Can Asean start-ups have US tax obligations without any US operations?

Taxpayers with a dormant US holding company for fundraising should be aware of the US tax implications resulting from this structure.

The Asean start-up scene has been stunning. The success of the region, which is home to the world’s largest Special Purpose Acquisition Company (SPAC) merger and over a dozen unicorns, did not go unnoticed by the capital markets on the other side of the Pacific. The US, where a significant amount of the world’s venture capitalists (VCs) are based, remains an attractive place for Asean start-ups to not only raise funds but also take part in a mature ecosystem for mentorship and network. The most prominent US VCs can also bring brand power to their portfolio companies — something that cannot be bought easily.

It is not uncommon for US VCs to only want to fund through a US corporation. The start-up would oblige by forming a US corporation as the holding company for all of its operating entities, which are usually outside of the US, as the focus of many of the Asean start-ups are in the Asean or Asia-Pacific markets. Consequently, the start-up group, which merely has a US holding company but no real US operation, now falls firmly into the US tax net and faces multiple US tax implications and filings.

Basic rules

Most of the start-ups in such a structure would know about the obligation to file annual US tax returns. However, they are often unaware of the complicated controlled foreign corporation (CFC) regime and its reporting obligations.

In essence, the CFC regime is designed to subject certain US shareholders (e.g., the US holding company for the start-up group) to current US taxation on certain income (such as Global Intangible Low-Taxed Income (GILTI) and Subpart F income) earned by the CFC.

The US holding company would be required to file a Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, for each of its CFC entities within the group to report the CFCs operations and any income to be picked up by the US holding company for current taxation.

The GILTI regime, which was introduced in the 2017 US tax reform, is essentially a 10.5% federal corporate income tax on a US corporation for its deemed pickup of its CFCs’ income following a set of complex calculations, without receiving any actual distributions. The Subpart F regime targets passive income earned through CFCs, amongst a few other income types.

It should be noted that the Internal Revenue Service (IRS) assesses penalties and interest on not only underpayment of tax, but also compliance filing delinquencies.

Looking into the future, as part of President Biden’s tax reform proposal, the 21% US federal corporate income tax rate and the 10.5% GILTI rate may increase to 28% and 21%, respectively, along with a number of expansions to the GILTI regime (e.g., jurisdiction-by-jurisdiction calculation). These proposed changes could make the US holding company structure even more burdensome from a US tax perspective.

What this means to potential start-ups

Practically speaking, a start-up may not be profit-making for a while at both the holding company and subsidiary levels and thus not likely to be subject to any US cash tax. However, corporate structures, once put in place, can be difficult and expensive to unwind, Hence, it is important to plan properly upfront. In addition, investors in later funding round may conduct due diligence on the group, which may surface any non-compliance or exposures regarding US taxation. This article focuses on US federal corporate income tax consideration during the non-profitable years of a start-up; it has not even considered the complexity when or if the group turns profitable.

Other than the tax challenges detailed above, a US holding company may also deter certain non-US investors due to CFIUS (Committee on Foreign Investment in the United States) rules that can give rise to local market legal challenges depending on the industry.

US anti-inversion rules

Once a start-up experiences these US tax challenges, it will naturally look to replace the US holding company and often, a Singapore or a Cayman holding company is chosen. This is called an “expatriation” or “inversion”.

In general, an expatriation or inversion is a transaction or a series of transactions in which a US multinational corporation redomiciles to a foreign jurisdiction by causing a foreign corporation to become the new parent of the group. It may be done unilaterally or pursuant to a merger or acquisition with another company. There are anti-inversion tax rules that apply.

These are complex tax rules but in the worst-case scenario, if the 80% shareholding threshold is met (where 80% or more of the shareholders remain the same), the foreign acquiring corporation is treated as a US corporation for US federal income tax purposes, which effectively negates the objective of the inversion structure. Other adverse US tax consequences can still occur even if the original shareholders hold lesser than 80% in the new inversed structure.

It is worth noting that a portion of the shares of a foreign acquiring corporation may be disregarded if it is attributable to passive assets (e.g., cash) for purposes of calculating the ownership percentage thresholds.

President Biden’s tax reform proposal has highlighted tax inversion as a way for US corporations to try and avoid future US tax, and has proposed to further tighten the rules by reducing the aforementioned 80% threshold to 50% (along with some other proposed tightening rules), making it harder to mitigate inversion risks.

Notwithstanding the ownership thresholds, a US multinational corporation may invert unilaterally without continuing to be treated as a US corporation for US tax purposes by satisfying substantial business activities requirement – the foreign acquiring corporation and its subsidiaries have at least 25% of each of the employee headcount, compensation, assets and gross income from the jurisdiction in which the foreign acquiring corporation was organised. The foreign acquiring corporation must also be subject to tax as a resident in the jurisdiction in which it is organised.

If the US company enters into an M&A with a non-US company, this may be an opportunity to invert out of the US. However, the non-US company will need to be significant. Therefore this is a material business decision and should not be undertaken only for US tax planning purposes.

What this means to start-ups and their investors

As the US remains an attractive place for fundraising, it is important for Asean start-ups and potential investors to consider the US tax rules for both the short-term and long-term time frames. They should look at the bigger picture including the overall business and legal considerations. After all, tax is only one of the factors for decision-making. Start-ups should review their structure holistically and plan to manage the tax implications, avoiding costly restructuring later.

As for potential investors, notwithstanding that there may be no US entity in the transaction perimeter at the point when they decide to invest, they should look into the target group’s historical restructurings to see if the company has had a US holding structure, and if so, whether an inversion had occurred and the US tax implications that it might have been or could be subjected to.

The co-authors of this article are former EY Partner Hsin Yee Wong and former EY Senior Manager Michael Xiang.