Anchin’s U.S. Expansion Playbook: When Does a Foreign Business Need to Set Up a Separate U.S. Entity?

Missed Part 1 of our U.S. Expansion Playbook series? Click here to read the first article.

Once a foreign business begins operating in the U.S., it should consider establishing a separate entity to conduct its U.S. business. Having a U.S. entity allows a foreign parent to separate itself from their day-to-day U.S. operations, but more importantly, it acts as protection against potential U.S. tax exposure. For example, if a foreign business wants to establish a physical presence in the U.S., such as a store or office, it may be advisable to have a U.S. entity serve as the tenant of the property. This approach can help prevent the foreign parent from being treated as having a permanent establishment in the U.S. In addition, foreign businesses that have U.S. employees should look to incorporate a U.S. entity to manage their U.S. payroll obligations.

Financial and Operational Advantages

There are some other financial and operational reasons for setting up a separate U.S. entity as well. Having a U.S. entity with an Employer Identification Number (EIN) is usually necessary to set up a U.S.-based bank account and can be necessary for obtaining certain forms of financing. Additionally, foreign businesses with significant U.S. sales or revenue often find it more efficient to operate through a U.S. entity, as it simplifies both federal and—more critically—state tax compliance.

Choosing the Right U.S. Entity Structure

If a foreign business decides to establish a separate U.S. entity, there are several legal forms it can choose from, some of which are more suitable than others for foreign businesses entering the U.S. market. The most common are:

• C Corporation: A separate and distinct legal entity that acts as a “blocker” for U.S. tax purposes
• Limited Liability Company (LLC): Similar to a branch, profits and losses flow from this entity to a foreign parent
• Limited Partnerships (LPs): Ordinarily used in JVs or fund structures

Since S Corporations are entities that cannot be owned by non-U.S. persons, it is not a viable option for foreign businesses.

It should be noted that in the domestic context, LLCs are by far the most common vehicle to use, however, for foreign operating and investing businesses, it is far more common to utilize a C Corporation.  This is done for various reasons, but most commonly, it is used to alleviate the need for the foreign parent or investor to file tax returns in the U.S., and create a permanent establishment in the U.S. as outlined above.

LLCs also alleviate the double taxation that could occur when operating via a C Corporation, where the company pays tax on its profits and the shareholders pay tax on the dividends when distributed. LLCs have one layer of taxation on the owner. However, this double layer of taxation can still arise when owned by a foreign parent or investor that is also a corporation under U.S. entity classification rules. Therefore, tax efficiency in the domestic context is not necessarily mirrored by foreign ownership when an LLC is used by foreign owners.

Other Important Factors to Consider

If a foreign business sets up a separate U.S. entity, it should also consider how this entity will be treated under the tax laws of its home country, as well as whether there will be any intercompany transactions between the foreign parent and the U.S. entity. The U.S. has tax treaties with numerous countries, which may allow for reduced withholding tax treatment in the U.S. for any dividends, interest payments, or royalties between the two countries, as well as the potential for tax credits in the foreign parent’s country of incorporation. Additionally, most intercompany transactions will come under the auspices of transfer pricing rules, which will need to be reviewed. These issues will be discussed in more detail in a separate article.

It is important to note that the U.S. has no federal company law, and the rules regarding the formation, operation, and dissolution of business entities are generally defined by state law. Discussing these considerations with accountants, lawyers, and professional advisors is essential to ensure the appropriate choice is made for you and your business. A future article will elaborate on the choice of state for incorporation purposes and the prevalence of using Delaware for this purpose.

For more information on the nuances of foreign businesses setting up an entity in the U.S., please reach out to Kevin Brown or Gwayne Lai of Anchin’s International Tax Group or your Anchin Relationship Partner.

Stay tuned for the next installment of our U.S. Expansion Playbook series, which will explore the basic considerations of establishing a U.S. entity, including an in-depth breakdown of the different entity types available.