Many U.S. government contracting companies are continuing to expand their global footprint by performing contracts in other countries. The opportunity to engage in cross-border business activity on a global scale may lead to significant growth in revenue. The cost to implement an infrastructure in a foreign country will impact the profitability of a contract. It is often necessary to comply with certain foreign tax, accounting, business licensing, and regulatory requirements in the country where a contract is performed. Additional specialized U.S. international tax reporting requirements also could apply.
It is possible to mitigate certain risks by planning in advance before the contract begins in the foreign country. These risks may include noncompliance with foreign corporate income tax return filing requirements, foreign payroll tax reporting, value-added tax requirements, business licensing, labor laws, and other regulatory requirements in a foreign country. Noncompliance with U.S. international tax reporting rules also may result in significant penalty risk.
When the U.S. and foreign compliance issues are overlooked in the process of performing a contract, this is usually questioned in the merger and acquisition due diligence process for an eventual sale of the U.S. company. In any thorough M&A due diligence process, there will be a focus on U.S. federal, state and local, and international tax compliance. The international tax due diligence analysis will consider compliance with U.S. international tax rules and foreign tax requirements in foreign countries.
One of the most significant issues is whether the U.S. government contractor is considered to have a taxable presence in a foreign country. Many U.S. government contracts are performed on a U.S. military base or at a U.S. embassy in a foreign country. In a foreign country that has a U.S. income tax treaty in effect, the threshold question is whether the U.S. company has a taxable presence through a permanent establishment (PE) in the foreign country. Some U.S. government contracting companies may not realize that access to and use of facilities or premises on a U.S. military base or at a U.S. embassy can create a taxable presence through a permanent establishment in some treaty countries such as the U.K. This depends on the facts and circumstances of each situation. The local foreign tax rules will apply for the interpretation of the treaty in the foreign country. A Status of Forces Agreement (SOFA) such as the NATO SOFA may not necessarily provide any tax exemption or relief. When the U.S. company has a permanent establishment in a foreign country then it becomes necessary to allocate revenue and cost for the performance of the contract to the foreign country. This can lead to a foreign corporate income tax return filing requirement and a foreign corporate income tax liability. Additionally, when a U.S. company has a PE in a treaty country, this requires the filing of the U.S. federal Form 8858 for the reporting of a foreign branch with the U.S. federal income tax return.
In other countries without a U.S. income tax treaty, taxable presence is determined by the local foreign tax rules. From the U.S. tax perspective, a U.S. company could have a reportable foreign branch if there is an office or fixed place of business where employees work in the foreign country or if a trade or business is carried on in the foreign country with maintenance of a separate set of books and records.
Another common issue is whether the U.S. government contractor is required to comply with foreign payroll tax reporting for U.S. expatriate employees and local or third country foreign national employees. If the U.S. company has a PE in a treaty country then it is usually a requirement to register for and comply with foreign payroll tax reporting in the foreign country. Foreign payroll tax reporting can be required in addition to U.S. payroll tax reporting for U.S. expatriate employees working overseas. In such situations, it may be necessary to administer what is referred to as a “shadow” or parallel payroll structure in the United States and in the foreign country. The U.S. employer can allow certain tax exemptions through the U.S. payroll when U.S. expatriate employees are subject to foreign income tax withholding through foreign payroll or if they otherwise would qualify for the foreign earned income exclusion.
Other foreign value-added tax (VAT) rules also could apply when U.S. government contractors import or export equipment and supplies into or from a foreign country. Payments to independent contractors also could be subject to foreign VAT.
In some instances, a U.S. government contractor may consider forming a foreign subsidiary company to function as a subcontractor to perform the U.S. government contract in a foreign country. There are many U.S. and foreign tax considerations that are at issue for ownership of a foreign subsidiary company. These include the U.S. entity classification of the foreign company as a foreign pass-through entity or a foreign corporation, intercompany revenue and cost allocation for transfer pricing purposes, and the cross-border payroll structure. A U.S. parent company’s ownership of a foreign subsidiary company implicates many technical U.S. international tax rules. These rules determine what the U.S. tax consequences are and how information is reported on the U.S. federal income tax returns of the U.S. parent company and its respective U.S. owners.
Overall, U.S. international tax and foreign tax compliance issues may often come to light in the M&A due diligence process for U.S. government contractors. If non-compliance is discovered in due diligence this could lead to a purchase price adjustment and/or escrow holdback to account for the risk of liability.
Aronson’s team of U.S. federal, state and local, and international tax professionals have worked with many U.S. government contractors in the buy-side and sell-side M&A due diligence process. Through Aronson’s network of affiliated global accounting firms worldwide, we have the capability to help U.S. government contractors implement a compliant infrastructure in a foreign country before the contract begins.
For more information, please contact Alison Dougherty at ADougherty@aronsonllc.com or (301) 222-8262.