Did You Know That…? When Your Foreign Entity Should Do a ‘Protective Filing 1120F’ in the U.S.
Many European companies operating in the U.S. underestimate their possible tax presence in the U.S. and its effect on Corporate Income Tax. If they have a nexus in the U.S. with their foreign entity, their Corporate Income Tax filing (1120F) is due by 15 June*.
Although European companies often see the U.S. as one of the most interesting expansion markets, the fear of litigation, as well as the administrative complexity, upfront cost, and maintenance of having a U.S. subsidiary, make these companies decide to do business in the U.S. remotely from their main entity in Europe.
Even if there is a U.S. subsidiary in place, we see that this entity is sometimes merely used as a payrolling vehicle or sales and marketing office, meaning the actual transaction with the U.S. customer is still done via the European HQ.
Thus far, many of these companies that actually have a permanent establishment in the U.S. have probably not even been aware that they have been ‘flying under the radar’ of federal and state tax authorities in the U.S. With the increase of AI and information exchange between international tax authorities in Europe and the U.S., and between the U.S. Federal government and the state & local authorities, TABS has also seen an increase in cases where tax authorities in the U.S. did start to ask questions why the European entity was not filing taxes in the U.S.
Is it the more expensive U.S. dollar (13% increase in three years) making the original investment higher while making the European company’s product or service more competitive due to the lower Euro? Or are companies encouraged by a number of globally operating ‘Employers of Record’ that make it appear as if you can run payroll in the U.S. with the European entity without tax and legal repercussions? Is it an increase in E-commerce activities via platforms like Amazon that allows you to do business in the U.S. with the European entity, or is there uncertainty about the impact of the November elections? A combination of the above factors may explain why an increasing number of companies decide not to set up a U.S. entity while doing business in the U.S. and try to develop the U.S. Market ‘remotely’.
Whether this is a wise choice remains to be seen and depends on the specific situation. Based on the survey (Dutch Ventures in the U.S.) done by TABS, this ‘remote model’ doesn’t maximize the full potential of the U.S. Market. However, if the decision is made to do business in the U.S. with the foreign entity, at least this entity should prepare itself for the tax consequences and consider filing Corporate Income Tax form 1120-F each year. Especially if its U.S. clients have been asking for the foreign entity to complete one or more W8BEN-E forms throughout the year.
What Are The W8BEN-E And 1042-S Forms
Whenever a non-U.S. company sends an invoice to a U.S. entity for a transaction that took place in the U.S., the U.S. customer may have to do a withholding on the invoice and act as a withholding agent for U.S. Corporate Income Tax. This is typically not something that the client is happy to do. Alternatively, it may send the European vendor the IRS form W8BEN-E to complete. In this form, which can be quite intimidating to complete, the European vendor informs the U.S. client of its tax status in the U.S., which often leads to a claim to a bilateral tax treaty. The vendor states that there is no effectively connected income (ECI) in the U.S. since it doesn’t have a permanent establishment (PE) in the U.S. and that it claims tax treaty benefits to prevent double taxation. It allows the client to make full payment on the invoice without withholding (and remitting to the IRS) for federal Corporate Income Tax. The U.S. customer will send a 1042-S form to the IRS at the end of the year and a copy to the European vendor. This form states how much the European vendor was paid and how much was withheld from the vendor and paid to the IRS by the U.S. client. Since typically no funds were withheld from its invoices, many European companies think that they don’t have to do anything after that. However, one can officially only claim tax treaty benefits if one does file Corporate Income Tax in both countries. Note that this doesn’t mean the European vendor pays in both countries.
The Pros and Cons of a Protective Filing via Form 1120-F
European companies that are unsure whether their activities rise to the level of a U.S. permanent establishment with their U.S. trade or business may, therefore, consider what’s known as a protective filing via Form 1120-F.
The main reason to do this is that the filing preserves the right of the European company to later claim any deductions against gross income to which it may have been entitled.
If an 1120-F is not filed, and it’s later determined by the IRS that U.S. tax was, in fact, owed the foreign corporation will not be allowed to take any deductions from its gross revenue. When the company files form 1120-F the IRS has typically only three years to question the filing. Filing a protective Form 1120-F solves this potential problem by preserving the ability to deduct normal business expenses without having to report any income or deductions on the protective return itself.
Some foreign businesses may be reluctant to file a protective 1120-F because it alerts the IRS that tax may be owed, so an audit may more likely be triggered. With the increased information exchange between various authorities (European tax authorities, U.S. Customs, IRS, U.S. States Revenue Agencies), we feel that companies can no longer ‘just hope’ that they’ll fly under the radar. And if the authorities won’t track them down, it may have negative consequences in due diligence exercises when the company tries to raise funds or in the event of a complete merger or acquisition.
* For companies with a December fiscal year-end