By Anthony Diosdi
The United States taxes foreign corporations and nonresident individuals on the net amount of income effectively connected with the conduct of a trade or business within the United States. Therefore, under the Internal Revenue Code, the existence of a trade or business is the touchstone of U.S. taxation of a foreign business profits. Despite its importance, there is no comprehensive definition of the term “trade or business” in the Internal Revenue Code or its Regulations. The relevant case law suggests that a U.S. trade or business exists only if the activities of the individual within the United States are considerable, continuous, and regular.
A foreign corporation or nonresident alien individual engaged in a U.S. trade or business is subject to U.S. taxation on the income effectively connected with the conduct of that U.S. trade or business. Effectively connected income includes the following five categories of income:
1) Certain types of U.S. source income;
2) Certain types of foreign source income attributable to a U.S. office.
3) Certain types of deferred income that are recognized in a year that the foreign person is not engaged in a U.S. trade or business, but which would have been effectively connected income if the recognition of the income had not been postponed.
4) Income from an interest in U.S. real property that a passive foreign investor has elected to treat as effectively connected income, and
5) Interest income derived from U.S. obligations by a bank organized and doing business in a U.S. possession.
A foreign corporation or nonresident alien individual engaged in the conduct of a U.S. trade or business can claim the following deductions against effectively connected gross income:
1) Expenses, losses, and other deductions that are directly related to effectively connected gross income (e.g., cost of goods sold), as well as a ratable portion of any deductions that are not definitely related to any specific item of gross income (e.g., interest expenses);
2) Foreign income taxes imposed on either foreign-source effectively connected income or U.S.. source effectively connected income that is subject to foreign taxation by reason of the income’s source rather than the taxpayer’s citizenship, residence, or domicile;
3) Charitable contributions made to domestic charitable organizations, and
4) In the case of a nonresident alien individual, casualty and theft losses with respect to personal use property located within the United States and a personal exemption deduction.
Applicable Federal Tax Rates
The progressive rate schedules applicable to U.S. persons also apply to the effectively connected income of foreign persons. The applicable federal rate for foreign corporations is 21%. The applicable federal rates for nonresident alien individuals ranges from 10% to 37%. For nonresident aliens, the applicable schedules include those for single taxpayers, married individuals, married individuals filing separately, and surviving spouses. Nonresident aliens generally cannot use the head of household or married filing jointly rate schedules.
Introduction to the Branch Profits Tax
Foreign investors considering investing in the United States through a corporate structure must consider the branch profits tax and plan for the 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% 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.
Tax on Branch Interest
The rationale for the branch profits tax is to place U.S. branch and subsidiary operations on a tax parity. The branch interest withholding tax is designed to further this objective. Under the branch interest withholding tax, any interest paid by a foreign corporation’s U.S. is treated as if it were paid by a domestic corporation. The effect of this rule is to recharacterize the interest payment as U.S. source income and thereby subject any interest received by a foreign person from a U.S. branch to the 30% withholding tax which ordinarily applies to U.S. source interest income. As a general rule, interest is considered to be “paid by” a U.S. branch if either the underlying liability is designated by the taxpayer as a branch liability or the liability has a particular connection with branch operation. Examples include a liability that is reflected in the books and records of the U.S. trade or business, a liability secured predominantly by a U.S. asset, or a liability specifically identified by the taxpayer as a liability of the U.S. trade or business.
Tax on Excess Interest
In addition to the branch interest withholding tax, the branch profits tax regime also imposes a tax on excess interest. The idea behind the excess interest tax is that any interest expense that is deductible against the branch’s U.S. taxable income also should give rise to an income inclusion, which is analogous to what happens when a U.S. subsidiary corporation makes an interest payment. A foreign corporation’s excess interest equals the excess of:
1) The amount of interest expense that is deducted against the foreign corporation’s effectively connected income, over
2) The amount of interest deemed paid by the foreign corporation for purposes of the branch interest withholding tax.
Under this provision, on the last day of the foreign corporation’s taxable year, the foreign corporation is deemed to have received a payment of interest from a wholly-owned domestic corporation equal to the foreign corporation’s excess interest. The effect of this provision is to subject the foreign corporation’s excess interest to the 30% withholding tax that ordinarily applies to U.S. source interest income. However, if a tax treaty with the country of which the foreign corporation is a resident exempts or reduces the withholding rate for interest income, that treaty relief may be taken into account. In all cases, the tax due on excess interest must be reported on the foreign corporation’s income tax return and estimated tax payments are required.
Withholding On U.S.-Source Investment Type Income
The United States taxes the gross amount of a foreign person’s U.S. source nonbusiness (or investment type) income at a flat rate of 30%. In addition, the person controlling the payment of the income must deduct and withhold U.S. tax at the 30% rate. Thus, once the appropriate amount of U.S. taxes is withheld, a passive foreign investor generally has no further U.S. tax obligation.
Nonresident alien individuals and foreign corporations are subject to the U.S. withholding taxes. Withholding is required with respect to any income that meets the following two tests: 1) the income is fixed or determinable, annual, or periodic, and 2) the income is derived from sources within the United States.
Fixed or determinable, annual, or periodic income includes interest, dividends, rents, royalties, salaries, wages, premiums, annuities, and other forms of compensation. Any person having control, receipt, custody, disposal, or payment of an item of U.S. source nonbusiness income to a foreign person is obligated to withhold U.S. tax. A withholding agent must deposit taxes withheld with a federal reserve bank or an authorized financial institution using a federal tax deposit coupon or through electronic funds transfer.
Effectively Connected Income and the Branch Profits Tax Withholding Rules
Withholding is not required on any U.S. income that is connected with the conduct of a U.S. trade or business. Although such income is exempt from withholding, it is subject to U.S. taxes at the regular graduated rates. Interest, dividends, rents, royalties, and other types of nonbusiness income are treated as effectively connected income if the income is derived from assets used in or held in use in the conduct of a U.S. trade or business or activities of the U.S. trade or business are a material factor in the realization of the income.
Taxation of U.S. Real Property Interests and the Branch Profits Tax Rules
When U.S. real estate became a popular investment with foreigners in the 1970s, the favorable tax treatment accorded foreign investors in U.S. real property became a domestic political issue. Congress responded in 1980 by enacting the Foreign Investment in Real Property Tax Act of 1980 (or “FIRPTA”), which tried to equate the tax treatment of real property gains realized by domestic and foreign investors. Prior to FIRPTA, foreign persons generally were not taxed on gains from the disposition of a U.S. real property interest. Under FIRPTA, gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange, or other disposition of a U.S. real property interest are taxed in the same manner as income effectively connected with the conduct of a U.S. trade or business. This means that gains from dispositions of U.S. real property interests are taxed at the graduated rates, whereas losses are deductible from effectively connected income.
A U.S. real property interest includes interests in any property located in the United States. For this purpose, an “interest” in real property means any interest (other than an interest solely as a creditor), including fee ownership, co-ownership, a leasehold, an option to purpose or lease property, a time-sharing interest, a life estate, remainder, or reversionary interest, and other direct or indirect right to share in the appreciation in value or proceeds from the sale of real property.
A U.S. real property interest also includes any interest (other than an interest solely as a creditor) in a domestic corporation that was a U.S. real property holding corporation at any time during the five-year period ending on the date of the disposition of such interest or, if shorter, the period the nonresident held the interest. This provision prevents foreign persons from avoiding FIRPTA tax by incorporating their U.S. real estate investments and then realizing the resulting gains through stock sales, which ordinarily are exempt from U.S. taxation. A domestic corporation is a U.S. real property holding corporation if the fair market value of its U.S. real property interests equals 50% or more of the net fair market value of the sum of the corporation’s following interests:
Please see Illustration 3 below for an example of the calculation of the branch profits tax.
Illustration 3.
Ace is a nonresident alien individual whose only connection with the United States is the ownership of a U.S. corporation, USAland. USAland has cash of $40,000 and a parcel of undeveloped land located in the United States with a net fair market value of $60,000. Under FIRPTA USALand is a U.S. real property holding corporation because over 50% of its net fair market value constitutes a U.S. real property interest ($60,000 divided by $100,000 equals 60%). As a result, the United States imposes the FIRPTA tax on Ace’s gain on the sale of shares of USALand. For this purpose, a domestic corporation is treated as owning a proportionate share of the assets of any corporation it controls.
To ensure collection of the FIRPTA tax, any transferee acquiring a U.S. real property interest must deduct and withhold a tax equal to 15% of the amount realized on the disposition. The amount realized is the sum of the cash paid or to be paid (excluding interest), the market value of other property transferred or to be transferred, the amount of liabilities assumed by the transferred, and the amount of liabilities to which the transferred property was subject. Withholding requirements also apply to distributions made by a domestic or foreign corporation, to the extent the distribution involves a U.S. real property interest. As with the withholding taxes in general, a transfer that fails to withhold is liable for any uncollected taxes.
IRS Filing Requirements
A foreign corporation that is engaged in a U.S. trade or business at any time during a taxable year must file Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. This requirement applies even if the foreign corporation has not effectively connected income, has no U.S. source income, or all of the corporation’s income is exempt from U.S. tax by reason of a treaty position. A foreign corporation that is not engaged in a U.S. trade or business but that has income subject to U.S. withholding taxes must also file Form 1120-F, unless its liability for the year is fully satisfied by the withholding tax.A foreign corporation engaged in a U.S. trade or business must make squarely estimated tax payments of its tax liability. However, no estimated tax payments are required with respect to the branch profits tax.
A nonresident alien individual who engages in a U.S. trade or business must file Form 1040NR, U.S. Nonresident Alien Income Tax Return. This requirement applies even if the nonresident alien has no effectively connected income, has no U.S. source income, or all of its income is exempt from U.S. tax by reason of a treaty position. A nonresident alien who is not engaged in a U.S. trade or business, but who has income that is subject to U.S. withholding taxes, must also file Form 1040NR, unless his or her liability for the year is fully satisfied by the withholding tax.
In order to effectively audit the transfer prices used by a U.S. subsidiary of a foreign corporation, the Internal Revenue Service (“IRS”) often must examine the books and records of the foreign parent corporation. In response, Congress enacted the requirement that each year certain reporting corporations must file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, and maintain certain books and records. A domestic corporation is a reporting corporation if, at any time during the taxable year, 25% or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. A foreign corporation is a reporting corporation if, at any time during the taxable year, it is engaged in a U.S. trade or business, and 25% or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. In filing a Form 5472, the reporting corporation must provide information regarding its foreign shareholders, certain other related parties, and the dollar amounts of transactions that it entered into during the taxable year with foreign related parties. A separate Form 5472 is filed for each foreign or domestic related party with which the reporting corporation engaged in reportable transactions during the year.
Failure to file required tax returns can not result in steep penalties, but can also result in the disallowance of all deductions to the foreign investor.
Conclusion
This article was designed to provide the reader with an introduction to the branch profits tax rules. Sometimes foreign investors may utilize tax treaties to reduce or even eliminate the withholdings associated with the branch profits tax and the associated U.S. tax. However, the planning associated with tax treaties can be incredibly complicated. If you are a foreign investor considering investing in the United States, you should consult with a tax attorney who has a deep understanding of the taxation of cross border transactions.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. 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.