Onshore Or Offshore? Where's Business Better?
The perils and profits of leaving the U.S. for overseas markets
By Mark E. Battersby
s more and more textile, apparel and fiber companies face stiffer and stiffer
competition, they are beginning to look overseas for growth and profits. Not too surprisingly, with
worldwide customers eager for U.S. products and services, many American textile business owners and
managers have already discovered that they can no longer ignore the vast potential of operating in
According to the U.S. Small Business Administration, more than 90 percent of small businesses that have not exported or done business abroad could do so profitably today. Doing business abroad, whether merely investing, participating in joint ventures, importing or exporting or providing services, is a whole new world out there: a whole new world that, in many respects, is just like the one here in the United States.
The United States taxes the worldwide
income of U.S. citizens, resident aliens and domestic corporations – without regard to whether the
income arose from a transaction or activity originating outside its geographic borders. In other
words, whether the income arose from a fibers plant doing business exclusively within the United
States or from a U.S. individual or firm doing business or investing outside its borders, the
ever-vigilant Internal Revenue Service (IRS) wants the U.S. government’s share.
On the plus side of the ledger, paying U.S. taxes means operating under an income tax system that the U.S. textile operation’s management is already familiar with, as confusing as it might be. The downside to doing business abroad means that another tax system, that of the country where the fiber, spinning, weaving or yarn company does business, must also be considered.
Fortunately, a textile company may deduct foreign income tax paid or accrued – or may apply it as a credit against U.S. income tax. While this credit is intended to cover foreign income taxes, it is also permitted to cover taxes imposed in lieu of income taxes otherwise generally imposed by the particular country.
Naturally, where the tax of a particular foreign country is not determined to be the substantial equivalent of income tax, it will not qualify for the credit.
Uncle Sam is really serious about collecting his share from the foreign operations of every textile company. The U.S. tax rules contain a provision that permits the IRS to tax even those foreign earnings that aren’t distributed to shareholders.
Wherever a foreign corporation is controlled for an uninterrupted period of 30 or more days by U.S. shareholders, those shareholders are taxed on some of the corporation’s undistributed earnings as well as its distributed earnings. Operating much like the accumulated earnings tax on domestic corporations that retain earnings and profits beyond the needs of the business, the controlled foreign earnings tax penalizes those textiles companies that retain excess earnings in an effort to reduce the tax burden of their shareholders.
Under the controlled foreign company rules, a U.S. shareholder is a U.S. person who actually or constructively owns 10 percent or more of a foreign corporation’s voting stock. Furthermore a "U.S. person" includes not only a U.S. citizen or resident alien, but also a domestic partnership, a domestic corporation and even estates and trusts.
A controlled foreign corporation is generally one in which more than 50 percent of the voting interest or total value is owned by U.S citizens on any day in the corporate tax year.
There are quite a few programs
operated by various U.S. government departments and agencies that all have one common purpose: to
help the U.S. businesses and profit abroad. From the U.S. Department of Commerce to the Small
Business Administration, help is usually only a phone call away. In fact, so eager is the U.S.
government to pave the way abroad for U.S. businesses, they have already paved the way with a
series of treaties and agreements.
NAFTA links Canada, the United States and Mexico to promote conditions of fair competition in the free-trade areas. It is designed to substantially increase investment opportunities in their territories.
Even better, U.S.-based textile apparel and fibers businesses expanding into Mexico may increase their access to Central and South America as well as by using Mexico’s existing linkages in Latin America.
Naturally, other governments are just as eager to assist their businesses and citizens. A free-trade and economic policy bloc of 15 European nations: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom, was launched as the European Economic Community in 1958. Just this year, they adopted a common currency, the euro, currently being phased in among their member nations.
The relatively new euro accounts for
only about 1 percent of world trade conducted by small businesses. In fact, about 80 percent of
global trade among American small-business owners is conducted in dollars, according to J. David
Richardson, a visiting fellow of international trade policy at the Institute for International
Economics in Washington, D.C. In contrast, nearly half of big business deals are in foreign
currencies, including the euro.
Other experts contend that small companies, which often are seeking to improve their profit margins, should be among the first into the foreign-exchange marketplace. Currency fluctuation "is an aspect of management that the U.S.-based can control," said Greg Davis, a risk-management associate for foreign-exchange services at Bank of America. "If they managed that risk, they could save money."
These days, managers of the U.S. companies that choose to trade in foreign currency don’t simply have to roll up their sleeves and deal with fluctuating guilders or yen. Instead says Keith Cheveralls, managing director of foreign exchange at BankBoston, they can purchase "window contracts" that lock in a purchase price to a fixed foreign-currency rate.
Get comfortable soon: Davis says that as euro-only trade increases within the European Union obviating currency exchange, "there are going to be more companies in Europe that will request payment in euros."
On a negative note, foreign currency or "funny money" is also the number one risk faced by those companies expanding or operating abroad.
From an economic standpoint, costs may rise due to changes in foreign currency rates, making a U.S. company’s products or services uncompetitive in the world market in general. There’s not much that any textile business can do about economic risk. It’s just a normal business risk everyone must endure.
So-called "transaction risk" is, however, another matter. Transaction risk translates as the chance there will be an unfavorable move in a specific currency between the time you make an investment or begin a project and the time it is completed. In this case, you could require all payments in advance. But, like insisting on payment in U.S. dollars, this practice could put many companies at a severe competitive disadvantage.
Most textile company managers are most concerned with commercial and country risks. Unlike exchange-rate risks, these can actually be insured—if the textile company is willing to pay the increased costs.
Commercial risks might include the default or bankruptcy of a buyer or foreign partner. Country risks are political and include war or unilateral currency restrictions that might be imposed in less stable nations.
Admittedly, this kind of insurance is pretty pricey on the private market, but the U.S. government operates an Export-Import Bank (Eximbank) that is trying to become more helpful to small business’s insurance concerns. There programs allow small companies to be more aggressive in selling or investing in foreign markets, thus helping the balance of trade deficit.
Although the United States taxes the
worldwide income of U.S. citizens, resident aliens and domestic corporations – without regard to
whether the income arose from a transaction or activity originating outside its geographic
boundaries, there are some U.S. tax benefits when doing business abroad.
A qualifying individual, for example, who works abroad and who receives income from foreign sources may choose to exclude up to $74,000 (for calendar year 1999) of foreign-earned income as well as certain employer-provided housing costs from their U.S. taxable income.
However, in order to qualify for either the exclusion for foreign housing costs or the foreign earned income exclusion, a U.S. citizen working abroad must make a tax home in a foreign country and meet either the bona fide residence test or the physical presence test.
An individual must be a bona fide resident of a foreign country or countries for an uninterrupted period that includes a full tax year. During a period of bona fide residence, the individual may leave the foreign country for brief or temporary trips elsewhere for vacation or business. Once the bona fide residence test is met, the excess housing costs exclusion is available for any partial tax year in which the period of residence began or ended.
It should be noted that an individual will not be considered to be a bona fide resident of a foreign country if he or she files a statement of non-residency with the foreign authorities and is help exempt from such country’s income tax.
An individual meets the physical presence test if 330 full days out of any 12-consecutive month period are spent in a foreign country (or countries). If an individual falls short of the physical presence test requirements because illness forces his return to the United States (or, if he leaves the foreign country under his employer’s orders), he will not qualify.
Earned income is defined, at least in this case, as wages, salaries or professional fees and other amounts received as compensation for personal services actually performed during the period in which the bona fide residence test or physical presence test is met. If a taxpayer is engaged in a trade or business in which both personal services and capital are material income-producing factors, a reasonable allowance as compensation for the personal services, not in excess of 30 percent of his share of the net profits of that trade or business, is considered earned income.
Limiting Foreign Loopholes
Realizing that it is relatively easy
to generate losses when expanding or investing abroad, the IRS has established regulations that
require paybacks for all foreign losses claimed. That’s right, overall foreign losses sustained in
a tax year are subject to recapture in later years.
An overall foreign loss is the amount by which gross income from foreign sources is exceeded by the sum of expenses, losses and other deductions properly allowable to such foreign source income. Any net operating loss deductions, foreign expropriation losses and uncompensated casualty or theft losses are not taken into account.
Similarly, gain on the disposition of business property predominantly used outside the United States during the preceding three-year period is also subject to the recapture rules unless, of course, the property was not a material factor in the realization of income by the taxpayer. The amount recharacterized is 100 percent of the gain or, if less, the overall foreign loss. Generally, nonrecognized gain as well as recognized gain is subject to recapture.
Foreign source gain that otherwise would not be recognized is recognized and recharacterized. Therefore, a disposition of foreign business property may result in both a reduction of the limitation on foreign tax credit and an increase in the textile operation’s income.
As competition increases in the United States and opportunities continue to open up abroad, it is easy to see why so many textile-related businesses have chosen to grow or expand into other countries. Although Uncle Sam will continue to demand the U.S. government’s share of overseas profits, tax and economic treaties and an abundance of help all clear the path.
Editor's Note: Mark E. Battersby is a tax and financial advisor from Ardmore, Pa. He writes a weekly farm taxes column syndicated in 45 newspapers and a topical tax column carried by several trade magazines and more than 25 business publications.