Can 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.

In brief

• Southeast Asian start-ups can benefit from US VCs by forming a US holding company for all operating entities outside the US.
• Despite lacking real US operations, start-ups that do so will still face multiple US tax implications.
• Potential investors should examine the target group’s historical restructurings for records of a US holding structure to prepare for any US tax implications.

The Southeast Asian start-up scene has been stunning. The success of the region, which is home to the world’s largest Special Purpose Acquisition Company 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 number of the world’s VCs are based, remains an attractive place for Southeast Asian start-ups to not only raise funds, but also take part in a mature ecosystem for mentorship and networking. 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 its operating entities, which are usually outside the US as the focus of many Southeast Asian start-ups are in the regional or Asia-Pacific markets. Consequently, the start-up group, which merely has a US holding company but no real US operations, now falls firmly into the US tax net and faces multiple US tax implications and filings.

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 up front. In addition, investors in a later funding round may conduct due diligence on the group, which may reveal any non-compliance or exposures regarding US taxation. This article focuses on US federal corporate income tax considerations 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 seek to replace the US holding company and often, a Singapore or 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 less 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 like cash for the purpose 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. It also proposed a further tightening of 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 a 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 organized. The foreign acquiring corporation must also be subject to tax as a resident in the jurisdiction in which it was organized.

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. This is therefore 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 fund-raising, it is important for Southeast Asian start-ups and potential investors to consider the US tax rules for both the short- 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 to avoid 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. If so, they should consider whether an inversion had occurred and the US tax implications that it might have been or could be subjected to.

This article was written by former EY Partner Hsin Yee Wong.