With the downturn in the U.S. economy—and the real estate industry in particular—many U.S. architecture and engineering (A&E) services firms are looking outside the U.S. for opportunities. These firms must carefully consider U.S. and foreign tax issues when structuring a foreign A&E services contract. Failure to address tax issues associated with a foreign contract can seriously affect an A&E services firm’s profit on a contract.
A U.S. exporter of services may be subject to a foreign country’s income tax if the service provider has sufficient presence in the foreign country to be deemed to be doing business there. Taxation in the foreign country can be in the form of a gross basis tax, e.g., withholding tax on service fees, or on a net basis, i.e., gross income less deductions. This decision depends on the law of the foreign country; however, foreign laws may be overridden if the foreign country has a tax treaty with the U.S. Income tax treaties include a permanent establishment (PE) article. The PE article provides guidance on whether the treaty party’s activities give rise to a fixed place of business resulting in the foreign party being subject to taxation in the other country on its business profits. Most treaties provide that a building site, construction or installation project must exceed a certain length of time, e.g., 12 months, before a PE exists.
If the A&E services firm will be subject to withholding tax on its gross service fee income, it will need to consider if the withheld tax can be used to offset U.S. income tax. This offset is referred to as foreign tax credit. In general, a U.S. taxpayer is permitted a foreign tax credit equal to the U.S. income tax equivalent on foreign source income. Expenses related to foreign income must be allocated to and reduce foreign source income.
Regarding provision of services, Sections 861(a)(3) and 862(a)(3) generally treat income from personal services as having a source where the services are performed. The theory underlying this source rule is that the place where services are performed is the situs of the economic activity giving rise to the income. Therefore, income from services performed within the U.S. is generally U.S. source income, while income from services performed outside the U.S. is generally foreign source income. The nationality and residence of the payor and recipient of the compensation, the place where the service contract is made and the form, place and time of payment do not affect the source under this general rule. In addition, the source of the income is not affected by whether the recipient performs the services as an employee or independent contractor.
The application of the sourcing rule is highly relevant if there is withholding tax and the A&E services firm is performing services both in and out of the U.S. Failure to properly address withholding tax could result in an economic loss on the contract, as the amount of foreign tax credit the A&E services firm is allowed to claim as a credit against its U.S. tax liability on the foreign income can be severely limited.
A&E services firms also need to consider applicable taxes besides income taxes. Taxes such as value-added taxes, customs duties and business services taxes need to be considered. For example, Brazil imposes a variety of import taxes on the company importing services from a nonresident service provider. The total of these import taxes is a whopping 24.25 percent. China requires the foreign service provider to pay a business tax, generally 5 percent, regardless of whether the services are performed in China. If such taxes are not addressed by the A&E services firm on the front end, the contract may not be profitable or the A&E services firm may not be competitive.
A&E services firms need to consider the application of foreign income and social taxes on any employees who may need to perform services in a foreign country. Income tax treaties typically will exempt individuals from income taxation where the individual’s presence does not exceed a certain period of time, e.g., 183 days, and the compensation is not born by a company having a PE in the other country. Accordingly, an A&E services firm’s employees typically will be exempt from foreign income tax, but a careful analysis of the treaty and administrative requirements to qualify for treaty benefits is required. For example, Canada requires the individual to obtain a waiver under the U.S. and Canada income tax treaty in advance of receiving compensation to avoid payroll tax withholding. The U.S. also has Social Security agreements with many countries that can prevent individuals from being subject to duplicate social taxes.
Finally, the interest charge-domestic international sales corporation (IC-DISC) is an export incentive A&E services firms should consider. While the IC-DISC is beyond the scope of this article, note that A&E services for projects located outside the U.S. are qualified exports receipts for purposes of the IC-DISC export regime. In most cases, the IC-DISC can provide a permanent 15.8 percent tax savings or more for qualifying U.S. exporters.
A&E services firms may encounter numerous pitfalls when entering into foreign services contracts. Addressing the tax issues in connection with the bid and contract drafting process can help avoid surprises and offer a healthier return on the contract. For more information, contact your BKD advisor.