By Anthony Diosdi
By introducing the U.S. branch profits tax, Congress substantially reduced the desirability of a foreign corporation as the vehicle for operating a U.S. trade or business. Previously, foreign corporations often were the vehicle of choice for U.S. investments, since (as now), use of a properly established and maintained foreign corporation generally avoided U.S. estate tax issues, and dividends often could be repatriated free of U.S. withholding tax. Withholding tax on dividends from a foreign corporation applied only if earnings and profits from U.S. trade or business were greater than 50 percent of worldwide earnings and profits, and then only a proportionate amount of the dividend suffered the withholding tax. U.S. income tax treaties with intermediary countries offered the possibility of repatriation of earnings totally free of second-tier U.S. taxes. Further, foreign corporations engaged in U.S. business could borrow abroad, deduct interest against U.S. earnings, and pay out interest to foreign creditors free of U.S. withholding tax or at reduced rates under treaties, and like U.S. corporations at the time, often could be liquidated tax-free. Thus, with proper planning, U.S. trade or business earnings generally could be repatriated free of U.S. income tax or at favorable rates either through current dividends or through liquidated distributions at termination of the investment. This all changed when Congress enacted Internal Revenue Code Section 884.
Internal Revenue Code Section 884(a) now imposes a 30 percent branch profits tax on the post-income tax earnings of a foreign corporation’s U.S. trade or business, to the extent not reinvested in a U.S. trade or business by the close of the tax year. Reinvestment and withdrawal are measured by annual changes in the value of the equity of the foreign corporation’s U.S. trade or business. The tax is imposed on the “dividend equivalent amount (“DEA”) of the corporation’s “effectively connected earnings and profits” for the taxable year as computed under Internal Revenue Code and as modified and adjusted by the branch profits tax regulations. The branch profits tax is payable in the same manner as a foreign corporation’s regular tax, except that no estimated tax payments are required with respect to the branch profits tax.
Calculation of the Branch Profits Tax
The branch profits tax is calculated 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 the reduction for dividend distribution, 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 equality 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.
Below, please see an illustration as to how the branch profits tax is calculated.
Assume that Company X, a foreign corporation, operates a branch sales office in the U.S. During the first year of operation, Company X 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. Company X’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 year U.S. net equity | -$500,000 |
| Increase in U.S. net equity | $250,000 |
| DEA [A – B] | None |
During year 2, Company X 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, Company X’s dividend equivalent amount for year 2 is $150,000, computed as follows:
| (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 |
| DEA [A + B] | $150,000 |
DEA is reduced by the excess of “U.S. net equity” at the close of the year over the U.S. net equity at the close of the preceding year. DEA is increased by the excess of U.S. net equity at the close of the present taxable year, provided that the increase may not exceed the accumulated effectively connected earnings and profits at the close of the preceding taxable year to the extent not previously taxed. “U.S. net equity” is the foreign corporation’s “U.S. assets” less its “U.S. liabilities” at the end of the taxable year. U.S. assets and U.S. liabilities are generally those effectively connected with the foreign corporation’s U.S. trade or business, subject to special rules for certain assets and liabilities.
If a tax treaty with the country of which the foreign corporation is a resident provides an exemption from the branch profits tax or a reduced rate of tax, that treaty relief can be taken into account if the entity satisfies certain requirements. However, the treaty rates will not apply if the foreign corporation is wholly owned by a U.S. corporation.
The attorneys at Diosdi Ching & Liu, LLP represent clients with international tax planning throughout the United States.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.