Business and Legal Climate in the United States
The business climate in the United States, though subject to business cycles, is the largest, most dynamic and durable in the world. The freedom to compete gives would-be entrants the greatest opportunity to succeed and entrenched players the greatest risk of failure. Central to the business climate is the virtual absence of political risk and the stability and predictability of the legal system.
Although stories of runaway punitive damage verdicts give many business executives pause about investing or doing business in the United States, the fact is that from 1989-1995, plaintiffs actually prevailed less than half the time and succeeded in getting a punitive damage award in fewer than 3 percent of those cases. In 1997, two-thirds of cases where plaintiffs won were overturned on appeal. On the other hand, courts follow prior decisions in determining the outcome of a lawsuit, and that gives businesses the ability to predict the likely outcome of a particular course of conduct and comfort in the sanctity of contracts.
The U.S. tax system, although very complex, is generally less burdensome than most countries’ when you consider income, VAT, employment and property taxes combined. Also, the United States is party to myriad multilateral and bilateral tax treaties that reduce or eliminate many of the duplicate tax burdens between countries.
Limitations on Conducting Business in the United States
Generally, the United States imposes few controls on investment by foreign entities that are not imposed on domestic entities. However, federal law does restrict and regulate foreign ownership and control in certain key industries.
National Security and Defense.
The Exon-Florio amendment to the Omnibus Trade and Competitiveness Act of 1988 gives the President the power to suspend, prohibit or dismantle mergers, acquisitions and takeovers of American companies by foreign investment that threaten national security. While there is no formal definition of foreign control that would “threaten” national security, the evaluation criteria differs where the foreign entity is owned or controlled by a foreign government. The President may consider several factors in evaluating national security concerns; the primary one is domestic capacity to meet national defense requirements in view of any potential takeover. The President also may consider the potential for the proliferation of terrorism, missiles, nuclear and biological weapons and any potential effect of the transaction on American technological leadership in areas affecting national security.1
The Nuclear Regulatory Commission (NRC) issues licenses for using nuclear material for medical, industrial and commercial purposes, including research and development. The NRC is prohibited from issuing licenses for the production and handling of atomic energy to any individual, corporation or entity that is owned, controlled or dominated by a foreign corporation or foreign government. The policy rationale behind this is the protection of domestic defense, security, health and safety.
Generally, foreign investors may participate in NRC-licensed activities if the foreign entity does not hold a majority interest in the venture and the licensed activities are controlled by U.S. citizens. In the past, the NRC has imposed the following conditions on foreign participation in the applicant’s licensed activities: (1) the foreign entity cannot hold more than a 50 percent ownership interest in the venture; (2) the directors, officers and managers of the licensed entity must be U.S. citizens who are not controlled by, or under the influence of, a foreign entity or person; (3) officers and employees of the venture responsible for the custody and control of nuclear materials must be U.S. citizens; and (4) only people with security clearances and permits may have access to restricted data involving plant technology. The NRC may impose additional limits on foreign investors seeking to own a portion of a domestic nuclear power plant.
The Public Utility Holding Company Act of 1935 (PUHCA) states that, unless exempted, any entity owning more than 10 percent of the voting securities of a public utility is considered a “holding company.” Holding companies are subject to the provisions and restrictions of this act and must register with the Securities and Exchange Commission (SEC). However, foreign entities seeking to acquire an interest in a U.S. utility may be able to avoid the requirement of SEC approval by qualifying as a Foreign Utility Company. The exemptions to the PUHCA requirements are available to small domestic utilities.
Based on the same national security rationale, federal law requires that all merchant marine vessels must be owned and operated privately by citizens of the United States. The merchant marine fleet serves as a military auxiliary in times of war and national emergency, and is essential to foreign and domestic commerce. Accordingly, all merchandise to be transported by water, or by land and water, between points in the United States must be carried by vessels built in and documented under the laws of the United States and owned by U.S. citizens. Additionally, a U.S. owner is prohibited from selling any interest in a vessel to a non-U.S. citizen without the approval of the Department of Transportation. (This does not apply to certain pleasure and fishing vessels.)
Federal Regulation of Foreign Investment and Control
Federal law limits or regulates foreign ownership and investment in the following industries:
U.S. citizens must own 75 percent of the voting shares of an air carrier, as well as constitute at least two-thirds of the board of directors and managing officers. In addition, the president of the air carrier must be a U.S. citizen. The Department of Transportation is primarily concerned with voting equity, but extensive foreign equity ownership absent voting power may result in a denial of participation. A foreign airline is permitted to own up to 49 percent of the total equity, but the limit of 25 percent of the voting equity remains.
Media and Communications.
The laws governing the communication industry are the key area of federal foreign investment regulation. These laws are intended to promote competition and reduce regulation to encourage quality services at low prices and rapid development of new technology. The Telecommunications Act of 1996 gives the Federal Communications Commission (FCC) the discretion to refuse to license any corporation (television, radio, common carrier, broadcasting, aeronautical services, cellular, and microwave and satellite communication) directly or indirectly controlled by any other corporation of which more than 25 percent of the capital stock is owned of record or voted by foreign persons, their representatives, a foreign government or by any corporation organized under the laws of a foreign country. Generally, the FCC would refuse the license because the public interest and national security would be served by the refusal or revocation of such license.
Additionally, under the Act, a four-prong Effective Competitive Opportunities (ECO) analysis applies to authorizations of foreign investors seeking to acquire either a controlling interest or more than a 25 percent interest in a U.S. communications carrier. The ECO test examines whether a foreign market is open by considering: (1) the presence of legal barriers to market entry by entities foreign to that market; (2) whether interconnection is permitted under reasonable and non-discriminatory charges, terms and conditions; (3) the presence of competitive safeguards (i.e., rules against cross-subsidization); and (4) the existence of a regulatory agency to protect the competitor.
Banking. The Foreign Bank Supervision Enhancement Act of 1991 mandated Federal Reserve approval for establishing U.S. offices by foreign banks if the bank is under comprehensive and consolidated regulation by its home country’s authority.
Mineral Leases and Timber Rights.
Deposits of natural resources and the lands containing them in the United States are available for exploitation by U.S. citizens, but not to foreigners, unless their home country grants comparable rights to Americans. Foreigners may hold mineral leases through their interests in U.S. corporations, provided that their home country does not deny similar rights to Americans. Aliens who are bona fide residents of the United States may obtain access to timber on federal lands.
Outer Continental Shelf Activities.
Federal regulations govern the outer continental shelf and off-shore leases. Foreign access is not prohibited because there is no citizenship requirement. Statutory provisions limit manning outer continental shelf rigs, vessels and platforms to U.S. citizens, with some exceptions.
Antitrust, Unfair Trade and Consumer Protection
Like many other countries, the United States has a regulatory system to deal with antitrust violations, unfair trade practices and consumer protection. U.S. antitrust and unfair practice laws are designed to help keep prices reasonable while deregulating the economy by lifting price controls on most goods and services. Antitrust issues may arise in the acquisition of a U.S. company, and the United States has laws that act as merger and acquisition control procedures. The goal of this merger review is to attempt to prohibit mergers and acquisitions that will have a serious anticompetitive effect on the U.S. economy in relation to any benefits from the transaction. Investors planning to acquire a U.S. company need to structure the acquisition to avoid prohibition and to comply with all notification and filing requirements.
Intellectual property rights in the United States for inventions conceived outside of the United States generally are covered by U.S. patent, trademark and copyright law. The foreign investor must meet all proper filing requirements, preserve the rights to intellectual property and avoid infringing on other parties’ intellectual property rights.
Labor Law Generally
Federal and state law prohibits discrimination in employment because of an individual’s race, age, gender, national origin, color, religion and disability status. State and/or federal laws also govern employee wage payment, including minimum wage and overtime for certain employees, health and safety, and employee benefits. Certain government contracts require compliance with affirmative action requirements, which require that employers insure that applicants and employees are treated without regard to an individual’s race, age, gender, national origin, color, religion and disability status.
The National Labor Relations Act gives employees the right to bargain collectively with employers. The law is enforced by the National Labor Relations Board. State law can impose additional requirements on employers. Union membership in the United States has fallen from 20 percent of the workforce in 1983 to 13.5 percent in 2000.
A federal income tax is imposed on the operations of foreign companies that maintain a permanent business location in the United States. If the foreign company chooses to do business in the United States through a subsidiary, the subsidiary is subject to federal income tax. If a joint venture form of enterprise is employed, each partner to the joint venture pays tax on its share of the joint venture’s income in such partner’s own tax return. The partners usually are employed through an entity that provides limited liability for its members.
State tax laws vary. For example, any branch of a foreign entity or a wholly owned subsidiary doing business in Pennsylvania is subject to Pennsylvania corporate net income tax, capital stock tax and franchise tax.
Many states impose additional restrictions on foreign ownership of businesses. Under Pennsylvania law, for example, foreign governments and aliens who are not resident in the United States cannot acquire an interest in agricultural land exceeding 100 acres, except such as may be acquired by device or inheritance, and such as may be held as security for indebtedness.
The choice of the state in which to organize or incorporate an entity is important. Business entities are creatures of state law, not federal law. A business entity can incorporate or form in any state it chooses, and its internal affairs are governed by the law of that state, even if the entity does not do business in that state. These laws can vary substantially from state to state. Federal laws, however, are uniformly applicable to business entities throughout the United States. With the help of legal counsel, you should determine which state may be preferable for forming your business entity and for compliance with state requirements. Issues to consider in these decisions include state requirements for various forms of business structure; corporate governance; stock and other securities requirements; labor and employment requirements beyond federal law; tax issues; and environmental laws. Let’s briefly examine some of these critical issues for businesses.
Forming a Business Entity.
Under the Delaware General Corporation Law (DGCL), the law applicable in the state most commonly chosen for incorporation, foreign investors can do business in the state by (1) forming a joint venture with an existing business enterprise; (2) acquiring an existing enterprise or subsidiary of another corporation; or (3) creating an enterprise owned by the foreign investor’s company, such as a new subsidiary, or a more informal structure such as a liaison office or branch office of the foreign investor’s company.
Joint ventures can take the form of any legal vehicle, but usually are either (1) a simple contractual relationship; (2) a partnership; or (3) a joint corporation. Advantages and disadvantages apply to each form. Factors to consider in choosing one of these forms include the size and complexity of the proposed venture, the anticipated length of the joint venture, the relationship among the parties, tax benefits and cash flow.
Simple contractual relationships are flexible, easily terminated and generally can be kept far more secret than other forms of joint ventures. However, the contract for such ventures must be carefully drafted to avoid problems down the road, and a court could hold the contractual joint venture to be a de facto partnership, obliging the investors to the fiduciary duties of that form of entity. In general, contractual joint ventures should be used for short-term, specific activities, such as an agreement between two companies to jointly develop a new product or service, and share in the profits or losses.
Partnerships generally are characterized by unlimited joint and several liability of the partners and restrictions on the assignment of partnership interest, particularly to nonpartners. There are three types of partnership agreements: (1) general partnerships; (2) limited partnerships; and (3) limited liability partnerships. General and limited liability partnerships are particularly common joint venture vehicles for commercial real estate and construction activities, and when a small group of trusting and familiar investors want to take advantage of tax transparency. Limited partnerships are rarely used as joint venture vehicles, because they usually are structured with one general partner and several passive investors, with greatly limited ability to be involved in the operations, as limited partners, but this form may be ideal if one party wants total control over the joint venture and the others only want to share in the profits.
A jointly owned corporation is the standard form of joint venture used when the venture has any economic significance and when the parties want the venture to be disclosed to the public. The preferred corporate form is the business corporation or the limited liability company. The business corporation often is used by companies that want the venture to be publicly listed on a stock exchange, to gain more shareholders and then progress independently of the shareholders. This form also is often a precursor to a merger of the companies involved in the joint venture. Limited liability companies usually are not used when the parties want the venture publicly listed; rather, they are used for investments or opportunities that will grow organically and not as acquisition vehicles. Limited liability companies allow for “pass-through” taxation, where profits are not taxed on the company level, but are taxed at the member level while providing the same liability protection as a limited partnership.
Acquiring an Existing Business Enterprise or Subsidiary of a Foreign Corporation
. Foreign investors can acquire these types of entities by acquiring the assets of the business or acquiring enough stock to assert de facto
control. Asset acquisitions of going business concerns carry important tax and legal consequences. The purchase price of the assets will become the new tax basis for those assets, usually resulting in a higher tax basis and higher tax depreciation deductions than purchasing stock in a business corporation. Purchasers in asset acquisitions usually can avoid the liabilities of the seller, including liabilities for back taxes.
In an asset acquisition, the buyer also is not obliged to assume any collective bargaining agreement with the seller’s employees and can set initial terms of employment with the seller’s workforce (with certain important limitations). Foreign investors should consult with counsel about other important tax and legal consequences of an asset acquisition.
Stock acquisitions also carry important tax and labor consequences. By purchasing equity interest in a business, the buyer inherits all tax attributes (such as basis) of the equity, as well as all tax liabilities and other liabilities, although normally tax loss benefits are limited or eliminated. In a stock acquisition, unlike an asset acquisition, the buyer must assume any pre-existing collective bargaining agreements. Again, foreign investors should consult with legal counsel about other important consequences of stock acquisitions.
A third way to acquire a going concern is a merger. Again, important tax and legal consequences apply. Presumably, the foreign entity would incorporate a U.S. wholly owned subsidiary just for the merger. The subsidiary would merge with the target company, which would be the “surviving” business entity of the merger. The foreign entity would own all the stock of the surviving entity, which would retain all of its assets and liabilities, and maintain a separate corporate existence from the foreign entity.
Certain mergers can be completed tax-free, depending on the amount of voting stock, cash or other consideration exchanged in the merger. Analysis of significant tax filing and other obligations must be considered before deciding on such a transaction. As with stock acquisitions, the merged entity must assume any pre-existing collective bargaining agreements. As the concept of a merger does not have an equivalent in many foreign jurisdictions, it is essential to have experienced counsel who can harmonize the often conflicting systems.
Acquiring an existing business entity can trigger certain foreign investment control laws. Beyond the complex federal laws that apply to any securities transaction, foreign investors may be subject to special federal acquisition review procedures where the acquisition affects a certain share of the U.S. market. Many states also have “anti-takeover” provisions that can help publicly traded corporations resist “hostile” takeover bids.
Key federal laws include the Exchange Act of 1934, the Hart-Scott-Rodino Antitrust Improvements Act and the International Investment and Trade in Services Survey Act. The Exchange Act requires investors acquiring more than 5 percent of a business entity’s publicly traded stock to file certain personal and financial information with the SEC. The Exchange Act also governs tender offers (public offers to pay more than the current market price for publicly traded shares of a company the offeror wants to control). The Hart-Scott-Rodino Act requires federal review of mergers or acquisitions when certain market share thresholds are crossed. The required filings, fees and negotiations with the federal government in the event of objections can be onerous. The International Investment and Trade in Services Survey Act requires reporting of all foreign investment in U.S. business enterprises where a foreign entity acquires 10 percent or more of the ownership of a U.S. business with more than $3 million in assets, or the acquisition of 200 or more acres of real estate. Several categories of forms must be filed for such investments, depending on the type of business involved.
Anti-takeover laws of many states include a fair price provision, which gives shareholders the right to receive “fair value” for their stock in the event of an acquisition by a shareholder with 20 percent voting power (fair value being at least the highest price paid by the controlling shareholder in the 90 days before the acquisition). These laws also often allow publicly held companies to bar acquisitions or combinations by an interested shareholder (generally the owner of at least 20 percent of outstanding stock), unless the transaction is approved by the board of directors and a majority of shareholders within strict deadlines. Other provisions allow publicly held companies to limit the voting power acquired in certain stock acquisitions, and to disgorge profits realized by controlling shareholders following attempts to gain control of the company. The latter provision is designed to prevent controlling shareholders from putting the company “in play,” then profiting from being bought out by a third party or the company itself.
Creation of an Enterprise Owned by the Foreign Investor’s Company
. Instead of acquiring an existing business, the foreign investor’s company could create a new subsidiary, liaison office or branch office.
A subsidiary can be any type of business entity. Forming a subsidiary triggers a number of legal and tax obligations, as outlined above. Let’s assume that the subsidiary will be a business corporation. Before starting operations, the subsidiary must:
- draft certificate of incorporation and bylaws
- capitalize the company
- form a board of directors
- choose corporate officers
- sign the certificate of incorporation and file it with the Secretary of State of the state selected for incorporation.
The certificate of incorporation and bylaws must be carefully crafted, as they establish the business name, ownership and voting rights of certain classes of stock, terms, conditions and scope of power for directors and corporate officers, and other critical aspects of business operations. Depending on the capital structure of the corporation, a number of complex securities issues may need to be addressed. Legal counsel should be sought for all of these matters.
The foreign entity forming the subsidiary has the option of reporting its tax activity as well as that of the subsidiary in a consolidated federal tax return. In such a case, the foreign business entity and the subsidiary are a “consolidated group,” and the income of one can be offset by the losses of another member. Many states do not allow consolidated tax returns. Because of this, careful tax planning can allow taxpayers to minimize, and in some cases completely avoid, corporate net income, capital stock and franchise taxes.
Instead of forming a subsidiary, a foreign company could open a branch or liaison office in the U.S. For legal and tax purposes, a branch office is treated as a part of the same company as the main office, not as an independent entity. To form a branch office in most states, the foreign company must file an application to transact business in the state. Once approved, the foreign company must generally file an annual report with the applicable Secretary of State identifying the outstanding capital and the company’s officers and directors. The foreign company also must pay an annual franchise tax. The time and cost of establishing a branch often is less than that required to establish a subsidiary business corporation.
This article touches briefly on some of the most important issues to be considered by a foreign company or individual interested in investing or establishing business operations in the United States. Legal counsel familiar with these issues at the federal and state level play a critical role in ensuring the success of such investments and operations.
While government regulation, legal issues and tax issues may seem daunting to a new investor, the regulatory and legal framework is actually less complex than in many countries, and the rules and procedures establish a stable basis for making investment and business operation decisions. Because of this, as well as the size and dynamic nature of the market, the United States remains extremely attractive to foreign investors interested in new or expanding business opportunities.
1 For additional information regarding the Exon-Florio Amendment to the Omnibus Trade and Competitiveness Act of 1988, see “Issues in Acquisitions of Defense Industry Contractors,” by James D. Rosener, 1998.
© 2002 Pepper Hamilton LLP. All rights reserved.
James D. Rosener