Legal Considerations for Establishing Operations in the United States
Business and Legal Climate in the United States
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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 run-away punitive damage verdicts give many business executives pause about investing or doing business in the United States, the fact is that from 1989 to 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 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 As amended by the Foreign Investment and National Security Act of 2007, transactions that involve foreign governments, a threat to national security, or control of critical infrastructure are now subject to a 45-day formal investigation. Exceptions are available for foreign government transactions if the Secretary or Deputy Secretary of Treasury and the lead agency certify that there is no national security threat.
Nuclear Power. 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.
Public Utilities. The Public Utility Holding Company Act of 2005 (PUHCA) states that, unless exempted, any entity that directly or indirectly owns, controls, or holds, with power to vote, 10 percent or more of the outstanding voting securities of a public utility company or of a holding company of any public utility company is itself considered a "public utility 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.
Maritime Industries. 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, owned by U.S. citizens crewed by U.S. citizens and permanent residents. 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:
Airlines. 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, and the carrier must be under the actual control of U.S. citizens. 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.
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
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
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 11.1 percent in 2014.
The Patient Protection and Affordable Care Act requires that U.S. businesses employing at least 100 full-time employees provide health insurance to at least 70 percent of their full-time employees in 2015 and 100 percent of their full-time employees by 2016. Businesses that fail to provide coverage, or provide inadequate coverage, to employees will be liable to the IRS for a penalty of up to $2,000 or $3,000 per employee.
State Restrictions
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 devise 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. 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 forms are the business corporation and 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 afforded to a limited partner in 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 Securities Exchange Act of 1934, the Hart-Scott-Rodino Antitrust Improvements Act and the International Investment and Trade in Services Survey Act. The Securities 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 Securities 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. 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.
Corporate Governance
U.S. Federal Law also requires ongoing compliance with certain corporate governance regimes as outlined below:
Sarbanes-Oxley: The Sarbanes-Oxley Act, enacted in response to accounting fraud scandals in the early 2000s, has created significant reporting and other compliance requirements for any company, foreign or domestic, that is publicly traded in the United States. Among other requirements, a company must register with and submit to the jurisdiction of the Public Company Accounting Oversight Board, observe certain practices designed to preserve auditor independence, disclose certain financial information and information regarding conflicts of interest, and retain certain records for up to five years subject to civil and criminal penalties.
Foreign Corrupt Practices Act: In addition to the laws of all U.S. states which make it illegal to bribe any U.S. official, there is a comprehensive federal statutory regime that prohibits the willful use of any means to pay, or promise to pay, any official of a foreign government for the purpose of buying his or her influence in his or her official capacity. Violations of the Act come with both civil and criminal penalties.
Regulations for Financial Institutions: Financial institutions in the United States must comply with certain federal laws (in addition to numerous state laws on chartering and lending behavior).
The Dodd-Frank Wall Street Reform and Consumer Protection Act regulates all domestic and foreign companies "predominantly engaged in financial activities," other than bank holding companies and certain other types of firms (nonbank financial companies). The act creates the Financial Stability Oversight Council and Orderly Liquidation Authority (FSOC) which is granted broad investigative powers to determine whether a nonbank financial company poses a threat to the stability of the U.S. financial system and should therefore be subject to supervision by the Federal Reserve. Acting through the Office of Financial Research, the council can collect reports from nonbank financial companies and, if necessary, request that the Federal Reserve conduct an examination of a company to determine if it is systemically important. Nonbank financial companies that feel they may be considered systemically important should prepare themselves for possible requests from the council or even examinations by the Federal Reserve. These companies should closely monitor statements that come from the council to determine how often and to what degree these request tools will be used by the council.
Reforms to the Bank Secrecy Act under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USA PATRIOT ACT) require that U.S. financial institutions develop and implement anti-money laundering programs (AML programs). The purpose of the program is to identify funds that may go to criminal and terrorist enterprises. The programs must include: (1) internal policies, procedures and controls; (2) a designated compliance officer; (3) ongoing training for compliance personnel; and (4) an independent audit to test the program. In addition, financial institutions must have policies and procedures in place that will help them verify the identity of their customers.
Tax Overview
Federal Taxation. There is no federal VAT in the United States – the federal tax is generally based on the income of the business operation.
Subject to modification by tax treaties, a non-U.S. corporation that conducts business operations in the United States will be taxed under the following regime:
Branch Operations. A non-U.S. corporation that engages in business in the United States is generally subject to a corporate income tax on its income that is effectively connected to a U.S. business. The tax is levied on "taxable income," which is U.S. connected gross income less applicable deductions, and the maximum federal tax rate is 35 percent. The non-U.S. corporation is required to file an annual tax return on Form 1120F that reports the income and deductions of the U.S. operations. It is important to note that if a non-U.S. corporation is uncertain if it is engaged in a business in the United States, it may be well advised to file a "protective" U.S. tax return. If the non-U.S. corporation does not timely file a U.S. tax return and the IRS later determines the company was engaged in a U.S. business, the 35 percent tax is imposed on gross income, without the benefit of any deductions.
In addition to the 35 percent corporate tax, the non-U.S. corporation that does business in the United States is subject to a "branch profits tax." The branch profits tax is a substitute for a dividend withholding tax, because a branch does not pay dividends to its headquarters. In general, unless modified by an applicable tax treaty, the branch profits tax is levied at 30 percent on the net after tax earnings of the non-U.S. corporation that is not re-invested in the U.S. business. Because the branch profits tax is payable even if there has not been a cash repatriation to the non-U.S. corporation, a U.S. corporate subsidiary is frequently preferred, over a branch because the dividend withholding tax can be controlled by managing the timing of cash repatriations.
The sale of a U.S. branch gives rise to a U.S. tax charge for the non-U.S. corporation because it is selling assets located in the United States.
Subsidiary Operations. If a non-U.S. corporation forms a wholly-owned U.S. corporate subsidiary, the subsidiary is subject to tax as a U.S. corporation – its worldwide income is taxable on a net basis at a maximum rate of 35 percent. The non-U.S. corporation does not need to file a U.S. tax return, but the U.S. subsidiary will file its own U.S. tax return and may need to file an IRS Form 5472 on which the foreign ownership is identified.
Dividends paid by the U.S. subsidiary to the non-U.S. shareholder are subject to a 30 percent withholding tax, unless modified by an applicable tax treaty. The United States has very few tax treaties that do not contain a "limitation of benefits" article. The LOB provisions are very effective at denying treaty benefits to non-U.S. corporations that are not the intended beneficiary of the tax treaty, and preclude most treaty shopping.
The payment of the dividend withholding tax is generally managed by managing dividend payments. It is noted that if earnings are unreasonably retained to avoid the dividend withholding tax, the IRS may assert a penalty against the company.
Generally, the sale of the stock of the U.S. subsidiary by the non-U.S. corporation should not result in a U.S. tax charge to the non-U.S. corporate shareholder, unless the U.S. subsidiary is a U.S. real property holding company.
Joint Ventures. A U.S. venture partner will frequently suggest that a U.S. based joint venture be housed in a U.S. limited liability company or a U.S. partnership. For U.S. tax purposes, both the LLC and the partnership are pass-through entities. As a result, if the joint venture is an operating business, the non-U.S. corporate venturer is taxed as described above under branch operations.
The LLC or partnership has an obligation to pre-pay the 35 percent tax of the non-U.S. corporate venture partner, on a quarterly basis.
The IRS’ position is that the sale of the LLC or partnership interest is treated as a sale of the underlying assets, and is s
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.
Content contributed by attorneys of Troutman Sanders LLP and Pepper Hamilton LLP prior to April 1, 2020, is included here, together with content contributed by attorneys of Troutman Pepper (the combined entity) after the merger date.