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Here are 6 US – AU tax questions and 6 helpful answers.
US – AU Tax Questions
Peter Harper of Asena Advisers will discuss six US – AU tax questions with you in this episode. Here is what we learned but please listen in as Peter explains all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
US – AU Tax Questions
When you structure across the US – AU border, you easily run in to the following six questions.
1 – Debt or Equity
Should you send debt or equity across to your US operations?
When you set up a physical presence in the US – an actual operation and not just a 3PL warehouse for your e-commerce business and not just a virtual presence for your professional service business – so when you set up a physical footprint, you need funds in your US bank account. From nothing comes nothing.
But do you send the funds as debt or equity? The answer depends on how soon you expect to see your money come back.
Timing
Long-term you want to see the funds you send to the US coming back to Australia. But how soon?
What is your payback period?
Your payback period will determine whether you are better off sending debt or capital across to the US.
When an Australian business sets up a new operation in the US, it effectively is a start-up. It starts with a substantial capital outflow and after that will generate a loss and hence a negative cash flow for quite a while, before you might get out of the red.
The question is how soon you expect a positive cash flow. How soon will the US operation will be in a position to repay the money you sent over?
If the payback period is short, you do debt. If it is long, you do capital.
Debt Funding
Debt funding allows you a more efficient repatriation of funds. You just pay the loan back when you are ready.
The downside is that you need to pay market interest rates to qualify under Australia transfer pricing guidelines. And probably have tax leakage through the 10% withholding tax on these interest payments. How much pressure is that tax leakage going to put on the business?
In theory, you also need to consider the thin capitalisation rules – limiting the deductibility of debt. But the thin capitalisation rules have very high thresholds, so most of us can ignore these.
Capital Funding of a C-Corp
A C-Corp can only return capital when no retained earnings are left. Meaning you first need to pay out all retained earnings through dividends before you can repatriate capital.
So it is much easier and more efficient to repay debt than capital.
Capital Funding of a Multi Member LLC
For single-member LLCs you have the Loss Limitation Rules in the US.
In a multi-member LLC every partner has a basis – a cost base. That’s the amount you paid into the partnership as capital. When the LLC operates at a loss, the proportionate loss allocated to you reduces your cost basis under the US Loss Limitation Rules.
So neither scenario is ideal. The best outcome would be that the US operation requires as little capital or debt as possible.
2 – Debt to Blocker or LLC
When you have a C-Corp blocker holding an LLC – would you lend to the blocker or directly to the LLC?
You lend directly to the LLC. From a US perspective, the loan would be deemed to be made to the branch anyway.
3 – Withholding Tax Paid by Borrower = Assessable Income
When the borrower pays the withholding tax, does this mean you forego possible tax leakage or does the withholding tax go into your assessable income?
Let’s say a loan contract between an Australian Pty Ltd and a US C-Corp stipulates the following: The Australian Pty Ltd lends $10m to the US at 5% interest, so $500,000 per annum. The withholding tax on this interest income is $50,000 – 10% thanks to the US – AU treaty. So in theory the US borrower would transfer $450,000 to the Australian lender and $50,000 to the IRS.
But the contract stipulates something different. The US borrower agrees to pay the withholding tax out of its own pocket. So the US borrower transfers $500,000 to Australia and $50,000 to the IRS. The intention is to protect the Australian entity from any tax leakage.
Would this work?
The answer is: No, not like that. For two reasons.
1 – The Pty Ltd’s assessable income is interest payments + withholding tax. As a result, the assessable income would be $550,000 and then a FITO of $50,000. So this setup doesn’t avoid potential tax leakage.
2 – The WHT applies to the full amount the borrower pays, so in the example $500k plus $50k. 10% of that is $55k and …voila you have a circular reference.
So in summary, transferring the WHT to the borrower doesn’t remove the issue of tax leakage.
Technicalities of Withholding Tax
You probably already know this, hence just quickly: The interest is US-sourced income (FDAP) since the payer is in the US. Withholding tax is 30% per primary US tax law but then gets reduced to 10% by the US – AU treaty
The lender completes a W8-BEN or W8-BEN-E advising the borrower of its US tax status referring to the relevant article and tax treaty.
The borrower completes a form and submits the form plus withheld tax to the IRS.
4 – Treaty Relevant or Not
For a lot of Australian businesses the US – AU treaty is irrelevant. As long as you don’t have a physical presence in the US, you most likely don’t have any tax nexus – unless you derive FDAP – and hence don’t need the treaty.
If a transaction happens on a server in Australia or anywhere else in the world outside the US and you have no physical presence in the US, you have no US tax obligation – unless you derive FDAP.
When you manufacture inventory outside of the US and then sell it in the US, you don’t need the treaty either. The income is foreign-sourced and hence – unless you have a US Trade or Business that generated this income – not assessable in the US.
5 – Federal versus State Taxes
For e-commerce, software and other professional services, federal tax is usually zero, because the income is either sourced outside of the US or neither FDAP nor ECI.
So the music plays at state level, because the individual states in the US do not accept double tax agreements. So even though you don’t pay any federal income tax under the US – AU treaty, you most likely will still pay sales tax and possibly state income tax.
State income tax has a more industrial type component, whereas sales tax is driven by where the customer is based.
Even though sales taxes are automated on most sales platforms, they are usually by far the bigger issue – not just for Australian businesses in the US but for all. When an Australian-owned US operation is to be sold, unpaid sales tax is often the biggest pre-transaction issue – resulting in a hefty discount on the sales price.
Based on anecdotal evidence most Australian businesses end up in Florida, New York, California or Texas.
6 – Corporate Tax Residency
Putting FDAP aside, a foreign entity can only be taxed in the US is if it has a permanent establishment and ECI or – if it is from a non-treaty country – if it has US Trade or Business and ECI.
The Australian notion of Central Management and Control (CMC) is not really understood by US tax advisers, since foreign to their concept of corporate tax residency.
7 – Single Member LLC with ECI
The biggest issue around corporate residency is around single member LLc with ECI income.
Where you have a single member LLC – so one owner and also just that one manager / director – you have central management and control (CMC) in Australia. There is just no way around it.
With CMC is in Australia, the LLC is an Australian tax resident and hence the foreign hybrid rules in Subdiv 770 ITAA97 don’t apply.
If the LLC now has ECI in the US, the single member pays the US tax on it. But in Australia you have two companies and a FITO mismatch. The single member paid income tax for income it didn’t derive under Australian tax law, hence no FITO.
And the LLC has income but didn’t pay any tax, hence no FITO either. The LLC pays an unfranked dividend to its sole shareholder. As a result you are looking at an effective tax rate of around 60%. US federal income tax + US state income tax + 25% Australian corporate tax.
Corporate Single Member
If the single member is an Australian Pty Ltd, you have a way out. The LLC pays out the ECI as a dividend to the single member in the same income year. And now the Australian Pty Ltd has income on which it paid tax.
Individual Single Member
However, if the single member is an individual or trust, then there is no way out. You have a FITO mismatch and no solution. The US – AU treaty does not cover this issue.
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So this is a short summary of what we took away from this interview. But please listen in as Peter explains all this much better than we ever could.
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Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 01 August 2022
Tax Talks spoke to Peter Harper - CEO at Asena Advisors - for more details.
