PRC enterprises encounter a myriad of domestic and foreign tax issues when expanding overseas. This article is an overview of certain significant US tax issues that a PRC enterprise should be aware of in making outbound investments into the US.
Acquiring US business assets. If a PRC enterprise directly acquires US operating assets, generally the enterprise would be treated as conducting business in the US. As a result, the PRC enterprise would be subject to 35% US corporate income tax (plus state and local taxes), and would be required to file US tax returns and be exposed to US tax audits.
In addition, if an offshore special purpose vehicle (e.g., a Hong Kong or Cayman Islands entity) is used to acquire the US assets, the vehicle could be subject to an additional 30% “branch profits tax”, resulting in an effective tax rate of more than 50%.
On the other hand, an acquisition of the stock of a US corporation generally would not subject the acquirer to US taxation or tax return filing obligations. For these reasons, investments into the US are often structured as stock purchases rather than asset purchases. Alternatively, a PRC enterprise could use a newly formed or existing US corporate subsidiary to acquire the applicable US business assets.
Acquiring US corporations: US anti-inversion rules. US tax law contains a set of rules designed to deter “corporate inversions”, or transactions in which a US corporation becomes the subsidiary of a foreign parent. Typically, a US-based multinational group would engage in an inversion so that the group can become controlled by a foreign parent rather than a US parent, which if successful would reduce the overall US taxation on the group.
The US anti-inversion rules are highly detailed and complex; in addition, in recent years the US tax authorities have issued a series of regulations that significantly expanded the scope of the rules. As a result, they often lead to unexpected outcomes, and can apply to a seemingly innocuous acquisition transaction. Additionally, a small change in transaction structure could lead to significantly different results. For example, if a newly formed offshore (e.g., Cayman) parent company acquires a US corporation (or substantially all of its assets) for cash, generally the transaction would not violate the anti-inversion rules. On the other hand, if some management of the US corporation choose to exchange their shares for equity in the offshore parent company rather than for cash, the transaction could raise anti-inversion issues.
If the anti-inversion rules are violated, severe penalties can be imposed – for example, the offshore parent company could be permanently subject to US taxation as if it is a US corporation. For this reason, potential acquirers of US corporations should consider the application of the anti-inversion rules, particularly if some shareholders of the US corporation would become shareholders of the parent-purchaser as part of the transaction.
Concentrated US ownership: US “controlled foreign corporation” rules. Even if an acquisition transaction avoids violating the anti-inversion rules, if it results in US taxpayers or entities receiving significant equity in the parent purchaser, the parent could be treated as a “controlled foreign corporation” for US tax purposes. Specifically, if more than 50% of the stock of a non-US company is owned by “significant US shareholders”, the company would be treated as a controlled foreign corporation. For this purpose, a “significant US shareholder” means a US person or entity that owns at least 10% of the voting power in the non-US company. Note that a US person includes a US citizen, resident, as well as a green-card holder, who is generally treated as a US resident for tax purposes.
If a non-US company is treated as a controlled foreign corporation, its significant US shareholders could be subject to adverse US tax consequences – for example, they could be subject to current taxation on income earned by the parent company, even if the income has not been (or will never be) distributed to them. In addition, a controlled foreign corporation could have increased filing and disclosure requirements for US tax purposes. So care should be taken in monitoring whether a non-US company is a controlled foreign corporation and, if so, in mitigating the potential tax consequences to the significant US shareholders.
Profits repatriation: US dividend withholding tax. Generally, dividend by a US corporation is subject to a 30% US withholding tax. If the dividend distribution is made directly to a PRC enterprise, the withholding tax rate could be reduced to 10% under the US-PRC tax treaty, assuming that the PRC enterprise is a publicly traded company or otherwise has sufficient independent operations and substance for purpose of the treaty.
On the other hand, if a PRC enterprise invests in a US corporation through an offshore special purpose vehicle, dividends from the US corporation generally would not qualify for the reduced rate under the PRC-US treaty unless the special purpose vehicle is treated as a “pass-through entity” under PRC tax law.
Debt financing: US earnings stripping rules. To the extent a US corporation is capitalized with debt, US tax law contains limitations on the amount of interest expenses that the US corporation can deduct and the timing of the deductions, particularly if the US corporation takes on significant debt and its leverage ratio exceeds certain thresholds. In some cases, the debt could even be recharacterized as equity for US tax purposes, in which case the interest deductions would be denied altogether. Debt financings should therefore be carefully structured to ensure that they comply with the applicable US tax rules.
Exit planning: US capital gains tax and FIRPTA. Generally, a non-US person or entity is not subject to US taxation (and does not have to file US tax returns) on the sale of shares in a US corporation, as long as the seller does not otherwise conduct a business in the US. This applies whether the non-US seller is an individual, enterprise, fund entity or special vehicle. Thus, investments in US corporations generally can be exited in a tax-efficient manner.
However, a significant exception applies if the US corporation holds substantial US real property interests. Under the US FIRPTA (Foreign Investment in Real Property Tax Act) regime, if the US corporation’s assets consist of at least 50% US real properties, the non-US seller generally would be subject to various US tax rules, including: (1) withholding tax of 15% on the gross sales price; (2) full US income tax (up to 35% for corporate sellers and 40% for individuals); and (3) obligations to file US income tax returns. Investments in corporations with significant US real properties should be carefully considered in light of these rules. Planning opportunities include the use of corporate blockers and special vehicles in making the investments, as well as more sophisticated structures involving financial instruments and REITs.
Intellectual property planning. As part of an investment into a US corporation, often parties find it preferable to transfer ownership of the US corporation’s intellectual property (IP) outside of the US, to consolidate the IP of the group or to accomplish tax and other objectives. However, such transfers could implicate a number of significant US tax rules.
For example, if a US corporation sells its IP to a non-US affiliate, the sale would be subject to the US transfer pricing rules. Under these rules, transactions between related parties must be conducted at arm’s length. The applicable regulations contain detailed methodologies for determining the appropriate arm’s length sales price. If a sale does not satisfy the transfer pricing rules, the US tax authorities may retroactively adjust the sales price, and the adjustments could result in additional income to the US corporation, and other related interest and penalties.
On the other hand, if a US corporation transfers IP to a foreign affiliate through tax-free transactions, the US tax rules generally would impose an “exit tax”. Specifically, the US corporation would be treated as having sold the IP to the foreign affiliate for a series of annual “deemed royalties”. The US corporation must pay tax based on these deemed royalties (whether or not they are actually received) each year after the transfer, over the entire useful life of the transferred IP. In addition, the US tax authorities may adjust the amounts of these deemed royalties in subsequent years if it determines that the IP has appreciated in value.
Matthew Lau is a partner of Morrison & Foerster in Hong Kong. He can be contacted on +852 2585 0850 or by email at [email protected]