By Gabriel L. Valdes and David R. Yates
As of late, reference to foreign direct investment is routinely couched in the context of the developing world. Yet, according to annual data released by the United Nations Conference on Trade and Development, the United States has for many years led, and continues to lead, the world in foreign direct investment inflows. In short, investors from around the world continue to look to the U.S. as a destination offering minimal political risk, a skilled and educated workforce, a reliable infrastructure, and a transparent legal and business environment. While this may be surprising to many people, our economy remains an attractive destination.
Reaping the benefits of investment in the U.S., however, requires careful planning and structuring from a legal perspective, whether the investment is pursuant to a stock or asset acquisition, a merger, joint venture or establishment of new operations. While the key considerations vary substantially depending on the context of a given investment, there are a number of recurring concerns of importance to foreign investors.
Branch or Subsidiary
Foreign companies seeking to establish U.S. business operations generally have a choice to make between forming a subsidiary corporation or a branch.
A corporation is a legal entity separate from its shareholders and pays its own income taxes. The shareholder’s liability for the taxes, debts or obligations of the corporation is typically limited to the investment made by the shareholder in the corporation’s shares, provided that the subsidiary respects corporate formalities and is adequately capitalized. A subsidiary corporation pays taxes on its worldwide income on a net-basis and is subject to graduated tax rates that rise to a maximum of 35%. The two primary repatriation methods used by foreign shareholders and their U.S. subsidiary corporations are dividends and interest.
Generally, a U.S. corporation may be capitalized with equity or debt by its foreign parent and repatriate funds by declaring dividends or interest, respectively, in each case subject to a withholding tax of 30%. The capitalization/repatriation decision is often dictated by the presence of a bilateral tax treaty with the foreign parent’s home country.
A branch is a business venture undertaken in the U.S. directly by a foreign parent. A branch can be established in one of two ways: (1) operation through a limited liability company (that is taxed as a partnership or disregarded for tax purposes if held by a single member), or (2) direct operation by the foreign parent.
Under the latter structure, a foreign parent can directly enter into business activities and private contracts in the U.S. without forming an entity but the foreign parent will not be shielded from the liabilities that the branch incurs in its course of business. In such a case, the foreign parent will be required to file a corporate income tax return with the Internal Revenue Service and with the corresponding department of revenue of each state in which the foreign parent does business. A branch — whether or not operating as an entity — that generates “effectively connected income” is subject to tax on a net-basis at graduated tax rates, like a corporation. Likewise, whenever there is a decrease in the net U.S. assets of a branch, the branch is deemed to have made a payment equivalent to a dividend to the foreign parent and a “branch profits tax” is imposed on such decrease in assets at a rate of 30%.
All else equal, corporations offer a few distinct advantages over U.S. branches, such as shielding shareholders from liability arising from corporate actions, providing administrative ease from a tax and immigration perspective, and providing for more control over how and when funds come in and out of the company. On the other hand, U.S. branches permit the use of losses for the foreign parent if it is expected that the U.S. operation is depreciable-asset heavy and will generate substantial losses upon start-up that could be beneficial to offset income elsewhere. Essentially, the branch/subsidiary decision comes down to finding an optimal balance of legal protections and financial (including tax) efficiency.
State of Incorporation
If a foreign investor opts to form a corporation in lieu of a branch, the choice of which state in which to incorporate should be made in light of a number of economic and legal considerations. Many companies simply incorporate in their home state because of the administrative ease of doing so. Others choose to incorporate in states like Nevada or Wyoming, which offer some combination of no corporate income or franchise tax, nominal annual fees, minimal reporting and disclosure requirements, and stockholder privacy. A significant number of companies choose Delaware because it has an established body of corporate law (which allows for greater certainty and facilitates long-term planning) and a reputation of having a flexible and management-friendly body of law. From a tax perspective, there is no material advantage to be gained by incorporating in any particular state if the foreign parent’s business will be interstate in nature because the subsidiary will be subject to state and local taxation wherever it has an economic presence.
Avoiding the Estate Tax Trap
For individual foreign investors, a critical trap to be wary of is the estate tax. The U.S. imposes a tax of 40% on the estates of nonresident aliens. In general, the estate of a nonresident alien decedent is taxed on that portion of the alien’s gross estate located in the U.S., including, without limitation, items such as real and personal property, or stock of a U.S. corporation. In order to avoid the estate tax trap, individual foreign investors often make their investments here through a foreign corporation or “blocker corporation.” This structure allows the property to escape taxation because it is cut off by a foreign corporation, the “blocker,” and ownership interests in foreign corporations are not U.S. property for U.S. estate tax purposes.
Gabriel L. Valdes is an associate in the Miami office of Hunton & Williams. His practice focuses on general corporate representation including cross-border finance, and mergers and acquisitions. David R. Yates is a partner in the Atlanta office of Hunton & Williams. His practice focuses on international and domestic public and private mergers and acquisitions, divestitures, investments and strategic transactions.
South Florida Legal Guide 2014 Financial Edition