Worldwide: Expansion Of People's Republic Of China ('PRC') Business Operations Into The United States

Introduction

PRC businesses are increasingly looking at opportunities to expand their business operations into the United States. This article is a primer of the US tax considerations that a PRC business expanding into the United States should be aware of, as well as the relevant PRC tax implications¹.

Overview of US taxation of non-US businesses

Generally, a non-US business has three alternatives for establishing or expanding its US operations: a partnership, a branch office of the non-US corporation, or a US corporation. Below is a brief overview of the US tax rules pertaining to these structures, followed by specific analysis of each alternative.

Partnerships typically take the form of a limited liability company ('LLC') or limited partnership ('LP'). Partnerships are entities with two or more members and are fiscally 'transparent' vehicles for US tax purposes, meaning that the partnership's tax items (gain, loss, deductions, and credits) 'pass through' to the individual partners and are not taxed at the partnership level.

As a general matter, non-US persons and non-US corporations that expand operations into the US through an LP or LLC are subject to US Federal income tax to the extent that their income is (i) effectively connected to a US trade or business (referred to as effectively-connected income ('ECI')); or (ii) not connected to a US trade or business but is US-sourced and is fixed, determinable, annual, or periodical ('FDAP').

Typically, income from a business' US operations will constitute ECI. ECI is taxed at the maximum US Federal rate applicable to the type of income generated. A non-US partner's allocable share of income from a partnership (including ECI) is generally subject to automatic US tax withholding at the following rates: ordinary income (generally, income from business operations) is taxed at a maximum rate of 39.6%; short-term capital gains (i.e., capital gains from assets held for a year or less) at the same rates as ordinary income; and long-term capital gains (i.e., capital gains from business assets held for more than one year)²  at a maximum rate of 20%. FDAP income typically consists of interest, dividends, royalties, rents, etc. and is taxed at a flat 30% rate, applied on a gross basis with no deductions allowable for expenses.

If a non-US business expands through an unincorporated US branch office³  of a non-US corporation, the non-US corporation generally is subject to the maximum corporate tax rate of 35%, regardless of the character of the income. Shareholders in a non-US corporation are not subject to tax on the non-US corporation's earnings. However, a 30% 'branch-profits tax' generally is imposed on the after-tax earnings of the US branch if such earnings are not reinvested in the non-US corporation's US business. Dividends distributed to non-US shareholders are not subject to US tax.

Similarly, non-US businesses expanding through a US corporation are not subject to tax at the shareholder (ie. parent company) level until a dividend is distributed. A US corporation is subject to tax at a maximum rate of 35% on its worldwide income regardless of source or character. Dividends from a US corporation to a non-US shareholder generally are subject to 30% FDAP tax withholding by the United States (essentially mirroring the branch-profits tax applicable to non-US corporations).

The above rules generally apply in the absence of an income tax treaty. The US has a network of income tax treaties that often mitigate the tax impacts of these structures. The US-PRC income tax treaty (the 'Treaty'), in force since 1984, is one such treaty; its impact on PRC investment into the United States is discussed further below.

Overview of PRC taxation of outbound investment

As in the US, the PRC taxes its tax residents (individuals or entities) on their worldwide income. The current corporate income tax (also called 'enterprise income tax') rate is 25%. As with US corporations, all income of an enterprise is taxed at the same rate (ie. 25%) regardless of the character of the income.

Similar to the tax regimes in many countries, PRC tax laws provide that foreign sourced income qualifies for a foreign tax credit. There are two notable points about the PRC foreign tax credit system. First, the PRC has a per-country system – ie. the foreign tax credit should be determined on a country-by-country basis and the foreign taxes paid in two countries cannot be blended. This limitation aims to prevent the potential for foreign tax credit abuse. Second, the PRC foreign tax credit is limited to three corporate tiers; any foreign tax paid by the fourth tier or lower tier subsidiary is not creditable in the PRC.

Although outbound investment by the PRC is still relatively new, PRC tax laws already contain comprehensive anti-avoidance rules. The most significant rules in this area are the anti-deferral controlled foreign corporation ('CFC') rules. A CFC in the PRC is defined almost the same as a CFC in the US⁴, except that purely PRC individually-owned foreign entities are not CFCs because the individual PRC income tax laws have not been amended timeously. The rest of the CFC rules are, however, quite different from the US CFC rules - in short, the PRC CFC rules mainly target undistributed earnings of CFCs. Such earnings are taxed in the hands of PRC shareholders if they are kept for non-distribution without reasonable business purposes (holding for future re-investment does not constitute a reasonable business purpose).

The other set of anti-avoidance rules on outbound investment deals with the deemed PRC tax residency of foreign subsidiaries of PRC enterprises. If such subsidiaries are considered effectively managed in the PRC, they are deemed to be PRC tax residents and subject to the full 25% enterprise income tax. The main criteria used for determining whether effective management is occurring in the PRC are that the decision-makers of the company mainly reside in the PRC and that the decisions are mainly made in the PRC.

Entity alternatives for US investment

Partnerships and LLCs

Chinese businesses expanding into the US through an LP or LLC are subject to US tax on their distributable share of partnership income to the extent that they have a permanent establishment ('PE') in the United States under the terms of the Treaty. A PE generally includes, among other things, a place of management, a branch, an office, or the furnishing of consultancy services through employees or other personnel. Typically, the activities of the partnership will constitute a PE of the PRC business in the United States, although in limited circumstances it may not⁵. For the purposes of this article, we will assume the expansion of operations into the US will create a PE in the United States. Assuming the LP or LLC has a PE, it is subject to US Federal income tax under the ECI/FDAP regime discussed above.

Branch of a PRC corporation

A PRC corporation that operates in the US through an unincorporated branch or a wholly-owned LLC, is subject to US Federal income tax at the entity level at the maximum corporate rate of 35%, regardless of income character. Importantly, the 'branch-profits' tax noted above is eliminated under the Treaty for qualified PRC corporations that are more than 50% owned by PRC residents.

US corporations

US corporations are also taxed at the entity level and shareholders are not subject to tax until a dividend is distributed. Income of a US corporation is taxed at 35% regardless of income character. Dividends to a Chinese shareholder are subject to 10% US withholding tax under the Treaty, resulting in an effective US tax rate of 41.5% to the Chinese shareholder.⁶

Conclusion

Given the 35% corporate tax rate and 10% withholding tax on dividends, a US corporation is generally not an optimal vehicle for a PRC business to expand operations into the US from an after-tax perspective (although there may be other non-tax reasons that a US corporation is otherwise desirable). The two remaining alternatives - a partnership or a branch of a PRC corporation - could each be attractive choices depending on the expected character of income to be earned from US operations.

If US operations are expected to yield significant long-term capital gains, an LP/LLC structure may be the best alternative, as the gains would be subject to a lower effective tax rate (20%) than if they were earned through a branch of a PRC corporation (35%).

However, if most income from operations will be ordinary income, a LP or LLC structure would result in a higher tax rate (39.6% versus 35%). The elimination of the branch-profits tax under the Treaty makes expanding through a branch of a PRC corporation attractive in these circumstances, since there will be no US tax on cash distributed by the branch to the PRC corporation (essentially equivalent to a tax-free dividend).

Lastly, because of the per-country limitation and three-tier limitation under the PRC foreign tax credit rules, and further due to the strict anti-avoidance rules, PRC investment into the US through a holding company in a third country may not generate any PRC tax benefit. Moreover, such a holding structure could be punitive from a US tax perspective. This would be particularly true for a Hong Kong holding company structure where a PRC enterprise invests in the US through a Hong Kong holding company (a structure preferred by a lot of PRC business executives). Since Hong Kong does not have a tax treaty with the US, the dividends paid to a US subsidiary would be subject to a 30% FDAP US withholding tax, versus 10% under the Treaty. In short, making PRC investment into the US directly would be preferred from a tax perspective in most cases.

Footnotes

1 US state and local tax consequences may also apply, but such taxes are beyond the scope of this article.

2 Capital gains in this context typically include gains from the sale of assets 'used' in the trade or business, but do not include gains from the sale of inventory or certain intellectual property.

3 Note that a wholly-owned LLC is treated the same as an unincorporated branch for US Federal income tax purposes.

4 For US purposes, a CFC is a foreign corporation of which more than 50% of the stock (by voting power or value) is held by a US shareholder holding at least 10% of the shares (by voting power or value) of the corporation.

5 For example, a PE does not include an office or branch which carries out solely 'preparatory or auxiliary' services. Therefore, expansion into the US to perform such marginal activities may not constitute a PE for purposes of the Treaty.

6 Effective tax rate is calculated by taking 35% of taxable income, then 10% of the remaining after-tax income. For example, on taxable income of $100, a US corporation would pay tax of $35; the remainder ($65) would be issued as a dividend, subject to 10% tax withholding ($6.50). The total tax payable on the $100 of income is thus $41.50, or 41.5%.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.