Should Foreign Holdco instead be organized as a US corporation? What tax factors are relevant to this decision? Explain your answer.
Introduction to Questions 1 and 2
The cosmetics and fragrance industry is global and includes long-established as well as emerging brands. For instance the US market contributes about 14% of the sales of L’Oréal SA a French company. Estée Lauder a Delaware corporation sells into 150 countries globally. The business model of the cosmetics and fragrance industry involves research manufacturing and distribution.
Typically the research is done primarily in the country where the parent corporation is incorporated and supports new products as well as packaging. Firms’ intellectual property (IP) portfolios are managed to protect product uniqueness and integrity and to achieve other business objectives in relation to competitors. Some firms license manufacturing IP as well as trademarks to third parties.
Affiliates located in multiple countries manufacture products using the cosmetics and fragrance formulas developed through research. Sales affiliates market and distribute products in local countries both directly and to distributors such as department stores who in turn sell to local consumers.
Question 1 (50%) – “Inbound” Structuring
Your Client’s Problem and Facts
Your client is a global US investment bank that has been approached by a group of three former senior cosmetics industry executives who think they can disrupt the industry by establishing a new competitor to the reigning industry giants (including L’Oréal and Estée Lauder) to target the US cosmetics market.
The founder executives are not US tax resident (i.e. each is a non-resident alien for purposes of United States tax law) and one or more of them are tax resident in a country that has an income tax treaty with the United States. Executive X has long experience in cosmetics manufacturing.
Executive Y has a strong network of relationships with department store buyers and other distributors. Executive Z is an expert in marketing both through traditional ad campaigns and through social media. Executives X and Y have indicated that they will have to spend material time in the US in connection with the business. It is possible that Executive Z could perform her
role remotely from outside the US.
The executives’ business strategy is to acquire or build strategically located modern automated cosmetics manufacturing operations to serve key US markets and to build cosmetics brands that appeal to younger consumers. They plan to resuscitate a historic cosmetics brand not in current use for which they have acquired the intellectual property rights. They anticipate that the business will sell almost exclusively into the US market for the foreseeable future.
The investment banker believes that she can raise $10 billion of capital from investors around the world. The investment bank has a pre-commitment for $2.5 billion from an anchor investor a non- US multinational not in the cosmetics business but known for making large-scale investments in promising situations. Additional funds can be raised from private investors or in a public offering.
The banker shares an outline of an entity structure (inserted below) that came from a business advisor who has little experience in developing tax efficient structures for “inbound” investments into the US. The banker thinks the structure “needs work.”
The diagram shows: (i) at the bottom: the operating business footprint where business functions are performed and customers located; (ii) in the middle the holding/financing structure through which the cash flow generated by the business is returned to owners and creditors; and (iii) at the top the founders and investors whose capital is invested in the business.
The banker is seeking to (i) minimize US host country tax on the income generated by the business (including both the tax on business income and any withholding tax on distributions) and (ii) allow the after tax amounts to be paid to founders and investors at the lowest tax cost each without disturbing the operation
of the business itself.
The outlined proposed entity structure shared by the banker uses a non-US corporation as the top tier entity (Foreign Holdco). Foreign Holdco would wholly-own a Delaware LLC which in turn would engage in R&D conduct or contract for manufacturing develop marketing campaigns and sell cosmetics into the US market through unrelated retailers and stores owned directly.
The three executives would transfer the rights to the intellectual property related to the historic cosmetics brand to the Foreign Holdco and the Foreign Holdco would license the US rights in this intellectual property to the Delaware LLC for an arm’s length royalty. The Foreign Holdco would borrow to fund operations within the Delaware LLC.
With respect to non-US tax law note that it is possible to locate Foreign Holdco in a treaty country that imposes corporate income tax at a rate of 15% or in a non-treaty country that does not tax income of a business conducted in the United States. You should assume that Foreign Holdco would be exempt from home-country tax on dividends from US subsidiaries and on US business Foreign Holdco
(holds pre-existing IP
U.S. mfrg. sales
IP license Interco
income earned through a branch but that US-source royalties and interest would not be tax-exempt for Foreign Holdco. Foreign Holdco’s home country taxation would be the same whether or not it is eligible to benefit from a US treaty.
Your Client’s Questions
The investment banker is coming to you to help develop an efficient tax structure for the new enterprise taking account of the various interests including those of the executives who have come to her for advice. In connection with that objective the investment banker has a number of questions for you set out below to help her understand trade-offs.
She believes that the proposed structure will require adjustments. Her overarching question is what US structure and planning ideas for the business would you recommend assuming that the business will be almost exclusively US for the foreseeable future?
- How would the proposed structure be taxed by the US? Analyze the structure under both the assumption that Foreign Holdco is in a treaty jurisdiction and also under the alternative assumption that Foreign Holdco is not in a treaty jurisdiction. Consider the tax treatment of the income generated by the business income any withholding tax on distributions and income earned by the executives attributable to their time in the US.
- Should Foreign Holdco instead be organized as a US corporation? What tax factors are relevant to this decision? Explain your answer.
- With respect to tax considerations raised by the copyright to and trademarks for the historic brand should it be held by Foreign Holdco or in a domestic entity owned by Foreign Holdco? Is it possible to reduce US tax by charging a royalty? If so what limitations are there? Would you recommend any changes to the proposed structure? Explain your answers.
- Will interest on the debt incurred by Foreign Holdco be deductible for US tax purposes? Would it be better from a US tax perspective for the lender to loan directly to the Delaware LLC if it is a disregarded entity? Would a direct loan be better if the Delaware LLC were classified as a corporation? Explain your answers.
- Which entity would you recommend employ the executives? Would you make any changes to the structure in order to mitigate any US tax costs for the executives assuming that one or more of them could spend less than half a year physically in the United States? If so what changes would you make? Explain your answer.
- Do you think that the relevant US rules strike the right balance between encouraging inbound investment and protecting the US tax base? Why or why not?
Question 2 (50%) – “Outbound” Structuring
Your Client’s Problem and Facts
Assume that your client Velron Incorporated (Velron-US) is a US corporation that aims to pursue
the cosmetics business globally and to become the “next Estée Lauder.” Until 2021 Velron has
had only US operations. Now in 2021 it plans to expand to international operations.
Velron has plans to establish a manufacturing operation in Country A a European country which has an effective corporate tax rate of 10%. It is considering whether to establish a manufacturing operation in Country B. Country B borders the United States and has an effective corporate tax rate of 20%.
Alternatively existing US manufacturing operations could supply the local markets that Country B’s manufacturing operation otherwise would supply. Velron anticipates that it will need sales operations to support sales into about 30 countries within 3 years.
Velron anticipates that its manufacturing and service affiliates each will be profitable and that all transfer pricing is arm’s length. Each manufacturing unit will produce cosmetics and sell the product to unrelated distributors at prices negotiated by Velron-US with the distributors.
A Velron manufacturing affiliate (or Velron-US if it supplies foreign markets directly) will contract with a service company in each local market to provide local marketing services purchase local advertising and liaise with the local distributor on marketing in each local market. The service affiliates will receive a standard cost-plus 8% of cost (excluding third party costs of advertising) which the IRS has agreed is arm’s length.
Your Client’s Questions
- Starting with the non-US manufacturing affiliate(s) how would you recommend that they be structured? What entity type (e.g. US or non-US; corporate or flow-through) should be used? Should the manufacturing affiliate(s) be directly owned by the U.S corporation? If not what structure do you recommend? Explain your recommendations. Be sure to describe and compare the US tax consequences for Velron-US under the several regimes in place in the US for taxing the non-US operations of a US corporation.
- Compare the tax considerations that would result from using a Country B affiliate to manufacture and supply cosmetics to some of the non-US markets versus using US manufacturing capacity for this supply. Which do you recommend from a US tax
perspective? Explain your recommendations.
- How do you recommend that Velron organize its intellectual property rights for tax purposes? Should it license its intellectual property to manufacturing affiliates in exchange for a royalty should it transfer the intellectual property as a sale or should it
take a different approach? Would your answer differ depending on the foreign effective tax rate of the manufacturing affiliate? Explain your answer.
- Velron plans to incur debt to support its expansion in particular the capital expenditures related to building manufacturing operations. Compare the tax considerations that would result from incurring debt at the US corporation level and contributing the proceeds or on-lending to foreign affiliates compared to incurring debt at the level of Country A and/or Country B.
Which would you recommend? What other tax-related recommendations would you make with respect to debt financing for the Velron international expansion? Explain.
- This structure planning is assumed to occur in 2021 four years after the passage of the TCJA. What are the most important differences in this planning in 2021 compared to similar outbound planning prior to the TCJA? Do these changes successfully create a more even playing field among jurisdictions as their supporters claim? Briefly explain
why or why not.