Exporters generally don't consider tax issues in executing an export program. But this is not wise, because a little attention to tax issues offers US exporters the opportunity to reduce their US income tax liability and potentially enables US exporters to sidestep foreign income tax liability. The tax issues that US exporters should consider in executing an export program relate to US Federal income taxation, state income taxation and foreign country income taxation.
In discussing these tax issues this article will differentiate among three types of US exporters as outlined below:
- US exporters who export on a direct basis and make export sales to foreign buyers through their own efforts either by responding to foreign inquiries or by sending traveling sales employees overseas.
- US exporters whose export sales to foreign buyers are made through related intermediaries, such as offshore sales employees, offshore representative offices, offshore branches or offshore subsidiaries.
- US exporters whose export sales to foreign buyers are made through unrelated intermediaries, such as dependent sales agents, independent sales agents, dependent distributors or independent distributors.
US Federal Income Taxation
US Federal income taxation applies to all US exporters -- no matter what type. US income tax policy subjects the worldwide income of all US taxpayers to US income taxation, regardless of where they earned the income or the currency in which they received the income. In the case of US exporters, US federal income tax is applied against the US exporters' export profits.
The nature of a US exporter's export profits varies based on exporter type. Direct exporters and exporters whose export sales are made through offshore sales employees, offshore representative offices, offshore branches, dependent sales agents and independent sales agents typically earn their export profits via sales made to foreign buyers. Whereas exporters whose export sales are made through offshore subsidiaries, dependent distributors and independent distributors typically earn their export profits via sales made to these entities.
The commissions earned by an exporter's sales agent and the resale margins earned by an exporter's distributor are not included in a US exporter's export profits for federal income tax purposes, unless the sales agent or distributor is deemed to be the exporter's offshore employee, offshore representative office or offshore branch. Likewise, the resale margins that are earned by an exporter's offshore subsidiary are not included in a US exporter's export profits for federal income tax purposes, unless the offshore subsidiary:
- distributes its resale margin to the exporter through a dividend; or
- is a flow through entity for tax purposes; or
- is a controlled foreign corporation that is at least 10% owned by the US exporter and that has tainted or subpart F income. (See IRS Code sections 951 - 964.)
Unfortunately, there is no practical way US exporters can avoid US Federal income taxation of their export profits. Shifting export profits offshore to a subsidiary, related sales agent or related distributor doesn't work. This is because the IRS requires arm's length pricing on sales made by a US exporter to a related party.
U.S. Federal Income Tax Can Be Deferred
Exporters can, however, elect to defer US Federal income taxation on a portion of their export profits by establishing an offshore subsidiary, provided that the offshore subsidiary is not a flow through entity for tax purposes or a controlled foreign corporation as defined above. Establishing an offshore subsidiary enables US exporters to split their export profits into two components:
- export profits from their sales to the offshore subsidiary; and
- export profits from the offshore subsidiary's sales to foreign buyers.
The first export profit component is subject to US Federal income tax, whereas the second component is not subject to US Federal income tax until it is distributed to the exporter in the form of a dividend.
Exporters can also elect to exempt a portion of their export profits from US Federal income taxation by establishing a foreign sales corporation. A foreign sales corporation (FSC) is a related intermediary incorporated outside the US that either acts on behalf of a US exporter as a commission agent or buys product from a US exporter for resale to foreign buyers.
FSC's are exempt from US federal income tax on a portion of their foreign trade profits that are generated through their dealings with their US exporter shareholders. This exemption enables US exporters who are FSC shareholders to effectively lower the rate of US federal income tax that applies against their composite export profits.
State Income Taxation
State income tax laws differ state by state. Consequently, it is not possible to give an overview of how states tax the profits of US exporters in the context of this article. Nonetheless, it is important for US exporters to keep in mind that some states apply the same principals as the IRS in taxing the worldwide income of their taxpayers.
Likewise, it is important to keep in mind that some states offer the possibility to reduce taxes due on export profits through the establishment of a FSC. In considering tax issues related to their export programs, US exporters should invest sufficient time to understand how their states tax an exporter's export profits and whether such states permit the establishment of foreign sales corporations to reduce the tax amount normally due.
Foreign Country Income Taxation
Foreign country income taxation of US exporter's export profits varies based on whether a US exporter exports on a direct basis or through an intermediary. Foreign countries tax the commissions earned by a US exporter's sales agents. They also tax the resale margins earned by a US exporter's offshore subsidiaries and distributors.
These results are not surprising, given the fact that a US exporter's offshore subsidiaries, sales agents and distributors maintain a separate tax presence in a foreign country. What is surprising, however, is that foreign countries frequently reach beyond these income types and beyond these entities in taxing a US exporter's export profits. Generally speaking, foreign countries will tax a US exporter's export profits if the US exporter is considered to be trading or doing business in the country.
The concept of trading or doing business in a country is variable and subject to individual country definition found either in a tax treaty between the country and the US or in the country's tax law when no tax treaty exists. Country by country definition notwithstanding, some generalizations can be made with regard to trading or doing business in a foreign country.
- Direct exporters based in the US are typically not considered to be trading or doing business in a foreign country, unless perhaps they either transfer title to their export shipments in the foreign country or conclude contracts in the foreign country.
- US exporters who export via related intermediaries are typically considered to be trading or doing business in a foreign country by virtue of the fact that they have a presence or permanent establishment in a foreign country in the form of their related intermediary.
- US exporters who export via unrelated intermediaries are not considered to be trading or doing business in a foreign country unless the unrelated intermediary is classified as a dependent intermediary or unless the unrelated intermediary has the power to enter into contracts on behalf of the US exporter.
Foreign country taxation of a US exporter's export profits is not a disastrous situation for a US exporter. This is because US exporters can recover to some extent either by deducting the foreign taxes they pay from their US taxable income or by applying the foreign tax paid as a credit against their US tax liability.
Foreign tax credits must be segregated according to income category and are limited in that they can not exceed the amount of US tax due on the income in question. This means that US exporters may be faced with excess foreign tax credits if a foreign country's tax rate exceeds the US tax rate. But this too is not a disastrous situation for a US exporter because US exporters can carry excess foreign tax credits back or forward to use in other tax years.
Despite the fact that foreign taxation of a US exporter's export profits does not spell disaster for a US exporter, it is generally in a US exporter's best interests to sidestep foreign country taxation when possible. US exporters who are not exporting through a related intermediary should therefore structure their export transactions so that they are not seen as trading or doing business in a foreign country.
(Article appeared in the 1995 Official Export Guide)
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