Expanding Law Firm Operations Globally

[Ed. Note: The June edition introduced numerous accounting-related issues that firms confront when they use foreign currencies. This new article raises additional accounting-related challenges of international compensation and taxation, while also highlighting the broader planning issues associated with a law firm's decision to expand its operations globally. The article authors, both from PricewaterhouseCoopers' Law Firm Services Practice, had A&FP's readership specifically in mind when preparing this analysis.]

Operating An International Law Firm: Risks And Rewards

It's not surprising that law firms are extending their reach internationally, particularly if you consider the growth of their multinational clients. Large multinational companies across a wide variety of industries are expanding globally in order to capture new markets, reduce operating expenses, take advantage of lower manufacturing costs, and meet worldwide consumer demand.

These same multinational companies insist on a high level of responsiveness from their own service providers, especially regarding how to address and resolve international business issues. International law firms are compelled to demonstrate critical mass, local presence and depth of knowledge, by operating in diverse markets around the world.

Global Structuring

One of the most important decisions facing a law firm with global aspirations is determining which structure to use in a particular host country. The ideal structure type depends on the relevant laws of both the host country and the home country.

The laws of the prospective host country contemplate tax rules and bar rules (bar rules are covered in a later section). Under the tax rules of the host country, a law firm might not be able to operate in the form that it uses in its home country. Consider the following example: If a U.S. law firm is structured as a limited liability partnership (LLP), the tax ramifications of operating a branch office in Australia could be significant. Australia considers a U.S. LLP to be a corporate entity, so it would claim the right to tax the firm's global income. To operate the branch as an LLP, this firm should create a new Australian LLP and ensure that the original U.S. LLP never does business in that country.

Likewise, a U.S. firm that is structured as a personal service company ' a corporate form ' can operate in the UK only if the corporation is incorporated in the EU or EEA and its owners are suitability qualified as lawyers for UK purposes.

A law firm's home country laws are just as important. Indeed, for a law firm organized in the United States, they are critical. Other countries sometimes focus on the formalities of a proposed transaction; ie, if the paperwork is executed properly, they may overlook the “substance” or underlying economics of the deal. In the U.S., however, substance is a prime factor used by the IRS in evaluating how a law firm will be treated on a global scale. This is one reason why U.S. law firms tend to be more conservative than their non-U.S. counterparts in choosing their global structures.

Take, for example, a U.S. firm operating a “branch” office in Italy. Although the U.S. firm considers the Italian office to be a branch office for global purposes, under Italian rules, the office must be a separate legal entity that is controlled solely by locally admitted lawyers. Consequently, in Italy, the income of the Italian entity will be taxed solely to the Italian partners. By contrast, if global control and profit sharing exist, then the IRS will likely assert that the two firms should be treated as one global partnership for U.S. tax purposes, regardless of the Italian documentation.

U.S. firms, therefore, should consider a variety of structural options when operating internationally. These options include a partnership, parallel partnerships, separate legal entities, strategic alliances, and umbrella structures.

Partnerships

If a U.S. law firm currently operates through a partnership structure, then the simplest way to expand into most countries is via a branch office. Local laws in some countries, however ' notably Turkey, Hungary, and Canada ' prohibit U.S. firms from operating through a branch office. If allowable, a partnership clearly affords the greatest operational flexibility.

On the other hand, there are two considerable disadvantages associated with operating as a global partnership: the requirement to file tax returns wherever the firm does business, and unlimited personal liability for malpractice.

The tax laws of many countries view a partnership as a pass-through entity, so that the tax on partnership income is the responsibility of each equity partner. But a long-debated question has been: Which partners pay tax on which income? Should income earned in, say, Germany be allocated for tax purposes only to partners resident in that country (and not to nonresident partners, thereby limiting tax compliance requirements)? Or should income earned in Germany be allocable to all equity partners worldwide, all of whom would then be subject to German tax. The latter approach necessitates filing of global returns by all partners.

Not long ago, this controversy was (at least in theory) put to rest, from a U.S. perspective, when the IRS issued a Revenue Ruling concluding that global filing of tax returns by all equity partners is the correct procedure. Revenue Ruling 2004-3, 2004-7 I.R.B. 486 (February 17, 2004). While this ruling may have surprised some firms, it was consistent with established tax compliance practice of the U.S. and the EU. Unfortunately, for some law firms, it will increase the global compliance responsibilities of their partners.

The second significant shortcoming of the general partnership structure is that each partner has unlimited liability for debts of the firm. Public accounting firms have painfully demonstrated just how dramatic it can be for each partner to have unlimited personal liability. To address this issue, many general partnerships in the U.S converted to limited liability partnerships (LLPs). This trend accelerated once firms realized that there was no stigma associated with the change, and that there was general acceptance on the part of the business public.

Although LLP conversions have largely alleviated concern over unlimited liability within the U.S., many foreign jurisdictions do not respect an entity structured as an LLP in the U.S. When a U.S. LLP practices law in some other countries ' notably Belgium, Germany and possibly England ' it is unclear if partner liability will actually be limited, or if LLP owners will instead still be treated as general partners. To our knowledge, this vital issue has not yet been the subject of litigation outside the U.S.

Corporate Structures

One variant of the LLP is the limited liability company (LLC), a corporate entity that is taxed in the U.S. as a partnership. Very few U.S. law firms that elected to become LLCs are actually practicing law outside the U.S., however, because the LLC may be taxed as a corporation in foreign countries. If an LLC tries to practice in France, for example, France will focus on the corporate structure and very possibly conclude that the entity is a corporation and not a partnership.

Recently, Germany issued a public letter ruling that provides guidelines on classifying a U.S. LLC operating within its borders. An LLC may now be classed as a partnership, corporation or branch office, contingent on an analysis of all relevant facts and circumstances.

The LLC and similar corporate structures, including the personal service corporation (PSC) and S Corporation, are therefore of limited use for international operations.

Structure Mixing

Law firms that are restricted in terms of the structure types they can employ might decide to use different structures in different countries. For example, an S Corporation law firm operating in the United States might form a general partnership or an LLP in another country, making the newly formed entity's partners the owners of the S Corporation. While this arrangement is cumbersome, it demonstrates that “mixing and matching” can work when expanding internationally.

Parallel Partnerships

Another possible structuring option contemplates using parallel partnerships to try to limit the personal liability of the individual partners or the number of cross-border tax filings. In a parallel partnership, very few partners are partners in both firms. Conceptually, those partners can be used as “bare” trustees to allow income from one firm to flow to partners in the other firm (this is typically done between the UK and the U.S.) or, more aggressively, to balance income between the two firms.

From a U.S. tax filing perspective, it's not certain that a parallel structure has the desired effect. If there is global profit sharing (as is the norm), the IRS may view the structure as a global firm ' especially if there is also global control (which, too, is normally the case).

In response to this IRS view, some firms have tried to use common partners as “valve” partners. Valve partners were created for the sole purpose of limiting the number of individual partners required to file cross-border tax returns. When parallel firms share global profits and one firm earns more than its share of the global pot, valve partners draw more of their income from the first firm in order to balance the share of income going to the partners in the second firm. Valve partners and parallel partnerships have been used to reduce or eliminate global income tax filing requirements for the larger group.

Informal advice from the IRS, however, suggests that the IRS deems valve partner relationships as ineffective, and is likely to treat them as a ploy to thwart U.S. filing requirements.

Umbrella Structures

The newest structure being considered by some law firms uses an “umbrella” concept. An umbrella structure involves the formation of a global governance entity, which recommends standards and policies for member entities that practice law in their respective countries. There are no common partners between the member entities, so that partners are only partners in their member firms. Also, in an umbrella structure, there is no global profit sharing, although it is likely that there is some sort of cost sharing (either through a separate entity or through agreements) between the member entities. Since there is no global profit sharing, an umbrella structure is very difficult to implement in a lock-step organization. Depending on how an umbrella structure is implemented, each country or region of the world might be considered a separate operating unit.

In theory, for example, an umbrella structure could allow a U.S. LLP to be a member in an umbrella structure with a UK LLP, a general partnership in Australia, a separately owned entity in the Czech Republic, and a locally owned partnership in Italy. While this structuring arrangement seemingly solves many of the issues previously identified, it also carries with it many uncertainties ' especially regarding how the IRS will treat the structure.

Strategic Alliances ' Best of Friends

Law firms that want to avoid the hassles and complications of opening a foreign office might opt, instead, to form a strategic alliance with a local firm. The obvious reward is gaining access to qualified local lawyers who will not compete against the firm, but will be best of friends when referring work back and forth. Such an alliance avoids the significant cost and administrative distraction of building an entirely new practice or of merging with a local firm, and the attendant risk that such investment may not generate the anticipated benefits.

Typically used as an introductory or trial relationship, many alliances end with both firms going their separate ways. Reasons for the frequent demise of alliances vary. Often one firm refers work to the other firm without equal reciprocity; or perhaps one firm may form a relationship with the alliance partner's direct competitor. Dissimilarities related to culture, compensation and quality of work product are also important obstacles to overcome.

Such issues notwithstanding, alliances can be effective. Smaller law firms, for instance, have operated successful alliances of ten or more firms throughout the world, thereby providing global legal capabilities for their existing clients that would have been impossible if the allied firms were operating on their own.

The final word on global structuring options is that there is no simple solution. The ultimate structure type chosen depends on the relevant tax and business implications, local bar rules, various regulatory restrictions, and ' maybe more important ' the firm's culture. As a result, international law firms can have complicated structures that use disparate arrangements throughout the world.

Foreign Assignments

Some law firms send their partners and associates abroad on assignments to one of their foreign offices or occasionally to an unrelated firm. Their primary objective is to provide better client service. Also important are intentions to strengthen existing international branches, to share pertinent legal expertise with foreign merger partners, and to facilitate the cross-pollination of knowledge ' communicating relevant information within the firm for use in other client engagements.

Successful foreign assignments involve heavy investments of management attention and other resources. Indeed, the cost of transferring lawyers overseas can be substantial, especially if the international assignment is to take place in a high-tax jurisdiction. A U.S. law firm associate paid $180,000 in Washington, DC, for example, can cost twice as much if assigned to a European or Asian city.

Before carrying out an international assignment, proper tax and compensation planning is essential. The firm should create a standard policy that will be applied as uniformly as possible to its expatriates. The firm may also want to consider instituting a tax equalization policy to ensure that expat partners and associates are compensated and taxed in the same manner as in their home country. An alternative to a tax equalization policy that is used by some firms with few assignees is to give a flat amount as an allowance to cover all extra costs while on assignment.

Finally, a careful review of each relevant host country's tax laws may result in significant tax savings for individual expats – or for all partners if taxes are equalized.

Local Bar Registration

Regardless of whether a law firm chooses to open a foreign branch, set up a new entity, or send staff abroad on international assignments, a law firm must formally “register” to conduct business with the local bar. While it is not our intent to provide legal advice, we are aware that local bar regulations do vary from country to country, with nonresident lawyers facing restrictions such as those described below.

In certain Southeast Asian countries, eg, India, Taiwan and Indonesia, local bar rules expressly restrict nonresident lawyers from either practicing law or sharing firm profits with locally admitted lawyers.

Other countries, eg, the Czech Republic, Hungary, Turkey and Brazil, require that local national lawyers own all local law practices.

In France, a U.S. law firm can open a branch office only if the firm was grandfathered under the pre-1992 Paris Bar rules. Further, unless an individual attorney was either grandfathered under the pre-1992 Paris Bar rules or has passed the French bar exam, he or she cannot practice law as a partner of the firm in France.

Some European and Asian countries, among them the UK and Japan, do allow lawyers who have not gained local qualifications to practice law within their borders; but they restrict the kinds of law they can practice and, in some cases, with whom they can share profits.

In most cases, U.S. lawyers who have not passed the local bar are permitted to practice only U.S. law, as local bar regulations generally preclude nonresidents from practicing local law. In some host countries where the practice of U.S. law by nonresidents is allowed, unique operating and compensation structures may be needed to enable attorneys to practice law that is compliant with both the local bar's requirements and the firm's home country tax regulations.

By registering with the local bar in advance of beginning operations, a law firm generates goodwill with the local government and is able to identify potential problems before they arise. Lawyers can then focus their time and attention on client matters instead of being distracted by organizational issues.

Office Setup

Once the structure in a foreign country is finalized and business registration completed, other administrative concerns must be addressed prior to commencing work. These include office location selection, language barriers, foreign communication costs, local customs, and labor laws.

Locating a foreign office wisely is vital to a law firm's success in a host country, since office location can enhance or hinder the firm's culture, image and reputation. As in the U.S., a law firm should preferably locate its foreign office space in close proximity to its clients.

Language is another key consideration when expanding globally, especially if the host country does not recognize English as its first language. Although English is widely spoken in many countries as a second language, the majority of law firms have found it beneficial both professionally and socially to communicate with foreign clients using their local language. This is true even where, as in most jurisdictions, the common law for major transactions (like mergers) is based on English-language (UK or U.S.) legal sources.

Even in major foreign countries, obtaining reliable telephone service is likely to be a frustrating and expensive process. In India, for example, it may take up to six months to get a telephone line installed successfully. To compound the problem, local telecommunications providers are seldom equipped to set up voice mail or high-speed Internet access. The resulting inefficiencies can thwart a law firm's global information technology network, thereby challenging the firm's ability to succeed abroad.

Finally, local customs and labor laws should be researched before much time and money is invested in establishing a foreign branch. For instance, many countries have more than ten public holidays, others have mandatory vacations of 5 or 6 weeks, some have strict regulations as to the number of hours that can be worked by employees (ie, associates and support staff) each week, and still others have severe limitations with respect to staff reductions.

France, in particular, has long been recognized as a country with laws that make it costly for an outside law firm to do business within its borders. Closing a French office, for example, can result in substantial severance costs.

Foreign Tax Filing

Once a law firm successfully navigates the administrative and logistical issues related to international expansion, tax planning becomes a fundamental part of doing business. In most foreign jurisdictions, law firms are required to file some type of local tax return. Foreign taxes can be assessed against the firm itself, or, if the firm is viewed as a pass-through entity, then against each equity partner.

Some countries that assess tax against individual partners are Japan, the UK, France, Belgium, Australia, Germany and (depending on the firm's local structure) Italy. Hong Kong and Singapore tax the branch, but the assessed tax is then allocated to each individual partner. Other countries like Hungary, Turkey, Russia, the Czech Republic and Poland tax the entity directly.

In addition, there are certain jurisdictions, like Spain, that allow resident lawyers to practice individually, but tax nonresidents at the entity level based on corporate tax provisions. To mitigate and lessen the compliance burden and the expense of filing individual returns, countries like the UK and Belgium allow nonresident partners to file composite returns.

Clearly, it is critical to understand the tax structure of the host country in which a law firm will be operating, so that management can then determine if the foreign tax will be greater than (or less than) the home country tax that will be assessed against the same income. It is wise to engage competent tax assistance when preparing foreign tax returns or when working with foreign tax inspectors.

Foreign Tax Credits

With U.S. marginal income tax rates currently at 35% (excluding various state income tax rates), and most foreign countries' marginal rates being in excess of that base, it is imperative for U.S. lawyers working abroad to attempt to prevent or mitigate double taxation on their worldwide income. (If a partner receives a guaranteed payment for services rendered outside the U.S., that, too, should be considered foreign-source income for U.S. income tax purposes. Guaranteed payments are discussed in a later section).

To reduce the impact of double taxation, U.S. citizens and residents can elect to take a credit on their U.S. tax returns for the foreign tax they pay on foreign-source income; but this measure is subject to complications, as the following scenario illustrates. Suppose a firm's partners receive a proportionate share of total domestic and foreign income. In this case, partners working in the foreign branch will have foreign-source income only in the ratio that the firm's foreign-source gross income from all foreign activities bears to total gross income. If the firm has very little net foreign-source income, a foreign-based partner may pay more foreign taxes than can be claimed as a credit on his or her U.S. personal income tax return. In such an “excess credit position,” the taxpayer can choose to take foreign taxes as an itemized deduction rather than as a credit. Applicable rules for doing so are complex, however, and the deduction will not reduce the partner's U.S. tax as effectively as a credit.

Ten or 15 years ago, U.S. law firms commonly used expat policies that benefited assignees but did not consider the implications for U.S.-based partners. As their international operations began generating profits, many of these firms came to appreciate that helping partners on foreign assignments could hurt the U.S.-based partners ' notably by reducing net foreign-source income.

To understand this negative result, consider where many international firms generate fee revenue. Many law firms have expanded into parts of Europe with local tax rates generally higher than those in the U.S. (eg, Germany, Belgium, France, the Czech Republic and the UK). Depending on the geographic mix of income, higher non-U.S. tax rates can make the partners' global effective tax rate higher than the U.S. effective tax rate. This tax rate differential is exacerbated by countries that disallow deductions for crucial business expenditures. For example, in the UK there is no depreciation deduction available for office leasehold improvements (unless they qualify as plant) or for many types of meal and entertainment costs.

When faced with these challenges, a law firm must be open to changing its culture and customs so that partners on assignment or resident in foreign offices are compensated differently. Fortunately, various tax-planning strategies are available to increase foreign tax credits or reduce excess credits. Some solutions might entail better tracking of where services are rendered, allocation of certain home office expenses to foreign offices, adjusting the level of guaranteed payments given to partners, or simply having fewer partners on assignment outside the U.S. Generally the firm's goal should be to minimize the partners' aggregate global taxes, even if some partners are affected negatively.

Double Tax Treaties

A law firm does not have to open an entire office in a foreign country to be characterized as “doing business internationally.” On the contrary, most foreign countries will withhold tax on services provided in their country by residents of another country. This withholding, which is assessed on the gross amount of the service fees, ensures that a nonresident partner pays tax to the host country.

Under Article 14 of most double-tax treaties with the U.S., fees from the practice of law are treated as independent personal services and, for foreign tax credit purposes, are sourced where services are performed or rendered.

Note: As recently changed, the U.S.-UK treaty does not include Article 14 and now relies on Article 7. Under newer interpretations of Article 7, a partnership can create a permanent establishment, and, therefore, Article 14 is no longer needed. It is believed that treaties negotiated in the future will eliminate Article 14.

Some countries such as Spain, Italy and Indonesia assess withholding under a claim-of-right doctrine. The doctrine suggests that a country has a right to withhold tax on the gross fee ' regardless of where the work was performed or the treaty in effect.

To avoid withholding tax issues, the U.S. Treasury Department has negotiated double-tax treaties with many countries. These treaties prohibit withholding taxes when the law firm and its partners are residents of a country that has a double-tax treaty with the host country. To obtain certification for double-tax treaty protection (Form 6166), eligible partners should submit a written request (on newly issued Form 8802) to the IRS Foreign Certification Group in Philadelphia.

If services are rendered in a host country that does not have a double-tax treaty with the U.S. (eg, Brazil, Argentina or Venezuela), taxes will be withheld at the normal statutory rate in effect for that specific country. Procedurally, the law firm collects its bill net of withholding tax at the time that payment is made.

Guaranteed Payments

An integral part of an international law firm's compensation structure, guaranteed payments are used in a variety of ways. For example, guaranteed payments may be used to:

• Enable a U.S. partner assigned to a foreign office to claim a Section 911 exclusion (ie, an earned income exclusion) when the partner's share of the firm's foreign-source income is too low.
• Allow French-based partners to maximize the benefits of Article 14 of the French-U.S. double-tax treaty, which allows up to 50% of a French-based partner's income to be allocated back to the U.S.
• Help a solicitor in the UK maximize the benefits of his or her pension scheme.
• Allow a Chinese national in Hong Kong to avoid filing tax returns in the U.S.

In all instances, careful thought must be given to why guaranteed payments are needed and what the appropriate amounts should be. It is important to understand that guaranteed payments are a contributing cause of excess credit positions as global law firms continue to evolve and mature.

When incorporating guaranteed payments into a law firm's compensation system, management should focus on the way in which they are calculated. Internal Revenue Code Section 707(c) requires that guaranteed payments be calculated without regard to the income of the firm. All too often, law firms ignore that requirement, since they set total compensation by a lock-step system or some other formula and then back into the amount of the guaranteed payment. A better way would be to compensate a partner based on a combination of a guaranteed payment and a reduced share of firm income. Fixing the guaranteed payment up front may cause an imbalance in the compensation system, however, because the partner might receive either too large a share of the firm's profits or not enough.

Caution should also be exercised with regard to the treatment of guaranteed payments in other countries. Since the concept of a guaranteed payment is primarily a U.S. concept, most other countries do not fully understand how to account for them within their tax systems. For example:

• Partners receiving only guaranteed payments in Belgium could be fully taxed on these payments by Belgium, insofar as they might be considered employees instead of partners ' or they could avoid tax on some portion of the guaranteed payment, insofar as Belgium considers it to be part of the total income of the partnership.
• Partners in Germany might use guaranteed payments to avoid taxation, unless a treaty provision causes the income to be pulled back to Germany and subject to German taxation.
• A U.S. partner who pays UK tax on a remittance basis while on assignment there may use a guaranteed payment as a means to create foreign-source income that is not taxed in the UK but can be used to claim more foreign tax credits or to reduce excess credits in the U.S.

The operative advice is to use guaranteed payments only after carefully considering all their consequences.

The Reward

As summarized above, operating an international law firm presents many risks and rewards. From structuring foreign operations, registering for practice, and choosing a foreign office location, to mitigating foreign taxes and maximizing foreign tax credits, going global necessitates thorough planning and foresight. The ultimate reward of foreign expansion is to emerge stronger and more competitively positioned for the increasing globalization of business.

[Ed. Note: The June edition introduced numerous accounting-related issues that firms confront when they use foreign currencies. This new article raises additional accounting-related challenges of international compensation and taxation, while also highlighting the broader planning issues associated with a law firm's decision to expand its operations globally. The article authors, both from PricewaterhouseCoopers' Law Firm Services Practice, had A&FP's readership specifically in mind when preparing this analysis.]

Operating An International Law Firm: Risks And Rewards

It's not surprising that law firms are extending their reach internationally, particularly if you consider the growth of their multinational clients. Large multinational companies across a wide variety of industries are expanding globally in order to capture new markets, reduce operating expenses, take advantage of lower manufacturing costs, and meet worldwide consumer demand.

These same multinational companies insist on a high level of responsiveness from their own service providers, especially regarding how to address and resolve international business issues. International law firms are compelled to demonstrate critical mass, local presence and depth of knowledge, by operating in diverse markets around the world.

Global Structuring

One of the most important decisions facing a law firm with global aspirations is determining which structure to use in a particular host country. The ideal structure type depends on the relevant laws of both the host country and the home country.

The laws of the prospective host country contemplate tax rules and bar rules (bar rules are covered in a later section). Under the tax rules of the host country, a law firm might not be able to operate in the form that it uses in its home country. Consider the following example: If a U.S. law firm is structured as a limited liability partnership (LLP), the tax ramifications of operating a branch office in Australia could be significant. Australia considers a U.S. LLP to be a corporate entity, so it would claim the right to tax the firm's global income. To operate the branch as an LLP, this firm should create a new Australian LLP and ensure that the original U.S. LLP never does business in that country.

Likewise, a U.S. firm that is structured as a personal service company ' a corporate form ' can operate in the UK only if the corporation is incorporated in the EU or EEA and its owners are suitability qualified as lawyers for UK purposes.

A law firm's home country laws are just as important. Indeed, for a law firm organized in the United States, they are critical. Other countries sometimes focus on the formalities of a proposed transaction; ie, if the paperwork is executed properly, they may overlook the “substance” or underlying economics of the deal. In the U.S., however, substance is a prime factor used by the IRS in evaluating how a law firm will be treated on a global scale. This is one reason why U.S. law firms tend to be more conservative than their non-U.S. counterparts in choosing their global structures.

Take, for example, a U.S. firm operating a “branch” office in Italy. Although the U.S. firm considers the Italian office to be a branch office for global purposes, under Italian rules, the office must be a separate legal entity that is controlled solely by locally admitted lawyers. Consequently, in Italy, the income of the Italian entity will be taxed solely to the Italian partners. By contrast, if global control and profit sharing exist, then the IRS will likely assert that the two firms should be treated as one global partnership for U.S. tax purposes, regardless of the Italian documentation.

U.S. firms, therefore, should consider a variety of structural options when operating internationally. These options include a partnership, parallel partnerships, separate legal entities, strategic alliances, and umbrella structures.

Partnerships

If a U.S. law firm currently operates through a partnership structure, then the simplest way to expand into most countries is via a branch office. Local laws in some countries, however ' notably Turkey, Hungary, and Canada ' prohibit U.S. firms from operating through a branch office. If allowable, a partnership clearly affords the greatest operational flexibility.

On the other hand, there are two considerable disadvantages associated with operating as a global partnership: the requirement to file tax returns wherever the firm does business, and unlimited personal liability for malpractice.

The tax laws of many countries view a partnership as a pass-through entity, so that the tax on partnership income is the responsibility of each equity partner. But a long-debated question has been: Which partners pay tax on which income? Should income earned in, say, Germany be allocated for tax purposes only to partners resident in that country (and not to nonresident partners, thereby limiting tax compliance requirements)? Or should income earned in Germany be allocable to all equity partners worldwide, all of whom would then be subject to German tax. The latter approach necessitates filing of global returns by all partners.

Not long ago, this controversy was (at least in theory) put to rest, from a U.S. perspective, when the IRS issued a Revenue Ruling concluding that global filing of tax returns by all equity partners is the correct procedure. Revenue Ruling 2004-3, 2004-7 I.R.B. 486 (February 17, 2004). While this ruling may have surprised some firms, it was consistent with established tax compliance practice of the U.S. and the EU. Unfortunately, for some law firms, it will increase the global compliance responsibilities of their partners.

The second significant shortcoming of the general partnership structure is that each partner has unlimited liability for debts of the firm. Public accounting firms have painfully demonstrated just how dramatic it can be for each partner to have unlimited personal liability. To address this issue, many general partnerships in the U.S converted to limited liability partnerships (LLPs). This trend accelerated once firms realized that there was no stigma associated with the change, and that there was general acceptance on the part of the business public.

Although LLP conversions have largely alleviated concern over unlimited liability within the U.S., many foreign jurisdictions do not respect an entity structured as an LLP in the U.S. When a U.S. LLP practices law in some other countries ' notably Belgium, Germany and possibly England ' it is unclear if partner liability will actually be limited, or if LLP owners will instead still be treated as general partners. To our knowledge, this vital issue has not yet been the subject of litigation outside the U.S.

Corporate Structures

One variant of the LLP is the limited liability company (LLC), a corporate entity that is taxed in the U.S. as a partnership. Very few U.S. law firms that elected to become LLCs are actually practicing law outside the U.S., however, because the LLC may be taxed as a corporation in foreign countries. If an LLC tries to practice in France, for example, France will focus on the corporate structure and very possibly conclude that the entity is a corporation and not a partnership.

Recently, Germany issued a public letter ruling that provides guidelines on classifying a U.S. LLC operating within its borders. An LLC may now be classed as a partnership, corporation or branch office, contingent on an analysis of all relevant facts and circumstances.

The LLC and similar corporate structures, including the personal service corporation (PSC) and S Corporation, are therefore of limited use for international operations.

Structure Mixing

Law firms that are restricted in terms of the structure types they can employ might decide to use different structures in different countries. For example, an S Corporation law firm operating in the United States might form a general partnership or an LLP in another country, making the newly formed entity's partners the owners of the S Corporation. While this arrangement is cumbersome, it demonstrates that “mixing and matching” can work when expanding internationally.

Parallel Partnerships

Another possible structuring option contemplates using parallel partnerships to try to limit the personal liability of the individual partners or the number of cross-border tax filings. In a parallel partnership, very few partners are partners in both firms. Conceptually, those partners can be used as “bare” trustees to allow income from one firm to flow to partners in the other firm (this is typically done between the UK and the U.S.) or, more aggressively, to balance income between the two firms.

From a U.S. tax filing perspective, it's not certain that a parallel structure has the desired effect. If there is global profit sharing (as is the norm), the IRS may view the structure as a global firm ' especially if there is also global control (which, too, is normally the case).

In response to this IRS view, some firms have tried to use common partners as “valve” partners. Valve partners were created for the sole purpose of limiting the number of individual partners required to file cross-border tax returns. When parallel firms share global profits and one firm earns more than its share of the global pot, valve partners draw more of their income from the first firm in order to balance the share of income going to the partners in the second firm. Valve partners and parallel partnerships have been used to reduce or eliminate global income tax filing requirements for the larger group.

Informal advice from the IRS, however, suggests that the IRS deems valve partner relationships as ineffective, and is likely to treat them as a ploy to thwart U.S. filing requirements.

Umbrella Structures

The newest structure being considered by some law firms uses an “umbrella” concept. An umbrella structure involves the formation of a global governance entity, which recommends standards and policies for member entities that practice law in their respective countries. There are no common partners between the member entities, so that partners are only partners in their member firms. Also, in an umbrella structure, there is no global profit sharing, although it is likely that there is some sort of cost sharing (either through a separate entity or through agreements) between the member entities. Since there is no global profit sharing, an umbrella structure is very difficult to implement in a lock-step organization. Depending on how an umbrella structure is implemented, each country or region of the world might be considered a separate operating unit.

In theory, for example, an umbrella structure could allow a U.S. LLP to be a member in an umbrella structure with a UK LLP, a general partnership in Australia, a separately owned entity in the Czech Republic, and a locally owned partnership in Italy. While this structuring arrangement seemingly solves many of the issues previously identified, it also carries with it many uncertainties ' especially regarding how the IRS will treat the structure.

Strategic Alliances ' Best of Friends

Law firms that want to avoid the hassles and complications of opening a foreign office might opt, instead, to form a strategic alliance with a local firm. The obvious reward is gaining access to qualified local lawyers who will not compete against the firm, but will be best of friends when referring work back and forth. Such an alliance avoids the significant cost and administrative distraction of building an entirely new practice or of merging with a local firm, and the attendant risk that such investment may not generate the anticipated benefits.

Typically used as an introductory or trial relationship, many alliances end with both firms going their separate ways. Reasons for the frequent demise of alliances vary. Often one firm refers work to the other firm without equal reciprocity; or perhaps one firm may form a relationship with the alliance partner's direct competitor. Dissimilarities related to culture, compensation and quality of work product are also important obstacles to overcome.

Such issues notwithstanding, alliances can be effective. Smaller law firms, for instance, have operated successful alliances of ten or more firms throughout the world, thereby providing global legal capabilities for their existing clients that would have been impossible if the allied firms were operating on their own.

The final word on global structuring options is that there is no simple solution. The ultimate structure type chosen depends on the relevant tax and business implications, local bar rules, various regulatory restrictions, and ' maybe more important ' the firm's culture. As a result, international law firms can have complicated structures that use disparate arrangements throughout the world.

Foreign Assignments

Some law firms send their partners and associates abroad on assignments to one of their foreign offices or occasionally to an unrelated firm. Their primary objective is to provide better client service. Also important are intentions to strengthen existing international branches, to share pertinent legal expertise with foreign merger partners, and to facilitate the cross-pollination of knowledge ' communicating relevant information within the firm for use in other client engagements.

Successful foreign assignments involve heavy investments of management attention and other resources. Indeed, the cost of transferring lawyers overseas can be substantial, especially if the international assignment is to take place in a high-tax jurisdiction. A U.S. law firm associate paid $180,000 in Washington, DC, for example, can cost twice as much if assigned to a European or Asian city.

Before carrying out an international assignment, proper tax and compensation planning is essential. The firm should create a standard policy that will be applied as uniformly as possible to its expatriates. The firm may also want to consider instituting a tax equalization policy to ensure that expat partners and associates are compensated and taxed in the same manner as in their home country. An alternative to a tax equalization policy that is used by some firms with few assignees is to give a flat amount as an allowance to cover all extra costs while on assignment.

Finally, a careful review of each relevant host country's tax laws may result in significant tax savings for individual expats – or for all partners if taxes are equalized.

Local Bar Registration

Regardless of whether a law firm chooses to open a foreign branch, set up a new entity, or send staff abroad on international assignments, a law firm must formally “register” to conduct business with the local bar. While it is not our intent to provide legal advice, we are aware that local bar regulations do vary from country to country, with nonresident lawyers facing restrictions such as those described below.

In certain Southeast Asian countries, eg, India, Taiwan and Indonesia, local bar rules expressly restrict nonresident lawyers from either practicing law or sharing firm profits with locally admitted lawyers.

Other countries, eg, the Czech Republic, Hungary, Turkey and Brazil, require that local national lawyers own all local law practices.

In France, a U.S. law firm can open a branch office only if the firm was grandfathered under the pre-1992 Paris Bar rules. Further, unless an individual attorney was either grandfathered under the pre-1992 Paris Bar rules or has passed the French bar exam, he or she cannot practice law as a partner of the firm in France.

Some European and Asian countries, among them the UK and Japan, do allow lawyers who have not gained local qualifications to practice law within their borders; but they restrict the kinds of law they can practice and, in some cases, with whom they can share profits.

In most cases, U.S. lawyers who have not passed the local bar are permitted to practice only U.S. law, as local bar regulations generally preclude nonresidents from practicing local law. In some host countries where the practice of U.S. law by nonresidents is allowed, unique operating and compensation structures may be needed to enable attorneys to practice law that is compliant with both the local bar's requirements and the firm's home country tax regulations.

By registering with the local bar in advance of beginning operations, a law firm generates goodwill with the local government and is able to identify potential problems before they arise. Lawyers can then focus their time and attention on client matters instead of being distracted by organizational issues.

Office Setup

Once the structure in a foreign country is finalized and business registration completed, other administrative concerns must be addressed prior to commencing work. These include office location selection, language barriers, foreign communication costs, local customs, and labor laws.

Locating a foreign office wisely is vital to a law firm's success in a host country, since office location can enhance or hinder the firm's culture, image and reputation. As in the U.S., a law firm should preferably locate its foreign office space in close proximity to its clients.

Language is another key consideration when expanding globally, especially if the host country does not recognize English as its first language. Although English is widely spoken in many countries as a second language, the majority of law firms have found it beneficial both professionally and socially to communicate with foreign clients using their local language. This is true even where, as in most jurisdictions, the common law for major transactions (like mergers) is based on English-language (UK or U.S.) legal sources.

Even in major foreign countries, obtaining reliable telephone service is likely to be a frustrating and expensive process. In India, for example, it may take up to six months to get a telephone line installed successfully. To compound the problem, local telecommunications providers are seldom equipped to set up voice mail or high-speed Internet access. The resulting inefficiencies can thwart a law firm's global information technology network, thereby challenging the firm's ability to succeed abroad.

Finally, local customs and labor laws should be researched before much time and money is invested in establishing a foreign branch. For instance, many countries have more than ten public holidays, others have mandatory vacations of 5 or 6 weeks, some have strict regulations as to the number of hours that can be worked by employees (ie, associates and support staff) each week, and still others have severe limitations with respect to staff reductions.

France, in particular, has long been recognized as a country with laws that make it costly for an outside law firm to do business within its borders. Closing a French office, for example, can result in substantial severance costs.

Foreign Tax Filing

Once a law firm successfully navigates the administrative and logistical issues related to international expansion, tax planning becomes a fundamental part of doing business. In most foreign jurisdictions, law firms are required to file some type of local tax return. Foreign taxes can be assessed against the firm itself, or, if the firm is viewed as a pass-through entity, then against each equity partner.

Some countries that assess tax against individual partners are Japan, the UK, France, Belgium, Australia, Germany and (depending on the firm's local structure) Italy. Hong Kong and Singapore tax the branch, but the assessed tax is then allocated to each individual partner. Other countries like Hungary, Turkey, Russia, the Czech Republic and Poland tax the entity directly.

In addition, there are certain jurisdictions, like Spain, that allow resident lawyers to practice individually, but tax nonresidents at the entity level based on corporate tax provisions. To mitigate and lessen the compliance burden and the expense of filing individual returns, countries like the UK and Belgium allow nonresident partners to file composite returns.

Clearly, it is critical to understand the tax structure of the host country in which a law firm will be operating, so that management can then determine if the foreign tax will be greater than (or less than) the home country tax that will be assessed against the same income. It is wise to engage competent tax assistance when preparing foreign tax returns or when working with foreign tax inspectors.

Foreign Tax Credits

With U.S. marginal income tax rates currently at 35% (excluding various state income tax rates), and most foreign countries' marginal rates being in excess of that base, it is imperative for U.S. lawyers working abroad to attempt to prevent or mitigate double taxation on their worldwide income. (If a partner receives a guaranteed payment for services rendered outside the U.S., that, too, should be considered foreign-source income for U.S. income tax purposes. Guaranteed payments are discussed in a later section).

To reduce the impact of double taxation, U.S. citizens and residents can elect to take a credit on their U.S. tax returns for the foreign tax they pay on foreign-source income; but this measure is subject to complications, as the following scenario illustrates. Suppose a firm's partners receive a proportionate share of total domestic and foreign income. In this case, partners working in the foreign branch will have foreign-source income only in the ratio that the firm's foreign-source gross income from all foreign activities bears to total gross income. If the firm has very little net foreign-source income, a foreign-based partner may pay more foreign taxes than can be claimed as a credit on his or her U.S. personal income tax return. In such an “excess credit position,” the taxpayer can choose to take foreign taxes as an itemized deduction rather than as a credit. Applicable rules for doing so are complex, however, and the deduction will not reduce the partner's U.S. tax as effectively as a credit.

Ten or 15 years ago, U.S. law firms commonly used expat policies that benefited assignees but did not consider the implications for U.S.-based partners. As their international operations began generating profits, many of these firms came to appreciate that helping partners on foreign assignments could hurt the U.S.-based partners ' notably by reducing net foreign-source income.

To understand this negative result, consider where many international firms generate fee revenue. Many law firms have expanded into parts of Europe with local tax rates generally higher than those in the U.S. (eg, Germany, Belgium, France, the Czech Republic and the UK). Depending on the geographic mix of income, higher non-U.S. tax rates can make the partners' global effective tax rate higher than the U.S. effective tax rate. This tax rate differential is exacerbated by countries that disallow deductions for crucial business expenditures. For example, in the UK there is no depreciation deduction available for office leasehold improvements (unless they qualify as plant) or for many types of meal and entertainment costs.

When faced with these challenges, a law firm must be open to changing its culture and customs so that partners on assignment or resident in foreign offices are compensated differently. Fortunately, various tax-planning strategies are available to increase foreign tax credits or reduce excess credits. Some solutions might entail better tracking of where services are rendered, allocation of certain home office expenses to foreign offices, adjusting the level of guaranteed payments given to partners, or simply having fewer partners on assignment outside the U.S. Generally the firm's goal should be to minimize the partners' aggregate global taxes, even if some partners are affected negatively.

Double Tax Treaties

A law firm does not have to open an entire office in a foreign country to be characterized as “doing business internationally.” On the contrary, most foreign countries will withhold tax on services provided in their country by residents of another country. This withholding, which is assessed on the gross amount of the service fees, ensures that a nonresident partner pays tax to the host country.

Under Article 14 of most double-tax treaties with the U.S., fees from the practice of law are treated as independent personal services and, for foreign tax credit purposes, are sourced where services are performed or rendered.

Note: As recently changed, the U.S.-UK treaty does not include Article 14 and now relies on Article 7. Under newer interpretations of Article 7, a partnership can create a permanent establishment, and, therefore, Article 14 is no longer needed. It is believed that treaties negotiated in the future will eliminate Article 14.

Some countries such as Spain, Italy and Indonesia assess withholding under a claim-of-right doctrine. The doctrine suggests that a country has a right to withhold tax on the gross fee ' regardless of where the work was performed or the treaty in effect.

To avoid withholding tax issues, the U.S. Treasury Department has negotiated double-tax treaties with many countries. These treaties prohibit withholding taxes when the law firm and its partners are residents of a country that has a double-tax treaty with the host country. To obtain certification for double-tax treaty protection (Form 6166), eligible partners should submit a written request (on newly issued Form 8802) to the IRS Foreign Certification Group in Philadelphia.

If services are rendered in a host country that does not have a double-tax treaty with the U.S. (eg, Brazil, Argentina or Venezuela), taxes will be withheld at the normal statutory rate in effect for that specific country. Procedurally, the law firm collects its bill net of withholding tax at the time that payment is made.

Guaranteed Payments

An integral part of an international law firm's compensation structure, guaranteed payments are used in a variety of ways. For example, guaranteed payments may be used to:

• Enable a U.S. partner assigned to a foreign office to claim a Section 911 exclusion (ie, an earned income exclusion) when the partner's share of the firm's foreign-source income is too low.
• Allow French-based partners to maximize the benefits of Article 14 of the French-U.S. double-tax treaty, which allows up to 50% of a French-based partner's income to be allocated back to the U.S.
• Help a solicitor in the UK maximize the benefits of his or her pension scheme.
• Allow a Chinese national in Hong Kong to avoid filing tax returns in the U.S.

In all instances, careful thought must be given to why guaranteed payments are needed and what the appropriate amounts should be. It is important to understand that guaranteed payments are a contributing cause of excess credit positions as global law firms continue to evolve and mature.

When incorporating guaranteed payments into a law firm's compensation system, management should focus on the way in which they are calculated. Internal Revenue Code Section 707(c) requires that guaranteed payments be calculated without regard to the income of the firm. All too often, law firms ignore that requirement, since they set total compensation by a lock-step system or some other formula and then back into the amount of the guaranteed payment. A better way would be to compensate a partner based on a combination of a guaranteed payment and a reduced share of firm income. Fixing the guaranteed payment up front may cause an imbalance in the compensation system, however, because the partner might receive either too large a share of the firm's profits or not enough.

Caution should also be exercised with regard to the treatment of guaranteed payments in other countries. Since the concept of a guaranteed payment is primarily a U.S. concept, most other countries do not fully understand how to account for them within their tax systems. For example:

• Partners receiving only guaranteed payments in Belgium could be fully taxed on these payments by Belgium, insofar as they might be considered employees instead of partners ' or they could avoid tax on some portion of the guaranteed payment, insofar as Belgium considers it to be part of the total income of the partnership.
• Partners in Germany might use guaranteed payments to avoid taxation, unless a treaty provision causes the income to be pulled back to Germany and subject to German taxation.
• A U.S. partner who pays UK tax on a remittance basis while on assignment there may use a guaranteed payment as a means to create foreign-source income that is not taxed in the UK but can be used to claim more foreign tax credits or to reduce excess credits in the U.S.

The operative advice is to use guaranteed payments only after carefully considering all their consequences.

The Reward

As summarized above, operating an international law firm presents many risks and rewards. From structuring foreign operations, registering for practice, and choosing a foreign office location, to mitigating foreign taxes and maximizing foreign tax credits, going global necessitates thorough planning and foresight. The ultimate reward of foreign expansion is to emerge stronger and more competitively positioned for the increasing globalization of business.