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DOING BUSINESS IN USA

FORMS OF BUSINESS ORGANISATION

Principal forms of doing business

Foreign investors face no particular problems establishing companies in the US. The general requirements for US corporations are described below.

Requirements of a corporation in the US
There is no federal company law in the US. Similarities in state legislation, however, make it possible to provide the following outline of requirements. Recent changes to corporate-governance laws apply only to publicly listed companies.

Capital. No minimum for manufacturing companies, except for the funds needed to start operations and obtain credit. Most states requiring minimum paid-in capital specify US$1,000. Minimum capital requirements are in effect, however, for banking, insurance and related activities. The banking industry uses capital requirements set by the Bank of International Settlements in Basle, Switzerland; requirements for the insurance industry are established by the National Association of Insurance Commissioners, headquartered in Washington, DC.

Most states require that subscribed capital be fully paid in before authorized shares are issued. There are no legal reserve requirements.

Founders. Traditionally a minimum of three; a growing number of states permit one (often corporate) incorporator. Some states have residence or citizenship requirements for founders; in practice, these do not present an obstacle since incorporators are needed only for organizational formalities.

Directors. Frequently, a minimum of three; many states now allow one. Generally, no restrictions on residence or citizenship apply. For publicly listed firms, the firm’s chief executive officer (CEO) and chief financial officer (CFO) must certify all financial reports filed with the Securities and Exchange Commission (SEC). A firm may not lend funds to any of its directors or executive officers unless such loans are made in the ordinary course of the firm’s lending business. Terms must be the same as those offered to the general public. The SEC may prohibit any person found guilty of fraud from serving as an officer or director of a firm. Directors may not purchase, sell or otherwise transfer securities under their individual retirement account plans. Changes in directors’ and executive officers’ share ownership must be filed with the SEC within two business days. Since July 2003 these filings must be made electronically and be available for public viewing on the company’s website.

Management. No nationality or residence requirement. No stipulations that labor be represented on the board of directors or in management.

Disclosure. Financial data must be published by all companies the year they are established; thereafter, data are required only of those listed on national securities exchanges. Some states require annual filings (containing minimal information) by foreign corporations licensed to do business in the state. If a firm has 500 or more shareholders and more than US$1m in assets, it is subject to the reporting requirements of the Securities and Exchange Act of 1934 and to various state reporting requirements. (The Securities and Exchange Act and its amendments pertain primarily to publicly owned corporations, dictating corporate disclosures made in annual reports, insider-trading reports, balance sheets, income statements, proxy material and other public reporting.)

SEC guidelines require a publicly listed company to disclose quickly any changes in its financial condition or operations. Pro forma financial information contained in any public disclosure must not be misleading and must be reconciled with the firm’s financial condition and operating results under generally accepted accounting principles (GAAP). The SEC will review each firm’s periodic reports at least once every three years. A firm may not discriminate against an employee if he or she assists in an investigation or proceeding involving an alleged violation of securities law. During an investigation, the SEC may petition a court to freeze any “extraordinary” payments by the firm to its directors, officers, controlling persons, agents or employees. Liabilities incurred in connection with a violation of securities laws may not be discharged by bankruptcy.

Taxes and fees on incorporation vary by state, but they are generally low. In states with the simplest filing procedures, it may cost as little as US$40 to start a company with capital of up to US$100,000. The most common procedure is to file a certificate with a county clerk to create a legal entity with the prefix “dba,” which stands for “doing business as ...”

Types of shares. Both common and preferred shares may be issued; holders of preferred shares usually receive fixed interest plus certain voting rights. Dividend payments are not deductible for the payer (unlike interest payments on many forms of debt). Both bearer and registered shares are allowed, though registered shares are more popular. Many states do not require a stated par value per share. Corporations may also issue bonds and other debt instruments.

Control. Shareholder meetings must normally be held every year, sometimes within the state of incorporation. Those meetings typically occur in the spring—April or May. Voting is usually by proxy if the company’s shares are widely distributed. Ownership of 25% of a company’s shares constitutes a controlling interest; however, ownership of 5% or more of a company’s shares requires notifying the SEC, with some statement about the shareholder’s intentions. Collective action on proxy votes can significantly increase the voting power of smaller groups.

Establishing a branch

As a rule, foreign companies operate in the US through local subsidiaries rather than through branches, for reasons of convenience or because of legal and tax considerations. Branches of foreign corporations are generally subject to a 30% tax on their profits sourced in the US. Any company investing in the US should carefully review how taxation of its US and foreign income would be affected by the establishment of a branch.

A branch of a foreign concern qualifies in the various states under the same general rules as those for an out-of-state corporation. No special requirements exist for setting up a branch operation, other than registering with local authorities. A branch must have adequate bookkeeping for tax purposes. No minimum level of capitalization is required, and no statutory audit is required. All liabilities of the branch are considered those of the foreign corporation. Special provisions do apply, however to branches of foreign-owned banks.

Setting up a company

Foreign investors face no particular problems establishing companies in the US. A firm may organize under the laws of any one of the 50 states, the District of Columbia or the US commonwealths. Through a fairly simple procedure, it can then set up offices, plants or other permanent establishments under the corporation laws of other states. Legally, a corporation is considered domestic only in the state in which it is incorporated and is considered “foreign” elsewhere. Most firms do business in more than one state, and the state of incorporation is often different from the site or sites of operation.

Companies may choose a location based on which state’s laws offer the greatest flexibility for the types of securities that may be issued, where board of directors’ meetings must be held, whether US citizens must be on the board and so on. Consideration may also be given to reasonable local taxation and low incorporation costs. Because of their more liberal corporate laws, Delaware, Maryland and New York are favored states of incorporation. Consultation with an experienced corporate lawyer is recommended before selecting a state.

The certificate of incorporation, which must be filed with the secretary of state (of the state of incorporation), generally includes a corporate name (often required to be followed by “Inc,” “Co” or “Corp”), purpose or purposes, duration (usually perpetuity), amount of capital, par value of shares (if any), location of statutory office, registered agent for service process and the number of directors.

To qualify outside the state of incorporation, a firm must take the following steps with each state where it intends to do business: file its certificate of incorporation; submit an application containing information on its activities and management (the amount of detail required depends on the state); and pay filing fees. A lawyer should determine the states in which a company should or must officially qualify; it is a good idea to proceed cautiously, since qualifying makes the firm liable for state taxes and for future lawsuits in the state. Moreover, failure to qualify in a state where a firm is deemed to be “doing business” can result in fines and other penalties.

Interstate public share and bond offerings—by domestic or foreign firms—are legal, but offerings of more than US$500,000 must conform to certain Securities and Exchange Commission guidelines.

BUSINESS TAXATION

Overview

Tax jurisdiction in the US is divided among the federal government, the 50 states plus the District of Columbia, and local counties and municipalities. All residents and foreign individuals and corporations engaging in business or investment transactions in the US are subject to some form of US taxation. A firm’s tax burden depends on the jurisdictions in which it operates and earns taxable income.

In general, US corporate tax rates are low compared with those in other industrialized countries. Most companies making a direct investment in the US choose to do so through a subsidiary rather than a branch for tax reasons. Licensing is an option that carries certain non-tax benefits (and drawbacks) compared with direct investment. Exporting to the US demands knowledge of complex and often changing tariff and duty regulations, but it is still a viable alternative to direct investment.

There are no uniform rules on the definition of taxable income or on the apportionment of income among the various tax jurisdictions. Hence the advice of a tax attorney is practically indispensable to any newcomer to multi-state business.

The US Congress passed the American Jobs Creation Act on October 7th 2004, the first broad-based restructuring of corporate taxes in two decades.

A key element of the 2004 legislation is the phasing out of the FSC/ETI regimes, both of which were declared illegal export subsidies by the WTO. The EU subsequently imposed retaliatory tariffs on US imports, which had increased to 12% in October 2004 and would further increase by 1% a month until the regimes were eliminated. Under the new legislation, the ETI exclusion is generally repealed for transactions after December 31st 2004, although under a two-year transition period (with a binding contract exception), ETI benefits will be available in 2005 and 2006 at 80% and 60%, respectively. The EU lifted the sanctions, but challenged certain aspects of the ETI repeal legislation.

Other important provisions of the new legislation include:

* The general tax rate for “production activities” of manufacturing companies will drop by three percentage points to 32% for 2005 and 2006, to 29% for 2007, 2008 and 2009, and to 26% for 2010 and thereafter. The definition of both “manufacturers” and “production activities” for these purposes is broad. Along with traditional manufacturing, construction, engineering, energy production, computer software and agricultural processing are also included. When fully implemented in 2010, the deduction will amount to 9% on the lesser of qualified production income or total taxable income. Many companies that received no benefit under the FSC/ETI program will pay lower taxes under the new legislation. By 2010, the new program could cost a total of US$500bn by some estimates, although offsetting investment and job creation seems certain.

* The Act provides a one-year tax benefit for corporations that are US shareholders and that receive dividends from CFCs. Subject to various limitations and conditions, a US corporation may elect to deduct 85% of certain “cash dividends” it receives from its CFCs.

* The 2003 increase to US$100,000 in small-business expense write-offs, which was originally to drop back to US$25,000 for 2006, has been extended through 2007. The threshold is indexed for inflation, providing a limit of US$102,000 for 2004.

* S Corporation rules, governing small businesses, have been refined. The permitted number of shareholders has been increased to 100 from 75, and all members of one family can be treated as one shareholder. Other conditions have been relaxed and simplified, making S Corporation status more attractive for new business formations.

Several other measures affect companies with international operations. The number of foreign tax credit categories is reduced from nine to two (effective in 2007). Foreign tax credits may be carried forward for ten years (up from five) and carried back for one (down from two). The alternative minimum tax (AMT) foreign tax credit that was limited to 90% of total AMT has been eliminated

Taxable income and rates

The US has a graduated system of corporate taxation. Corporations pay 15% on the first US$50,000 of taxable income; for income of US$50,001–75,000, the rate is US$7,500 plus 25% of the amount exceeding US$50,000; for income of US$75,001–100,000, the rate is US$13,750 plus 34% of the amount exceeding US$75,000; for income of US$100,001–335,000, the rate is US$22,250 plus 39% of the amount exceeding US$100,000; for income of US$335,001–10m, the rate is US$113,900 plus 34% of the amount exceeding US$335,000; for income exceeding US$10m-15m, the rate is US$3.4m plus 35% of the amount exceeding US$10m; for income exceeding US$15m-18.33m, the rate is US$5.15m plus 38% of the amount exceeding US$15m; for income exceeding US$18.33m, the rate is a straight 35%.

These rates apply both to the worldwide income of US corporations and to the income of foreign corporations that is effectively connected with a US trade or business. Capital gains are subject to tax at the same rates, and capital losses may be deducted only from capital gains.

Corporations are subject to 20% alternative minimum tax (AMT) on AMT income if this amount exceeds the regular tax on regular taxable income. AMT income is computed by making adjustments to regular taxable income, which consists of adding back all or a portion of certain deductions and tax credits that are otherwise allowable in computing regular income taxes. AMT income also includes a percentage of adjusted current book earnings. A credit against regular corporate tax for future years is generated to the extent AMT exceeds regular current corporate tax.

Comparisons of tax rates levied by the states are not entirely meaningful because the definition of taxable income varies by state. Many states apply taxes at a flat rate (usually 5–10%), but some have graduated rates. State taxes are generally applied to income allocated to each state. Some of the highest tax rates are in Iowa (12%), North Dakota (10.5%), Pennsylvania (9.99%), District of Columbia (9.975%) and Minnesota (9.8%), according to the Federation of Tax Administrators. Five states (Nevada, South Dakota, Texas, Washington and Wyoming) have no state corporate income tax, with a few exceptions (for example, certain bank and financial institutions are taxed in South Dakota).

In addition, the imposition of income taxes at the city level is spreading. Most local tax structures take as their starting point “federal taxable income” and then make adjustments to allocate and apportion the income. Most of these taxes are in the 1–2% range (though New York City has a rate of 8.85%). Both state and municipal taxes are deductible for federal tax purposes.

There are no excess-profits taxes at the federal or state levels.

Taxable income defined
Legally, a corporation is considered a resident only in the state in which it is incorporated. For example, a Delaware company and a German corporation, each with operations in New York, are both considered non-resident in New York State. A firm may organize under the laws of any one of the 50 states and then, through a simple procedure, apply for a certificate of authority to operate and set up offices, plants or other establishments under the corporation laws of other states.

A corporation’s tax burden depends on the number of states in which it operates. There are no uniform rules on the definition of taxable income or on the apportionment of income among the various jurisdictions.

Consequently, any company that operates interstate will be risking over-taxation or under-taxation, since some items of income are likely to be taxed either more than once or not at all. The advice of a tax attorney or accountant is indispensable to any newcomer in multi-state business.

Non-US corporations are generally subject to US tax on income from US business operations. If the non-US corporation is from a country that has no tax treaty with the US, that corporation’s business income is taxable only if it is “effectively connected with the conduct of trade or business within the US.” “Effectively connected income” can include any gain from the sale of US real property, any income connected with participation in a partnership that engages in US business, or any income received as beneficiary of an estate or trust so engaged. Under various income tax treaties, a non-US corporation is taxable on a net basis only on income attributable to a “permanent establishment” in the US. All non-US corporations are taxed on a gross withholding basis on US-sourced portfolio income, such as dividends, interest, rents and royalties that are not effectively connected. Tax treaties often reduce the 30% withholding rate.

The first step in determining federal income tax on effectively connected income is to compute effectively connected gross income, the sum of net revenue from sales or services (gross revenue less the cost of goods and services sold), interest earned and net US-source, long-term capital gain connected with the US business.

The following deductions are made from effectively connected gross income to arrive at effectively connected taxable income: depreciation of assets, rent, salaries, professional fees, charitable contributions to US charities up to 10% of taxable income, net operating losses, and state and local income taxes.

Items that are not tax-deductible include most dividends, going-concern value, expenses related to tax-exempt income, political contributions, costs for certain types of life insurance, legal penalties and costs related to tax-free corporate restructurings.

US corporations must pay tax on worldwide income, including income from branches, whether or not it is repatriated. Profits from active operations of overseas subsidiaries usually are not taxed until they are remitted as dividends. Worldwide income includes income from a business, compensation for services, fees and commissions, rents, royalties, interest, dividends, gains from dealings in property and income from a partnership. Appreciation in the value of an asset is not considered income unless the gain is recognized through a sale or other disposition.

No expense is deductible from gross income unless it is specifically allowed under the tax law as “ordinary and necessary” and was paid or incurred during the taxable year in connection with the operation of a trade or business.

The heart of the AMT is its use of “adjusted current earnings” (ACE) as a separate test of taxability, in addition to a list of “preference” items that are subject to minimum tax. In computing minimum tax, a company first calculates its regular taxable income and tax, including all the various deductions, exemptions and exclusions. Then, starting with regular taxable income, it adds back these preferences and makes certain other adjustments to calculate minimum taxable income. Next, it compares this figure with ACE as reported to shareholders, a regulatory agency or a bank for purposes of obtaining a loan. If ACE exceeds minimum taxable income, 75% of the difference is added to minimum taxable income. Then the US$40,000 corporate exemption is subtracted, and the minimum tax is calculated on the remainder at a 20% rate. The corporation’s liability is the greater of this result or the regular tax.

State corporate income taxes are usually assessed on total taxable income allocated to the state, but a few states (Alabama, Iowa, Missouri and North Dakota) assess on net income after federal taxes. All states use some portion of the federal definitions of taxable income as a base for taxation; most states use some income figure from the federal return as a starting point and then apply specific state rules. Only four states (Alabama, Arkansas, Mississippi and Utah) do not start with some federal tax-return number.

States have the right to impose an income tax on a multi-state corporation only if that corporation establishes sufficient presence (“nexus”) in that particular state. For state income tax purposes only, a federal statute provides that the solicitation of sales of tangible personal property will not cause nexus to exist. However, it has been left to the states and to the courts to define what constitutes solicitation of sales and unprotected activities. Soliciting the sales of services or the storage of inventory in a state will often create a taxable nexus. Moreover, a number of states have taken the position that the licensing of a trademark or trade name may create nexus when the licensee uses the trademark or trade name in their states.

States may base a multi-state corporation’s income tax on the corporation’s entire income, including that which is foreign sourced. States may apportion a share of such total income to the state’s jurisdiction, using a three-factor apportionment formula that considers the percentage of property, payroll and sales a company has in the state. Most but not all states have adopted this approach. Those that apportion on the basis of only one factor usually opt for sales; others use sales and one of the other two factors. The state taxable income determined by this formula may differ from the actual amount of income earned in the state as determined by separate accounting for operations within the state. (The franchise tax, noted above, is imposed without regard to physical presence, and also frequently uses the three-factor apportionment formula.)

Foreign income of resident firms is taxed at regular corporate rates. To avoid double taxation on income earned outside the US (including income repatriated in the form of dividends from non-US companies), a firm may claim a foreign tax credit for foreign income taxes paid. The extent to which a foreign income-tax credit may be used to offset the US tax is subject to various limitations.

Tax deferral is denied for various types of “tax haven” income. Moreover, if a corporation participates in or co-operates with an international boycott as a part of doing business in a foreign country, the foreign tax credit and tax deferral are denied to that corporation. Companies must report all information regarding participation in an international boycott to the Internal Revenue Service.

A branch of a foreign corporation is taxed in the same way as a domestic corporation on income that is effectively connected to its US operations. US-source income that is not effectively connected is taxed at a flat 30% rate, unless that rate is reduced by an applicable tax treaty. The assessment of income tax is generally based on the branch’s records, assuming they reflect the income that may be considered derived from the assets or activities of the branch. Expenses to be deducted must be allocated between the branch and the parent company. Branch profits remitted to the parent company are subject to a 30% branch-level tax, unless that rate is lowered by an applicable tax treaty.

Depreciation
Depreciation provisions are referred to as the modified accelerated cost-recovery system (MACRS). The law authorizes a reasonable deduction for the exhaustion of, or wear and tear on, property that is used in a trade or business or to produce income. Depreciation is permitted on tangible property, except for inventory, stock in trade, land (apart from improvements) and certain natural resources. Depreciation is also permitted on certain intangible assets such as patents or copyrights that have limited useful lives. The cost of an acquired intangible asset (such as goodwill, going-concern value, patents, permits, franchise, trademark or trade name) can be amortized over 15 years from the date of purchase.

Cost-recovery periods under the cost-recovery system are set according to the class of property concerned. Most of the cost-recovery classes are based on the type of asset rather than on the industry that uses them. For example, cars, trucks and equipment for research and development are depreciated over five years. Other assets are in the 3-, 7-, 10-, 15-, 20-, 27.5- or 39-year classes. Assets in the 3-, 5-, 7- or 10-year classes receive 200% declining-balance depreciation and the half-year convention. Those in the 15- and 20-year classes depreciate at a 150% declining-balance rate and the half-year convention. The other periods use the straight-line method and the mid-month convention. For all, a switch to straight-line depreciation occurs at a certain point to maximize deductions. A special provision allows for 30% “bonus” depreciation in certain limited instances under economic stimulus legislation enacted in 2002. Recently proposed legislation would further enhance the depreciation rules and provide additional opportunities to expense certain assets. But the future of the proposed legislation is uncertain.

Allowances for depletion of natural resources are generous. There are two methods of calculating depletion: cost and percentage. The depletion allowable for any tax year must be the higher of the two methods (except for timber, where the cost-depletion method is required). States set their own depletion rules. The annual cost depletion is generally calculated, on the accrual basis, by dividing the adjusted basis of the natural resource by the total number of recoverable units and multiplying the result by the number of units sold, or on the cash basis, by the number of units for which payment has been received. Percentage-depletion deductions are 5–22% of gross income, depending on the resource. The annual percentage depletion is based on a percentage of the gross income arising from the property during the year; however, the deduction must usually not exceed 50% of the net taxable income from each property, computed without the deduction for depletion. The percentage used varies with the type of resource. Proposed legislation would provide additional tax incentives for natural-resource and energy production, but the future of the proposed legislation is uncertain.

Taxes on interest
In general, US-source interest income paid by a US borrower (including original issue discount (OID) on obligations maturing more than six months from the date of issue) and US-source interest income paid by the US branch of a foreign firm may be subject to withholding tax at a 30% rate, unless the withholding tax is reduced or eliminated by a US statute or an applicable tax treaty. The most important exemption from interest withholding tax is the portfolio-interest exception (this exception also applies to OID that would otherwise be subject to withholding).

Interest (and OID) generally qualifies as portfolio interest in the following circumstances:

* If the obligation is not required to be issued in registered (non-negotiable) form and is issued under arrangements designed to ensure that it will be sold only to non-US persons; or

* If the obligation is issued in registered form, whether or not it is required, and IRS Form W-8BEN is furnished to the obligor (or payor of the interest), stating that the owner is not a US person.
In addition, interest will not qualify for the portfolio interest exception in the following circumstances:

* If the lender owns 10% or more of the shares of the borrower directly or indirectly under broad attribution rules;

* If the obligation is a loan by a bank in the ordinary course of the bank’s business;

* If certain contingent interest, such as interest based on a percentage of the profits of the US borrower or interest determined by reference to a change in the value of assets owned by the borrower; and

* If interest is paid by a US parent corporation to a controlled foreign corporation on loans from the foreign subsidiary.

Taxes on dividends
Dividends paid by US corporations to foreign shareholders (whether incorporated or unincorporated) are generally subject to a withholding tax of 30%, unless reduced or eliminated by an applicable tax treaty.

Domestic corporations may be entitled to a 100% dividends-received deduction (DRD) for dividends from subsidiaries that are 80% or more controlled by the domestic parent. A lesser DRD of either 70% or 80% is allowed in certain circumstances in which a smaller ownership percentage exists. Dividends from subsidiaries included in consolidated returns are effectively eliminated from determination of consolidated taxable income, with a corresponding reduction in the parent’s basis in the subsidiary’s stock.

Remittances of US branch profits of a foreign corporation to the foreign “home office” of the firm are subject to a 30% branch-profits tax (unless reduced by an applicable tax treaty) that is meant to replace the dividend withholding tax that would apply if the branch were a US subsidiary. In general, the branch-profits tax rate on corporations that are “qualified residents” of a foreign country is reduced to the treaty withholding rate for treaties that have entered into effect or have been modified since 1987 (1986 for Canada). Foreign corporations may be exempt from branch-profits tax under earlier treaties that have not yet been replaced or modified if they meet the “qualified resident” requirement.

Taxes on royalties and fees
The US imposes withholding tax at a 30% rate on US-source royalty income paid to foreign licensors for the right to use intangible property such as patents, trademarks and copyrights in the US. This tax sometimes applies to purchases of intangible property for use in the US, to the extent the payments depend on productivity or profitability of the licensee. Withholding tax is reduced or eliminated under many US tax treaties. Fees for services performed in the US by foreign corporations may be subject to US tax as effectively connected income. Withholding tax at a rate of 30% may apply to payments for such services, but the recipient corporation receives a refund to the extent the tax withheld exceeds actual tax liability. Even this withholding tax can be avoided if the foreign corporation furnishes Form W-8ECI to the payor, showing that it is taxable on the income as income effectively connected with a US trade or business. However, the foreign corporation is then fully subject to tax on this income on a net income-tax basis.

Capital gains taxation

The federal government taxes net gains on the sale or exchange of assets held for investment purposes at the same rates as ordinary income (35% for the top bracket). If a net loss results from sales or exchanges by a corporation, the loss may not be deducted from ordinary income, but may be carried back three years and then forward five years and deducted from capital gains.

Gains from the sale of depreciable property used in business are treated as ordinary income to the extent that such gains result in the recovery of past depreciation. Certain exceptions exist for the sale of real estate. Anything exceeding that amount is taxed as described in the previous paragraph. Net losses from sales or exchanges of such depreciable property may be deducted from ordinary income.

Foreign income and tax treaties

The US has tax treaties with more than 50 countries that reduce or eliminate withholding taxes on payments made to residents of the treaty partner. With a few exceptions, the treaties do not lower the 30% US withholding-tax rate on income from real estate rentals and natural resource royalties paid to residents of treaty countries, but they do reduce the tax rates on other types of income. Tax treaties reduce/eliminate US taxes of residents of foreign countries but generally not the US taxes of US citizens and residents; such persons are subject to US tax on worldwide income.

Existing treaties with some countries will probably be renegotiated to conform more closely to the US model treaty, which resembles that of the Organization for Economic Co-operation and Development (OECD). The US is seeking to incorporate in revised tax treaties the key provisions of the US model income-tax treaty, in particular, provisions on branch taxes and rules to discourage “treaty shopping.”

The US recently has begun to agree to a zero rate of withholding on certain parent-subsidiary dividends. This is the case with new or updated treaties with Australia, Japan, Mexico, the Netherlands and the UK.

Transfer pricing

Planning for methods, documentation, penalties and other transfer-pricing issues is a complex undertaking. Companies may treat as tax deductible any charges paid to affiliated companies as long as they represent arm’s length transactions. One exception applies in the earnings-stripping rules, which disallow deductions for certain corporate interest accruing to an affiliate if a number of conditions exist, including that the affiliate is not subject to US tax on that interest (for example, through tax treaty reductions).

The IRS has increased its scrutiny of intercompany transfers. New rules now in place increase the compliance burden for corporations and give the IRS greater latitude in combating transfer-pricing abuses. The agency has set up an advance approval procedure for companies’ transfer pricing methods and international cost sharing arrangements. The main aim is to shorten the time it takes to settle tax liabilities under Section 482 of the tax code. Under the procedure, a company should submit a request for an agreement on a method of setting arm’s length prices, accompanied by an economic analysis of the pricing policies of the taxpayer and the industry. If the transactions occur in a country with which the US has a tax treaty, the company must also obtain the approval of that country’s revenue authority. These advance pricing agreements have become common.

Turnover and other indirect taxes and duties

There is no general federal sales or value-added tax in the US.

Most states and many municipalities levy sales taxes. Five states do not charge sales tax: Alaska, Delaware, Montana, New Hampshire and Oregon. The last four of these states also do not have any municipal sales taxes. Among the other states, rates range from 2.9% (Colorado) to 7% (Rhode Island and Tennessee), according to the Federation of Tax Administrators. Combined rates, including local rates, can range as high as 11% (Alabama).

These sales taxes are almost always assessed on the final consumer purchase, with wholesale transactions remaining tax exempt. This distinguishes US sales taxes from European-style value added taxes, which are assessed on the difference between the sales price and the cost at every stage of production and distribution.

Many states and municipalities exempt certain items or charge low sales-tax rates on them. Non-prepared foods and medicines often enjoy this favorable treatment, which varies widely across the country. In contrast, states and municipalities often assess special taxes on services such as cable television and telephone billings, and hotel and motel lodging.

The federal government levies excise taxes on the manufacture, sale and consumption of certain commodities, such as tobacco, liquor and gas. Excise taxes, generally imposed at the wholesale level, are the legal responsibility of the seller. There are also excise taxes on the sale or use of any ozone-depleting chemical by a manufacturer, producer or importer and a manufacturers’ excise tax of up to 12% on a number of goods—both domestic (based on the manufacturer’s selling price) and imported (based on the landed value). Taxes on services apply to telephone charges and airport departures.

Several federal excise taxes have lapsed in recent years. A 10% luxury tax on certain retail goods (such as yachts, jewelry, furs and aircraft) was repealed under the Clinton administration and a 3% luxury tax on the purchase price of expensive cars lapsed at end-2002.

Other taxes

The independent exercise of taxing powers by the 50 states and by municipalities has resulted in a maze of levies in the form of franchise, license, stamp, estate, property and other taxes.

Tax compliance and administration

Under the self-assessment system in place in the US, the federal income-tax return for a US corporation (Form 1120) or a foreign corporation engaged in a US trade or business (Form 1120F) must be filed by the 15th day of the third month after the end of the company’s taxable year. Extensions of up to six months may be granted. Quarterly payments of estimated tax liability are required if the annual tax liability is US$500 or more.

Penalties are fixed percentages, ranging up to 25% (or up to 40% in the case of certain transfer-pricing penalties). The balance of the final tax due, in excess of payments based on estimates, is payable by the due date for the tax return. In addition to adopting a calendar year, a company may generally choose any fiscal year it wants, provided the year ends on the last day of a calendar month (other than December unless a 52-53-week year is adopted). Subsequent changes in a fiscal year normally require approval by the Internal Revenue Service.

PERSONAL TAXATION

Taxable income and rates

The tax burden on individuals is low in the United States compared with other industrialized nations. It is a progressive system on paper, though this is complicated by an intricate system of tax regulations. For higher-income individuals, the US tax code phases out personal exemptions and imposes a ceiling on itemized deductions.

In May 2001 the US Congress approved the Bush administration’s Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which cuts taxes by US$1.35trn over a decade. Under the legislation, marginal rates were reduced across the board. All of these tax breaks, including the reduction in tax rates and repeal of the estate tax, are set to expire at the stroke of midnight on December 31st 2010. This expiration of the tax measures, or “sunsetting”, is an accounting device that allows the government to consider the costs for a ten-year window to comply with congressional budget parameters. Additional legislation, and revised fiscal calculations, will be required to make the reductions permanent.

In May 2003 Congress passed a second sweeping tax-cut package, the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA). The legislation, with a price tag of US$350bn over a decade, accelerated the cuts to marginal rates, the increase in the child tax credit and marriage penalty relief provided by EGTRRA, and reduced taxes on certain corporate dividends and capital gains.

In September 2004 Congress passed the Working Families Tax Relief Act (WFTRA) of 2004, a US$146bn bill, which extended popular middle-income tax relief provided by JGTRRA. The legislation extended marriage penalty relief, the US$1,000 child tax credit and the expanded 10% income tax bracket through 2010. It also extended the increased AMT exemption amounts (US$58,000 for married couples and US$40,250 for singles) through 2005.

In October 2004 Congress passed the American Jobs Creation Act of 2004, which repealed the extraterritorial income tax regime, restructured corporate incomes taxes and made minor changes to individual income tax rules. Among the few changes enacted for individuals is a new itemized deduction for state and local sales tax through 2005.

Personal tax rates changed as a result of the tax-cut package that the US Congress passed in late May 2003. The tax rate structure consists of six brackets: 10%, 15%, 25%, 28%, 33% and 35%. For 2005, the upper five brackets come into effect at taxable income levels, respectively, of US$14,600, US$59,400, US$119,950, US$182,800 and US$326,450 for joint returns; US$7,300, US$29,700, US$71,950, US$150,150 and US$326,450 for single returns; US$10,450, US$39,800, US$102,800, US$166,450 and US$326,450 for heads of households; and US$7,300, US$29,700, US$59,975, US$91,400 and US$163,225 for married taxpayers filing separately. Brackets are indexed annually to reflect inflation.

Qualifying dividends are now taxed separately from other personal income because of the recent changes. They are assessed at a flat rate of 15%, or a reduced rate of 5% for individuals in the 10% or 15% tax brackets.

The capital gains tax for individuals also declined as a result of the tax-cut package of late May 2003. The flat rate fell to 15% with a required long-term holding period of more than 12 months. (The 25% rate remains unchanged for certain real estate gains and the 28% rate for gains on collectibles and small business stock.) For individuals in the 10% or 15% personal tax brackets, the long-term capital gains rate is 5%.

States actively collect income tax from non-residents as well as individuals who reside in their territory. Non-residents must have gross income sourced from that state (for example, non-resident partners and S-corporation shareholders or non-residents performing services in the state). Rules for determining taxable income vary, as do tax rates, but in general the state income tax burden is light compared with the federal. Counties and municipalities might levy [spam word detected] taxes.

Determination of taxable income
Individuals must include in their taxable income all forms of remuneration and allowances, all interest (except that from state and municipal bonds) and the value of other perquisites, such as cars and free or subsidized housing. Certain dividends and long-term capital gains are considered separately, and assessed at flat tax of 15% (5% for lower-income tax-bracket recipients).

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) made three major changes to the tax-rate system: the creation of a new 10% tax bracket; the gradual reduction of the top tax rate to 35% (from 39.6%); and the reduction of most other tax rates by 3 percentage points. The law would, over time, increase the standard deduction and expand the 15% bracket for married couples. These measures were meant to ease the so-called marriage penalty, which causes many two-wage-earning couples to pay more tax filing together than they would filing as single individuals. These provisions mitigate the penalty by increasing the standard deduction and 15% tax bracket for married couples to twice that of single taxpayers.

The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) made most of these changes effective immediately and retroactively to January 1st 2003. It also reduced the tax rate on personal qualifying dividend income and long-term capital gains to a flat 15% (5% for lower-income tax-bracket recipients through 2007, and zero % in 2008). Moreover, the law increased the child tax credit to US$1,000 per child (from US$600).

JGTRRA, however, includes a complicated set of expiration dates, or “sunsets” for these measures. The cuts in personal tax rates expire at end-2010 as originally scheduled under EGTRRA; the new low rate on dividends and capital gains lapses at end-2008; and family-oriented relief in the higher standard deduction and expanded 15% tax bracket for married couples and improved child tax credits were to conclude at end-2004.

Congress, however, in the Working Families Tax Relief Act (WFTRA) extended the marriage penalty relief and increased child credit so that it now applies through 2010. It also extended the increased AMT exemption through 2005.

For 2005 taxpayers may take a standard deduction from taxable income in the following amounts: US$10,000 for married persons filing jointly (up from US$9,700 in 2004); US$5,000 for married persons filing separately (from US$4,850); US$7,300 for heads of households (from US$7,150); and US$5,000 for single taxpayers (from US$4,850).

Taxpayers with documented deductible expenses exceeding these amounts must itemize them in order to deduct the higher amount. The following expenses are eligible for itemized deduction: certain taxes paid (state and local taxes on income, sales and property); interest paid on borrowings to make investments (limited to the amount of investment income, with a carryforward for any excess); home mortgage interest (including second-mortgage interest within certain limits); charitable contributions; medical expenses exceeding 7.5% of adjusted gross income; theft and casualty losses exceeding certain amounts; and tuition for education necessary for one’s job, union dues and other job-related expenses, and expenses for producing income, to the extent they exceed 2% of adjusted gross income. The deduction for business meals and entertainment is generally 50%.

Except for investment interest, theft and casualty losses, and medical expenses, itemized deductions for higher-income taxpayers are reduced by 3% of the amount by which their adjusted gross income exceeds certain thresholds. This reduction, however, may not exceed 80% of the deductions subject to the limitation.

Residency

All US citizens and residents, including resident aliens, pay federal tax on their worldwide income and are allowed a foreign tax credit for foreign taxes paid or accrued. Aliens who have entered the US as permanent residents and who have not officially surrendered or lost the right to permanent US residency are taxed as US residents. Also taxed as residents are aliens who meet a “substantial presence test,” which requires physical presence in the US for (1) 31 days during the current calendar year and (2) a weighted number of 183 days over the course of the current calendar year and the two immediately preceding calendar years.

Non-resident aliens pay US personal taxes on all income from US sources “effectively connected” with trade or business in the US on a net basis at graduated rates. Investment and other fixed or determinable income not “effectively connected” with a US trade or business is taxed at a flat rate of 30% or a lower treaty rate, regardless of the amount.

Special expatriate tax regime

There are no special tax breaks for expatriates working in the US. An individual becoming a resident alien should consult a tax accountant about tax planning.

Capital taxes

Many localities impose a tax on real estate, usually to support public schools and other local services.


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