U.S. subsidiary or branch: U.S. Tax considerations
This article is the second of a series looking at the tax aspects of an Israeli company’s U.S. activity, as its business grows. This article looks into whether a U.S. business activity should be structured as a branch or subsidiary. Certain considerations are unrelated to tax, such as increased potential liability to the Israeli company if it operates in the United States directly as a branch as opposed to a subsidiary. However, many important issues are tax driven as they have a significant impact on the “bottom line”.
First, some basic facts: the U.S. corporate tax rate is very high – 34%+ percent for any sizeable U.S. activity, plus state-level corporate tax rates of about 6-8%. In Israel, the tax rate is 25%. In analyzing the exposure to US tax, the treaty states that the US may tax the profits of an Israeli company that are attributable to a permanent establishment. Thus to save on taxes, Israeli companies seek ways to minimize the profits attributable to the U.S. and rather have the profits attributed activity outside the U.S.
If the permanent establishment is a U.S. subsidiary of an Israeli company, the U.S. tax rates are as set forth above. Plus there is a 12.5% dividend tax rate on dividends paid by the subsidiary to the parent. However, the subsidiary receives no deduction for the dividend.
If the permanent establishment is a branch, the tax rate is 34%+ as set forth above, plus a potential branch tax. A branch tax of 12.5% will be imposed on the “dividend equivalent amount” (“DEA”) of the Israeli corporation’s U.S. profits. For purposes of simplicity, the DEA for a year is the U.S. profits of the Israeli company during that year, plus the net U.S. “equity” of the company last year, minus the net U.S. equity this year (the addition and subtraction can result in a negative number in which case the DEA is reduced). U.S. equity means U.S. assets minus U.S. liabilities.
Thus, in essence, at a high level, both the U.S. subsidiary and US branch are taxed the same way.
As set forth above, a main issue facing the Israeli company is how to reduce the size of the profit pie subject to U.S. taxation, hence reducing U.S. corporate, branch and dividend taxation. By operating the U.S. business as a branch, controlling what portion of the business is attributable to the U.S. and which to Israel becomes messy, as all activity is conducted by the same entity. This factor weights in favor of a subsidiary.
Some ways of reducing profits attributable to the U.S. are branch/subsidiary neutral. For example, in manufacturing businesses, it is wise to reduce the role of the U.S. entity to a minimal – such as having it involved primarily in sales and marketing, while the “core activity” takes place outside the U.S. The essence of this approach is to apportion the “profit” so to minimize the role that the U.S. affiliate plays in the transaction. In such case, whether the Israeli company operates as a subsidiary or branch is less relevant.
However, other methods of reducing the share of profits attributable to the U.S. involve using royalties, interest or transfer pricing mechanisms to “strip” the U.S. subsidiary of income. At a high level, royalties and interest paid by a U.S. entity to an Israel parent are taxed in the U.S. at 15% and 17.5% respectfully, plus the payor gets a deduction for the payment, which is not the case with a dividend. (Note that certain interest paid by the U.S. entity to the Israeli creditor is not subject to any U.S. tax, making planning all the more valuable.)
All these tools (royalties, interest and transfer pricing) usually involve intricate contractual relationships between separate but related legal entities. As a result, entering into such agreements between separate entities (parent/subsidiary) are much “cleaner” and easier to defend than are agreements between company and its branch – which is the same legal entity.
In sum, for reasons of exposure to general and tax liability, as well as for reasons of tax savings, operating in the U.S. by way of a subsidiary is often preferred.
The next article in this serious will deal exclusively with debt/equity and interest issues between the non-U.S. parent and U.S. affiliate.
Monte Silver Monte Silver is a U.S. lawyer based in Israel specializing in U.S. tax matters. He formerly worked for the Internal Revenue Service and the U.S. Tax Court.
This article does not constitute legal advice.