In the final installment of our collaboration with TaxTalks, the number-one podcast for Accountants, CEO Peter Harper breaks down the six most common questions entrepreneurs face when taxes in both the United States and Australia. From debt vs equity to corporate tax residency, Peter and host Heide Robson have the answers for you.
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Peter Harper: Probably the single biggest area of risk, I think, for Australians that own US LLCs is around Australian residency risks for US LLCs, where you have a single member LLC; so one owner, (and) they’re also the manager, so the director or equivalent. And in that scenario, what else can you be but essentially manage and control from Australia? If it’s generating US-sourced income, you’ve got this situation where you don’t have the foreign tax, (and) the FITOs don’t flow through, right? You get a FITO mismatch, and you’re effectively going to be treated as though you’re paying an untracked dividend after an Australian shareholder, which can result in an effective tax rate in the sort of early sixties.
Announcer: You’re listening to Australia’s podcast for accountants: TaxTalks, the podcast to grow your firm.
Heide Robson: Welcome to Episode 357 of TaxTalks. This is Heide Robson, and thank you to Class for sponsoring this episode.
Heide Robson: In this episode, Peter Harper of Asena Advisors in New York will cover six US Australian tax questions with you that have come up. Should you use debt or equity funding when expanding into the US? How’s withholding tax treated when the borrower assumes the withholding tax debt as part of the contract? And what about LLCs with ECI in the US, but CMC in Australia?
Heide Robson: These are just some of the questions we recover in this episode. And again, it focuses on the US, but the questions will also apply to cross-border structures with other countries, and the answers from the Australian tax side will most likely be the same. And so I’m hoping that even if you don’t have any US clients, but you have international clients elsewhere in the world, that you still find this episode helpful.
Heide Robson: Before we start, please let me just quickly play you the legal disclaimer that Peter Harper has recorded for you.
Peter Harper: So (while) we talk about these complex questions, I want to caution listeners that each case that may come before them will be unique, and it is vital that they consult with someone that has US expertise in order to handle delicate matters. These topics are not simplistic and need experience and proficiency to tackle, so please reach out to us to address any issues that your clients may bring up with the diligence they deserve.
Heide Robson: So now to six US Australian tax questions. Here is Peter Harper of Asena Advisors in New York, California, and Florida.
Announcer: Question One: Debt or equity?
Heide Robson: Let’s assume the US operation needs a loan from Australia. How would you structure this loan, and also would you send a loan, or would you send equity?
Peter Harper: It really depends. I mean, the biggest thing with debt versus equity is (the) US, like Australia, has in-capitalization rules around that limit (or) the amount of debt deductibility, and the value of that for an US operation. But in the context of a business that’s expanding into the US (for) the substantial majority of folks that we advise, they might be very established in a foreign market, but this is effectively a start-up.
Peter Harper: So, invariably, what that looks like, at least in the first number of years, you’ve got losses, substantial capital outflows, and significant losses. So the benefit of having a debt funding something is that you have the ability to more efficiently repatriate profit. The downside of debt is that you’ve got to pay market rates and interest to qualify under Australian transfer pricing guidelines.
Peter Harper: So I think the single biggest thing on the debt-to-equity scenario that we focus on initially is what’s the payback period. Because, you know, you’ve got this situation where you can see an Australian business that’s lending a substantial amount of cash to America or America is not making enough money to cover its costs, and then you’ve got tax leakage because you’ve got an obligation to pay interest back. And so it’s a matter of understanding how much pressure, if any, during that period of time is that circularity or that tax leakage going to put on the business, if any, and then kind of manage the cash flow. And it’s different for every business.
Heide Robson: Yes. So if the payback period is quite short, you can do debt because you then don’t have this leakage through interest for a long time. If the payback period is quite long, you would do capital.
Peter Harper: Correct. And then the only other point to note on that (is) the downside of capital is if payback does turn out being quick and you wish to repatriate funds back to Australia, that’s got to go out via dividends until such time, as you have no retained profits in the US, and only after that can you do a return of capital through like a share buyback or something like that. So it’s far more efficient to repatriate invested capital through debt over equity. It’s just a question of how, as you rightly flagged, what is the payback period.
Heide Robson: Okay, so if you pay back capital, you can’t return capital until all retained earnings have been paid out via dividends?
Peter Harper: Correct.
Heide Robson: Okay. But that is if you have a C Corp. If we have an LLC, then does it also apply to an LLC that hasn’t made in a corporate election?
Peter Harper: It depends on the position with respect to your basis. If it’s a partnership (with) multiple owners, every partner has (a) basis. So if there is…
Heide Robson: The cost base.
Peter Harper: Cost base. And so what happens (is) when you operate at a loss, that reduces your cost basis in the partnership. And so there can be a similar outcome in the sense that by the time you actually have some degree of funds that might be sufficient to repatriate, there’s no basis if you’ve run up a big loss at the start because that’s been converted. Effectively, what happens is under the US loss limitation rules, when you operate a partnership at a loss, the percentage of your basis gets converted to the loss and reduced concurrently. So yes, to answer your question, yes, but it just depends on the nature of what each individual investors or owners of basis-es in the partnership.
Heide Robson: So it really would be best if the US operation could stand on its own feet quite quickly, because (in) other scenarios alone that comes with strings attached with a loan, you need to make sure that the interest is at market rates for it to be accepted in the US and Australia. And for equity, you have the problem that you first need to distribute retained earnings before you can distribute capital.
Peter Harper: Correct.
Announcer: Question Two: Loan to blocker or direct.
Heide Robson: If you have a scenario where you have a C corp blocker holding an LLC, would you lend to the C corp blocker that then on-lends to the LLC, or would you lend directly to the LLC from Australia?
Peter Harper: You know, you just (lend) directly to the LLC because from a US perspective, they would deem that as being lent effectively to the branch.
Heide Robson: Which is the LLC?
Peter Harper: Yep.
Heide Robson: So you might as well pay it directly to the LLC because the US will just treat it as being made to the LLC anyway.
Peter Harper: Yep.
Heide Robson: Okay, good.
Announcer: Question Three: Can withholding tax become accessible income?
Heide Robson: Withholding tax. If Australia loans money to a US entity, and the US entity then agrees to bear the withholding tax, is that possible? How is this treated?
Heide Robson: First of all, is it possible to do that? And then how is this treated in the US and Australia? Does the Australian entity then have (an) assessable income of interest plus withholding tax, or can the interest just arrive in Australia without any tax considerations? So let’s say Australia lends $10 million to the US and then receives $500,000 each year as interest at 5%. And the US entity agrees to pay the withholding tax, which let’s assume is, I think at interest is 10%, isn’t it? The withholding tax for interest is usually 10%, correct?
Peter Harper: That’s correct, yeah. So what’s basically happening is the interest is FDAP income. So it’s US-sourced income. And so what’s happening is when you have this obligation, you’ve got an Australian company lending to a US taxpayer, it is paying interest back to Australia that is considered FDAP income, so it’s caught up in the US sourcing net. So then, given that the Australian company doesn’t have any connection to the US, the US government wants the US borrower to collect the tax on its behalf. So it would normally be able to go to collect 30%, but because of the treaty, that’s reduced to 10%.
Peter Harper: The lender will have to complete a form called a W-8 BEN, where it references the relevant treaty number that reduces the article, that reduces the rate of withholding to 10%, then submits that to the borrower. The borrower completes a particular form and submits that to the IRS. And then on the Australian side, the lender is getting a FITO for the withholding tax that’s been paid. And then to the extent of any shortfall, as far as tax that would be otherwise due on the interest, it’ll pay for the tax.
Heide Robson: Okay. So if you assume the interest is $500,000, the withholding tax would be $50,000. The US entity pays the $50,000 to the IRS with the form, which is most likely a W-8 BEN-E, correct? Because with an E at the end, if the Australian entity is a company or a trust, correct?
Peter Harper: Correct.
Heide Robson: And then the Australian entity wouldn’t have (an) interest income of $500,000; it actually would have (an) interest income of $550,000 and would then receive a FITO of $50,000. So it’s actually not possible to circumvent this whole issue of withholding tax by having the payer pay it.
Peter Harper: No, correct. No.
Heide Robson: Good. So that means the Australian entity still then has the issue that they have to pay tax on the $50,000 that (was) used to pay the withholding tax, and they will lose the FITO when it’s paid out unless they structured it in a different way. But if it’s just a plain Australian Propriety Ltd having done this, then they pay tax on the withholding tax and don’t get a FITO ultimately down to the owners, correct?
Peter Harper: Yeah. Correct.
Announcer: Question Four: Tax treaty relevant or not?
Heide Robson: If you sell inventory into the US that was produced outside of the US, it’s not US-sourced, it’s foreign sourced. And hence, you don’t even need the treaty, correct?
Peter Harper: Correct. Yeah, and this is the biggest thing in the Internet world and you’ve taken this example, you’re sending stuff in. But for a lot of people, treaties aren’t relevant because if a transaction is happening on a server that sits in Dubai or sits in some other location, right, and you don’t have any physical footprint in another jurisdiction, then you’re not going to have any US sourced income.
Heide Robson: Fair point.
Announcer: Question Five: State versus federal taxes.
Heide Robson: General question: Do you only cover federal tax or do you also look at state tax? And if you also look at state tax, do you cover all states, or are there certain states that feature much heavier in your work than others?
Peter Harper: We have offices in California, Florida, but most folks that are working in this space… I mean, the tax software is so strong these days that a lot of the state tax rules are kind of automated into the platform. This is as far as tax preparation goes, and there is a certain level of harmonization with respect to the state rules. The jurisdictions that we do most of our work in Florida, New York, California, (and) Texas, it’s just by virtue of where that’s where most of the Australians jurisdictions, (or) most of the Australians are.
Heide Robson: Yes. Going back to the three scenarios we had, the three types of businesses being e-commerce, software, or an actual business in the US; for the first two, federal tax doesn’t really matter so much because it’s not taxable in the US because you don’t have ECI or FDAP, so federal tax is usually zero where, really, the music is playing a state tax. Do you agree?
Peter Harper: 100%. So this is the biggest area, and we don’t actually get involved very regularly with e-commerce businesses or with businesses that are not going to have some physical footprint just because there can be a huge amount of risk around state income tax and definitely around state sales tax.
Peter Harper: So that state income tax still has a lot of more industrial-type components when it comes to determining whether you have nexus to a particular state. But state sales tax is very much driven by where the customer is based. There was a very substantial case called Equal Weight Fair a number of years back, which really sort of set the benchmark for this. And it’s actually the single biggest tax issue that we see pre-transaction when folks are selling businesses, right, where they haven’t properly or adequately complied with their sales tax obligations, which can subsequently result in discounts to market values under tax warranties.
Heide Robson: So you’re saying of the two main state taxes, which are income tax and sales tax, sales tax is usually the much bigger issue.
Peter Harper: Correct.
Heide Robson: And income tax is often not such a big issue because of this public law, 86 to 72. So as long as you don’t have a physical presence and you just sell your product, be it a physical product or software, etc., then you’re usually exempt from income tax. Is that why?
Peter Harper: Yeah, correct.
Heide Robson: So beware the sales tax.
Peter Harper: Beware of the sales tax. That’s right.
Announcer: Question Six: Corporate tax residency.
Heide Robson: Tax residency in the US seems to only be a word for individuals, but for entities, that doesn’t really seem to be this concept of tax residency, correct?
Peter Harper: It is the case. So under the US law, a corporation will only be a resident of the US if it’s incorporated in the US. The only way a foreign entity can be taxed in America is if it has a permanent establishment and effectively connected income, or if it’s not from a treaty country, it’s got a US trade or business. So yeah, the notion of a central management and control that you have in Australia is not something that’s a readily understood notion for US corporate tax advisors.
Announcer: Question Seven: Single member LLC with ECI.
Peter Harper: One other thing I think that’s really critical here that I’d seen that (I) just kind of made notes on it, because you’d asked about it, is this: the biggest area where we see the residency question, and actually probably the single biggest area of risk I think for Australians that own US LLCs, is around residency risk, (or) Australian residency risk for US LLCs.
Peter Harper: So what’s often the case? Someone will send me some documentation; they’ve got a US LLC, the single member LLC. So one owner, they’re also the manager, so the director or equivalent. And in that scenario, what else can you be but essentially manage a control from Australia? It’s beyond question. And so the impact of that is if it’s a resident of Australia, it’s not a hybrid for the purpose of Division 770.
Heide Robson: Yes, the foreign hybrid rules don’t apply?
Peter Harper: Yeah, the foreign hybrid rules don’t apply. So you’ve got this scenario where if it’s generating US-sourced income, you’ve got this situation where you don’t have the foreign tax, the FITO don’t flow through, right? You get a FITO mismatch, and you’re effectively going to be treated as though you’re paying an unfranked dividend out on an Australian shareholder, which can result in an effective tax rate in the sort of early sixties if you’ve got income that’s being generated in a high tax state of the US.
Heide Robson: So if you have a single member LLC that does have ECI, then the single member is liable to pay tax on this ECI in the US. So in our case, This would be the Australian Propriety Ltd who is paying US tax in the US. But then the LLC is also a tax resident in Australia, so the LLC has taxable income in Australia, and the LLC didn’t pay any tax. Hence, the LLC doesn’t get a FITO, and the Australian entity paid tax. But it wasn’t for tax that actually the Australian Propriety Ltd derived. Hence, the Australian Propriety Ltd doesn’t receive a FITO either. Is that what you’re saying?
Peter Harper: Yeah. And the same, similar thing would happen is you have an Australian company as the owner. I think it’s, it’s even more of a common mismatch if it’s an individual.
Heide Robson: Is it not possible to marry the two? Because I think there was a case in England where a similar problem occurred and the English court decided that it is possible to kind of marry the two, especially since the LLC income will flow into the Australian entity, be it an Australian Propriety Ltd or an English (one).
Peter Harper: Think the – I think about it in the context of Australian Propriety Ltd, it’s less of an issue because you’ve got an Australian company, you’ve already paid tax in the US, so there’s not more tax at the entity level. And then what you would have is you’d have a dividend going from company to company from Australia, which wouldn’t necessarily create an issue under Australian law.
Peter Harper: But there’s an issue if it’s an individual owner; if it’s an individual owner, I don’t think there’s a solution because I think the flow on effect is that you’ve got this situation, because the way that the rules work. And this is often the case that we will see the accounting done for these things where all the profits being pulled out each year, but it’s clear that they’re an Australian resident. So when the profits being pulled out, if it’s an Australian resident company, how is that treated, right? It can only come out in one way and that’s the non-frank dividend.
Heide Robson: If you have this scenario where you have an LLC that is 100% held by an Australian Propriety Ltd and you have ECI and hence you’re paying tax in the US, then you would just have the LLC declare a dividend within the financial year so that the Australian Propriety Ltd has income on which it basically paid tax?
Peter Harper: Correct, yeah.
Heide Robson: But if you have an Australian Propriety Ltd that is holding the LLC, then we also have the issue of branch profit tax, correct?
Peter Harper: Correct.
Heide Robson: But branch profit tax only applies if the LLC has ECI, correct, or FDAP?
Peter Harper: Correct.
Heide Robson: If the income is in this third bucket, it’s neither for FDAP nor ECI. Then we don’t have the issue of branch profit tax, correct?
Peter Harper: Correct.
Heide Robson: And if the individual is holding the LLC, the good point is that we don’t have a branch profit tax. But the bad point is that if the LLC pays tax in the US, then you basically pay tax again. That’s what you’re saying, correct?
Peter Harper: Yeah, what I’m really saying is I don’t see how when you’ve got a single member LLC owned by an Australian resident, I just don’t see how it can not be an Australian resident company. The only way to change that is to appoint an independent director or- sorry, manager in the US and segregate the general nature of those types of entities. Is that that’s just often not the case. They’re kind of managed that way, but it’s a big issue.
Heide Robson: And the treaty doesn’t address this, correct?
Peter Harper: Absolutely not, yeah.
Heide Robson: I had three big learnings in this episode:
Heide Robson: Number one: look at the payback period to determine whether to send debt or capital to your US operations. If the payback period is short, do debt. If it is long, do equity. And also consider the tax leakage the Australian entity might have if you have a company in your structure. The Australian entity pays withholding tax on the interest income from debt funding, and the resulting FITO might get lost, putting strain on the cash flow in Australia.
Heide Robson: Number two: having the borrower cover the withholding tax out of their own pocket doesn’t protect you as the lender from tax leakage, since that additional payment just counts as assessable income anyway, and then creates a circle of reference and hence, it gets very messy. So avoid adding withholding tax on top of interest, and instead, have it deducted from interest. So if you go back to the example we used in the interview, we had interest payments of $500,000, so then have the borrower withhold $50,000, and then transfer $450,000 to you. So don’t do any funny business with your withholding tax, don’t add it to the interest payment, etc. It gets very confusing and you end up with circular references.
Heide Robson: Number three: avoid an individual holding a single-member LLC. If you expect the entity to have ECI in the US and, hence, (have) to pay tax in the US, the single member LLC held by an individual has a FITO mismatch that has a high chance of resulting in double taxation. And the reason is that the single member LLC will be most likely an Australian tax resident, and then you have a mismatch of who has the income and who has paid the tax. If you have a company holding the single member LLC, then the Australian company pays branch profit tax of 5%. But you can avoid a FITO mismatch by declaring a dividend from the LLC to the Australian Propriety Ltd in that year. And that avoids the FITO mismatch because the Australian Propriety Ltd will have dividend income on which it paid US tax. So it gets a FITO. But, of course, you still have a tax leakage nevertheless when you distribute from a company.
Heide Robson: So it all comes down to whether you expect to have ECI in the US. If you expect to have ECI, avoid a single member LLC held by an individual and to avoid tax leakage altogether, avoid a company in your setup.
Heide Robson: In the next episode, Episode 358, let’s go to a mini series I have wanted to do with you for a while, and that is how to set up your overseas team. Over the next two weeks, five listeners will talk about the trials and tribulations they face with different setups overseas. And in the episode thereafter, I will share with you the little I know about how to actually set up your team. Your own team, without a provider in between a provider like tour or similar, but a team that is directly employed by you. So that is the plan for the next three weeks.
Heide Robson: Until then, thank you for listening, and thank you to Class for their support. Bye for now, and see you in next episode.