Doing Business in the Us A

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Doing business in the USA


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TABLE OF CONTENTSPAGENO.

FOREWORD .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

INTRODUCTIONGeography and Population . . .. . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . .. . . . . . . . . . .. .

Political System... .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Communications and Transportation .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Services and Exchange Controls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Finance.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Grants and Incentives .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ..

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REGULATORY ENVIRONMENTAcquisitions and Mergers . . . . .. . . . . . . . . . .. . . . . . . . . . .. . . . . . . . . . .. . . . . . . . . . . ..Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Consumer Protection and Special Industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Legal Protection for Intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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FORMS OF BUSINESS ORGANIZATIONSUnited States Corporation . . .. . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . .. . . . . . . . . . .. .Branch of a Foreign Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Partnership .. .. ... .. .. .. .. ... .. .. .. .. ... .. .. .. .. ... .. .. .. .. ... .. .. .. .. ... .Limited Liability Company .. . .. . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . .. . . . . . . . . . ..Sole Proprietorship ... .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .

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TAX REGIME AND ITS DOCTRINESSubstance Over Form .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ..Transfer Pricing .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .Tax Treaties.. ... .. .. .. .. .. ... .. .. .. .. ... .. .. .. .. ... .. .. .. .. ... .. .. .. .. ... .

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TAXATION OF BUSINESS OPERATIONSTaxation of United States Resident Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Affiliated Companies and Consolidated Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Computation of Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Timing Differences and Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Debt Versus Equity. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ..Depreciation and Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Foreign Source Income Rules and Foreign Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . .

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TAXATION OF FOREIGN CORPORATIONSPermanent Establishment Rule and Business Income . . . . . . . . . . . . . . . . . . . . . . . . . . .Nonbusiness Income and the Foreign Investment in Real Property Tax Act (FIRPTA)Branch Operations and the Branch Profits Tax (BPT) . . . . . . . . . . . . . . . . . . . . . . . . . . .

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FOREIGN PERSONNEL IN THE UNITED STATESEntry into the United States . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .U.S. Taxation of Resident Aliens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .U.S. Taxation of Nonresident Aliens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Estate and Gift Tax .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ..Employees' Rights. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .

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This booklet is designed to pr ovide an overview of the business cli mate in the

Uni ted States. The discussion sur veys the many and vari ed considerat ions involved in establ i shi ng a business enterpr i se in the Uni ted States. Whi le every attempt has been made to keep thi s brochure current and concise, the rapi di ty of change and the complexity of our interrelated world mean that consultati on with professional advi sors i s indi spensable. The highly ski ll ed and dedicated professi onals of PKF l ook for ward to worki ng with you to implement your business plans. Whether i t i s in one of our l ocati ons in the Uni ted States or the many locations around the worl d, we are committed to responsiveness and dedi cated to excellence.

Although the greatest possible care has been observed i n dr awi ng up thi s publi cation, the possibil i ty always exists that certai n infor mati on has in time

become outdated or i s no longer correct. PKF, therefore, accepts no li abi li ty for the consequences resul ti ng from acti vi ti es undertaken on the basi s of thi s publi cation. Consultati on with a pr ofessional advisor remai ns necessary at all times.


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FOREWORD

This booklet has been produced as a service tothe clients of the member firms of PKFInternational Limited and as an introduction tothe fiscal and commercial environment of the

United States for those who are consideringdoing business within its jurisdiction. Thecontents are not intended to be exhaustive, andthe booklet should not be used as the basis forany decision in the complex areas of U .S.commercial and tax law. Because the laws of theUnited States are in a constant state of change,both legislatively and judicially, clients areadvised to seek specific advice from any memberfirm of PK F before proceeding with any activitiesinvolving the United States.

INTRODUCTION

Geography and Populat ion

The total area of the United States is 3,679,192square miles. The mainland stretches nearly2,800 miles from the Atlantic Ocean to thePacific Ocean and approximately 1,600 milesfrom Canada in the north to Mexico in the south.In addition, Alaska, northwest of Canada andbordering on the Arctic Ocean, and Hawaii, lyingin the Pacific Ocean approximately 2,000 milesfrom the mainland, comprise the noncontiguousportions of the United States. The population of the United States is approximately 280 million.Similar tax laws and special rules apply in theCommonwealth of Puerto Rico and the overseasterritories of A merican Samoa, Guam, NorthernMariana Islands, and the U.S. Virgin I slands.

Poli t ical System

The United States declared its independencefrom the United Kingdom in 1776 andestablished a federal republic which now consistsof fifty separate states and the District of

Columbia, the seat of government. The countryhas a written constitution; the legal system isbased upon English common law. However, thestate of L ouisiana derives its law from theNapoleonic civil code, and eight states havecommunity property laws. The federalgovernment is a tripartite system consisting of independent executive, legislative, and judicialbranches. The various states have similarstructures.

Eco n o mics

A free enterprise system coupled with anabundance of natural resources and a highlyeducated work force produced a gross domesticproduct of $9.255 trillion at the end of 1999. TheUnited States has evolved from primarily anagricultural economy in the 19th century to ahighly industrialized one for most of the 20thcentury. However, in the past few years, thecountry's orientation has become increasinglyservice based. The United States is a majorcontributor to international financial agenciesand has concluded a free trade agreement withCanada and Mexico (NAFTA). I t is also amember of the World Trade Organization(WTO), the General Agreement on Tariffs and

Trade (GATT), the Organization for EconomicCooperation and Development (OECD), AsiaPacific Economic Cooperation (APEC) and theOrganization of American States (OAS).

Comm unicat ions and Transpor ta t ion

The nation has a comprehensive network of bothinternal and external communications systems.

The transportation network for the movement of goods and services is extensive and varied.

Serv ices and Exch ange Cont ro ls

The United States has several internationalfinancial centers, with the two major centerslocated in New Y ork and Los Angeles.Washington, DC is a focal point for government-assisted financing, while Chicago, Miami, Atlantaand Dallas/Houston are major regional financialcenters. There are no exchange controls.Information returns are sometimes required onthe transfer of large sums of cash or cashequivalents.

Finance

The United States banking market comprisesseveral types of financial institutions such ascommercial banks, investment banks, savingsbanks, savings and loan associations, and creditunions. In addition, a variety of specializedinstitutions offer asset-based financing; theseinclude leasing companies, finance companies,and factoring companies. Commercial banks arethe most important supplier of funds tobusinesses. Short-term financing is usuallyarranged as a line of credit. Medium-termfinancing, generally five to seven years, is oftenused by foreign investors to begin operations inthe U.S. As a condition of the loan, a bank


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usually requires execution of a note and a formalloan agreement which may restrict the borrower'sdecision-making powers through specialcovenants. Personal guarantees and auditedfinancial statements are commonly required.Investment bankers are often called upon toarrange financing through the sale of stock, debtobligation, or commercial paper.

Grants and Incen t ives

Few specific concessions are granted by thefederal government, but perhaps the mostimportant factor is that the United Statesgovernment provides equal treatment to bothdomestic and foreign investors. While notgranting special tax packages to foreign investors,the government refrains from imposingdiscriminatory tax burdens on them. Whatconcessions or tax holidays are available aregenerally offered by state, city or localgovernments and are tied directly to investmentsin the specific jurisdiction.

When the United States negotiates tax treaties,it generally agrees to reduced withholding taxrates on dividends, interest, royalties, and certainother income. In addition, there is an exemptionfrom withholding on interest on bank andinsurance company deposits and certain portfolioinstruments. Specific tax relief is available forforeign sales corporations (FSC) which aredesigned to encourage export of U .S. products.

The relief is available to an FSC whether it isowned by United States or foreign taxpayers.

This legislation was recently repealed as a result

of complaints from the World TradeOrganization and was replaced with certainexclusions from income for extraterritorialincome. FSC provisions are grandfathered untilthe end of 2001.

REGULA TORY ENVIRONMENT

The regulatory environment of the United Statesis a combination of open competition andconsumer protection. The U.S. Constitution

contains an interstate commerce clause whichpermits the federal government to exerciseregulatory control over all businesses engaged ininterstate commerce. Residual regulatorypowers reside in the states and their localgovernmental units. Over the past few years,government policy has loosened some of theeconomic regulations which had been previouslyimposed. The policy has been to encourage thedissemination of information which allows

investors and consumers to provide discipline inthe marketplace. There are no price or currencycontrols, but a minimum wage for employees isestablished.

Acq uis i t ions and Mergers

The federal laws governing mergers andacquisitions are administered by the Federal

Trade Commission and the Department of J ustice. These laws are intended to prohibit,under certain conditions only, mergers oracquisitions which might have the effect of substantially lessening competition. In the caseof certain large transactions, advance notice mustbe given to the Federal Trade Commissionpursuant to the Hart-Scott-Rodino Act.

Securi t ies

The Securities and Exchange Commission (SEC)is the primary federal agency that regulates the

offering of securities in the United States. Oneof its primary functions is to assure full andaccurate disclosure of financial and businessinformation with respect to securities sold in theUnited States. The SEC also regulates thesecurities markets and may bring enforcementactions for improper actions taken with respectto securities transactions. A foreign investor whowishes to acquire a U.S. corporation may tendercash or issue its own securities in exchange forthe stock of the U.S. company. A tender offerrequires the foreign investor to file certaininformation with the SEC. If the acquisition is tobe made through the issuance of securities, the

acquiring company must file a registrationstatement with the SEC. All U .S. companieswhich have securities registered with the SECand all companies whose shares are listed on astock exchange are required to file periodicreports with the SEC. These quarterly andannual reports are also required of anycorporation whose stock is sold over-the-counterand which has assets of more than $10 million orat least 500 shareholders. All reportingcompanies must have their financial statementsaudited annually and reviewed by independentaccountants on a quarterly basis.

There are separate requirements for obtaining alisting on any one of the stock exchanges.Companies must also be aware that many statesalso have specific requirements for filing anddisclosure of securities transactions.

Unlike many foreign jurisdictions, no statutoryaudit requirements exist except for reportingcompanies.


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Consu mer Pro tect ion and Specia l Indust r ies

There are a number of consumer protection lawswhich are enforced by several different federalagencies, including the Consumer Product SafetyCommission (CPSC), the EnvironmentalProtection Agency (EPA ), and the Food andDrug Administration (FDA). Companies musttake notice of the various agencies which havethe authority to regulate specific products orprocesses of the firm. In addition, certainindustries are subject to regulation because of the nature of their activities. The Department of

Transportation (DOT) has jurisdiction overrailroads, trucking, water transport, and pipelinesengaged in interstate commerce. The FederalCommunications Commission (FCC) hasauthority over television, radio, and datatransmission. Banks, insurance companies, andpublic utilities are all subject to regulation at thefederal level and, in most cases, also at the state

and/or local level.

Legal Pro tect ion fo r In tang ib les

United States law extends legal protection forcertain intangible assets. A copyright lasts fromthe moment of its creation until 50 years afterthe death of the creator. Computer softwarequalifies for copyright protection. A trademarkneed not, but should, be registered with the U.S.Patent Office. A trademark is good as long as itis used; it lapses after two years of nonuse. Apatent granted by the United States PatentOffice will last for 17 years. While historicallygranted for protecting tangible property, patentshave recently been issued for new forms of life(i.e., genetic engineering).

FORMS OF BUSINESSORGANIZATIONS

Uni ted S ta tes Corporat ion

A corporation is a separate legal entity usually

created under the laws of one of the states or theDistrict of Columbia. Each state has enacted itsown laws regarding the formation and operationof corporations. Although the basic corporatelaws are similar, there are differences which mayargue for or against specific states in which toincorporate. Historically, the State of Delawarehas tended to be the jurisdiction of choice forowners planning multi-state operations. Thedocuments necessary to create a corporation may

be obtained from the secretary of state's office inthe capital of the state. After incorporation,annual reports must be filed and a fee must bepaid. A corporation doing business outside itsstate of incorporation may find it necessary toregister to do business in other states.Registration is accomplished by filing theappropriate documents and filing fee with thesecretary of that particular state. Generally,registration will automatically subject acorporation to taxation (including state and localincome and franchise taxes) in that jurisdiction.

Technically, the classification of an entity as acorporation for tax purposes is independent fromthe entity's status under state law. Taxregulations interpreting the Internal R evenueCode classify an entity as either an eligibleentity or as a corporation under the check-the-box rules. The entity is treated as an eligibleentity unless it is one of the types of entitiesmandatorily classified as a corporation. An

eligible entity is an entity that neither meets thedefinition of a trust nor a corporation. Eligibleentities are able to elect corporate status. If noelection is made, then the entity is treated as apartnership for tax purposes if it has two or moreowners, or as disregarded as an entity separatefrom its owner if it has a single owner. Typicalexamples of an eligible entity are limited liabilitycompanies (L LC), partnerships or soleproprietorships (discussed below).

Under regulations, certain business entities areper se corporations (i.e., mandatorily treatedas corporations for tax purposes):

A business entity organized under a federalor state statute or under a statute of afederally recognized Indian tribe, if thestatute describes or refers to the entity asincorporated or as a corporation, bodycorporate, or body politic. Such entitiesinclude governmentally charteredcorporations, as well as businesscorporations.

A business entity organized under a statestatute, if the statute describes or refers tothe entity as a joint-stock company or joint-

stock association. An insurance company. A state-chartered business entity

conducting banking activities, if any of itsdeposits are insured under the FederalDeposit Insurance Act.

A business entity wholly owned by a state orany of its political subdivisions.


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A business entity that is taxable as acorporation under a provision of the Codesuch as a publicly-traded partnership.

Business entities formed under the laws of U.S. territories and possessions.

Certain foreign businesses classified underIRS prescribed lists.

These corporations are called "regular" or Ccorporations. A United States C corporation issubject to United States tax on its worldwideincome regardless of where earned. Earnings of a U.S. corporation are generally subject todouble taxation: initially at the company leveland then at the shareholder level when dividendsare received. A distribution from a U.S.corporation to a shareholder will be treated as adividend to the extent paid out of current oraccumulated earnings and profits. Dividends arenot deductible by the corporation. Some relief rules exist for certain intercompany dividends.Dividends which are paid by a U.S. corporation

to non-U.S. persons are subject to 30 percentwithholding unless reduced by treaty.

If certain requirements are satisfied, a closely-held U .S. corporation generally may be exemptfrom tax by electing to be classified as an electingsmall business or S corporation. S corporationshareholders agree to be taxed currently on theirshare of the company's earnings, whether or notdistributed. In exchange, the corporation leveltax is not applied. The availability of an Scorporation is limited since all shareholders mustbe individuals who are either U.S. citizens orresidents, or certain trusts and tax-exemptorganizations.

Branch o f a Foreign Corporat ion

A branch is a part of a corporation and not aseparate legal entity in the U.S. A foreigncorporation may establish a United States branchand commence business at any time. Adviceshould be sought from legal counsel regardingthe merits of registering to do business in statesin which the branch intends to operate and thepossibility of obtaining limited legal liability. If aforeign corporation wants to establish a U.S.

branch, use of an LLC should be considered.(See discussion below.) As a general rule, theUnited States branch of a foreign corporation issubject to regular U.S. income tax on its netincome which is effectively connected to theUnited States business. Investment type incomenot effectively connected with a U.S. trade orbusiness is taxed at 30 percent or lower treatyrate. The United States has also enacted abranch profits tax (BPT) which is imposed in

addition to the regular corporate tax. The BPTis calculated as 30 percent of the "dividendequivalent amount" and can result in federalcorporate tax liabilities as high as 54 percent.

The BPT tax can be reduced or eliminatedthrough tax treaties.

Par tnersh ip

For legal purposes, a partnership is defined as anassociation of two or more persons formed tocarry on a business for profit as co-owners. Thetax law defines a partnership to include asyndicate, pool, joint venture, or otherunincorporated organization by which anybusiness is conducted and which is not, forfederal income tax purposes, a corporation, trust,or estate. Each state and the District of Columbia has its own laws governing theformation and operation of partnerships.Limited partnerships are usually formed underthe state's recognized Limited Partnership A ct.

Publicly traded partnerships are defined as thosewhose interests are traded on an establishedsecurities market (or a secondary or equivalentmarket). Publicly traded partnerships are taxedas corporations.

Partnerships are generally treated as conduits forU.S. income tax purposes, and each partnerrecognizes a proportionate share of income, loss,and credit, whether or not distributed to thepartners. Partnership law allows for muchflexibility for allocation of profits and losses aswell as distributions so long as the partnershipagreement meets the substantial economiceffect rules in the regulations. Any partnershipengaged in a trade or business in the U.S. whichhas foreign partners must withhold the highestU.S. tax rate on the foreign partner's distributiveshare of business income. Similar rules mayapply at the state level to nonresident-partners.

Limi ted Liab i l i ty Com pany

The limited liability company (LL C) is arelatively new organizational structure. I tspurpose is to provide limited liability for owners,while maintaining a single level of tax. It offersthe advantages of both S corporations andpartnerships, while eliminating some of thedrawbacks of the entities. Properly structured, itis treated as a partnership for tax purposes,providing all of a partnership's flexibility with thelimited liability protection of a corporation.Unlike an S corporation, it may have foreignpersons as members. LLCs provide significantflexibility for U .S. tax planning and the use of these entities has become common. Single-


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member LLCs can serve as divisions of corporations or as owners of sole proprietorshipswhile enjoying limited liability protection. Statetax planning needs to be considered with LLCssince the treatment is varied throughout thenation.

Sole Propr ie to rsh ip

A business may be conducted directly by anindividual, with the results of operationsreflected on a separate schedule of the personsindividual income tax return. This approach hasthe advantages of informality and direct controlover the enterprise, but it is accompanied withthe great disadvantage of unlimited personalliability.

TAX REGIME AND ITSDOCTRINES

There are a number of tax regimes in the UnitedStates and its political subdivisions. The federalgovernment imposes income taxes oncorporations, individuals, estates, and trusts. I talso imposes payroll taxes, the primary one beingthe Social Security tax which is levied on both theemployer and the employee. There are alsoestate and gift taxes and a number of excisetaxes. No national sales or value added tax isimposed. The various political subdivisions (bothstates and cities) impose various taxes as well.

These include income, inheritance, sales,intangibles, and property taxes. Although notdiscussed in detail in this booklet, state and localtaxes can significantly increase ones tax liability.

The United States individual income tax systemis a self-assessment scheme which requireswithholding of tax from employees salaries andcertain other payments. When a taxpayer isrequired to withhold taxes on payments toanother person, the taxpayer is in a fiduciaryrelationship and must remit the withheld taxes tothe government. Failure to withhold or failure toremit will generally subject the taxpayer to

liability for the taxes as well as penalties. Inaddition, businesses and individuals are requiredto make quarterly estimated payments during theyear.

After the close of the taxpayer's tax year,taxpayers must file a tax return which reports alltaxable income and allowable deductions. Thetax is computed on net taxable income andcompared with the total taxes which the taxpayer

either had withheld from income or paid asestimated installments of tax. The net of thesetwo becomes either the final tax payment by, orrefund to, the taxpayer. All returns are filedunder penalty of perjury.

The Internal Revenue Service is a branch of theDepartment of the Treasury. I t is responsible foradministering the tax law, and its missionincludes interpreting tax laws, auditing taxreturns, and collecting revenue. Absent amaterial misstatement of income or fraud, thestatute of limitations (SOL) on a tax return is aperiod ending on the later of three years fromthe date the return is filed (or required to befiled) and two years from the date of payment. If a return has not been filed, the SOL period willnot begin, leaving the year open indefinitely.

The federal tax law is enacted by the UnitedStates Congress and the legislative structure isfound in the Internal Revenue Code of 1986

(IRC), as amended. The Department of the Treasury and the IRS issue interpretations of thestatutory provisions. Frequently, disagreementsarise between taxpayers and the IRS concerningthe proper tax treatment of various items and,after administrative reviews within the IRS, manycases end up in federal court. Several of thesecourt-derived interpretations are integral to anunderstanding of the fabric of United States taxlaw.

Substance Over Form

A constant thread in the administration of U.S.tax law is that the substance of a transactiontakes precedence over the form of thetransaction. The complexity and rapidity of bothstatutory changes and economic developmentsresult in dichotomies and discontinuities betweeneconomics and taxation. Therefore, transactionscan often be structured in several different ways,and as a consequence, the tax results may vary.Proper planning is essential in this environmentbut, if litigated, the courts will generally decidethe tax consequences based on the economics of the transaction taken as a whole. However,taxpayers can be held to the form of a

transaction chosen even if, in substance anothertreatment is more reasonable.

Transfer Pr ic ing

Transfer pricing issues relate to the broadauthority of the IRS to allocate income,deductions, credits, and other items between oramong related entities to prevent evasion of tax


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or to clearly reflect income. The courts havegenerally upheld both the authority andmethodologies of the tax reallocations. The IRSmay make such adjustments as are necessary, inwhich, either by inadvertence or design thetaxable income of a controlled taxpayer isaffected by its dealings, either directly orindirectly, with a member of the same controlledgroup. Adjustments made by the IRS to onemember of a group may require correlativeadjustments to other affected group members.

The IRS increases its scrutiny on the transferpricing when related United States and foreigngroup members are involved. Regulations havebeen issued which reinforce the arms-lengthstandard and increase the emphasis oncomparability and documentation. Severalmethods are permitted to determine a properarms-length price, including the use of transaction comparables, comparable profits, andprofit split methods. Taxpayers must identifyand document the best method under thecircumstances. Failure to maintaincontemporaneous documentation of pricingdeterminations, including a written transfer pricestudy, could result in substantial penalties (up to40 percent of the tax due). IRS adjustmentscould also result in double taxation since sometreaty country partners may not give correlativeadjustments in United States transfer pricingcases. In such case, competent authority shouldbe consulted if a treaty country is involved tocreate some level of certainty in its intercompanytransactions.

To mitigate controversies in transfer pricingdisputes, the IRS is encouraging the use of Advanced Pricing Agreements (APA ). An APAis a prospective agreement between the I RS andthe taxpayer to determine compliance with thearms-length standard. I t is expected that whentreaty partners are involved, the competentauthorities in the relevant countries will beinvolved in the process. If possible, taxpayersshould seek bilateral agreements to ensure thatthe pricing strategy is agreed upon by bothcountries.

Tax Treaties

The United States enters into tax treaties for theprimary purpose of eliminating double taxation. The United States Model Income Tax Treaty(based on the OECD Model) has been the basisfor all recent treaty negotiations. Under theUnited States Constitution, treaties and publiclaws are given equal weight. Where there areconflicts between statute and treaty, the mostrecent controls. There has been a tendency inrecent U.S. tax law changes to include treaty

override provisions. Newer treaties also containan anti-treaty shopping rule which limits thebenefits of the treaties to bona fide residents of the contracting states. After a treaty isnegotiated and signed, it must be ratified by theUnited States Senate before it is effective.

TAXA TION OF BUSINESS OPERATIONS

Taxation of United States Resid ent Corporat ion

A U.S. resident corporation is a companyincorporated under the laws of a state or theDistrict of Columbia. I t is also an entity treatedas a corporation under check-the-box regulations(see discussion above). The place wheremanagement is located and control is exercisedis irrelevant. A resident corporation is taxed bythe United States on its worldwide income,including capital gains, without regard to thesource of such income. Net taxable income issubject to a graduated rate structure rangingfrom 15 percent to 35 percent.

At certain income levels, higher marginal ratesare imposed to eliminate the benefit of thegraduated rates for corporations. The highesteffective rate is 35 percent.

United States corporations are required to fileincome tax returns for each tax year, generallyfor twelve months. Income tax returns are dueon the fifteenth day of the third month followingthe close of the taxable year. For companies onthe calendar year, the return is due March 15.Extensions of time to file may be obtained for upto six months. Estimated income taxes must bepaid quarterly during the year. Penalties areimposed for failure to make adequate estimatedpayments.

Aff i l ia ted Com panies and Conso l idated Returns

Members of a group of U .S. corporationsaffiliated by 80 percent or more of directownership may elect to join in the filing of aconsolidated United States income tax return.An affiliated group exists where one or morechains of includible corporations are connectedthrough share ownership with a common parentcorporation. The common parent files onereturn on behalf of the entire group. Non-includible corporations, including foreigncorporations, are prohibited from joining such agroup. Generally, it is advantageous to file a


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consolidated return in order to combine losses of some members with income of other members.However, there will be occasions where it is adisadvantage. Once a group has elected to fileon the consolidated basis, it must continue to doso unless the ownership chain is broken or theIRS grants permission to discontinue filing onthat basis (which happens only on rareoccasions).

Lo sses

United States tax laws distinguish between netoperating losses (NOLs) and capital losses. Anet operating loss is the excess of tax deductionsover the company's gross income. Subject tolimitation, an NOL may be carried back twoyears and forward twenty years until fullyutilized. While NOLs can be used in aconsolidated group, there are limitations onusing the carryforward losses frompreconsolidation years or where there has beena change in ownership. Capital losses will ariseon the disposition of capital assets and may onlyoffset capital gains. To the extent not used in thecurrent taxable year, capital losses may becarried back three years and forward five years.Restrictions exist, similar to those for NOL s,when the company experiences changes inownership.

Comp utat ion of Taxable Incom e

Taxable income is defined as gross income minusall allowable deductions. Gross income includesbusiness income, gains, interest, dividends, andall other accretions to wealth, unless specificallyexcluded from taxation. Although gains wouldnormally be taxed or losses deducted whenrealized, recognition may be postponed underthe tax law. Mere accretion or diminution of wealth, for example, generally is not arecognition event. Deduction of expenses andlosses may be claimed only to the extent set forthin the Internal Revenue Code. A corporation isallowed to deduct the cost of goods sold, intereston indebtedness, and other ordinary andnecessary business expenses. Capitalexpenditures may not be currently deducted, butthe cost may be recovered under depreciationand amortization rules. Dividends paid toshareholders may not be deducted, but there is apartial to full exclusion for certain dividendsreceived by one U.S. corporation from anotherU.S. corporation.

A corporation may also be subject to thealternative minimum tax (A MT). The AMT iscalculated by adjusting regular taxable income toeliminate certain preferences which areallowable as deductions for regular tax purposes.

The AMT rate is 20 percent and is payable if itexceeds the regular tax liability. AMT isdesigned to accelerate the timing of income andAMT paid is available as a credit against regulartax in future years if regular tax exceeds currentAMT.

The tax laws also prescribe several penalty taxeswhich may be imposed, such as accumulatedearnings and personal holding company taxes. Those add-on taxes are imposed if thecorporation retains excessive earnings or holdssubstantial passive assets.

Timing Differences and Preferences

A number of special rules in the United Statestax law result in income being taxed ordeductions being allowed in tax periods differentfrom the financial statement reporting periods.Some of these items are permanent differencesbetween book and tax income, while somemerely affect the timing of their recognition.

The corporate income tax return requires areconciliation of these differences (commonlycalled Schedule M items). Differences may alsoarise between the bases of assets or liabilitiesreported for financial statements and thosereported for tax purposes.

Debt Versus Equi ty

In establishing the capital structure of a UnitedStates corporation, the fact that interest paid isdeductible, while dividends paid are not, placesa high premium on the appropriate classificationof capital infusions. The characterization givenby the parties is not the sole determinative factorsince the IRS has the authority to recharacterizedebt as equity. The debt-to-equity ratio is one of the more important factors used in making thisdetermination. In general, a generally acceptedratio is 3:1, although in litigation, higher ratioshave been sustained.

Additional factors taken into account inanalyzing an instrument as equity or debt includesuch elements as terms, creditors' rights, and theeconomics of the entire operation including debtcoverage and cash flows. Special rules relate tothe deductibility of certain foreign related partyinterest when the debt to equity ratio of thecorporation exceeds 1.5:1. These rules, known asthe earnings stripping provision, could result inthe indefinite deferral of interest deductions.Also, accrued unpaid interest owed to foreignrelated parties is not deductible until paid.

Deprecia t ion and Am ort izat ion


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Since capital expenditures may not be written off in the year incurred, the tax law has establisheda system of depreciation in order for the taxpayerto recover its cost over the estimated useful lifeof the property. In an effort to minimizecontroversies between the I RS and taxpayers, thelaw sets up tables based on a ModifiedAccelerated Cost R ecovery System (MACRS).

Tangible personal property is depreciated over athree-, five-, seven-, ten-, 15- or 20-year periodusing an accelerated method. Residential realproperty is depreciated on a straight line basisover 27.5 years and nonresidential realty over 39years. For tangible property, recapture of depreciation will occur at the time the propertyis sold.

Some capital expenditures are not covered underthe depreciation rules, rather, they are handledthrough special statutory amortization rules.Expenditures such as organization costs, start-upcosts, research and development expenses, anddepletion for natural resources are recoveredthrough amortization deductions. Thecapitalized cost of goodwill and many otherintangibles obtained in connection with theacquisition of a trade or business are amortizedover a 15-year period beginning in the month of acquisition.

Foreign Source Incom e Rules and Foreign Tax Credit

A United States corporation is taxed on itsworldwide income and gains. In addition,income of a foreign affiliate may be imputed, asa deemed dividend, to the U.S. corporationunder the so-called Subpart F rules. To providerelief from double taxation, the U.S. businessmay claim a foreign tax credit or deduct foreigntaxes paid or accrued. Only taxes based on netincome or capital gains may be credited. Taxeswhich cannot be claimed as a credit may bededucted. The foreign tax credit is subject toseparate limitations based on type of income.Excess credits may be carried back two years andforward five years. A company may also creditcertain "deemed paid" foreign taxes related toforeign earnings from actual or imputeddividends.

TAXA TION OF FOREIGN CORPORATIONS

A foreign corporation is any corporation which isnot organized under the laws of a state or theDistrict of Columbia. The income of a foreigncorporation may be taxed under two separate tax

regimes. First, income from United Statessources and certain types of foreign sourceincome which are effectively connected with aU.S. trade or business and are defined asEffectively Connected Income (ECI), are taxedat graduated U.S. corporation tax rates. Second,certain types of U nited States source fixeddeterminable annual or periodic (FDAP) incomeare taxed at a flat rate of 30 percent of grossincome, unless a lower treaty rate applies.

The threshold questions of whether a foreigncorporation is subject to United States tax are (1)whether or not it has U.S. source income, and (2)whether the company is engaged in a U.S. tradeor business. If the foreign company is resident ina treaty country, the treaty may affect thisdetermination (see discussion below). As ageneral rule, a foreign corporation will be subjectto U.S. tax during the year if it has any U.S.source income. FDAP income will be taxed at 30percent or the reduced treaty rate; ECI willusually be taxable by the United States only if,and to the extent that, the foreign corporation isengaged in a U.S. trade or business. If theforeign corporation is a resident of a treatycountry, the U.S. must show that a permanentestablishment has been created in the U.S. totax the business income.

Permanent Estab l i shment Rule and Bu s in ess In co m e

A foreign corporation resident of a treatycountry conducting business in the United Statesis normally subject to U.S. income tax onbusiness income only if it has a permanentestablishment in the U.S. (as defined by theapplicable treaty) and then only to the extentthat such income is attributable to the permanentestablishment. In general, an agent's office is notconsidered a permanent establishment unless theagent regularly exercises power to negotiate andconclude contracts or has inventory which heregularly sells on behalf of the foreign company.Also, the agent must not be economically andlegally dependent upon the foreign corporation.

To the extent attributable to a permanentestablishment, a foreign corporation's U.S.source business income and gains are taxed onthe same basis and at the same rates as a U.S.corporation. Business income is generallydefined as income "effectively connected" withthe conduct of a trade or business in the UnitedStates. A foreign corporation may claim allordinary and necessary business expensesassociated with the production of ECI, includingcertain head office expenses. In addition, theU.S. operation of the foreign corporation may


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claim a credit against U.S. tax for foreign taxespaid with respect to such income.

Nonbu siness Income and the Foreign Investment in Real Proper ty Tax Ac t (FIRPTA)

Certain types of FDAP income are taxed at a flatrate of 30 percent or lower treaty rate. FDAPincome is income which is not effectivelyconnected with the conduct of a trade orbusiness. I t includes interest, dividends, rents,royalties, annuities, and gains from the sale of certain property. Gains from the sale of UnitedStates real property are subject to tax under theFIRPTA provisions of the tax law. A foreignperson's gain or loss on the sale or otherdisposition of a U.S. real property interest(USRPI) is taxed under FIRPTA as if the salewas effectively connected with the conduct of aU.S. trade or business. FIRPTA gain recognitionmay be required even if the disposition is in an

otherwise nontaxable transaction. A USRPIincludes direct as well as indirect ownership of U.S. real property through a U.S. real propertyholding company (USRPHC). A USRPHC is adomestic corporation whose real estate assetscomprise greater than 50 percent of thecorporations total assets. A withholding tax of 10 percent of the gross sales price is generallyrequired on the disposition of a USRPI byforeign persons, except that partnerships mustwithhold a higher percentage (up to 35 percent)of the gain reported on the disposition. I t ispossible to obtain from the IRS a withholdingcertificate which reduces or eliminates the

otherwise required withholding. Gain on the saleof stock of a USRPH C is also taxable underFIRPTA.

Branch Operat ions and the Branch Profi ts Tax (BPT)

Income from the operation of a branch in theU.S. will generally be considered effectivelyconnected with the conduct of a U.S. trade orbusiness. The branch would then be taxed atgraduated rates, as previously discussed.However, additional taxes may apply including:branch profits tax (BPT), branch interest tax(BIT), and second level withholding. The BPT isa 30 percent tax on the branch's income which isnot reinvested in the United States operations.

The rate may be reduced or eliminated by treaty.I t is in addition to the graduated corporate tax.Gross income is computed from the branch'sseparate records, and expenses are allocatedbetween the branch and the head office basedupon specific allocation rules described in taxregulations

In addition to the BPT, a BIT is imposed at a 30percent statutory rate on interest paid by orimputed to a U.S. branch with respect to aforeign corporation. The taxable interestamount represents the excess of the interestdeduction over the interest paid. The rate maybe reduced or eliminated by treaty.

FOREIGN PERSONNEL IN THE UNITED STATES

Entry in to the Uni ted S ta tes

Foreign nationals seeking entry into the UnitedStates as nonimmigrants are required to havevisas which can be applied for at a U.S. ConsularOffice. A foreign national is referred to as an"alien" and, for U nited States tax purposes, isclassified as either a resident alien or anonresident alien. In the year of entry ordeparture, an alien may be classified as both aresident and a nonresident and will be requiredto file a "dual status" return. The correctidentification of the alien's status is critical fordetermining the proper tax liabilities for the year.

An alien is categorized as a nonresident alienunless he or she meets one of the two residencytests. The first test automatically classifies analien as resident in the U.S. if the person is alawful permanent resident, a status obtained byholding a green card, at any time during the year.

The second test which would give the alienresident status is the substantial presence test. Inorder to meet the test, the alien must bephysically present in the U.S. on at least 31 daysduring the current year and 183 days over athree-year lookback period. The 183 days testconsiders all days present in the current year,one-third of the days present in the firstpreceding year and one-sixth of the days presentin the second preceding year.

These definitional rules do not override anytreaty definitions of residency. Further, if certainconditions are met, an alien can elect to betreated as a United States resident, which may be

advantageous in certain circumstances. Whileexceptions exist, many aliens who have worked inthe United States are required to obtain sailingpermits before leaving the country. Thesepermits are issued by the IRS.

U.S. Taxation o f Resident Alien s

A resident alien must report, and is taxed on,worldwide income in the same manner as aUnited States citizen. If the aliens income is


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subject to double taxation, the foreign tax creditsystem is designed to mitigate double taxation. I tis possible that if the foreign country has a highertax rate than the United States, the full creditwill not be available.

Generally, a tax return is due by April 15 for theincome earned in the prior calendar tax year.Resident aliens are eligible to claim the same

deductions as U.S. citizens. Part-year residentaliens must allocate deductions between theresident and nonresident periods. State andlocal income tax may also apply.

The U.S. tax rate brackets are adjusted annuallyto reflect inflation. The rates range from 15 to39.6 percent on taxable income. The benefit of the personal exemptions and certain itemizeddeductions are limited once adjusted grossincome exceeds a certain threshold.

U.S. Taxation of Non residen t Aliens

A nonresident alien is usually subject to UnitedStates income tax only on U.S. source income.

The manner in which this income is taxeddepends on whether it is effectively connectedwith the conduct of a trade or business. Incomethat is effectively connected is taxed at graduatedrates in the same manner as a U.S. citizen orresident alien. Salaries, wages and earnings fromself-employment from the performance of services in the United States is effectivelyconnected income, and other types of incomesuch as interest, dividends, rents, and royaltiesmay be so classified. U.S. source income that isnot effectively connected is subject to a flat 30

percent or lower treaty rate. Nonresident aliensare allowed to deduct expenses related toeffectively connected income. Expenses whichcan be claimed generally include ordinary andnecessary business expenses and state and localtaxes, and some moving expenses. If the alien hasincome from dependent personal services, the taxreturn is due by April 15, unless he/she is outsidethe country at that time. If the income is onlyfrom nonwage sources, the return is due by June15.

Estate and Gift Tax

A U.S. transfer tax (estate and gift tax) may beimposed on the transfer of property from adonor/decedent to his or her donees/heirs andapplies to both resident and nonresident aliens.For a resident alien, the gross estate includes allproperty of the decedent at the time of death,including real property located outside theUnited States. For a nonresident alien, the estateconsists only of property situated in the UnitedStates including shares of stock in U .S.corporations. Property is included in the estate at

the fair market value at the date of death (oralternate date six months later) and certaindeductions and liabilities may be claimed againstthe gross estate. An unlimited deduction may beclaimed for transfers to a surviving spouse butonly if he or she is a U.S. citizen or legalpermanent resident. For a resident alien only,the deduction can be obtained for an alien spouseby using a qualified domestic trust.

There are various reporting requirements forforeign gifts to U .S. donees and for transfers byU.S. donors to foreign trusts designed to keep theU.S. government informed of cross-bordertransfers of funds.

Employ ees ' Righ ts

The United States Congress has enacted anumber of laws in past years which give specificprotection and rights to employees. Additionalprotections have been added by agencyrulemaking and court decisions. Individual states

and local governments have also enacted lawswhich complement or extend benefits beyondthose mandated by the federal government.

These restrictions on businesses and benefits tothe employees include the following:

minimum wage and maximum hour rulesnondiscrimination in employment practicespension guaranteescollective bargaining rightsnotice of termination protectionhealth and safety requirementsunemployment compensationdisability benefitsnondiscrimination against lower-compensated employees in the benefitsprovided

The most financially significant of these programsis the Social Security Act which providesretirement, disability, and health benefits. Theprogram is funded by a payroll tax imposed onboth the employer and employee at a 2001 taxrate of 7.65 percent. The 6.2 percent FICA rateapplies to the first $80,400 of wages (indexed forinflation). The medicare rate (1.45 percent)applies to all wages, since there is no limit on theamount of earnings subject to the medicareportion of the tax. Self-employed individuals pay

based on a tax rate of 15.30 percent levied on thesame income bases (12.4 percent on the first$80,400 and 2.9 percent on all self-employedincome). Resident and nonresident aliens withU.S. source wages or salary compensation incomeare subject to these taxes. The United States hasentered into a number of social insurancetotalization treaties which mitigate doubletaxation and/or benefit reductions for citizens of treaty countries temporarily employed in theUnited States.

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