Growth of Cross-Border e-Commerce
With the digitization of the global economy, cross-border buying and selling has never been easier. According to BigCommerce, online merchants who sell to international consumers can boost sales by up to 15%. Furthermore, a study by SimilarWeb has shown that international e-commerce web traffic grew 33% year-on-year in 2020, which is almost 3x the rate of growth for domestic web traffic.
Without a doubt, cross-border sales to consumers in foreign markets is increasing at an unprecedented rate and will be a key driver of any e-commerce merchant’s success going forward.
Challenges of Cross-Border Sales
For online e-commerce sellers who sell goods internationally, accepting and processing cross-border payments is not without its challenges.
When sellers set up a domestic merchant bank account and a payment processing service, they will have to report where their business is registered and tax resident in. Once the business location is registered, all sales that come from within that country will qualify as domestic sales. Whereas the sales originating from outside that country will result in cross-border fees.
Credit card processing fees (i.e., cross-border interchange fees), as well as foreign currency conversion fees can significantly reduce the margin on a merchant’s cross-border sales compared to domestic sales. This is shown in Exhibit A below.
Exhibit A – Additional fees on cross-border sales
Since 2020, credit card processing networks have increased cross-border interchange fees in light of the cross-border e-commerce growth. While many countries impose a cap on domestic card processing fees, there are no regulatory bodies governing the additional rate card processing network will charge on cross-border sales. Not only that, charging a higher rate for processing international credit card transactions is arguably justified by the banks given the higher risk of fraud.
In addition to the higher interchange rate on processing foreign credit cards, there is also foreign currency conversion fees to the merchant when foreign customers pay using their local currencies. This is an additional fee of 1 to 2% charged to the merchant for converting the foreign currency to the merchant’s domestic currency for payout.
While it may be possible for merchants to pass on the conversion cost to the foreign consumers, doing so may jeopardize their online shopping experience leading to decreased sales.
Why This Matters to Sellers
As an example, if an e-commerce store has $2 million of revenue from cross-border sales, all of this amount may be subject to approximately 2.8% in additional costs if they use a payment platform like Stripe or Shopify Payments.
This is an annual cash cost and margin hit of $56,000, which will only increase year-on-year in proportion to the growth of cross-border sales as shown in a numerical example in Exhibit B below.
Exhibit B – Estimated Cost of Cross-Border Sales over a 5-year Horizon
Over a 5-year horizon, assuming that the year-on-year international sales growth is 30%, the costs can add up to over $500,000. Platforms such as PayPal may charge up to 5.2% on cross-border sales, which is even more prohibitive.
It is important that online sellers understand the impact these fees have on their margins, as well as how to manage such costs as they expand in the global market.
How to Save On Cross-Border Fees and What Are The Tax Implications
One possible way to eliminate the cross-border fees is by incorporating a local entity and obtaining a local bank account in the region where there are significant cross-border sales.
This is so that credit card transactions can be routed to a local bank in the same region where the card was issued. Because these transactions will be processed locally, the sales that once were cross-border will be considered domestic thereby avoiding the cross-border fees.
As an example, for a Canadian Shopify seller with a bank account domiciled in Canada, any sales originating from Canadian-issued credit cards are domestic sales resulting in the standard domestic credit card processing fees and no currency conversion costs. However, it is not uncommon for a Canadian seller to quickly see growth in US sales given the size of the US market and its proximity to Canada. Oftentimes, a Canadian seller’s US sales exceed Canadian sales, thereby subjecting the online US sales to up to 2.8% in additional costs discussed above.
These costs can be saved if the Shopify seller incorporates a US corporation and obtains a US-domiciled bank account connected to a US-based storefront so that online sales from US customers are considered “domestic” from the perspective of the US entity and US banks.
While this concept sounds simple enough, sellers will need to consider the relevant cross-border tax implications of setting up an entity in a new country so that the right cross-border tax structure can meet the objective of achieving the cross-border fee savings.
Below are some questions one may want to consider when structuring the new entity from a tax perspective:
- How much presence in the US is there currently (i.e., by way of US-based employees, contractors, sales agents, third-party logistics (3PL) providers, leasing US warehouse for maintaining inventory to sell to US customers)?
- Is there flexibility for the individuals who own the business (and/or directors of the business) travel to the US? Is it possible for US-based directors, managers, and employees to be appointed?
- What should be the appropriate business entity type for the US entity (i.e., C-Corp, LLC, general partnership, limited partnership, etc), and what will be the differences in the corporate income tax treatment between these entity types from a US, Canada, and cross-border tax perspective?
- Should the US entity be a subsidiary of the Canadian corporation or directly held by the individual(s) who own the Canadian corporation?
- What types of activities should the US entity perform? For example, will the US entity be collecting the USD payments on behalf of the Canadian seller, or does it make more sense for the US entity to perform additional functions such as purchasing its own inventory and making the sales to US consumers?
- Should the existing Canadian entity be providing intercompany management services to the US entity, and if so, how much should the US entity pay in management fees to the Canadian entity?
These are just some of the considerations that will need to be explored as part of the tax planning and structuring exercise of setting up a new entity in a new country. Each e-commerce seller has its own needs as well as specific set of facts and circumstances, and therefore the tax structure will need to adequately accommodate to such needs.
It also is important to recognize that the benefit (i.e., annual cash savings from avoiding the cross-border fees) from setting up and maintaining a legal entity in a new jurisdiction will need to outweigh the costs in order to make this undertaking worthwhile. These costs include professional services fees (legal, tax and accounting costs), as well as certain operational considerations.
Generally, if a seller’s cross-border sales is reaching $1 million per year (and concentrated in a particular region (i.e., the US)), the potential for cross-border cash savings for a non-US seller will be approximately $28,000 in annuity. If this is the case, it will be worthwhile for the seller to begin the process of exploring the tax structuring options available to achieve such savings, especially considering the fact that the savings will increase in proportion to the growth of sales.