% or 40% of the underpaid taxes, depending on the size of the understatement. GermanCo can avoid those penalties, even if the IRS does not accept its transfer prices, so long as GermanCo has completed a transfer pricing study before the income tax return has been filed. That study must meet the requirements of the regulations and must apply the best method for determining GermanCo’s transfer prices.
The most common pricing method is the comparable profits method (CPM), which determines the arm's length price by referring to objective measures of profitability (profit-level indicators) derived from uncontrolled taxpayers that engage in similar business activities with other uncontrolled taxpayers under comparable circumstances (comparable parties). An arm's length range of results is determined based upon the amounts of profit that the tested party would have earned if its profit-level indicators were equivalent to those of the uncontrolled taxpayers.
The allocation of income between related entities is a major tax issue for multi-national companies. Tax regulations provide definitive rules for the resolution of transfer pricing controversies and avoidance of penalties. They should be carefully reviewed so that a cogent and supportable pricing strategy can be developed to help withstand an onerous, expensive, and time-consuming IRS audit examination of income tax transfer pricing.
State Taxation of a German Entity “doing business” in California
California law dictates that so long as GermanCo is “doing business” within the limits of California, it is subject to the franchise tax. The California Code defines “doing business” as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” If GermanCo is “doing business” in more than one jurisdiction, the state will utilize a formula to determine what portion of the business’ income should be taxed in California and what portion should be taxed elsewhere. In extremely simplified terms, the apportionment formula considers the location of the business’ (1) property, (2) payroll, and (3) sales.
In Barclays Bank PLC v. Franchise Tax Bd. Of California, the U.S. Supreme Court expressly approved California’s ability to use apportionment to determine the taxation of a foreign entity doing business in California.
United States law generally respects the distinction between a business entity and the individuals (or entities) that are owners of that business entity. This becomes important when the entity engages in acts or behavior that harm a third-party, as the third-party’s ability to sue the individual owners of the business entity depends on whether or not the type of entity involved provides liability protection to its owners. Generally, U.S. corporations, limited liability companies, and limited partnerships afford liability protection to some or all of their owners, however, a general partnership will provide no such protection. If the entity is organized under the laws of Germany, the U.S. will look at the internal laws of the Germany to determine whether that type of entity offers liability protection to its owners. A German individual conducting business in the United States should consider operating through an entity that offers liability protection.
CIRCULAR 230 DISCLOSURE
THE DISCUSSION OF TAX CONSIDERATIONS WAS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY TAXPAYER, FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE. ANY TAX ADVICE CONTAINED HEREIN WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE. EACH PARTY SHOULD SEEK ADVICE BASED ON THE PARTY’S PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.