When it comes to due diligence and tax structuring, it’s important that buyers consider the effect that the presence of a foreign corporation has on a transaction’s taxation and overall deal value.
Background: Tax classification of foreign subsidiaries
The United States has unique rules that allow certain types of foreign entities to be treated as either flow-through entities or corporations for U.S. purposes. For example, if a U.S. corporation owns a German GmbH, the owner can elect to treat that entity as a flow-through versus the default corporation status for U.S. tax purposes. The general concept is that, in the United States, a foreign corporation’s income is not taxed until repatriated, and flow-through entity income is taxed immediately. As a result, it’s critical to understand the tax classification of a foreign subsidiary when conducting effective tax structuring; this should also be verified during due diligence.The issues below apply when purchasing a business that owns a foreign subsidiary that’s classified as a corporation.
Inadvertent repatriation
The United States typically doesn’t tax the income of a subsidiary that’s classified as a foreign corporation for tax purposes until it’s transferred to the U.S. parent. However, the U.S. tax code has several sections that may deem certain corporate actions to be transfers even though the parent didn’t intend to bring income from the foreign subsidiary into the United States. These deemed transfers result in the U.S. parent recognizing income to the extent of current or accumulated earnings and profits.A common deemed transfer of unrepatriated earnings occurs when a U.S. parent pledges more than 66 2/3 percent of its foreign subsidiary’s stock as collateral for its debt instrument. This may occur when all assets of the U.S. parent are pledged as collateral for the debt instrument and the ownership of the stock isn’t specifically excluded. U.S. tax law treats this as a repatriation of income if the subsidiary has current or accumulated earnings and profits.
In some rare instances, a foreign subsidiary may be permitted to provide money to its U.S. parent without incurring tax as long as certain limits and rules are observed. If a target’s foreign corporation has attempted to make transfers to its U.S. parent that it believed qualified as non-repatriation transfers, pre-transaction due diligence should include a review of the transfers to make sure that they meet the stringent requirements of a non-taxable event.
If transfers are subject to tax, they’re generally treated as occurring on the last day of the foreign corporation’s tax year. If transfers subject to tax have occurred before the transaction, the U.S. parent would continue to be accountable for these liabilities after the transaction to the extent that they haven’t been paid. It’s also possible that the income would be reported within the period that the buyer owns the business. As a result, it’s important that the acquirer identify any exposures during due diligence so that protections can be negotiated.
Tax compliance concerns
U.S. businesses are required to file several returns when they own a foreign corporation. While most of these forms are informational, failure to file them accurately and on time can result in penalties as high as $10,000 or even $25,000 per form. These forms report a variety of different information to the Internal Revenue Service (IRS) and other jurisdictions, such as the activities of foreign subsidiaries, holding of foreign bank accounts or assets, or transactions with countries that are boycotting Israel.Along with the dollar penalties, failure to file this information accurately and timely will result in a suspension of the statute of limitations for the business’s income taxes. The statute will not expire until three years after the date on which the IRS is provided the appropriate information.
U.S. Tax elections
When a target owns a foreign corporation, the buyer may make certain elections that can impact the utilization of the foreign corporation’s U.S. tax attributes. Some of these elections may have implications to the seller. Purchase agreements often make restrictions on the use of these elections, so it’s advantageous to negotiate before completing the deal. The buyer and the seller need to know the buyer’s intent with regard to the elections prior to the deal in order to properly calculate the impact that tax relating to the transaction will have on the value of the deal.These potential issues make it necessary for a buyer to undertake additional due diligence when a U.S. parent owns a foreign corporation. The presence of a foreign corporation in a merger or acquisition raises some very specialized concerns that ultimately may impact value.
