Picking The Right Entity To Minimise Taxes In Offshore Transactions
11 October 2010
Posted by: Author: Jonathan Marseglia
Picking The Right Entity To Minimise Taxes In Offshore Transactions
An entity can expand beyond the border of its country of residence using several methods. One of the issues that must be considered is what form should the parent entity use to conduct business in the other country. Would using a branch allow the parent to lower its overall tax burden since the branch would not be considered a legally separate entity, or would it be more beneficial to have two legally separate entities with the parent receiving monies from the subsidiary? Although some companies may not give this issue the consideration it deserves, there can be severe tax repercussions from picking the wrong entity type, including substantial differences in treaty benefits as well as differences in the taxes levied on each.
All international tax treaties treat subsidiaries and branches using separate and distinct rules. Many countries use the Organisation for Economic Cooperation and Development’s (OECD) Articles of the Model Convention with Respect to Taxes on Income and Capital (Model Treaty) as a template for their international tax treaties; thus the Model Treaty seems like a good starting point for discussing treaty distinctions between branches and subsidiaries.Under the Model Treaty, subsidiaries are considered legally separate entities. Thus, there are provisions, which decide which country has the right to tax dividends, interest, royalties and rents (collectively ‘passive income’), as well as other types of income which tells which country has the right to tax, and may include the rates which must be levied.
The Model Treaty allows only the hosting country to tax branches when the branch is operated through a permanent establishment (as defined in Article Five of the Model Treaty) located in the host country. Article Seven of the Model Treaty states that when a permanent establishment is used to generate profits in another country, the income received by the parent should be handled as a business profit. Further, it allows expenses and deductions created as a result of earning income, provided it is attributed to the permanent establishment. When a subsidiary pays passive income to its parent, both the parent and subsidiary are taxed according to the relevant article(s) in the treaty dealing with that type of income. While the articles may permit both contracting states to tax certain income, they limit the percentage levied in some cases (for example: dividends) if the parent-subsidiary relationship meets certain criteria.
Some countries levy branch tax on income attributed to a branch. These taxes typically apply only to business conducted using permanent establishments or to certain articles that affect branches rather than subsidiaries. Article Nine of the Model Treaty prevents related companies from using non arms-length transactions to funnel passive income to or from related companies inorder to minimise the total group tax burden, affects both subsidiaries and branches and ensures that the treaty is not used to artificially manipulate either party’s tax burden.
Deciding which type of entity is more beneficial for tax purposes depends on the articles of the treaty, the tax rates in the treaty for the respective countries, and the tax rates for the countries themselves, especially when the tax rates are not spelled out in the treaty. One advantage that branches have is that they have the ability to be taxed in only one jurisdiction if there is no permanent establishment.
Most of the money the branch contributes to the parent is considered active income as long as it is a continuation of the parent’s active trade or business. Further, the permanent establishment can deduct expenses and other deductions from income attributed to it. However, branches can be subject to additional taxes, such as the branch tax, which do not affect subsidiaries. Subsidiaries mostly pay passive income to their parent companies and, unless the treaties give lower rates, these rates can sometime reach thirty per cent or higher. However, many countries do give an exemption or deduction for passive income paid by a subsidiary, especially where the parent has a majority ownership interest in it.
South Africa-Mauritius Treaty
Under the South Africa-Mauritius Double Tax Treaty (SAM DTT), Article Five states what will constitute a permanent establishment, which includes: "place of management, branch, office, factory…”. Paragraph seven of Article Five distinguishes subsidiaries and branches by stating that when a company, which is a resident of one of the contracting states controls or is controlled by a company in the other contracting state, those facts in and of themselves do not constitute a permanent establishment. Article Five specifically includes branches and excludes subsidiaries (unless there are abnormal circumstances); thus, it is likely that there will be a distinction between the treatment of branches and subsidiaries within this treaty.
Article Seven discusses business profits with paragraph one stating that when an enterprise resident in one contracting state does business in the other, it will be taxed only in its state of residence unless the business is conducted using a permanent establishment. Where a permanent establishment is found, paragraph three permits deductions for the managerial and administrative expenses incurred in managing that permanent establishment, except with respect to passive income paid to the parent. Article Ten, dealing with dividends, states that both contracting states to tax dividends passed from a resident of one state to a resident of the other.
The state where the money is being paid from, however, is limited to a fifteen per cent withholding tax, unless the company being paid holds ten per cent of the capital of the company paying. In that case, the withholding tax drops to just five per cent. Additionally, Article Twenty-three allows a deduction for taxes paid on the profits used to pay a dividend when the recipient owns ten per cent of the capital of the paying company. However, when a permanent establishment in one state pays dividends to a resident of the other, those dividends are considered either business profits or interdependent personal services. Depending on how business profits are taxed, when the ownership requirement is met, it may be more advantageous to use the five per cent withholding rate for subsidiaries rather than be subject to full taxes in both.
Articles Eleven and Twelve (interest and royalties, respectively) are similar in that if the royalty comes from a branch using a permanent establishment, they are taxed as business profits rather than under those respective articles.
The SAM DTT, like the Model Treaty, gives preferential treatment for the payment of dividends, especially when a certain ownership interest is met. However, as with the Model Treaty, one must such as this one to ensure that neither contracting country can claim that the entity in the other country is a controlled foreign corporation, since that allows the parent corporation to be taxed on the controlled corporations income in the parent’s state regardless of whether income actually passes.
While branches do not have to worry about this issue, if they operate a permanent establishment, their effective tax rate could be higher than five per cent. However, parents are allowed to deduct expenses related to the branch’s operation and income production (except for passive income). Thus, as with everything, these advantages and disadvantages must be weighed in deciding how to conduct business.
Differences in tax treatment
When a countr y levies taxes on income, classification of the entity being taxed makes a significant difference. For example, if a German company wanted to open an office in the United States, in addition to treaty considerations, the parent would have to decide whether it is better for the group that the new entity be a subsidiary or a branch. The following are some of the considerations that the German company should look at in making a decision.
If the German parent uses a subsidiary, they will have zero withholding taxes on dividends, unless it has a less than 80 per cent interest in the subsidiary, in which case it will be subject to a five per cent withholding. Unlike dividends, royalties and interest paid to a German parent are fully taxable, and withholding taxes may be deducted against those types of income, but only from that particular country. With a branch, there is a flat five % withholding tax. Clearly there is a benefit in using a subsidiary over a branch when the parent meets the threshold control amount and the income passed between subsidiary and parent is dividend.
However, a subsidiary must take care to avoid being subject to the German Controlled Foreign Corporation rules, which can allow Germany to tax the income of a foreign subsidiary as it is earned and before it is distributed to the parent corporation.However, branches are not without their pitfalls; because unlike a subsidiary that can exchange assets for shares in a tax-free transaction, when assets are put into a branch, the assets are taxed as if they are sold at the current market value.
If the parent owns at least 50 per cent of the subsidiary, the subsidiary and the parent are considered financially linked, although they still must file individual tax returns.This means that the parent will be responsible for any taxes owed with the right to offset with any relevant deductions. Some income, such as dividends, however, are 95 per cent exempt from tax if the parent is a corporation, or 40 per cent exempt if not a corporation, with the taxpayer having the ability to use 60 % of any related expenses and deductions related to the dividend income, in order to offset the tax burden. With a branch, all income is attributed to the parent, unless the branch sells personal property (i.e. property other than inventory) that is attributed to it.
Some of Germany’s double tax treaties exclude foreign income for branches.However, branches in these jurisdictions are also subject to being scrutinised by the German revenue authorities in order to ensure that a fair and equitable division of income between the parent and branch, especially if the branch is considered a permanent establishment in the other jurisdiction (since the income would not be attributed to the parent). When there are no German treaties or when the German treaties do not exempt foreign income, losses from foreign income are allowed, but may only be used to offset income from that particular source of income (forestry, agriculture, active trades) within that particular country (as opposed to the US where losses from foreign income may be used to offset foreign income from another country).
Where a parent uses a jurisdiction that Germany has a double tax treaty that excludes foreign income from branches, having a branch may be quite advantageous, especially if a subsidiary would have to pay royalties or interest rather than dividends. With a branch, there are extra costs in assuring compliance in a country where foreign income is exempted, since those branches are subject to heavy scrutiny for income shifting. However, if there were substantial deductions against the income being earned, or if the parent is a corporation that meets criteria, a subsidiary might be more beneficial since the deductions would offset the income. Further, neither the parent nor the subsidiary would be subject to the level of scrutiny that a branch in a jurisdiction where income is exempt would be subjected to.
Branches have significant benefits including the ability to be subject to tax in only one jurisdiction. Under some treaties, the parents may deduct expenses related to the branch’s production of income. Further, contributions to the parent often arise from active income, as long as the branch continuation of the parent’s active trade or business; thus, the branch can take expenses, deductions and losses to offset its income and so can the parent. Under some German treaties, foreign income from branches is exempt from taxation. However, branches can be subject to additional taxes, such as the branch tax, which do not affect subsidiaries.
Subsidiaries mostly pay passive income to their parent companies and, unless the treaties give lower rates, these rates can sometime reach 30 per cent or higher. However, many countries do give an exemption or deduction for passive income paid by a subsidiary, especially where the parent has a majority ownership interest in it, which can be equal to or lower than branch taxes. These treaties also tend to give low withholding taxes on dividends and the parent’s country may exclude dividends received by a foreign subsidiary where a certain ownership interest is met. Also, because the subsidiary is a legally separate entity, the parent is not normally taxed on the subsidiary’s income.
However, subsidiaries are prone to being subject to controlled foreign corporation rules, where all of the income of the subsidiary is attributed to the parent as the subsidiary earns it, rather than as it is distributed to the parent.Choosing the right entity is a facts-and-circumstances test. There are benefits and detriments to both, and neither is a perfect fit. However, both branches and subsidiaries present unique tax planning opportunities, which can minimise the parent company’s tax burden with regard to doing business in another jurisdiction.
Source : By Jonathan Marseglia (TaxTALK)