Expanding your business overseas -
5 tax questions you need to ask first
Sally Preston
As new global markets provide infinite opportunities to expand and grow, businesses face both challenges and opportunities. In this article, we focus on the tax considerations of expanding internationally. Now we will not be providing you with a comprehensive guide (as that would be a whole book!) but instead break it down into some key questions you should seek help with before entering the market.
Whilst this should not of itself deter your expansion plans, it is potentially one of the largest costs and risks to your international expansion if not carefully planned.
Let’s say, you have decided to expand your business overseas. You know the market; you understand most of the red tape involved; and you have a plan. Have you thought about tax though? We provide you with the top 5 things we think you need help with before you launch.
What structure does your business operate through?
How will overseas profits be taxed?
How can profits made overseas be brought back to the owner?
How will cross-border transactions be treated?
Do I understand the business’ Australian and overseas reporting obligations?
We will not be covering indirect taxes such as GST, import duty, foreign value added taxes etc. in this article. We will focus instead on income tax.
1. Type of structure
When leaping to expand your business offshore, there are decisions to be made regarding the structure (or lack thereof) you may use. At a high level, the options are:
No physical presence overseas
This may be appropriate where you do not intend to set up a location in the foreign country, with employees, contractors etc. Instead, you intend to sell to foreign customers from the home base in Australia. You may have a marketing employee or contractor on the ground in the foreign country but they cannot agree on contracts etc. They simply market the business for you and the sales and contracts are through the Australian business.
The existing Australian business or structure becomes a permanent establishment in the overseas country.
A business may become a permanent establishment in a foreign country when they go beyond the above – that is, they have more presence in the country although still do not operate through a separate business structure. Instead the Australian structure may register to operate their business in that country.
This means that there is not a separate legal entity. One consideration may be whether exposes the Australian entity to unnecessary risk?
A separate legal structure is set up overseas.
For example, this may be a body incorporated in that country or some other structure that is available in that country. This may be owned by the Australian structure or owned by a separate structure or directly by the business owners. It operates legally separate from the Australian structure. If the decision is made to put a formal structure in place, it is essential that your Australian adviser seeks assistance from a tax adviser and likely also a lawyer in the foreign country. Most Australian advisers do not have the required in-depth knowledge of foreign country laws and taxes. Particularly when these may change as fast as the Australian laws do! The foreign adviser will then work with the Australian tax adviser to design the best structure for your business based on your intentions and plans.
This structure may be simpler to both understand and to operate cross border. It may even be that a foreign bank account is near impossible to set up without there being a foreign entity in place.
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Each option gives different tax outcomes, and these should be thoroughly advised on before making the decision. We discuss at a high level what these may be further in answering the remaining questions.
2. How will overseas profits be taxed?
This one is way more complicated than one article. However, we will attempt to give you the good, the bad, and the ugly on this, based on each structure (above).
It is important to first note that in general, an Australian resident (individual or entity) is taxable on its worldwide income. Therefore, where your Australian company generates income in a foreign country, it will be expected to pay tax on that income.
Therefore, determining whether the structure you use is an Australian resident is an important step. A company is a resident for tax purposes in Australia if it satisfies the following:
It is incorporated in Australia; or
It is not incorporated in Australia however it carries on business in Australia; and
o Has either its central management and control in Australia; or
o Voting power controlled by shareholders who are residents of Australia.
There are similar rules for trusts as well.
Many countries will determine whether they tax income based on the source of the income. Australia has agreements with a large number of foreign countries which are called “Tax Treaties” or “Double Tax Agreements”. These agreements often specify that the foreign country only has taxing rights where the business has a permanent establishment in the country (structure option 2) or of course where it is a tax resident of that country by being established in that country (Structure option 3). Where there is no permanent establishment as in option 1 above, then it may be that the income is not taxed in the foreign country and is only taxed in Australia.
Where the income is taxed in the foreign country, it may be that a foreign income tax offset is available to offset Australian tax also payable.
Where there is a foreign branch or permanent establishment it is generally necessary to track the income generated in each country to report this income in the foreign country. This will require an element of set up in your accounting systems.
There are complex rules around attributing certain profits made by a foreign company to the parent company in Australia in some circumstances. These rules are beyond the scope of what we will talk about today. Your Australian international tax expert will discuss these with you.
3. How can profits made be repatriated to the owner?
Under structure options 1 and 2, the profits are already in the hands of the Australian entity, as there is no separate legal structure. However, for option 3, where a separate structure is established, there will need to be a way to return the profits to the Australian owner. The Australian owner may be the Australian entity or it may be a different structure in the group i.e. owned directly by the shareholders.
Example 1
Let’s use the simple example of a company that is incorporated overseas that is owned 100% by an Australian company. The Australian company is owned by an individual.
Let’s say the foreign company is in the USA. The company generates profits of $1,000 before tax. The USA company tax rate is 21%. So the company pays tax on this. Did you know that in the USA 44 of the USA states also levy tax on company income? Let’s say the average state tax on our company profits is 8%. This means that a total of 29% of our profit is lost to the USA tax system. The remaining amount would be available to declare as a dividend to the Australian company shareholder.
In Australia, we have rules that when an Australian company receives certain dividends they are treated as non-assessable non-exempt income. This means that the Australian company does not pay Australian tax on these amounts. It also does not utilise any foreign income tax offsets from the USA tax it might otherwise have had. So the company does not pay any tax.
However, when the company pays this income to the shareholder, it will declare a dividend. As no Australian tax was paid on the income there are no credits (what we call franking credits) to send with the dividend. This means that the shareholder receives the net cash of $710 without a franking credit. In its tax return, we assume the shareholder will pay tax on the $710 received at the marginal tax rate (up to 47%). This is modelled out below.
What is the outcome of all of the above? It means that the $1,000 profit may be eroded by both USA and Australian taxes of $623.70 leaving only $376.30 in the shareholder's hands – an effective tax rate of 62.4%. This is not unique to the USA, this is common in many jurisdictions.
The above assumes the only interaction between the Australian company and the USA subsidiary is via the payment of any dividends and has a very simple view of the tax rates and point of tax.
4. How will cross-border transactions be treated?
It is more common that the companies transact with one another in a variety of ways. Some examples of the type of transactions include:
Loans between them – for example the Australian business may loan the foreign business startup costs and working capital.
Sale of inventory – it may be that the Australian business manufactures all the goods and provides them to the foreign business for sale.
Use of intellectual property; systems and processes – if the Australian business is where all the knowledge, systems and processes is owned, it may charge the overseas structure for access to this.
Recharge of overhead costs – where the Australian parent incurs the costs of the senior executive salaries; licencing etc. it may with to charge a management type fee for the support it offers to the overseas business.
It may also be that the above transactions go the other way i.e. the foreign businesses provide assistance to the Australian business.
There are some complex rules regarding these type of cross border transactions and we will just mention them here:
Withholding - There is a requirement that, unless an exception applies, an Australian resident entity must withhold from interest, royalties, and unfranked dividends paid to non-residents. This is generally at a rate of 10% for interest and 30% for royalties and unfranked dividends, noting any tax treaties between the transacting countries can impact the rates. So if the Australian entity makes payments that fall into these categories there may be a withholding requirement.
Transfer pricing - The transfer pricing rules in the tax law address arrangements under which profits are shifted out of Australia, primarily through the mechanism of inter-company and intra-company charging. The rules seek to substitute arm’s length conditions for the actual conditions operating between entities engaged in transfer pricing and for the tax payable to be based on the arm’s length conditions.
Thin capitalisation - a thinly capitalised entity is one whose assets are funded by a high level of debt and relatively little equity. Under the thin capitalisation rules, the amount of loans provided between the Australian entity and the foreign entity should be monitored.
5. Do I understand the business’
Australian and overseas reporting obligations?
This is really important and the obligations in a foreign country may be completely different from Australia. So some key questions to ask your adviser might include:
Do I need to be a registered business?
Can I set up a bank account?
Do I need a local director or representative to operate the business?
What regular reporting obligations do I have to authorities – i.e. indirect taxes returns; income tax returns.
What do I need to know if I hire employees?
Plus many more…..
Expanding internationally can really open the gateway for your business, but it is not something to just jump into. Formulating a plan and seeking advice and assistance are essential.