Breaking Into The US Market: How Do US Federal And State Taxes Affect Your Bottom Line.

In these tough economic times, it is hard to find any good news. But there is a silver lining, especially for businesses currently exporting to or doing business in the United   States. With the decline of the US Dollar, America becomes a less expensive place to do business in.

The purpose of this post is to present, through an example, how much your business growth and profit depend on an understanding and an adequate management of US business tax.

The question non-US entrepreneurs should ask themselves is: “Can taxation in the US affect my business bottom-line? And if so, how?”  The quick answer to these questions is taxation in the US often affect a non-US business in a significant way.

To illustrate my point, here’s a small case study of the business evolution of a fictitious company named SpanCo in the US.

Facts: SpanCO is a Spanish company based in Madrid selling fine wine across Europe and Mexico.  Let’s follow this Spanish business expanding in the United States.

1/ SpanCo warehouses its wine in the United States:

SpanCo, as described in the facts, is already established in Mexico. The company is now interested in warehousing its wine inventory in California. The consequence of that decision would mean the following:

1. At the Federal level: SpanCo would generally be exempted from income tax at the federal level. In fact, the use of a facility solely for the purpose of storage of goods belonging to a non-US corporation is not enough to be considered doing business in the US.
2. At the State level: The particularity of the United   States tax system is that, SpanCo may find itself taxed at the state level, even if exempted at the federal level. It is so because holding inventory in California is enough to be required to file a tax return. What is also worth noting is that in certain states such as California, net taxable income is based on the sales in that jurisdiction. As a result, SpanCo may be liable only for minimum tax in the state.

2/ SpanCo expands its market in the United States:

Let’s now imagine that SpanCo’s wine tested well in the United States to the point where the company is now contemplating expanding itself in the Southwestern region of the country. Before committing to the project, SpanCo evaluates the cost of the expanding the US market, which includes the tax expenses.

Now, the expansion strategy will be dependent on which state SpanCo decides to enter. Some of the factors include:

1. State with net income tax protection: Certain states will permit exemption of taxation of net income if the taxpayer sells tangible goods. There are some specific requirements for that exemption that are relatively easy to understand. (see December 31, 2012 blog for more info on Public Law 86-272)
2. Inventory and sales destination strategy: US states generally tax net income based 3 factors, which are commonly sales, salary and property (including inventory). Consequently, SpanCo strategy would be to optimize employees’ location of work and warehousing of inventory in function of sales projection.
3. Federal tax implications: Because of the evolution of SpanCo activities in the US, the company would be better off incorporating a subsidiary in the US to avoid the compliance and fiscal weight of operating a branch.

3/ SpanCo submitting a proposal for a project in the US:

Now that SpanCo is well established as a provider of great Spanish wine in area, let’s imagine the company is now involved in servicing Californian vineyards. Effectively, local wine producers are interested in improving the quality of their wines. These US wine producers are thus requesting different Southern European wine specialists to advise them and build vineyards in America.

In order to submit a profitable proposal, SpanCo needs to evaluate the sales tax dimension of the project. Failing to do so could lead the Spanish company to submit an overpriced proposal to the client and therefore loose the contract to a competitor with a more reasonable price. At the same time, submitting an under-priced proposal, that is subsequently accepted, would probably dry out all profits.

Sales and use taxes are a relatively complicated subject to fully explain in a few paragraphs. But in short, sales and use tax may be imposed on the sales, transfer, or exchange of any taxable item or the performance of taxable services within a taxing jurisdiction.

Therefore, SpanCo will have to estimate how much in sales tax it will pay, should it be awarded the vineyard consulting/construction contract.

There would be at least 2 factors to consider when evaluating the tax costs related to the performance of the project the company is proposing for.

1. The type of persons or businesses involved: SpanCo could benefit from an exemption of state sales tax on material purchased for the project if the client is either a governmental entity or a non-for-profit. This is significant to know in order to save in tax expense, and consequently increase net profit on the project.
2. The type of transaction: SpanCo could potentially be subject to sales tax. For example, if the contract is to build a vineyard, then, material purchased for use in making improvements, repairs or modification to the real estate property of the client, will generally be taxable to the purchaser of that material. On the other hand, if the material is bought by SpanCo and then resold to the client on a stand- alone contract, the client is generally considered to be the ultimate purchaser of the material. Accordingly, SpanCo will commonly not be liable for sales tax.

4/ Conclusion

Tax is more than a financial housekeeping activity of a business. It is an essential part of determining the going concern of an enterprise. Having a general understanding of the subject along with an advisor should help managing the tax expenses that could make a difference between a profitable endeavor and one that is paying a greater amount than its fair tax share.