For many small and midsized businesses, getting their feet wet in the global economy is an economic necessity. Their domestic market may be becoming saturated, or they may find a demand for their product — be it goods or services — abroad. But the opportunities to sell overseas come with a number of pitfalls as well as potential benefits.
“It is necessary to be aware of the value-added tax or goods and services tax that many other jurisdictions apply,” noted Ryan Dudley, a partner and practice leader of the International Tax and International Services Group of Top 100 Firm Friedman LLP. “These are often broader than the sales tax in the U.S., so businesses often find themselves with small amounts of sales but with significant compliance obligations for filing the VAT, collecting and remitting VAT, and also just the registration for VAT. So that can be a significant burden, particularly if someone is selling relatively small amounts of goods and services overseas.”
Some of the other pitfalls that come up include significant reporting requirements in the U.S., Dudley observed. “For example, if you were to set up a foreign subsidiary to manage sales, it would need to be reported on your U.S. tax return,” he said. “If there is a foreign bank account involved, [Foreign Account Tax Compliance Act] reporting may be involved. There can be very severe penalties in the U.S. for failure to file these information returns, as well as the cost of filing the additional information.”
“The question of foreign exchange gains and losses can create an additional level of accounting compliance that many small businesses are not set up for,” Dudley said. “Then there’s the pitfall of creating nexus in a foreign jurisdiction for income tax purposes. Simply selling to another country will not create any income tax liability in that country, but if sales people are involved or if there is a more permanent presence, then you have to be concerned about paying taxes in that foreign country. That has its own compliance costs, as well as the issue of getting credit in the U.S. for the foreign taxes you paid.”
There are, however, some positives associated with expanding offshore, Dudley indicated. “Where a U.S. manufacturer is exporting goods overseas, it may be entitled to IC-DISC [Interest Charge Domestic International Sales Corporation] status, which can provide a reduced rate of tax on the income, particularly for closely held corporations.”
“And of course, there are benefits from structuring a business offshore that allows for income to be earned offshore and not subject to tax in the U.S. until it is remitted to the U.S.,” Dudley noted.
“There is a lot of complexity, red tape and pitfalls, but with a little planning and organization upfront these can be avoided,” he said. “But for smaller businesses these can involve significant costs relative to the total amount of business they expect to do overseas in the short term.”
Roger Harris, president of Padgett Business Services, agreed. “The complexity of getting into some markets requires that you have a good deal of business to justify the amount of research necessary to understand what you‘re getting into, and the enhanced compliance costs,” he said. “You have to be a certain size to understand how to make the product, sell it overseas, ship it overseas, and get paid in another currency and convert it. These are all the things that you don’t have to deal with if you’re selling to just one place in another state in the U.S.”
IMPORTANT QUESTIONS
“There are surprises around every corner,” cautioned Josh Ehrenfeld, corporate tax partner in the Nashville office of Burr & Forman LLP. “Every business model is different, and every jurisdiction is different. When a company comes to us and is getting ready to dip into international waters, and wants to know what the project might entail, we need to understand where they’re doing business and what the project is. We can’t get a full picture of what they are doing unless they give a full picture of where their revenues are coming from, where their expenditures are going to occur, and where the counterparts they’re engaging with are overseas.”
“It snowballs from there,” he continued. “You have to do a jurisdiction-by-jurisdiction approach to understand what your needs are. ... Foreign issues are very country-dependent. In the European Union, you get a little of both — tax rates are still country by country, but you do get some efficiencies on other regulatory issues.”
“A lot depends on two key issues,” he said. “Are we talking about an active sale or manufacturing business, or a more passive investment model; and what’s the business plan for earnings — to retain them overseas and grow the company, or repatriate the earnings and invest them here in the U.S.?”
“U.S. companies operating overseas will always be at a disadvantage relative to their foreign competitors,” he said. “That’s because we don’t have a territorial system of taxation; instead we have a worldwide tax, so companies need to be cognizant that they will have to overcome some of those issues when they structure their business model and when they organize their operations.”
“The issue of Subpart F income comes up immediately as soon as you start earning revenue outside the U.S.,” Ehrenfeld noted.
Generally, U.S. tax on the income of a foreign corporation is deferred until the income is distributed as a dividend or otherwise repatriated by the foreign corporation to its U.S. shareholders. But the Subpart F (named after Subpart F of the Internal Revenue Code) tax treats certain shareholders of controlled foreign corporations as if they currently received the income. “The point of Subpart F is to prevent deferral, by forcing you to recognize that income as it’s earned overseas, unless the business falls into certain carve-outs or exceptions that are meant to allow an active business to function in the jurisdictions where they are organized,” said Ehrenfeld.
“Those beginning to dabble in foreign transactions need to be aware of outbound tax rules on the U.S. side,” noted Selva Ozelli, a New York-based CPA and international tax attorney. “These would cover withholding taxes, information tax returns, and various other information returns. If they are making sales through a foreign subsidiary, there are specific rules that apply, in addition to the transfer pricing rules. Then, in addition to the U.S. outbound rules, they need to be very aware of the foreign tax rules that would apply. These companies are facing layers and layers of U.S. and foreign tax rules they would need to comply with, making it much more complicated.”
SIZE MATTERS
Amy Morgan, a senior product manager at Avalara, sees her mission as trying to cut through the complexity of overseas trade and make it palatable for the small or midsized firm. “I spent the last 16 years in international trade compliance at Nordstrom, Costco, Amazon and Microsoft,” she said. “Large companies are very reliant on international activity. They know they have exposure when it comes to tax, customs duty and trade regulations. A large company knows they have to hire specialists, licensed customs brokers and freight-forwarding specialists.”
To make matters easier for smaller businesses, Morgan is developing Avalara’s LandedCost solution, which aids users to calculate the true cost of a product when it reaches its destination at the customer’s door. “Landed cost includes the price plus shipping and the import duties and taxes that are required for a shipment to cross an international border,” said Morgan. “Depending on each individual country, there may be specific import taxes or fees that the customer is responsible for. When customers have to pay more than they were aware of, some just reject the shipment. They won’t pay extra just to have it delivered, so the poor retailer is out the transportation costs and the poor customer experience.”
“In addition to taxes and import fees, some products are prohibited from being shipped into another country,” Morgan said. “Also, each country has its own de minimis threshold. In the U.S. it’s $800 — any shipment shipped into the U.S. that is less than that doesn’t require any duties and taxes to be paid, but in Canada the threshold is $20. All of these add to the complexity.”
