U.S.“person”who are considering conducting business outside the U.S. should consider the tax consequences of such entrepreneurship. The US rules in this area are highly complex, and you also have to look to the tax rules of the country within which you are considering conducting business as well as to any tax treaty between the US and such other country.

Who is a US “person”?

A U.S. person, for purposes of US income tax, is defined as:

(1) a citizen or a resident of the US,

(2) a domestic partnership,

(3) a domestic corporation, or

(4) a domestic estate or trust.

A corporation or partnership is considered domestic if it was organized in the U.S. or under the laws of the U.S. or of any state. A trust is considered domestic if a court within the U.S. is able to exercise primary supervision over the administration of the trust or one or more U.S. citizens or residents have the authority to control all substantial decisions of the trust. An estate is generally considered domestic if the income of the estate is subject to US income tax.

Is Business Taxed in a Foreign Country?

A US person doing business in foreign countries are typically subject to the domestic tax laws of the foreign country where they engaged in business activities. However, if the US has entered into a tax treaty with the foreign country, the treaty will typically provide a higher threshold for taxation than the domestic tax laws applicable in the foreign country. The US individuals and corporation are generally not taxed by the foreign country unless the business activities do not create a permanent establishment (PE) in the foreign country. A tax treaty defines a PE using the following two general tests:

• Whether the corporation has a fixed place of business within the target country, as defined under the language of a specific treaty
• Whether the corporation operates in the target country through a dependent agent that habitually exercises the authority to conclude contracts on behalf of the corporation in the target country

A US person has many options for doing business in a target country without triggering a PE for treaty purposes. Once the permanent establishment is created, the entity will be taxed in the foreign country.

How does Business Go Abroad: Branches or Subsidiaries?

Once you have created a PE in a foreign country, the next decision is whether to form a branch or subsidiary. There are a few differences between a branch and a subsidiary.

Comparison between branch and subsidiary

How is a Foreign Entity Classified for US Tax Purpose?

The entity classification regulation under IRC 7701 (”the check-the box regulation”) allows certain business entities to choose their classification for federal tax purpose under an elective regime. Certain business entities are by definition classified as corporation under Treas. Reg. § 301.7701-2(b). They are often referred as to as “per se” corporations. That is, for US purpose, they must be considered corporations.  A business entity that is not expressly classified as a corporation under the regulations is referred to as an “eligible entity” and is permitted to elect its classification for federal tax purposes.

The regulations provide default classification rules for eligible non-U.S. entities (i.e., non-per se corporations) that do not make check-the-box elections. The key for the default classification for foreign entities is whether or not the members have limited liability. Whether the shareholders of an entity has limited or unlimited liability, the law of the country where the entity has been formed and the charter or by-laws of the entity itself will be the controlling factors. The rule for a foreign eligible entity is that it will default to be treated as:

• a corporation if all of its owners have limited liability,
• a partnership if it has two or more owners and at least one owner does not have limited liability, and
• a disregarded entity if it has a single owner that does not have limited liability.

This entity classification election (referred to as a “check-the-box” election) is made by filing IRS Form 8832, Entity Classification Election. The taxpayer must check the appropriate box, specify the date the election is to be effective, sign and file the form. The classification of foreign entity for US tax purposes has no effect for non-US tax purposes.

How is Foreign Entity Taxed for US Tax Purpose?

If a foreign entity is treated as a disregarded entity for US tax purpose, its income, deductions and credits are reported on the owner’s tax return. Foreign law will apply the foreign tax at the entity level when the entity is recognized as a tax paying entity under foreign law, even if it is a disregarded entity under US law. Under those circumstances, the person that is treated as owning the assets of the disregarded entity is considered as legally obligated to pay the foreign tax for US tax purposes. If the US owner is an individual or a C corporation, the foreign taxes are claimed as a foreign tax credit on the US federal tax return subject to limitation.

If foreign businesses are treated as partnership, the US owners must report their pro-rata shares of partnership income, deductions, and credits on their tax returns. If the foreign entity has losses or credits, these losses and credit can be used by the U.S. owner to reduce their U.S. taxes. The losses of the foreign entity are reportable on the owner’s US federal income tax return subject to any applicable basis limitation for foreign partnerships.

For U.S. tax purpose, foreign corporations are considered separate entities from their parent corporations or shareholders. Foreign corporations are generally not taxable on foreign income even if they have US shareholders. They are subject to US taxes only on U.S. business income and other U.S. source income. US taxes do not apply to a corporation whose entire income and operations are foreign. The U.S. has no taxing authority over a foreign corporation with no U.S. source income and no permanent establishment in the U.S. However, the U.S. tax laws do have taxing authority over U.S. shareholder of foreign corporations. That foreign income would be taxed only when it is “repatriated” that is, brought back into the U.S. as dividends to the U.S. shareholder. That means that US taxes could be deferred on foreign income earned by US persons through ownership of a separate foreign corporation. Nevertheless, The US tax code has set up certain restrictions to doing so. Theses restrictions are called the anti-deferral regimes.

Does a foreign entity need to keep business record?

you must file US tax returns as required and therefore you may be audited by the IRS. Your foreign business must maintain records of income and expense in accordance with US accounting principles. If you can’t prove your expenses, they may be denied by the Service. Remember that you must keep records as if you were in the US.

IRS reporting requirements

Foreign entities must file a number of U.S. tax forms. There are severe penalties for failure to comply with foreign entity reporting requirements.

• Form 8832 – A foreign corporation or limited liability company should review the default classifications in Form 8832, Entity Classification Election and decide whether to make an election to be treated as a corporation, partnership, or disregarded entity. A single member foreign LLC established by a U.S. person must file an election Form 8832 to claim disregarded entity status. If this form is not filed timely the LLC may be treated as a C-corporation and subject to corporation taxation.
• Form 8858-Information return of U.S. persons with respect to foreign disregarded entities –A U.S. person that directly, indirectly or constructively owns a foreign disregarded entity must file this form. An foreign disregarded entity is a foreign entity that is disregarded as an entity separate from its owner for U.S. tax purposes by filing Form 8823.
• Form 8865-Return of U.S. persons with respect to certain foreign partnerships –Form 8865 must be filed by a U.S. person who owned more than a 50% interest in a foreign partnership during the year or owned at least a 10% interest if the partnership was controlled by U.S. persons owning a 10% or greater interest. A U.S. person also has a filing requirement if he or she contributed property in exchange for a partnership interest if that person directly, indirectly or constructively owns at least a 10% interest, or the value of the property contributed exceeds $100,000.
• Form 5471-information return of U.S. persons with respect to certain foreign corporations –Form 5471 is filed by any U.S. person who is more than a 10% direct or indirect shareholder in a foreign corporation or any U.S. shareholder in a controlled foreign corporation (CFC), which  is a foreign corporation, more than 50% of which is owned by U.S. persons. A U.S. citizen or resident who is an officer or director of a foreign corporation may also have a filing requirement if a U.S. person acquired stock in a foreign corporation. If you or your business owns a foreign corporation, then you will want to file this form otherwise the penalty for not filing can be as high as $50,000.
• Form 926-Filing requirement for U,S,  transferors of property to a foreign corporation – Any U.S. person who transfers property to a foreign corporation and owns more than 10% of the stock, or any amount of stock if cash transferred is more than $100,000, must file this form with his or her U.S. tax return.
• Form TD F 90-22.1 – If you are a United States person (including a corporation, partnership, exempt organization, trust or estate) and have a financial interest in or signature authority over a foreign financial account, you are subject to a reporting requirement on Form TDF 90-22.1, Report of Foreign Bank and Financial Accounts (“FBAR”).
• Form 8938- statement of foreign financial assets – U.S. citizens or resident aliens who hold more than $50,000 (in the aggregate) in certain foreign assets (e.g., a foreign financial account, an interest in a foreign entity, or any financial instrument or contract held for investment that is held and issued by a foreigner) will be required to report information about those assets on an income tax return using Form 8938.  This requirement is in addition to the FBAR reporting.