By Anthony Diosdi
In general, when a domestic corporation pays a dividend to a foreign shareholder, a thirty percent (30%) tax is imposed. Recognizing that it is far more difficult for the Internal Revenue Service (“IRS”) to monitor when a foreign corporation pays a dividend, the tax law provides a mechanism to determine when funds invested in the United States in a U.S. trade or business are deemed “distributed” by the foreign corporation. This deemed “dividend equivalent” is at that time subject to a 30 percent tax- the so-called branch profits tax.
The branch profits tax is imposed at 30 percent rate on a foreign corporation’s U.S. trade or business effectively connected earnings and profits (the “Earnings”). In general, the Earnings represent taxable income with adjustments to arrive at trust economic income further adjusted to determine whether any of the Earnings have been reinvested in a U.S. trade or business and, thus, are not available to be “distributed” as dividends. After applying the tests found in the branch profits tax regulations, if any of the Earnings are considered reinvested, but in a later year are considered “disinvested,” the Earnings will be taxed at that time.
Besides filing of any required Forms 5471 and Forms 5472, the rules governing the branch profits tax, require the preparation of balance sheets for the foreign corporation’s U.S. trade or business at the beginning and end of each fiscal year. The difference between each year’s U.S. trade or business assets and U.S. trade or business liabilities (the “U.S. Net Equity”) is then determined and compared. If the U.S. Net Equity has increased during a year, there is a presumption that the Earnings have been reinvested to that extent and the branch profits tax will not be imposed on the reinvested portion of the Earnings. However, if the U.S. Net Equity has decreased, any prior year’s Earnings which were not previously subject to the branch profits tax because of their reinvestment are deemed distributed and not subject to the 30 percent branch profits tax.
Below are some additional comments about the branch profits tax:
1. If the branch profits tax applies and a foreign corporation is also taxed at the maximum U.S. corporate rate of 21 percent, the total U.S. tax would be approximately 51 percent- a significant tax liability.
2. If a foreign corporation earns profits subject to the branch profits tax, but also has a net operating loss from a prior year, the branch profits tax is determined without considering the losses- thus advanced tax planning is necessary to avoid the branch profits tax.
3. With proper planning, a foreign corporation may be able to sell or terminate all of its U.S. trade or businesses in a single year or, perhaps, over a two year period and, although corporate income tax may be due on any profits, it may be able to avoid the imposition of the 30 percent branch profits tax.
4. If a foreign corporation is incorporated in, or is resident of, a country having an income tax treaty with the United States, the branch profit rules may be modified with a tax treaty.
In summary, a foreign corporation’s operation of a U.S. trade or business requires not only an appreciation of applicable corporate income tax rules, but also a plan to avoid or minimize the 30 percent branch profits tax rules.
Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – 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.