In our US Market Entry Guide we talked about the timing and drivers for establishing an entity in the US. We are often asked by clients when is the right to incorporate. The right time is the time when your actions are going to result in a foreign entity having US sourced income.
As the world is getting smaller with the rise of online businesses and internet sales, businesses are beginning to sell their products to customers in all corners of the globe. Along with the benefits of allowing a business to cast a broad net, we have seen the rise of online sales cause a number of tax, legal and compliance complexities, particularly with online businesses selling their products to US customers.
In this blog post we will run through the framework of how international businesses are taxed in the US and whether a US tax liability is created.
US taxation basics
Generally, a foreign corporation will be taxed in the US on two categories of income:
a. Income that is effectively connected with the conduct of a US trade or business (ECI); and
b. Certain fixed and determinable annual or periodic (FDAP) income that is not ECI to a U.S. trade or business. These include (but are not limited to) interest, dividends, rents etc.
The key difference in taxation between ECI and FDAP income is that ECI is taxed at graduating corporate tax rates on a net basis and FDAP income is taxed at a fixed rate of 30% on a gross basis. For the purposes of this blog we will focus on ECI to a US trade or business with respect to active businesses.
It is important to first establish whether your business activities constitute being engaged in a US trade or business, and if so, whether income will be regarded as ECI.
Engaged in a US trade or business
Neither the US tax code nor the regulations define what it means to be engaged in a US trade or business. Whether a foreign person or entity is engaged in US trade or business is a question of fact. You usually are considered to be engaged in a U.S. trade or business when you perform personal services in the US, however in certain circumstances Whether you are engaged in a trade or business in the US depends on the nature of your activities.
As a general rule, the US activities must have a profit motive, be regular, continuous and substantial in order to have sufficient presence in the US to be considered engaged in a trade or business. Where a sufficient presence does not exist, any income will not be ECI as there is no business to be ‘effectively connected’ to.
A foreign taxpayer deriving income from the sale of inventory property through regular and sustained activities conducted within the US is engaged in a trade or business within the US. Inventory property is generally defined to be property sold by the taxpayer in the ordinary course of its business. It is important to point out that the abovementioned activities refer to activities conducted within the US.
As such, you are unlikely to have a US income tax liability where your business has no, or very little US presence, and you are selling direct to US customers on an online platform. This is because your business activities do not amount to a US trade or business.
As the threshold for establishing a US trade or business is fact based, it is important to be clear about what activities you have undertaken (i.e. procuring sales whilst in the US, warehousing, trade shows etc.) to determine whether your activities are enough to substantiate a US trade or business.
In my previous blog post I covered about state and sales tax requirements for foreign sellers. A foreign online seller may create a tax obligation in the US where their activities have triggered a state or sales tax nexus.
Caution should be exercised for foreign businesses doing business on Amazon FBA or using third party warehousing services in the US. Merely having products stored in a warehouse in state A before being sent to the customer in state B is often sufficient to cause a state tax obligation in state A. Each state in the US has different rules dictating sales and state tax nexus. It is important to understand whether a taxable nexus has been created to ensure compliance with the US tax regime to avoid substantial penalties and fees.