Foreign Investors’ Tax Implications for Small and Midsize Businesses – ThomasNet News

Foreign investors looking to acquire an interest in small and midsize U.S. companies face a big hurdle that can influence the economics of their negotiations and profoundly impact the value of their investments, and it’s the U.S. tax structure.

“One of the things that I see often and maybe is a temptation for some business owners is to think about the guts of the business deal first and to assume they deal with restructuring issues later,” said Mitch Thompson, a tax specialist at Squire Sanders in Cleveland.

Foreign investors considering a financial interest in U.S. companies must recognize that the U.S. is a high-tax jurisdiction, he told IMT.

“With an inbound investment, from a tax standpoint with an off-shore investor, valuation is a key issue that has to be addressed early,” he said.

The form of the investment — whether it’s going to be straight equity or something that’s going to be convertible — can have serious business and tax consequences, he said.

From a practical standpoint, some American manufacturers might be structured to tax purposes as S corporations, which would render them ineligible for foreign ownership unless they are restructured.

Courting foreign investment in such a company would mean restructuring by either terminating the S corporation status or putting the foreign investment at a lower-level tier to allow the U.S. owner to maintain S corporation status.

“Maybe drop everything into a lower-tier LLC or something like that and have the foreign investment come in there,” Thompson said. “That’s something that would have to be considered early on if the target was an S-corp.”

Becoming a limited liability company in the U.S. could directly subject the foreign investor to U.S. tax exposure. As such, the investor may want to establish a blocker, he said.

The blocker is a corporate entity that a foreign investor would use to come into an LLC “that might not be intuitive, and so you want to give thought to that. The non-U.S. investor is probably not going to want to invest directly in the LLC without some structuring,” Thompson warned.

Depending on how the foreign investor chooses to structure the financial acquisition, the investor could face relatively high U.S. withholding taxes, making it difficult to profit in the form of dividends or interest. The U.S. has many treaties that reduce the withholding tax on dividends to zero to encourage investment by nonresidents.

It’s also important for the foreign investor to understand how taxes will be levied in its home country after it repatriates profits and in the event it sells or otherwise relinquishes financial interest in the U.S. company.

“If you think of putting together a joint venture as something like a courtship, it can feel awkward or uncomfortable during the courtship phase to talk about how things are going to end and how the exit might occur… but it is important from the beginning to have some sense of what the exits might be,” Thompson said.

Other than real-estate-heavy companies, the U.S. doesn’t tax the capital gains of non-residents. Generally speaking, foreign investors can exit investments in U.S. companies that aren’t real-estate heavy and sell their corporate shares or their blockers’ shares without any U.S. tax, Thompson said.

Small and medium-size U.S. companies that are expanding by going abroad and buying an interest in a foreign company should investigate how their underlying business will be taxed overseas.

Just as many U.S. business owners are familiar with LLCs and S corporations in which the tax attributes flow through to the owners, a similar arrangement is achievable in foreign countries, Thompson said.

“That’s an early gauging item. Only certain types of entities in foreign countries can flow through back into the U.S. for U.S.-backed purposes, and we call this the check-the-box regime,” he said.

U.S. companies should always consider what their foreign tax exposure is going to be and how it’s going to work through their U.S. tax returns, Thompson said.

“They have to begin to understand things like foreign tax credits in the U.S. and other U.S. international tax concepts like anti-deferral regimes — all the new areas of tax law they’ll have to consider here in the U.S.,” he said.