In our last blog posting, we discussed that it is useful to conceptually divide cross-border taxation into the categories of “inbound” and “outbound.”  Inbound refers to non-U.S. persons with U.S. income and/or U.S. activities, and outbound refers to U.S. persons with non-U.S. income and/or non-U.S. activities.

Another useful classification for dealing with cross-border transactions is that of widely held companies and that of closely held companies.  These categories are useful for both inbound and outbound transactions.  Thus, inbound and outbound can be sub-divided as follows:

Widely Held Companies

Widely held companies have certain advantages and certain disadvantages in both the inbound and outbound contexts.  In the inbound context, if the widely held company is publicly traded, then one of its advantages is that it may more easily qualify for the limitation on benefits provisions included in most U.S. income tax treaties.  This qualification may allow it to be subject to lower tax rates on U.S. withholding taxes or, in some circumstances, to avoid U.S. taxation entirely.  One of the disadvantages of a widely held company in the inbound context is that it is more difficult to avoid branch profits taxes and/or dividend withholding taxes.

In the outbound context, a disadvantage is that widely held companies (typically “C” corporations) are subject to two levels of taxation - one tax at the corporate level as profits are earned and another tax at the shareholder level when profits are distributed.  Several other countries have “integrated” tax systems that allow shareholders to claim credits against their own income tax liabilities for taxes paid at the corporate level.  The U.S. does not have such an integrated tax system.  Consequently, profits earned by widely held corporations in the U.S. are generally subject to two levels of taxation.

An advantage of a widely held company in the outbound context is that foreign income taxes paid by foreign subsidiaries of the U.S. parent can generally be claimed as foreign tax credits in the U.S. when the foreign profits are distributed (or deemed distributed) to the U.S. parent.  These foreign tax credits are sometimes called “indirect” or “deemed paid” foreign tax credits.  If widely held U.S. parent companies were not allowed to claim deemed paid credits, profits earned by foreign corporate subsidiaries would ultimately be subjected to three levels of taxation: foreign corporate taxation, U.S. corporate taxation, and U.S. shareholder taxation.

Closely Held Companies

As with widely held companies, closely held companies have certain advantages and disadvantages in both the inbound and outbound contexts.

In the inbound context, an advantage of a closely held company is that it may be able to structure its U.S. operations to avoid branch profits taxes and dividend withholding taxes.  A disadvantage of a closely held company is that, depending on the structure, there may be U.S. estate taxation risks.

A brief discussion of the taxation of U.S. closely held companies is helpful to understand the advantages and disadvantages in the outbound context.  U.S. closely held companies are often structured to avoid entity level taxation.  This is typically achieved with the use of “S” corporations or partnerships.  Without an entity level tax, only the shareholders/partners are subject to U.S. income tax.

NB: Limited liability companies (“LLCs”) formed in the U.S. are often treated as partnerships for U.S. tax purposes.  However, LLCs can also be treated as S corporations, C corporations, or disregarded entities.

In the outbound context, a disadvantage is that a closely held U.S. parent company which is not structured as a “C” corporation does not qualify for deemed paid foreign tax credits.  Consequently, profits of foreign subsidiaries of closely held U.S. parent companies may be subject to two levels of taxation (foreign entity level tax and U.S. shareholder level tax).  However, an advantage of a closely held company is that it may be able to structure the operations of its foreign subsidiaries to be subject to only one level of worldwide taxation.

Complex U.S. Tax Rules for Both

Both widely held and closely held companies are subject to some of the same complex U.S. tax rules.  For instance, in the inbound context, some of the rules that apply to both types of companies include:

• Earnings stripping,
• Transfer pricing,
• U.S. withholding taxes, and
• Special U.S. tax reporting obligations.

In the outbound context, some of the rules that apply to both types of companies include:

• Deemed distributions as subpart F income,
• Interest charges and ordinary income characterization under the passive foreign investment company (“PFIC”) regime,
• Recharacterization of capital gain as ordinary income on sales or exchanges of stock in certain foreign corporations under Code § 1248,
• Transfer pricing,
• Foreign withholding taxes,
• Special rules for outbound transfers of property under Code § 367, and
• Special U.S. tax reporting obligations.

This blog posting touches on many issues and is not intended to cover any of the issues in depth.  Each of the sub-categories of cross-border taxation has many intricate rules that should be analyzed in detail with respect to each specific taxpayer.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.