FINANCIAL RELATIONSHIP BETWEEN OWNER COMPANY AND SUBSIDIARY

Please note that the guidance below is not a substitute for professional legal and/or tax advice. Any tax advice contained in the body of this e-mail is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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Typically, a US subsidiary will be created with the primary intent of accessing a large market with a product or idea that has already succeeded in France. This means that, up until that point, the intellectual property and development costs were assumed by the French owner company.

The following critical question now needs to be posed: what financial relationship will now exist between the French owner company and its US subsidiary? How this question is answered has massive consequences, as does failing to address this question. Why? Because taxing authorities in France and in the US will both be impacted and therefore both have a stake in the outcome. That means that taxing authorities in each country want to ensure that taxable income is maximized for their benefit. Further, any benefit to French authorities is a detriment to US authorities and vice versa. 

Navigating effectively through this starts by establishing “reasonable” financial terms between the French and the US companies right from the outset, and only changing those terms if and when significant operational changes occur. Reasonable financial terms are generally understood to mean that the French and US companies will behave in a way that closely approximates the way two completely unrelated parties would behave – resulting transactions are typically known as “arms’ length transactions”. Any two unrelated parties would negotiate terms and memorialize them in a contract, and that is exactly what is expected by taxing authorities in France and the US. Legal counsel either in France or in the US should therefore draft such contracts.

Any dealings that would elicit the negotiation of a contract between two unrelated parties should also elicit the drafting of a contract between the owner company and the subsidiary. At a minimum, that would include the following:

1. How revenues generated in the US will be spread between the US and France.
2. How much interest will be paid, typically by the subsidiary, for cash advances made by the owner company.
3. How the US subsidiary will pay for many other services provided by the French owner company, often labeled “management fees”.

1. REVENUE SHARING

Establishing a US subsidiary with the intent to strictly generate losses and never pay taxes in the US is not considered reasonable and is therefore not an option. Whatever agreement is reached between the French owner company and its US subsidiary needs to give the US subsidiary a reasonable chance at success – i.e. terms that unrelated parties would negotiate between each other. Although it is normal for the US subsidiary to generate losses for its first few years (much like any startup), the agreement reached with its owner company must give it some hope of success in the long run.

At the outset, the US subsidiary will sell something that was developed by the French owner-company. The revenues generated in the US could never be generated without the efforts made by the French company. Similarly, the US company is assumed to contribute something to this process and needs to be compensated for it. Typical solutions include the following:

• All revenues are assumed to remain those of the French owner company and the French company pays “reasonable” commissions to the US company – this presumes that the primary function of the US company is to sell.
• The US company buys everything it sells in the US from the French company at a “reasonable” price. Such a price would allow for both companies to share in the overall gross profit.
• The US company operates as a “Cost+” entity. This is an exception to the otherwise standard rule of arms’ length negotiations between owner company and subsidiary, only allowed by international treaties. Typically, this stipulates that all revenues generated in the US belong to the French owner company and that all costs incurred by the subsidiary, other than for CAPEX, should be reimbursed by the French company + a slight profit margin (thus the expression Cost “+”). That margin is generally established between 5 and 10%.

2. INTEREST

Market interest rates should be charged by the company making financial advances, or loans, to the other company. If such rates are not readily available, the IRS (US federal taxing authorities) publishes rates that are guaranteed to be accepted by the US taxing authorities.

3. MANAGEMENT FEES

Any and all services incurred by the owner company due to the existence of the subsidiary should be charged to the US subsidiary. This can consist of various costs incurred by the owner company. Typically, some of the owner company’s management has to spend time working towards the benefit of the US subsidiary – that time should be invoiced to the subsidiary to the extent that this time is tracked or can be reasonably estimated. Travel costs for employees of the owner company are also often incurred as a result of the creations of the US subsidiary. All these costs, when invoiced to the subsidiary, are often referred to as “management fees.”