Finnish/International Tax Issues for Establishing US Operations

1. Finnish/International Tax Issues for Establishing US Operations Silicon Valley 22 June 2004 Antti EerolaKPMG Nordic Tax Center, New York © 2000 KPMG

2. Agenda • General International Tax Principles/Concepts • Tax liability in Finland and US • Tax treaties and income types • Avoiding double taxation • Permanent establishment • Different internationalization phases • Comparison of export trade, branch and corporation taxation • Different entity forms • Corporate (and shareholder) tax planning • Corporate structure and income flows • Transfer pricing (IPRs) • Restructuring (e.g. inversion to US) © 2000 KPMG

3. General International Tax Concepts and Principles © 2000 KPMG

4. Tax Liability in Finland and US • Corporation established and registered in Finland is generally taxable in Finland on its worldwide income • The same principle applies to the US corporations • Effective place of management may lead to double residency and potential double taxation • Tax treaty to determine the residency and avoid double taxation • Tax treaties to allocate the right to tax income between the residence country and source country of income © 2000 KPMG

5. Tax Treaties and Income Types • The purpose of the treaties is to allocate the taxation right and avoid international double taxation • Domestic tax law cannot result to a higher tax liability than tax treaty • The residence and source country principles • Examples of Finland-US treaty • Business income taxed only in the residence country unless a permanent establishment is created • Interests only in the residence country • Dividends 5% withholding tax for the source country if at least 10% voting stock (tax exempt in Finland but no credit on withholding tax), otherwise 15% withholding tax • Royalties normally 5% withholding (0% in some cases) • The treaty income definition may be sometimes difficult, e.g. difference of royalty vs. business income vs. capital gains © 2000 KPMG

6. Avoiding Double Taxation • Tax treaties normally determines that the country of residence needs to eliminate double taxation either through credit or exemption method • Credit method prevailing (e.g. Finland-US treaty) • Normal credit method is the primary method in the Finnish internal law • Only taxes to government credited, per country and per income basis • Finnish net basis calculation vs. US gross basis calculation may result that withholding tax is not partially credited • US state and municipality taxes are not credit, nor accepted as deduction of the income (recent Supreme Administrative case) © 2000 KPMG

7. Permanent Establishment (PE) • If the PE is created, the country where the PE is may tax profits allocated to the PE • PE issues can arise in different phases of internationalization • Allocation of profits and costs to PE may create a risk of double taxation and increases administrative burden • In addition, registration, employer, accounting and tax filing responsibilities • PE is a fixed place of business through which the business is carried out, e.g. place of management, branch, office etc. (Finnish domestic law and tax treaties) • Negative list in the treaty excludes activities of preparatory and auxiliary in character © 2000 KPMG

8. Permanent Establishment (PE) • Activities carried out by an independent agent, such as commission agent or broker, should not create PE • Independence both economically and judicially and needs to act within its normal business limits and carry out most of the business risks • Dependent agent may create a PE if the agent acts on behalf of the Finnish company and habitually exercises an authority to conclude contracts in the name of the Finnish company • Negotiating the essential terms of the contract may create a PE • The US subsidiary can act as a dependent agent but the risk of PE is fairly high © 2000 KPMG

9. Different Internationalization Phases © 2000 KPMG

10. Different Internationalization Phases Export trade Branch (PE) in a foreign country Subsidiary in a foreign country Business income • Taxed only in Finland if no PE • Taxed only in Finland if no PE • Taxed in PE country • Normally taxed as subsidiary income PE risk • Minor • Activities need to be preparatory and auxiliary in order that PE is not created • Profit and income allocation issues • Minor as normally taxed anyway in the US • If dependent agent, higher PE risk Royalties • May be subject to WHT, normal credit limits in Finland • Definition of the income type • Income for the Finnish company (credit vs. exemption method) • May be subject to WHT, normal credit limits in Finland • Definition of the income type Repatriation of the profits • Direct income in Finland • Direct income in Finland (credit vs. exemption method) • US may apply a branch profit tax of 5% on the amount not reinvested in the US • Dividend distribution rules may be restrictive • Normally 5% WHT Losses • NA/Direct flow to Finland • Direct loss in Finland (credit vs. exemption method) • Losses cannot be adopted to Finland Transfer pricing • No transfer pricing issues as third party transactions • No transfer pricing but profit/income allocation issues • Intra-group transfer prices have to be at arm’s length Establishment • NA • Registration etc. formalities • No share capital • Registration etc. formalities • Share capital requirements Other issues • Business considerations to conduct business, legal considerations, such as liability issues • Joint ventures similar to subsidiaries except normally no/minor transfer pricing issues • Same principles apply in E-business although fact pattern may create new categorization issues © 2000 KPMG

11. Comparison of Branch vs. Subsidiary • If the creation of the PE can be avoided, the branch may be a good form to operate – may not be realistic in practice • Tax-efficiency may depend on the credit vs. exemption method and profitability level of the foreign operations • For example, loss-making operations allow direct tax deductibility in Finland for the branch • US branch profit tax of 5% should be taken into account for the profitable branch (profits not reinvested in the US) • The lower Finnish tax rate (tax base analysis should be made) may encourage to show profits in Finland • Transfer pricing, i.e. allocation of functions and risks ultimately determines the profit allocation • Finnish tax reform 2005 is introducing capital gains exemption for shares on certain circumstances (e.g. 1 year holding) © 2000 KPMG

12. Different Entity Forms • The US offers a variety of alternatives with respect to the entity form • Corporation • Subchapter S corporations (election to be treated as pass-through entities) • Partnerships fiscally transparent • LLC (election to be treated as pass-through entities) • Tax treatment of different entities may vary © 2000 KPMG

13. Corporate and (Shareholder) Tax Planning © 2000 KPMG

14. Corporate Tax Planning • Corporate tax planning normally consists of following elements • Corporate structure with tax rate comparison and income tax flows effects • Shareholder viewpoint is normally considered as net dividend optimization • Transfer pricing, i.e. allocation of functions and risks determining the intra-group profit allocation • Techniques to implement desired structures potentially have tax implication (e.g. exit tax) which need to be taken into account • Business, legal and other considerations should be integral part of the process © 2000 KPMG

15. Income Flows • The income flows, such as dividends, royalties and interests, may be subject to withholding taxes and may not be always fully credit as discussed earlier • The net dividend received depends on the shareholder’s residence and ownership percentage • Example • 100 income for the US subsidiary - 35 US tax – 65 net dividend – 3.25 WHT to Finnish parent not credited – net dividend 61.75 exempted a) 2004, if complementary tax liability can be avoided (29/71 of dividend otherwise) no additional tax for parent, no additional tax for the Finnish individual shareholder if dividend amount does not exceed capital income limit b) 2005, no complementary tax liability, Finnish individual shareholder subject to 0%, capital or earned income tax c) for the foreign shareholder potential withholding tax and the foreign country tax • 100 income for the Finnish parent – 29/26 Finnish tax – 71/74 net dividend – a-c) see above – for example WHT to US recipient either 5% or 15% © 2000 KPMG

16. Transfer Pricing • Intra-group transfer prices have to be at arm’s length • Strict documentation requirements in the US, Finland probably introducing in the near future • Intra-group transfer prices partly determine the profit allocation in the group • The more functions and risks, the more profit • Having the value-added functions and risks in a lower tax jurisdiction (such as Finland 29%/26% vs. US potentially 35%-40%), may be tax-efficient (note tax base and reserves) • Finnish CFC-rules need to considered if functions and risks are transferred from Finland to a low tax country • For example, it may be tax-efficient to own IPRs in Finland • Note that transfer of IPRs outside Finland subject to (exit) tax in Finland • Existing vs. future IPRs (e.g. contract R&D arrangement) © 2000 KPMG

17. Restructuring • As discussed, Finnish parent company – US subsidiary structure may be tax-efficient but not necessarily in all cases • Funding the operations through US may be one reason to implement US parent company structure • In the following, we have discussed certain inversion techniques, which we have categorized into 3 different groups • Finnish company is owned by Finnish companies vs. owned by individual shareholders • Finnish company does not have value for tax purposes • Finnish company has value for tax purposes and it is owned mostly by Finnish individual shareholders © 2000 KPMG

18. Inversion to the US Parent StructureCorporate shareholders and value/no value in Finnish company • Finnish government has proposed a new legislation according to which capital gains on shares (fixed assets) are exempt on certain conditions, e.g. 1 year holding and ownership of share capital is at least 10% • Therefore, if the conditions are met, the sale of the shares to the newly established US company would be exempted • The same applies to the share exchange; note that tax-exempt share exchange cannot be carried out between a non-EU country and Finland • 1.6% transfer tax • Cross-border merger to the US cannot be implemented • The taxation in Finland as share exchange, see above • Liquidation and consequent sales of business assets subject to the Finnish tax • US company can establish a Finnish subsidiary into which the existing Finnish company is merged but then the Finnish company’s shareholders would receive shares of the new Finnish subsidiary © 2000 KPMG

19. Inversion to the US Parent StructureNo value in the Finnish company and individual shareholder • If it can be argued for tax purposes that the Finnish company does not have a value, then the transfer of the shares or assets should not trigger any Finnish tax liability • Argument that no value exists unless third party funding is received (e.g. bankruptcy situation) • It should be considered whether to apply for an advance ruling • Timing between the transfer and funding? © 2000 KPMG

20. Inversion to the US Parent StructureIndividual shareholder and value • Capital gains are subject to 29% (28% 2005) Finnish tax • Applies to both sale and share exchange • Other techniques should be considered • Finnish tax avoidance provisions should be taken into account • All transactions should be based on business reasons and the main purpose of doing the transaction cannot be tax savings • Share exchange to Netherlands and further to the US has been used in the past • Finnish holding company under which the shares of the Finnish company are transferred and further sales to the US? © 2000 KPMG