Part 2: Expanding Your Business Outside the United States
July 3, 2019
Last month we presented the first in a series on taking your company global. This month, we are examining the initial questions that our hypothetical Delaware corporation, ABC Co., which makes and sells sporting goods, should research and answer before attempting to open an Indonesian subsidiary or to partner with its existing Indonesian supplier in a new joint venture.
Question 1: What types of legal entity are available?
Decisions regarding what type of corporate entity to utilize in an expansion abroad must be approached by weighing management and control desires and tax considerations. Exploring these issues is a multi-step approach which requires input from local legal counsel:
- Representative Office/Branch Office – Most countries, including Indonesia, offer the option of opening a “Representative Office” or a “Branch.” These generally are not independent entities but rather extensions of the foreign company itself. A Rep Office or Branch generally cannot engage in significant commercial activity (a Rep Office is more restricted than a Branch) but it often incurs no tax liability, including in Indonesia. A Rep Office or Branch is normally used when a company is not ready to commit to investing in a foreign country but wants a small initial toehold in-country to familiarize itself with the local market, pricing and laws, perform market research, or provide marketing for its products or services made outside the country. Some jurisdictions, such as Singapore, allow Rep Offices and Branches to exist for only a few years, while others like Russia allow them to exist indefinitely. Because ABC wants to own a factory, transact business, and ship goods from Indonesia, a Rep or Branch Office is not a good choice.
One cautionary note: some countries (including the US) consider Rep Offices and Branches to be stand-ins for the parent company and thus hold that ALL of the parent’s assets are at risk for liability incurred by the Rep or Branch Office.
- Corporation – While stock corporations exist in virtually all countries, in many (including Indonesia), a foreign person or company cannot wholly own a corporate entity. While ABC could buy into an already-existing Indonesian corporation (such as its supplier) or create a new corporation with a local partner, it would be limited by law in the percentage of shares it can own in the corporation. Thus, ABC would not be able to control management. While this option is not desirable for ABC, it may be fine for an investor who wants only a minority share in an existing company in order to take advantage of the company’s local contacts, business reputation, and customer base.
- Limited Liability Company – While foreigners are generally forbidden to wholly own LLC’s in Indonesia and other countries, some have created special corporate forms for foreign investors that allow 100% foreign ownership. In Indonesia, the Penanaman Modal Asing (“PMA”) is such a corporate form for foreigners. ABC has at least two options with PMAs: (i) create a wholly owned PMA, or (ii) create a joint venture PMA with a local partner in which ABC owns a super-majority of the interests (or otherwise controls decision-making). The PMA seems to be the best choice for ABC from a structural perspective due to its flexibility.
Question 2: What tax rates will apply to ABC’s new corporate entity and are there tax incentives that might lower those rates?
While ABC has decided against using the Rep Office or Branch form, such entities are not taxed in most countries. However, be aware that some nations, under certain circumstances, might require tax to be paid by the Rep or Branch Office on the company’s entire worldwide income. It is crucial that a company know the actions it must take (or not take) to incur such liability when it opens a Rep Office or Branch.
Most countries, including Indonesia, impose income taxes on the annual income of the company in their country, as well as taxes on dividends, interest and royalties paid to its owners, and tax rates may differ between residents and foreigners. (In addition, import/export taxes may apply to materials ABC imports and goods it manufactures and exports; local taxes may be imposed on ABC; and taxes must be withheld from employees’ salaries.) A very basic tax analysis for ABC would look like this:
- Income Tax – LLCs and corporations are generally subject to a 25% tax rate on Indonesian income, with an exception for some listed public companies (20%). There is a “small enterprise” exception that decreases the rate to only 1% for businesses with annual income under 4.8 billion Indonesian rupiah (about US$334,000), and to 12.5% for companies with annual income between 4.8 billion and 50 billion rupiah (about US$3.48 million). In addition, there are tax breaks for “pioneer” or strategic industries such as oil refineries, machinery, communication devices, infrastructure, and agricultural processing, and for manufacturing and other labor-intensive industries that increase exports. It is possible that ABC might be eligible to take advantage of the 12.5% rate for the first one or two years of its Indonesian operations, as it does not expect revenue to top $3 million in those years.
- Tax on Dividends, Interest and Royalties – Tax must be withheld from dividends, interest and royalties paid by Indonesian companies. The withholding rate is generally 0% for Indonesian residents (assuming certain conditions are met), and 20% for non-resident recipients, subject to a lower rate imposed by dual tax treaties.
- Tax Treaties – A “double-tax treaty” between two countries indicates that those nations have agreed to (i) give credit to their own citizens for income tax paid in the foreign country so the citizens do not pay double tax on that income, and (ii) decrease taxes on dividends, interest and royalties paid in the foreign country to the home country’s citizens. The United States has tax treaties with almost 70 foreign nations (see https://www.irs.gov/businesses/international-businesses/united-states-income-tax-treaties-a-to-z for a complete listing), including Indonesia, and that treaty reduces the 20% withholding rate for American non-residents in Indonesia to 15%. Even more favorable rates are available to Emerati citizens, as their tax treaty with Indonesia lowers the dividend and interest tax to only 10% on dividends and 5% on royalties. Because Dubai is a 0% tax jurisdiction, ABC might consider creating a Dubai holding company to own its interest in the Indonesian PMA in order to take advantage of these tax savings. Unfortunately, the US has no tax treaty with Dubai or the UAE, so re-patriating the funds to the US would incur US tax liability.
As a company targets foreign markets as potential locations for expansion, it is imperative to ascertain whether a double-tax treaty exists with the countries being considered. For example, among “emerging markets,” you might find Vietnam or Malaysia (0% tax on dividends through US double-tax treaty, credit for income tax paid) to be more attractive than Laos (no double-tax treaty, no credit for income tax paid, 10% rate on dividends) or the Philippines (double tax treaty, credit for income tax paid, but 10-25% on dividends). The lack of a US tax treaty with Laos, and many other countries means that US citizens or companies receiving income in those nations may have to pay double taxes on such income (once in that country and again in the US), rendering such investments less attractive unless off-shore holding structures or other means can be used to negate the tax disadvantages.
- Economic Development Zones – Indonesia, like many countries, has identified several special economic zones (SEZs) wherein investments receive tax reductions from 20% to 100% for 10-25 years. Companies who locate in a SEZ must own assets there such as a factory, land, or an office building related to its business operations. A company located in a SEZ must operate its business in the SEZ, i.e., it may not perform its main business operations from a Jakarta or other office. SEZs are located in underdeveloped areas close to natural resources like oil, rubber, cocoa, fisheries, palm oil and coal. The SEZs in Bitung (North Sulawesi), Sorong (West Papua), and Tanjung Api-Api (south Sumatra) are located on or near coastlines but port facilities are not nearly as advanced as in Jakarta. ABC might be interested in considering these three SEZs if they can work out the logistics of transporting their manufactured goods to a port for international shipping. SEZs provide excellent opportunities for new investments abroad, offering tax incentives, exemptions from tariffs, subsidies, and other advantages. For example, China has over 160 high-tech development zones, while Turkey offers about 70 tech development zones and over 300 “organized industrial zones.”
The contents of this Alert are for informational purposes only and do not constitute legal advice. If you have any questions about this Alert, please contact the Shulman Rogers attorney with whom you regularly work or contact us here.