Service Fees

Service Fees

April 01, 2007 | By Keith Martin in Washington, DC

Service fees that foreign subsidiaries of US companies earn for work outside the United States should be easier to insulate from US taxes in the future.

US multinational corporations struggle to avoid having to pay US taxes on their foreign earnings before the earnings are physically repatriated to the United States. The United States taxes American companies on worldwide income. However, it does not tax foreign corporations (unless they have US earnings). Therefore, most US multinational corporations operate abroad through one or more foreign corporations set up as subsidiaries. The foreign corporations act as “blockers” that prevent offshore earnings from hitting the US tax net.

Most blockers are in places like the Cayman Islands, Luxembourg or Holland that do not impose heavy taxes.

Thus, for example, a US company with an active business managing power plants in Africa might have a Dutch subsidiary to conduct this business.

This strategy only works for income earned from an active business.

The US will look through a blocker corporation and tax its US parent on any interest, dividends, rents or other passive income the foreign corporation earns.

It will also look through and tax the US parent on any fees earned for services provided outside the United States if two things are true. First, the blocker corporation is in a different country than where the services are performed. Second, the services require “substantial assistance” from the US parent or another affiliate. An example of substantial assistance is where US personnel or performance guarantees from the US parent are needed to help with a job or secure a contract. The assistance is “substantial” if it is worth at least 50% of the cost of the services or is otherwise a “principal element” in performing them.

The IRS changed its rules in January in a manner that makes it easier to defer US taxes on offshore fee income. The same rules apply as before, except the IRS said it will not claim the services require substantial assistance from an affiliated company unless what the affiliate contributes accounts for at least 80% of the cost of the services. It does not matter if they are a principal element of the services. The affiliate is not treated as having contributed anything if it is paid full price for its help.

The IRS announcement is Notice 2007-13.

US power companies with projects in foreign countries sometimes try to pull income out of the project country in the form of fees. The fees are deductible in the project country. This is a way of reducing taxes on the project earnings in the host country.

The IRS change should make it easier to do such tax planning without subjecting the income immediately to US tax.

Keith Martin