Non-US businesses face a variety of complex tax burdens when they choose to do business in the United States. A number of federal and state compliance and substantive tax obligations make doing business in the US potentially quite challenging, especially in California. However, many tax incentives exist that can mitigate the effect of some of these burdens. For example, taxpayers may find that doing business in locations outside the cities of Los Angeles and San Francisco can help them avoid the higher tax burdens existing in those cities. In addition, California offers a number of credits and incentives to taxpayers who conduct business in certain and certain specially designed zones. Of course, any non-US business must also consider the federal income tax consequences of doing business in the US but in many cases non-US taxpayers can take advantage of planning opportunities to reduce or possibly eliminate their US federal income tax liabilities. This article will review some of the most significant tax burdens and potentially planning benefits that non-US businesses may face in establishing a presence in the US through California.
In addition to California ranking as the world’s eighth largest economy in 2014, it is a gateway to numerous Asian and PanPacific investors and new companies entering into the United States. California’s economic gains were boosted by technology both in Silicon Valley in Northern California and in Silicon Beach located south of Los Angeles. In addition, tourism, trade and the resurgence of construction have further bolstered the California economy. The Golden State’s GDP of $2.203 trillion now ranks behind Brazil but ranks ahead of Russia and Italy in terms of GDP.1 While the technology sector was the leading driver of GDP growth, California saw a turnaround of manufacturing and increased agriculture (“ag”) and exports of ag products.2
California Economic Considerations
When planning to establish or expand business operations within California, taxpayers should engage a competent tax advisor and the relevant California state government officials. The Governor’s Office of Business and Economic Development (GO-Biz) encourages business owners and companies that will do business in California to apply USA: Businesses entering and investing into the United States through California — 2015 for qualified credits and incentives such as the California Competes Tax Credit. California is set to provide $151 million in tax credits in the fiscal 2014 year to small, medium, and large companies across the state. Last fiscal year, GO-Biz awarded $28.9 million to 29 companies that are planning to cumulatively create 6,000 jobs and invest more than $2 billion in California. California has several business credits and incentives for doing business in California and/or supporting its economic development and job growth. Some of California’s current credits and incentives are listed below: 3
- The California Competes Tax Credit is an income tax credit available to businesses that want to come to California or stay and grow in California. Unlike the Enterprise Zone program this program applies statewide. Thus, there are no geographic restrictions
A partial exemption from sales and use tax exists for certain manufacturing, biotechnology and research and development equipment purchases. The partial exemption applies only to the state sales and use tax rate portion, currently at 4.1875 percent. The exemption does not apply to any local, city, county, or district tax
A full sales tax exclusion from both state and local sales tax collection on equipment purchases exists for qualifying businesses that conduct qualifying activities (Advanced Manufacturing & Transportation and Alternative Energy). Sales tax rates vary by jurisdiction(typically 7% to 9.25%)
The New Employment Credit(NEC) is available for each taxable year beginning on or after January 1, 2014, and before January 1, 2021, to a qualified taxpayer that hires a qualified full-time employee on or after January 1, 2014, and pays or incurs qualified wages attributable to work performed by the qualified full-time employee in a designated census tract or economic development area, and that receives a tentative credit reservation for that qualified full-time employee
Corporate income tax credits are available to companies that have incurred qualified research & development expenses in California
A cash reimbursement for employment training costs incurred by employers set by a pre-determined two-year performance based contract is available. Contracts may vary based on number of employees enrolled, hours of training,training material and employee wages.
The California Small Business Loan Guarantee Program (SBLGP) assists businesses with the creation and retention of jobs while encouraging investment into low- to moderate-income communities. The SBLGP enables small businesses to not only obtain a loan it could not otherwise obtain but more importantly helps to establish a favorable credit history with a lender so the business may obtain loans in the future on its own without the assistance of the program.
Choice of Entity for Conducting Business in the United States
Non-US persons (“persons” hereinafter will refer to businesses and natural individuals) generally choose to do business in the United States in the form of a C corporation, a single member disregarded LLC (one non-US owner), or in certain circumstances as a US (domestic) partnership. Non-US persons (i.e., foreign shareholders) are precluded from owning a subchapter “S corporation.”
i. The C Corporation
Generally, C corporations are taxed on their business income at the entity level and the highest federal corporate income tax rate is currently 35%, regardless of whether the corporation makes distributions to the shareholders/owners. California’s corporate income tax equals a flat rate of 8.84%. Some of the benefits of operating as a C Corporation are: (i) limited liability for directors, officers, shareholders, and protection from employee lawsuits; (ii) corporations maintain perpetual existence even if an owner leaves the company; (iii) there is no limit to a corporation’s growth potential through the sale of stock(e.g., growth through common stock or equity).
There are other benefits resulting from structuring a US investment or US business operation as a C corporation. A business that needs substantial start-up and/or expansion capital may turn to venture capitalists for assistance. Usually, such financiers are interested in providing money for businesses organised as C corporations because there is more flexibility in structuring ownership arrangements. If there is the potential for growing the business to such a level that it can attract financing by becoming a public company traded on a national exchange (such as the New York Stock Exchange), the business must be a C corporation. Lastly, aside from the opportunity for shareholderemployees to obtain tax-free fringe benefits, C corporations have the ability to accumulate earnings for future expansion at a lower tax cost than other types of entities.
Some disadvantages of using a C corporation are: two levels of taxation - tax at the entity level and again upon distribution of profits at the shareholder level. For non-US shareholders, there is a statutory withholding tax upon distribution of dividends or interest, among other categories of income. The corporation must report and withhold tax on dividend distributions and other categories of fixed, determinable, annual, or periodical (“FDAP”) income such as interest, rents, royalties and US source service payments made to non-US persons (foreign shareholders). The US statutory withholding tax rate of 30% on these income items may be reduced or eliminated by an applicable income tax treaty.
Corporations have somewhat rigid corporate requirements imposed by State authorities (e.g., corporate compliance, board meetings / minutes, maintaining corporate records, hiring Directors, and observing other state law formalities). In addition, there are a series of tax forms that may need to be filed with federal, state, and even local officials, including corporate taxes, taxes on salaries and other employee compensation(Forms W-2), and interest and profit distributions (Form 1099-DIV and Form 1099-INT. A US corporation must file IRS Form 1120 to report its US business income for federal income tax purposes. The various tax forms and schedules for corporations can be complicated and may require the assistance of experienced and relevant tax professionals. In addition, corporations have to pay federal income taxes by March 15, one month before the individual federal tax filing deadline.
ii. The Limited Liability Company (“LLC”)
To receive pass-through treatment for profit distributions and expense/ loss items, one may form a limited liability company (LLC). Unlike C corporations, limited liability companies do not pay entity level tax unless the LLC elects to be classified as a C corporation for federal income tax purposes. An LLC with only one member, otherwise known as a single member LLC, is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes). As a result, the owner of a single member LLC must file a US federal income tax return taking into account the LLC’s income andexpense items. An LLC provides limited liability protection to its members (owners), but with fewer formalities and other requirements that apply to C Corporations. Also, while a C corporation may be regarded as a “blocker”, shielding non-US persons and shareholders from filing a US income tax return, an LLC’s profits and losses flow through to its owners.
The federal branch profits tax (“BPT”) treats a US branch (e.g., an LLC) of a foreign corporation as if it were a US subsidiary of the foreign corporation for purposes of taxing repatriations of profit. As such, the BPT puts the earnings and profits of a branch of a foreign corporation deemed remitted to its home office on equal footing with the earnings and profits of a US corporate subsidiary paid out as a dividend to its foreign parent.
The BPT is calculated and paid by the foreign corporation (shareholder or owner) on a Form 1120-F (U.S. Income Tax Return of a Foreign Corporation). The BPT applies regardless of whether the US trade or business of the foreign corporation is substantial compared to its worldwide activities. Thus, a foreign corporate owner of an LLC may need to file a US federal and state income tax return, and pay a “branch profits tax,” equal to 30 percent of the “dividend equivalent amount” when such
amount is distributed to the LLC’s non-US owners.4 Nonresident alien individuals and complex trusts are never subject to the branch profits tax. The branch profits tax generally applies to foreign corporate entities doing business in the US through a branch and thereby generating effectively connected income, including where a foreign corporation conducts a U.S. trade or business through an LLC. However, the branch profits tax rate may be reduced by an applicable income tax treaty.
For California state tax purposes, a branch most often operates as a C corporation subsidiary of the foreign parent / operation. A branch doing business as an LLC in California, while a flow through entity, is subject to tax at the entitylevel unlike for federal income tax purposes. The LLC is subject to the LLC fee on its income derived from or attributable to California. Fees are graduated as follows: $900 if income derived from or attributable to California is $250,000 but less than $500,000; $2500 if income derived from or attributable to California is $500,000 but less than $1 million; $6,000 if income derived from or attributable to California is $1 million but less than $5 million; $12,750 if
income derived from or attributable to California is $5 million or more.
iii. The Domestic (US) Partnership
As LLCs, partnerships do not pay entity level tax. Partnerships are otherwise regarded as fiscally transparent or flow-through entities in the United States. The partners are taxed on their share of income, regardless of distributions. Partners may deduct partnership losses to the extent of basis. Exemption from entity level taxation is a key advantage of partnerships. In addition, partnerships provide significant flexibility to allocate income and expense in a variety of ways to accommodate complex business arrangements. The key disadvantages of doing business through a partnership are: limited liability for some, but not all partners; raising capital may be more difficult; and complex rules apply to keep track of partnership capital and for other purposes. For example, IRC Section 875 provides that any non-US person shall automatically be considered as being engaged in a trade or business within the United States if it is a partner in a US partnership that is engaged in a US trade or business.5 The foreign partner will then have to allocate and apportion effectively connected income to the US trade or business, pursuant to the Internal Revenue Code, Treasury Regulations, US case law, and IRS Rulings.
A partnership must file an annual federal tax return (Form 1065) to report income, deductions, gains and losses from its operations. Although it does not pay income tax, it must provide its partners with a Schedule K-1 reporting the partner’s allocated share of income and expenses. In addition, foreign partners may be subject to withholding tax on distributions of effectively connected taxable income (“ECTI”) from the partnership.6 For California purposes, a partnership is also subject to the minimum $800 franchise / privilege tax but is otherwise treated substantially similar to how it is treated for federal income tax purposes.
iv. Choice of Entity Summary
Generally, foreign investors establishing US operations, with employees physically in the US, and anticipated revenue from the US market, operate in the form of a C corporation. Other favorable factors for operating as a C corporation include whether the foreign investor is located in an income tax treaty jurisdiction with the US, such as Australia, Canada, China, the UK, etc., and if whether there are affirmative plans to reinvest corporate earnings into the US business.
California State Taxation
ii. California Franchise / Income Tax
Foreign investors must be aware of California’s taxing schemes. All businesses are subject to the franchise tax (for the privilege of doing business) or the complimentary income tax (for California source income) at a flat rate of 8.84%. Banks and financial corporations are subject to a separate tax on their business revenues at 2% more than the franchise tax rate or 10.84%. Individuals considered residents are subject to the personal income tax on income from ALL sources, while non-residents are tax on revenues from business or services performed within the state. Tax rates are graduated up to a maximum of 1% to a maximum of 13.30% on taxable income in excess of $1 million.
California largely conforms to the federal Internal Revenue Code as it relates to items of income, deductions and exclusions. California uses federal taxable income as its starting point and then makes modifications in calculating California state taxable income. Differences between federal and state remain including differences in depreciation expense, bonus depreciation, capital gain or loss treatment, net operating losses and tax credits among others. Unlike for federal tax purposes where the foreign investor reports income that is effectively connected to the United States, California requires that a multinational taxpayer compute their California tax based on world-wide income unless the taxpayer elects to report income on a water’s-edge basis.7 Foreign investors that make this election report income from sources solely within the United States. Foreign investors must undertake a water’s-edge analysis and project whether US operations or foreign operations will be profitable within the 84 month election period to determine whether an election is favorable.
Foreign investors must be aware that if their US operations conduct business in multiple states including California, they must apportion their income among the states that the business operates.8 Crucial to the foreign investor’s ability to maximize their tax position is an understanding of California’s unitary tax concept9 and apportionment methodologies. California uses a single apportionment factor of sales to measure business activities attributable to the state.10 Moreover, there exist distinct sales factor sourcing rules based on whether the foreign investor is engaged in the business of selling services or goods. The foreign investor must be informed of the nuances of these sales factor sourcing rules to achieve accurate tax reporting and avoid over stating their tax liability.
The state of California does not have a single department of revenue. Rather multiple agencies must be contacted to begin business in the state and are listed below:
- Office of the Secretary of State (www.sos.ca.gov) - incorporation, entity formation, registrations to do business.
- Franchise Tax Board (www.ftb. ca.gov) - personal, corporate and business taxation matters and registrations.
- State Board of Equalization (www.boe.ca.gov) - sales and use tax matters, seller’s permits.
- Employment Development Department (www.edd.ca.gov) - employer and employee payroll taxes, state unemployment insurance matters.
ii. California Sales and Use Tax
Unlike most other countries, the United States does not have a national sales tax, or a national indirect tax, such as the Value Added Tax (VAT), or the Goods and Services Tax (GST). However, most states impose sales and use tax on the sales and transfer of goods and services. Each of these states however, separately defines what is subject to tax and provide for many exemptions from tax such as food items, medicines, agricultural machinery & equipment. Tax compliance, collection and remitting tax, rates of tax widely differ among state and local jurisdictions.
In California, sales tax generally applies to the sale of retail items and goods within the state. The use tax applies to the use, storage, and other consumption of those same items within California purchased from out of state. California services for the most part are nontaxable when separately stated in the invoice when goods are also sold with the services. For example, the purchase of computer hardware and installation set up is all subject to tax in a bundled invoice. However, the installation and set up services are not taxable when separately stated on the purchase invoice. While the “base” California state sales tax rate is 7.50%, cities and counties may assess additional “district taxes,” which increases the combined state & local rate to upwards of 9.5%. Fortunately, for the foreign investor, compliance is made easier as a single tax return is filed on behalf of all California jurisdictions.
The foreign investor is initially faced with deciding whether the nature of their California business activities require them to register as a “seller” of goods and to estimate the volume of their sales to begin monthly or annual filings.
iii. California Property Tax
The foreign investor should be aware that California does not impose a general ad valorem tax on real and personal property. Rather, local counties and special districts administer this tax. The overall rate of property taxation is limited to 1% of “full cash value” and is assessed on business property and real property, which includes land, building and improvements. Resale of inventory and raw materials are exempt from the tax.
iv. City of Los Angeles Business Tax
Los Angeles City Business Tax (“LACBT”) is generally imposed on all businesses for the privilege of engaging in business within the boundaries of the City of Los Angeles.11 The tax is measured on gross receipts attributable to business activities conducted within the City of Los Angeles. The foreign investor must consider whether having a Los Angeles address is in their best interest as a seller of goods or services. Having business activities outside the city allows the business to exclude from the measure of tax receipts that are otherwise attributable to Los Angeles. Apportionment methodologies exist depending on the nature of the business. A Tax Registration Certificate / permit from the City Office of Finance is required
for each business location in the city. A new business will receive annual renewals (i.e., tax returns) which are due on or before February 28th of every year. The annual tax liability is based on the preceding tax year’s gross receipts. The foreign investor may file for an exemption from the gross receipts tax under the “New Business Exemption”.12 The exemption is for a three-year period but timely registration and annual filing is required to maintain the exemption. The business tax rates range from 1.01% to 5.07% (per $1,000) depending on the nature of the trade or business engaged in. This classification is referred to as a “fund class” and determines the business’ tax rate. Retailers, wholesalers, multimedia business, professions & occupations and other services providers must be certain that they are appropriately classified to ensure proper taxation and liability.
v. San Francisco Business License
The foreign investor may also consider doing business in San Francisco as a major market location. Similar to Los Angeles, the foreign investor’s US business must have a valid Business Registration Certificate from the Office of the Treasurer & Tax Collector.13 Like Los Angeles, the tax is measured by gross receipts attributable to San Francisco. An entity conducting business in San Francisco must submit a Business Tax Registration application within 15 days of starting business. Generally, Business Registration Certificates are issued on an annual basis and are valid for the City’s fiscal year calendar, beginning on July 1st, and ending June 30th of the following year. All businesses with a taxable San Francisco payroll expense greater than $150,000 must file a Payroll Expense Tax Statement for their business annually by the last day of February for the prior calendar year (Jan. 1st - Dec. 31st) and must also renew their Business Registration Certificate for the next fiscal year (July 1st - June 30th) on or before May 31st if they plan to conduct business within the new fiscal year. The foreign investor must be aware of the same tax issues discussed for the City of Los Angeles.
While California is an attractive geographic location and marketplace from where the foreign investor may conduct business, California also poses many tax traps for the unwary. Diligence and compliance regarding existing and evolving federal, state, and municipal tax laws are necessary in order to avoid unforeseen tax liabilities. With appropriate tax advisors and tax planning the foreign investor may steer clear of these tax pitfalls.