The federal corporate income tax a U.S. subsidiary would have to pay ranges between fifteen to thirty-five percent depending on the amount of profit. The U.S. subsidiary can deduct payments to the German parent company for several expenses, such as royalties, interest and management fees. No withholding tax payment is required here. A withholding tax is however incurred when repatriating a cash dividend to the German parent company.
To avoid inadvertent treatment of the German parent company itself as a U.S. permanent establishment and because the U.S. subsidiary is subject to U.S. taxation, all U.S. activities should be transferred to the subsidiary. Otherwise, the consequence could be a double taxation (U.S. tax by the parent company in addition to the tax payable by subsidiary).To avoid the inadvertent treatment as a U.S. permanent establishment some precautions should be taken:
The sales office at the U.S. distribution center should not be used by employees of the German parent company. However, there is an exception from the treatment as a permanent establishment when only used as a warehouse, as stated in the German-United States Income Tax Convention of 1989 (called Treaty). To avoid the treatment of an inadvertent permanent establishment, the employees of the parent company involved in the build-out of the U.S. distribution center should only contribute to the initial set-up for a short term and strictly project-based.
Furthermore, the subsidiary should not have any preferred transfer pricing exposure. The pricing practices should be documented as required by the regulations.
Please note this specific constellation:
If an employee of the German parent company has the authority to contract on behalf of the German parent company in the U.S. and uses this authority “habitually” (this term is not defined in the Treaty; the exercise of this authority once or twice probably constitutes “habitual”). The treatment as an inadvertent permanent establishment could hardly be avoided under this circumstance.
The situation is different if the U.S. activities are undertaken as a branch of the German parent company. The U.S. branch as a permanent establishment would incur federal income taxes ranging from fifteen to thirty-five percent. Deductions appropriate to the taxed activities can be taken by the branch. A perquisite is that the branch benefits from the German parent companies expenditures, which include general and administrative expenses between the branch and the German parent company.
As a non-corporate entity the branch is not able to deduct payments for royalties, interest and management fees to its German parent company. The branch profits tax is designed similar to the U.S. subsidiaries’ withholding tax for dividends to its foreign shareholders. Please note that the U.S. branch’s earnings need to be segregated from other earnings of the German parent company.
In addition to the U.S. corporate income tax on the effectively connected income, the U.S. branch has to pay a treaty rate on its profit tax. However, the German parent company can avoid double taxation (the German tax and both U.S. taxes on the branch’s effectively connected income) through a foreign tax credit in Germany.
An advantage of operating as a branch is the permission of reducing the taxable income of the German parent company to offset the U.S. losses if occurred.
With all fiscal optimization you still have to consider the fact that through operating as a U.S. branch the German parent company becomes fully liable. Within the scope of legal conflicts with third parties, the U.S. subsidiary offers fairly broad protection. Through operating as the U.S. branch, the German parent company would become immediately liable.
Due to the above, most of our clients choose the option of operating the distribution center as a U.S. subsidiary.