By: Satya Yeruva and Yamini Jain

Foreign companies that operate in the United States should evaluate where to incorporate their business based on a careful consideration of state tax laws and other regulations. Additionally, foreign companies may also derive tax benefits by choosing to structure their US entity as either a subsidiary or branch office. These decisions can generate enormous tax savings for companies.

Case Study

A well-established Australian company operates in the United States through an Illinois-based subsidiary. The company is exploring whether they can save on taxes by:

• Redomiciling their subsidiary office from Illinois to another US state, and
• Converting their US subsidiary to a branch office.

company structure

The US company has the following features:

• It is a 100% subsidiary of the Australian parent company.
• Its office and employees are based in the state of Illinois.

It sells tangible products such as ceilings, fabric, and more to customers located in six US states: Arizona, California, Illinois, Michigan, Texas, and Wisconsin.

deciding whether to redomicile a us subsidiary office

United States federal income tax remains the same regardless of where a company is incorporated. However, state taxes can vary widely.

Usually, businesses have to file taxes in a state based on whether they have a tax nexus in that state. Nexus rules vary by state, and may include a physical presence standard, a minimum number of employees in the state, customer base or simply doing business in the state.

Since the case study client is selling tangible products, taxes are levied in the states where customers are located regardless of the location of its office and employees. However, it is important to note the below points:

• There is no tax benefit for the US company to domicile in a state where it has customers.
• Corporate versus gross receipts taxes:
  • Most states charge standard corporate income taxes on profits (gross profits minus expenses). Some states, however, impose taxes on the gross receipts of businesses with few or no deductions for expenses.
  • Six US states (Delaware, Nevada, Ohio, Oregon, Texas, and Washington) charge gross receipts taxes. Texas offers a deduction for either cost of goods sold or employee compensation but not both, whereas other states do not offer full deductions for either cost of goods sold or employee compensation.
  • South Dakota and Wyoming are the only states that do not levy either a corporate income tax or a gross receipts tax.
• Throwback rule:
  • Some states follow the throwback rule. Corporations may have income that is not taxed by any state, either because the company does not have a sufficient physical presence in states where it makes sales or because a state where they make sales does not charge any income or gross receipts tax. If the company is based in a throwback state, this income is “thrown back” and taxed in the state where the company is taxed, even though such income was not earned in that state.
  • If a company is incorporated in a non-throwback state, then it does not need to pay state taxes on this “nowhere” income that is not taxed in any state.
• Illinois follows the throwback rule. If the US company sells to customers in South Dakota or Wyoming, then all sales made in these states would be taxed in Illinois at 9.5%.
• Personal income taxes:
  • The US company also wants to help employees save money on their taxes. Employees are taxed at 95% in Illinois.

We compare three critical components below: a) corporate taxability, b) individual taxability, and c) throwback rules in states where the US company has customers, and in states with no personal income tax and/or no corporate tax.

 

	States	State Corporate Income Tax Rate	Individual Taxability	Throwback Rule Applies
1	Arizona	4.9%	2.5%-8% (graduated rate income tax)	No
2	California	8.84%	1%-13% (graduated rate income tax)	Yes
3	Illinois	9.50%	4.95%	Yes
4	Michigan	6.00%	4.25%	No
5	Texas	Gross Receipts Tax	0.00%	Not applicable (Gross receipts tax)
6	Wisconsin	7.9%	3.54 – 7.65% (graduated rate income tax)	Yes
7	Florida	4.458%	0.00%	No
8	Nevada	Gross Receipts Tax	0.00%	Not applicable (Gross receipts tax)
9	New Hampshire	7.7%	Taxes only on interest and dividends income.	Yes
10	South Dakota	No Corporate Tax	0.00%	Not applicable (no corporate income tax)
11	Tennessee	6.5% (a)	0.00%	No
13	Washington, D.C	8.25%	0.00%	Yes
14	Wyoming	No Corporate Tax	0.00%	Not applicable (no corporate income tax)
15	Alaska	0-9.4% (corporate tax brackets)	0.00%	Yes

Tennessee has gross receipts taxes in addition to corporate income taxes. The same is true for several states like Pennsylvania, Virginia, and West Virginia, which permit gross receipts taxes at the local (but not state) level.

The US company should consider moving to a location where employee taxes are either zero or low, and where the throwback rule does not apply. These states include Texas, Nevada, South Dakota, Wyoming and Florida.

Additionally, the US company should consider expanding its customer base in low tax rate states such as Wyoming and South Dakota.

tax implications of changing a subsidiary to a branch office

To decide whether a branch office or a subsidiary office is better for the US company from a tax perspective, your tax professional must analyze the applicable taxes, including tax treaties between the US and the country where the foreign company is headquartered. The US company in our case study is a subsidiary of the Australian parent company.

• A subsidiary company belongs to a parent company or holding company. The parent company holds more than 50% of the subsidiary’s stock.
• Although physically apart from a parent company’s main office, a branch office is not a separate entity from the parent company.
• The branch profits tax is imposed on income that is repatriated to the foreign company’s headquarters.

	Subsidiary	Branch
Federal Tax	Paid on net income.	Paid on net income.
Branch Profits Tax	Paid only on the dividends distributed to the holding company.	Paid at 30% of net income (considered a “dividend equivalent” amount), regardless of the dividends distributed. The tax does not apply on income reinvested in the US or used to pay US liabilities.
US-Australia Tax Treaty	Considers subsidiaries as separate entities. Taxation on dividend distributions is reduced under the treaty for subsidiaries.	Considers branches as an extension of the Australian company. May have tax filing and payment implications in Australia. The treaty does not discuss branch profit tax rates or related relief.

Based on the branch profits tax and the US-Australia Tax Treaty, the US company is likely to pay less tax as a subsidiary of the Australian company than it would as a branch office.

Conclusion

The decision on where to incorporate your foreign business in the US and whether to structure your entity as a branch or a subsidiary is a complex one and varies based on each business’s individual circumstances.

In addition to corporate domicile and branch and subsidiary considerations, there may be many ways that your foreign company can maximize US tax savings in the United States. For help analyzing your company’s tax savings opportunities, or for other advice specific to your company’s situation, please contact your trusted Chugh CPAs, LLP professional.

disclaimer 

This case study is based on our review of the relevant laws as of the date of publication only.  It is provided for general informational purposes and does not create an accountant-client relationship. All information should be independently verified. For case-specific questions, please consult your trusted accountant.