International Tax M&A Due Diligence for U.S. Government Contractors
February 12, 2021
Many US government contracting companies are continuing to expand their global footprint by performing contracts in other countries. The opportunity to engage in cross-border business activity on a global scale may lead to significant growth in revenue. The cost to implement an infrastructure in a foreign country will impact the profitability of a contract. It is often necessary to comply with certain foreign tax, accounting, business licensing and regulatory requirements in the country where a contract is performed. Additional specialized US international tax reporting requirements also could apply.
It is possible to mitigate certain risks by planning in advance before the contract begins in the foreign country. These risks may include noncompliance with foreign corporate income tax return filing requirements, foreign payroll tax reporting, value-added tax requirements, business licensing, labor laws and other regulatory requirements in a foreign country. Noncompliance with US international tax reporting rules also may result in significant penalty risk.
When the US and foreign compliance issues are overlooked in the process of performing a contract, this is usually questioned in the merger and acquisition due diligence process for an eventual sale of the US company. In any thorough M&A due diligence process, there will be a focus on US federal, state and local, and international tax compliance. The international tax due diligence analysis will consider compliance with US international tax rules and foreign tax requirements in foreign countries.
One of the most significant issues is whether the US government contractor is considered to have a taxable presence in a foreign country. Many US government contracts are performed on a US military base or at a US embassy in a foreign country. In a foreign country that has a US income tax treaty in effect, the threshold question is whether the US company has a taxable presence through a permanent establishment (PE) in the foreign country. Some US government contracting companies may not realize that access to, and use of facilities, or premises on a US military base, or at a US embassy can create a taxable presence through a permanent establishment in some treaty countries, such as the UK This depends on the facts and circumstances of each situation. The local foreign tax rules will apply for the interpretation of the treaty in the foreign country. A Status of Forces Agreement (SOFA), such as the NATO SOFA may not necessarily provide any tax exemption or relief. When the US company has a permanent establishment in a foreign country then it becomes necessary to allocate revenue and cost for the performance of the contract to the foreign country. This can lead to a foreign corporate income tax return filing requirement and a foreign corporate income tax liability. Additionally, when a US company has a PE in a treaty country, this requires the filing of the US federal Form 8858 for the reporting of a foreign branch with the US federal income tax return.
In other countries without a US income tax treaty, taxable presence is determined by the local foreign tax rules. From the US tax perspective, a US company could have a reportable foreign branch if there is an office, fixed place of business where employees work in the foreign country, or if a trade or business is carried on in the foreign country with maintenance of a separate set of books and records.
Another common issue is whether the US government contractor is required to comply with foreign payroll tax reporting for US expatriate employees and local or third country foreign national employees. If the US company has a PE in a treaty country then it is usually a requirement to register for and comply with foreign payroll tax reporting in the foreign country. Foreign payroll tax reporting can be required in addition to US payroll tax reporting for US expatriate employees working overseas. In such situations, it may be necessary to administer what is referred to as a “shadow,” or parallel payroll structure in the US and in the foreign country. The US employer can allow certain tax exemptions through the US payroll when US expatriate employees are subject to foreign income tax withholding through foreign payroll, or if they otherwise would qualify for the foreign earned income exclusion.
Other foreign value-added tax (VAT) rules also could apply when US government contractors import or export equipment and supplies into or from a foreign country. Payments to independent contractors also could be subject to foreign VAT.
In some instances, a US government contractor may consider forming a foreign subsidiary company to function as a subcontractor to perform the US government contract in a foreign country. There are many US and foreign tax considerations that are at issue for ownership of a foreign subsidiary company. These include the US entity classification of the foreign company as a foreign pass-through entity or a foreign corporation, intercompany revenue and cost allocation for transfer pricing purposes, and the cross-border payroll structure. A US parent company’s ownership of a foreign subsidiary company implicates many technical US international tax rules. These rules determine what the US tax consequences are and how information is reported on the US federal income tax returns of the US parent company and its respective US owners.
Overall, US international tax and foreign tax compliance issues may often come to light in the M&A due diligence process for US government contractors. If non-compliance is discovered in due diligence this could lead to a purchase price adjustment and/or escrow holdback to account for the risk of liability.
Aprio’s team of US international tax professionals have worked with many US government contractors in the buy-side and sell-side M&A due diligence process. Through Aprio’s network of affiliated global accounting firms worldwide, we have the capability to help US government contractors implement a compliant infrastructure in a foreign country before the contract begins.
Got questions? Contact Aprio’s International Tax team today to connect with an experienced advisor.
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