S Corporations Should Consider Incorporating Foreign Branch Operations in Light of Higher Tax Rates

Lowell Yoder, Contributor to Forbes and Head of McDermott Will & Emery’s U.S. & International Tax practice writes: As I pointed out in a blog in early 2012, there are 4.5 million S corporations in the U.S.  These businesses are operated in pass-through form, where only one level of income tax is imposed on earnings and it is paid by the owners—not the corporation.  Back in August of 2012, I suggested that S Corporations should start to plan for a possible tax rate increase in 2013 if the Bush tax cuts expired].  They expired.

Beginning in 2013, the top individual tax rate—with the new Medicare Tax—will increase from 35% to 43.4% (39.6% plus 3.8%; the 3.8% Medicare Tax generally does not apply to the S corporation income allocable to shareholders who are “active” in the business).  So, I am again suggesting that S corporations consider a change to their foreign operating structure, which could substantially reduce their tax costs.

S Corporation with Foreign Operations – A Case Study

To illustrate, let’s assume foreign operations deriving $10 million of income subject to a 20% foreign tax rate.

Income derived from conducting foreign operations in a branch is subject to U.S. tax with a credit for foreign income tax.  In 2012 the tax cost of such operations was $3.5 million—i.e., $2 million of foreign tax and $1.5 million of U.S. tax.  In 2013 the tax on the foreign branch’s income will be $4.34 million—i.e., $2 million of foreign tax and $2.34 million of U.S. tax.

Alternatively, conducting the operations in a foreign subsidiary generally would defer U.S. tax to the extent the earnings are reinvested in the foreign operations (which is an important assumption in this analysis).  This structure provides a current savings of $1.5 million in 2012.  With the higher rates, the tax deferral would be $2.34 million in 2013.

U.S. tax is imposed on the earnings of a foreign subsidiary when distributed to the S corporation.  In 2012, a dividend of the after-tax amount of $8 million paid by a corporation organized in a jurisdiction that has an income tax treaty with the U.S. would generally have been subject to a 15% tax rate (with no credit for foreign taxes), resulting in a total tax cost of $3.2 million ($2 million foreign and $1.2 million U.S.).

This cost of repatriation will go up in 2013 because the tax on qualified dividends increases from 15% to 23.8% (the Medicare Tax is imposed on this dividend regardless of a shareholder’s “active” or “passive” status).  Thus, an $8 million dividend received by the S corporation would bear a total tax cost of $3.9 million ($2 million foreign and $1.9 million U.S.).  But, the total tax on profits repatriated would still be less than if the profits were subject to direct U.S. taxation (i.e., $3.9 million vs. $4.34 million).

Should an S Corporation Operate in a Foreign Subsidiary or a Foreign Branch?

As general rule, the tax savings of operating in a foreign subsidiary rather than a foreign branch will be even greater in 2013, as illustrated by the comparison below (each S corporation would need to input its specific details to arrive at the relevant numerical analysis).

Comparison of Tax Consequences

	2012
		Foreign Subsidiary
	Branch	Reinvested	Repatriated
Income	$10m	$10m	$10m
Foreign Tax	$2m	$2m	$2m
U.S. Taxes	$1.5m	$0	$1.2m
Total Taxes	$3.5m	$2m	$3.2m
Available Cash	$6.5m	$8m	$6.8m

	2013
		Foreign Subsidiary
	Branch	Reinvested	Repatriated
Income	$10m	$10m	$10m
Foreign Tax	$2m	$2m	$2m
U.S. Taxes	$2.34m	$0	$1.9m
Total Taxes	$4.34m	$2m	$3.9m
Available Cash	$5.66m	$8m	$6.1m

Note that if the foreign income tax rate is 26% or higher, the total tax cost after repatriation would be greater than if the foreign operations were conducted in a branch (ignoring the time value of money for the period of time the U.S. income tax is deferred).

What Should an S Corporation Do Now?

An S corporation’s current foreign structure might not be optimal with the higher U.S. tax rates, and, if not, consideration should be given to changing it.  Incorporating foreign branch operations can save or defer substantial federal income taxes (and possibly state income taxes).