How Foreign Corporations Conducting Business in the United States are Taxed

Introduction

Foreign corporations are taxed in the United States on income from U.S. sources and on income that derives from the conduct of a U.S. trade or business or from passive investments. As a general rule, a foreign corporation that conducts a U.S. trade or business will be subject to the usual U.S. federal tax rates on net income “effectively connected” with a trade or business within the United States. See IRC Sections 871(b)(1) and 882(a)(1). Tax treaties generally provide that such income will not be taxed unless attributable to a permanent establishment maintained by the foreign person in the United States.

Despite its importance for U.S. tax purposes, there is no definition of the term “trade or business” in the Internal Revenue Code or the Income Tax Regulations. As a general rule, a U.S. trade or business exists only if the activities of a multinational corporation’s dependent agents within the U.S. are considerable, continuous, and regular. This is determined on the facts and circumstances of each case. The conduct of a U.S. trade or business by an independent agent of a multinational corporation is typically not imputed to it. A U.S. trade or business ordinarily includes the performance of personal services in the United States. Internal Revenue Code Section 864(b) provides that “the performance of personal services within the United States at any time within the taxable year” generally constitutes the conduct of a U.S. trade or business. There is, however, a de minimis exception for a nonresident alien who is present within the United States not more than 90 days during the tax year and receives no more than $3,000 as compensation for working in the United States for a foreign person, entity or office. See IRC Section 864(b)(1).

This exception permits nonresident aliens to make short business trips to the U.S. and avoid U.S. taxation. However, some income tax treaties permit greater exemptions for longer stays. In addition, the following safe harbor is provided for foreign investment in the trading of stocks and securities. Section 864(b)(2)(A) of the Internal Revenue Code provides a safe harbor to assure that foreign investors may trade in stocks and securities on U.S. markets without establishing a U.S. trade or business.

U.S. Trade or Business Income- The “Permanent Establishment Provision”

A foreign corporation engaged in a U.S. trade or business is subject to U.S. taxation on the income effectively connected with the conduct of the U.S. trade or business. Effectively connected income consists of the following:

1) Certain types of U.S.-source income;

2) Certain types of foreign-source income attributable to a U.S. office;

3) Income from an interest in U.S. real property that a passive foreign investor has elected to treat as effectively connected income, and

4) Interest income derived from U.S. obligations by a bank organized and doing business in a U.S. possession.

Effectively connected income includes all of the U.S. source income of a foreign corporation engaged in a U.S. trade or business. Effectively connected income typically includes only U.S.-source income. However, certain types of foreign-source income are treated as effectively connected income if the foreign corporation maintains an office or other fixed base in the United States and the U.S. office is a material factor in producing the income and regularly carries on activities of the type that produces such income.

Income tax treaties to which the U.S. is a party often have one or more articles that exempt foreign multinational corporations ability to exempt business profits from U.S. tax, unless those profits are attributable to a permanent establishment that is maintained within the United States. Article 7 of the U.S. Model Treaty reflects the approach used in treaties to determine the extent to which income will be attributable and taxed to a permanent establishment. Article 7(2) provides that the income so attributable will be the business profits that the permanent establishment “might be expected to make if it were a distinct and independent enterprise in the same or similar activities under the same or similar conditions.”

According to Article 5 of the United States Model Income Tax Treaty, a permanent establishment includes a fixed place of business (e.g., a sales office), unless the fixed place of business is used solely for auxiliary functions (e.g., purchasing, storing, displaying, or delivering inventory) or activities of a preparatory nature. A permanent establishment also exists if employees or other dependent agents habitually exercise in the United States an authority to conclude sales contracts in the foreign person’s or foreign corporation’s name. However, Article 5(3) of the U.S. Model Treaty permits a foreign person to pursue for up to 12 months certain specified activities that would otherwise constitute a permanent establishment without being deemed to have created a permanent establishment.

“Business profits” means “income from any trade or business, including income derived by an enterprise from the performance of personal services, and from the rental of tangible personal property.” See U.S. Mode Treaty, Art 7(7). This definition ultimately includes all income from business operations except compensation for personal services rendered by an individual. In general, the business profits of an enterprise of a treaty country will be taxable only in that country unless the enterprise is undertaken through a permanent establishment in the other country. Once the enterprise is conducting business through a permanent establishment, only the income attributable thereto may be taxed in the country where the profits are being generated. See U.S. Model Treaty, Art. 7(1).

A foreign person may have more than one permanent establishment in the United States. Income and losses from all such permanent establishment of a taxpayer will be combined to determine the U.S. income tax liability. As a result, losses generated by one may offset income produced by another.

A foreign corporation engaged in the conduct of a U.S. trade or business can claim the following deductions against effective connected income:

1) expenses, losses, and other deductions related to the effectively connected gross income.

2) Foreign income taxes assessed on U.S. effectively connected income, and

3) Charitable contributions made to domestic charitable organizations.

This article will next discuss specific areas items of effectively connected income and deductions that impact foreign corporations conducting business in the United States.

Banking Transactions

Not all lenders are commercial banks. Sometimes multinational corporations are involved in transactions that can be classified as banking transactions for purposes of U.S. taxation. The Income Tax Regulations has a number of tests to determine whether a multinational corporation is conducting a banking business in the United States. See Treas. Reg. Section 1.864-4(c)(5). The regulations provide that a foreign corporation will be deemed to be conducting a “banking, financing, or similar business in the United States” if the foreign corporation is engaged in a trade or business in the U.S. and if the activities consist of “any one or more of the following activities carried on, in whole or in part, in the United States in transactions with persons situated within or without the United States:”

1. Receiving deposits of funds from the public;

2. Making personal, mortgage, industrial or other loans to the public;

3. Purchasing, selling, discounting or negotiating for the public on a regular basis notes, drafts, checks, bills of exchange, acceptance or other evidence of indebtedness;

4. Issuing letters of credit to the public and negotiating drafts under those letters of credit;

5. Providing trust services for the public; or

6. Financing foreign exchange transactions for the public.

If a foreign multinational conducts financing transactions with unrelated U.S. persons or with related entities, careful consideration should be done to determine if the transaction or transactions can be classified as a banking transaction or transactions. These transactions can trigger special tax considerations.

Management of Real Property

Foreign multinational corporations often acquire U.S. real property. If a foreign multinational corporation holds real estate that will be rented, the foreign multinational corporation must make a decision how to treat the rental income for U.S. income tax purposes. As a general rule, the leasing of U.S. real estate will not give rise to a U.S. trade or business. If the leasing of real estate is not treated as income arising from a U.S. trade or business, the rental income will be subject to a 30 percent withholding tax without the benefit of any deductions to reduce the withholding tax. Foreign corporations may consider making a “net basis election” under Section 871(d) of the Internal Revenue Code to be taxed at U.S. tax rates. Upon making the net basis election, the foreign corporation will not be subject to the 30 percent withholding tax and will be permitted to deduct expenses associated with real estate, such as depreciation and property taxes. These expenses often exceed the taxable rental income.

Electronic Commerce

Electronic commerce has generated many difficult conceptual issues. Foreign corporations often produce computer programs, digital content, and e-commerce that are marketed in the United States. A foreign corporation can be found to be conducting a U.S. trade or business without having a fixed place of business in the United States, situations involving computer programs, digital context, and e-commerce should be carefully reviewed to determine if the activity amounts to a trade or business in the United States.

Interest Deductions

Multinational corporations often utilize loans to finalize their U.S. operations and to generate valuable interest deductions that can be utilized to offset U.S. tax liability. The problem in some is that payment of interest to a foreign parent company ordinarily is subject to a 30% withholding tax in the U.S. Certain multinational corporations who are a resident in certain treaty countries may qualify for a reduced withholding; however, regardless of whether a treaty applies, interest paid to a foreign corporation with respect to certain “portfolio debt interments” is not subject to U.S. withholding tax under a number of provisions stated in the Internal Revenue Code. See IRC Sections 871(h), 881(c), and 1441(a)(9). While avoiding U.S. withholding tax is important, ensuring that interest payments are deductible for U.S. tax purposes is equally important.

Internal Revenue Code Section 163(j) can potentially limit deductions for interest, including deductions for interest payments made on portfolio debt loans. Section 163(j) limits the deductibility of interest expense paid or accrued on debt allocable to a trade or business to the sum of business interest income, and 30 percent of “adjusted taxable income.” For these purposes, adjusted taxable income will be earrings before taxes and interest (“EBIT”). Any deduction in excess of the limitation is carried forward and may be used in a subsequent year, subject to limitations of Section 163(j)(2) (i.e., business interest income 30% of EBIT).

In addition, under Section 267A of the Internal Revenue Code, a deduction is disallowed for a disqualified related party amount paid or accrued pursuant to a hybrid transaction. A deduction is also disallowed for a disqualified related party amount paid or accrued by, or to, a hybrid entity. Any interest paid or accrued to a related party is a “disqualified related party amount” to the extent that under the tax law of the country where the related party is a resident for tax purposes or subject to tax: (a) the amount is not included in the income of the related party, or (b) the related party is allowed a deduction for the amount. The term “related party” means a related person as defined in Internal Revenue Code Section 954(d)(3). In general, a person is related if the same person controls more than 50 percent (by vote or value) of the corporation’s stock. A hybrid transaction refers to any transaction, series of transactions, agreement, or instrument, if one or more payments are treated as interest for federal income tax purposes, but are not treated as such for purposes of the tax law of the foreign country where the recipient of the payment is resident for tax purposes or is subject to tax. A hybrid entity means any entity that is either: 1) treated as fiscally transparent for federal income tax purposes, but not under the tax law of the foreign country where the entity is a resident for tax purposes or is subject to tax, or 2) treated as fiscally transparent under the tax law of the foreign country where the entity is resident for tax purposes or is subject to tax, but not for federal income tax purposes.

In addition, under equity recharacterization rules, the debt of a multinational corporate borrower may be reclassified as equity in the event of specified distributions or acquisitions involving related parties and debt instruments. Under these rules, distributions of debt instruments to shareholders, exchange of the instruments for affiliate stock, issuance of debt instruments in an internal asset reorganization, or issuance of debt instruments with the principal purpose of funding a transaction may be reclassified for U.S. tax purposes.

Finally, Internal Revenue Code Section 59A imposes a “base erosion alternative tax” (the “BEAT”) on certain corporations that have payments to related foreign parties. If the BEAT applies to a corporation, then the corporation is generally subject to an alternative minimum tax equal to the excess of 1) 10 percent of the entity’s “modified taxable income,” (i.e., net income without deductions related to interest and other expenses paid to foreign related parties) over 3) the entity’s regular tax liability. Consequently, if a U.S. corporation makes significant payments to foreign related parties, then such a U.S. corporation may be required to pay a tax in addition to regular U.S. tax liability.

A foreign person will be considered a foreign related party for BEAT purposes if it is 1) a 25 percent owner of a U.S. corporation; 2) related to a U.S. corporation or any 25% owner of a U.S. corporation (within the meaning of Internal Revenue Code Sections 267(b) or 707(b)(1) 0r 3) related to a U.S. corporation under Section 482 of the Internal Revenue Code. The constructive ownership rules of Internal Revenue Code Section 318 apply in determining whether any non-U.S. interest holders are 25% owners of a U.S. corporation or a person is related to a 25% owner. The BEAT applies only to corporations that have annual gross receipts of at least $500 million for the preceding three taxable years.

The Branch Profits Tax

Foreign corporations conducting business in the United States must understand and plan for a special tax known as the branch profits tax. By way of background, prior to the enactment of the branch profits tax in 1986, there was a substantial disparity between the tax treatment of earnings repatriations from U.S. branch and subsidiary operations. U.S. withholding taxes were imposed on dividend distributions from a U.S. subsidiary, but no U.S. tax was imposed on earnings remittances from a U.S. branch. Therefore, foreign corporations could avoid the shareholder level U.S. tax on their U.S.-source business profits merely by operating in the United States through a branch rather than a subsidiary of a foreign corporation.

Please see Illustration 1 below for an example.

Illustration 1.

Shony, a foreign corporation, owns 100 percent of Peach, a domestic corporation which derives all of its income from U.S. business operations. During its first year of operations, Peach has taxable income of $10 million and distributes all of its after tax earnings to Shony as a dividend. Assume that at the time, the U.S. corporate tax rate was 35% and that the applicable treaty withholding rate for U.S. source dividends was 5%.

Peach pays $3.5 million of U.S. tax on its $10 million of taxable income and then distributes a dividend to Shony of $6.5 million [$10 million of taxable income – $3.5 million of U.S. income taxes]. The dividend is subject to $325,000 of U.S. withholding tax [$6.5 million dividend x 5% withholding tax rate], which makes the total U.S. tax burden on Peach’s repatriated earnings equal to $3,825,000 [$3.5 million of U.S. income tax + $325,000 of U.S. withholding tax].

If Shony had structured its U.S. operation as a branch rather than as a subsidiary, Shony would still pay $3.5 million of U.S. income tax on its $10 million of income effectively connected with the U.S. branch operation. However, ignoring the branch profits tax, the repatriation of branch profits would be an internal fund transfer that is not subject to U.S. withholding tax. Therefore, without a branch profits tax, Shony could avoid $325,000 of U.S. withholding taxes by merely operating in the United States through a branch rather than a subsidiary.

The branch profits is a tax equal to 30% of a foreign corporation’s dividend equivalent amount for the taxable year, subject to treaty reductions. The dividend equivalent amount estimates the amount of U.S. earnings and profits that a U.S. branch remits to its foreign home office during the year. Therefore, similar to the withholding tax imposed on a U.S. subsidiary’s dividend distribution, the branch profits tax represents a second layer of U.S. taxes imposed on a foreign corporation’s U.S. source business profits.

For example, assume that the facts are the same as in Illustration 1, except now the effect of the branch profits tax are taken into account. If Shony had structured its U.S. operation as a branch rather than as a subsidiary, it would pay $3.5 million of U.S. income tax on its $10 million of effectively connected income [$10 million x 35% U.S. tax rate]. In addition, assuming the U.S. branch’s dividend equivalent amount equals the branch’s after-tax earnings of $6.5 million [$10 million of taxable income – $3.5 million of U.S. income taxes], Shony also would be subject to a branch profits tax of #325,000 [$6.5 million dividend equivalent amount x 5% tax rate]. Therefore, the branch profits tax creates a shareholder level U.S. tax that is equivalent to the U.S. withholding tax imposed on dividends.

The branch profits tax is payable in the same manner as a foreign corporation’s regular income tax, except that no estimated tax payments are required with respect to the branch profits tax.

Dividend Equivalent Amount

The tax base for the branch profits tax is the dividend equivalent amount, which estimates the amount of U.S. earnings and profits that a branch remits to its foreign home office during the year. Such an estimate must take into account the earnings and profits generated by the U.S. branch during the year, as well as any changes in the branch’s accumulated earnings and profits during the year. Consistent with this reasoning, a foreign corporation’s dividend equivalent amount for a taxable year is computed using the following two-step procedure:

Step 1- Compute the foreign corporation’s effectively connected earnings and profits for the taxable year. Effectively connected earnings and profits equals the earnings and profits attributable to income effectively connected with the foreign corporation’s U.S. trade or business, before any reductions for dividend distributions, the branch profits tax, or the tax on excess interest.

Step 2- Adjust the effectively connected earnings and profits amount for any changes in the foreign corporation’s U.S. net equity during the year. The effectively connected earnings and profits amount from Step 1 is reduced by the amount of any increase in U.S. net equity for the year (but not below zero), and is increased by the amount of any reduction in U.S. net equity for the year. In other words, an increase in U.S. net equity during the year is treated as a reinvestment of earnings and profits in the U.S. branch operation, whereas a reduction in U.S. net equity during the year is treated as a repatriation of earnings and profits.

Please see Illustration 2 below for an example of the calculation of the branch profits tax.

Illustration 2.

Shony, a foreign corporation, operates a branch sales office in the United States. During its first year of operations, Shony’s effectively connected earnings and profits are $250,000 and its U.S. net equity is $500,000 at the beginning of the year and $750,000 at the end of the year. Therefore, Shony’s dividend equivalent amount for year 1 is $0, computed as follows:

(A) Effectively connected earnings and profits……………………….$250,000

(B) Increase in U.S. net equity

End of the year U.S. net equity……………. $750,000

Beginning of the year U.S. net equity……..-$500,000

Increase in U.S. net equity……………………………………………..$250,000

Dividend equivalent amount [A-B]…………………………………………… None

During year 2, Shony has no effectively connected earnings and profits, and its U.S. net equity is $750,000 at the beginning of the year and $600,000 at the end of the year. Therefore, Shony’s dividend equivalent amount for year 2 is $150,000, computed as follow:

(A) Effectively connected earnings and profits…………………………..$0

(B) Decrease in U.S. net equity:

Beginning of the year U.S. net equity……… $750,000
End of the year U.S. net equity………………$600,000

Decrease in U.S. net equity……………………………………………….$150,000

Dividend equivalent amount [A + B]…………………………………………….$150,000

The determination of U.S. net equity is made as of the last day of the foreign corporation’s taxable year. U.S. net equity equals the aggregate amount of money and the adjusted basis of the property of the foreign corporation connected with the U.S. trade or business reduced (including below zero) by the amount of liabilities connected with the U.S. trade or business. The amount of U.S. connected liabilities is determined by applying the same formula used to determine a foreign corporation’s interest expense deduction, except that the assets value and liability amounts are based on end of year totals rather than annual averages. Generally speaking, an asset is considered to be “connected” with a U.S. trade or business to the extent the income produced by the asset or a gain from the disposition of the asset is effectively connected income. Various special rules are provided for applying this principle to specific types of assets, such as depreciable property, inventory, installment obligations, accounts receivable, bank deposits, and debt instruments.

Finally, special rules apply to the computation of the branch profits tax for a taxable year in which termination occurs. A termination includes the incorporation of a branch, the repatriation of all branch assets, a sale of all branch’s assets, or the liquidation or reorganization of the foreign corporation.

Conclusion

This article is intended to provide the reader with a basic understanding as to how foreign corporations conducting business in the United States are taxed. It should be evident from this article that this is a relatively complex subject. It is also important to note that this area of tax law is constantly subject to new developments and changes. As a result, it is crucial that foreign multinational corporations and foreign corporations doing business in the United States consult with a qualified International attorney. With careful individualized planning, the foreign corporations may eliminate or substantially reduce its U.S. tax liabilities emanating from U.S. business transactions.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.