By Alon Harnoy, Esq. Head of M&A and Meital Dror, Esq.
As the economy becomes increasingly more globalized, many foreign companies strive to enter into the US market. While great opportunities await in the US, foreign companies should first conduct extensive strategic, financial and legal planning prior to entering the US market.
Have a Clear US strategy. US Structure to be Consistent with that Strategy
We frequently advise foreign clients on legal structures that will enable them to access the US market. Prior to mapping out legal structures, one should first understand the foreign company’s global and US strategy, so that legal structures can track strategic goals. The strategic analysis should examine what business the foreign company seeks to do in the US. For example, does it only seek to sell products made outside of the US? Does it wish to establish a physical presence for warehousing inventory, or for conducting marketing and sales activities? The analysis should also look at the company’s long term commercial strategy (e.g., does the company wants to establish relationships with strategic business partners?) and its long term finance strategy (e.g., does the company want to access the US capital markets for fund raisings)? If a foreign company merely wishes to sell foreign goods in the US, having a physical and legal presence is not required. The foreign company may be able to manage its needs by entering into a contractual relationship with a distributor and, if applicable, registering to do business in the relevant US State(s). In the event that registration to do business is not required, appropriate structuring could insure that the foreign company would not pay income taxes in the US nor have to file any tax returns with the US tax authorities.
However, if the company is interested in hiring employees, leasing office space, or establishing a base for warehousing inventory or managing its supply chain, properly establishing a US legal entity provides important limitation of liability protection. In addition, operating a US business through a US entity can be attractive to North American trading partners and customers. Not only does a US corporate entity signal a marketing commitment to the North American market, but it also offers a contracting vehicle that is familiar and more predictable to those partners and customers.
Forming a US entity may provide certain tax benefits to a foreign parent, including, to the extent a corporation is used, shielding the foreign parent from having to file a US tax return and from being subject to the worldwide auditing capabilities of the US taxing authorities. We note that in some cases, however, a limited liability company may be the more efficient vehicle as the owners can elect to have the income of the LLC passed through the LLC and reported on its owners’ tax returns. Similarly, attention needs to be given to structuring of intellectual property, because, in the case of hi-tech companies, or owners of brands, moving the intellectual property into a US entity might mean that all world-wide licensing revenue of the parent company is now subject to US taxation.
Therefore, a determination about choice of entity also requires a careful tax analysis that takes into account factors such as the activities being conducted in the US and worldwide, the applicable tax rates in the parent company’s jurisdiction and in other jurisdictions where business in being conducted, the relevant participants, and any applicable income tax treaties between foreign jurisdictions and the US.
If a foreign company’s global strategy suggests that the US market is going to be a focus of world-wide operations, the company could take a more dramatic step towards establishing a US presence by inserting a US holding company on top of their non-US corporate structure, in a restructuring transaction known as a “flip”. This global restructuring provides additional benefits of (i) enhancing M&A possibilities for the new US parent company by adopting a corporate form that enables the use of certain US-style acquisition methodologies that may simply not be available for a foreign vehicle (such as forward or reverse triangular statutory mergers), and (ii) facilitating access to US public markets since a US GAAP financial reporting parent is an easier vehicle to list on US public markets than a IFRS or foreign GAAP reporting foreign private issuer, and in addition investors may have a preference to investing in the more familiar US vehicles.
US Subsidiaries Can Provide Qualified Companies Access to US Debt Markets
In addition to the benefits described above, for some companies an additional benefit of having a properly structured US entity is rapid access to the US debt markets. We know many U.S. lending institutions that are eager to provide credit facilities for US subsidiaries of foreign companies, where revolving loans are issued based on percentages of qualified assets or receivables. Some of these lending institutions do not require historical financial statements (which would not exist for a newly formed borrower), and would be willing to lend to properly formed entities based on their borrowing base of US assets or receivables and their projected financial statements. While this benefit, on its own, should not be reason to establish a US presence, the ability of the US entity to obtain such financing reduces the financial burden of the parent company to fund this US expansion, and may even offer financing at a lower cost of capital than the parent company could obtain in its home jurisdiction.
We mentioned above a restructuring known as a “flip” involving the insertion of a newly-formed US holding company on top of the foreign company’s non-US corporate structure. This global restructuring is easier to accomplish when the company is in its early stage. More mature companies tend to have larger numbers of shareholders, as well as significantly more relationships with third parties, which may need to be dealt with during the flip, as existing contracts might prohibit an exchange of shares of the foreign parent. Further, certain shareholders might have veto rights over any restructuring which could be a significant obstacle as the flip process typically requires shareholders’ approval.
Sometimes companies are asked to conduct a flip even though they would prefer not to. For example, a foreign company that is conducting an equity fundraising targeting U.S. venture capitalists or angel investors may find that the investors, even if they are willing to invest in the company, prefer not be exposed to foreign laws and compliance issues associated with investing in a foreign company. Additionally, trying to replicate typical US venture capital terms, such as anti-dilution and redemption provisions, can be difficult to accomplish in a foreign jurisdiction. Accordingly, investors may condition their investment on a completion of such a flip restructuring.
A flip transaction could result in a significant tax liability unless there is a tax exemption for the share exchange or unless there has been little appreciation in the value of the exchanged shares. In some countries, it is necessary to get verification from the applicable tax authorities that the flip is tax free. The tax exemption is often based on the idea that the old foreign company securities and the new U.S. company securities are fundamentally the same and represent a mere change in form and not in substance. Shareholders must also take into consideration the fact that a flip rarely generates revenues for the shareholders, and the shareholders will have to use other resources the pay for any tax liability that may arise. Therefore, given the time and expense involved in conducting a flip restructuring, a company should make sure that there are tangible benefits to having a US parent company before proceeding. Similarly, if a company is conducting a flip restructuring due to an investor request, the company should insure that it has sufficient commitments to close its funding round and that the requesting investors have signed binding commitments to fund upon completion of the flip.
In conclusion, there are many factors to be taken into account when foreign companies access the US markets. Given the time and expense involved in setting up legal structures, foreign companies should plan appropriately upon US arrival.