New tax applies to foreign vendors selling to the federal government

August 5, 2011

By Alan Lederman

A new federal tax applies to products and services that are sold to the U.S. government in 2011 and thereafter. The U.S. estimates that, every year, about $23 billion of products and services will be subject to this tax.

The tax applies to a foreign corporation selling to the federal government, whether or not that foreign vendor has any executives, offices, employees, income, assets or shareholders within the U.S. products and services purchased by the U.S. government for use overseas, as well as for use in the U.S., are taxable. Because this tax is equal to 2 percent of the gross selling price of the product or service, for low pretax net profit margin items, it may represent a large percentage, even a majority, of the foreign vendor’s pretax profit.

Among South Florida businesspeople quite possibly affected by this new tax are individuals involved with defense contractors whose foreign subsidiaries supply the U.S. military abroad, and individuals involved with companies established in Latin America that export products made there to the U.S. government. In the long run, there is a concern that some foreign countries will apply a retaliatory tax against products and services their government purchases that are exported from and originate in South Florida or elsewhere in the U.S.

Among the numerous interpretative uncertainties in the new law is which countries’ goods and services are entirely taxable, and which countries’ products are entirely excused from the tax. It is quite possible that the IRS will conclude that the tax applies to products and services originating in more than 100 countries, including Argentina, Brazil and China. By contrast, it appears that goods manufactured in, and services performed in, parties to the World Trade Organization Government Procurement Agreement (WTO-GPA) are excused from the tax. These 39 WTO-GPA countries include all members of the European Union, Canada, and Japan.

However, commentators are wondering if goods manufactured or services performed in countries that have entered into free trade agreements with the U.S., but are not parties to the WTO-GPA, are necessarily exempt from tax. Several Caribbean and Latin American countries fall within this category, including Chile, Costa Rica and the Dominican Republic.

Several non-WTO-GPA, non-FTA countries have comparable access to the U.S. government purchasing market as the WTO-GPA and FTA countries, because Congress has designated them as “least developed countries” or “Caribbean Basin countries,” or as beneficiaries of other U.S. laws. It is doubtful that these countries’ products and services are entitled to a tax exemption.

There are many other uncertainties concerning this new law. These include when the IRS will determine that activities in an exempt country, carried out in making a product from components originating in non-exempt countries, are extensive enough to qualify the good as manufactured in the exempt country. Also unclear is what documentation a foreign vendor of goods manufactured in an exempt country must deliver to the purchasing federal agency to avoid that agency withholding the tax from the vendor’s price. Despite the many technical uncertainties concerning this new law, however, foreign vendors may need to consider its possible implications now.