Unit 1: Introduction. Section 1.1: Instructions. Section 1.2: Learning Objectives

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1 991150: US Taxation of Foreign Business Entities v.2 Unit 1: Introduction Section 1.1: Instructions Course Requirements This course consists of the following: learning objectives, glossary of key terms, index, text and graphics to illustrate course subject matter, review questions and a final exam. To earn CPE credit, you are required to read all materials, answer the review questions and pass the Final Exam. Questions on the Final Exam will be based on content found in all portions of the course text. The link to the downloadable course index is to the left and bottom of the screen. In addition, you can download a printable file of the course text. After passing the Final Exam, you will receive a Certificate of Completion that is accessible on the Your Account page. You do not have to complete the course at one sitting. If you exit the course before you finish, your current location will be remembered and when you return to the course, you can pickup from where you left off. If you exit or logoff the Professional Education Center, this course will be saved. You can launch the course again from "Enrolled Courses" under Your Account. You have one year from the time you enroll in the course to complete it. Course Navigation To navigate throughout the course, you can use the course menu located on the left side of the screen to jump from one unit or section to another. Please note that this course has restricted navigation and you will not be allowed to proceed to a new unit until you have answered the review questions at the end of the unit. Section 1.2: Learning Objectives Course Overview This course, "US Taxation of Foreign Business Entities" provides an introduction to the taxation of foreign corporations, partnerships, trusts, and estates. It is intended for those who already possess at least an intermediate knowledge of US tax law as it applies to these forms of business entities, but who have not previously studied any aspect of the taxation of foreign business entities. The course presents an overview of the taxation of foreign corporations by providing an understanding of US residency requirements, and the filing requirements for Form 1120-F. The taxation of income that is effectively connected with a US trade or business and income that is not effectively connected with a US trade or business is further discussed. Taxes that foreign corporations are affected by such as the branch profits tax, tax on excess branch interest, and other tax considerations are described. -1-

2 Learning Objectives After completing this course, the course participant should be able to: Discuss the residency requirements, filing requirements, and accounting methods and periods regarding the US taxation of foreign corporations. Assess when income is effectively connected with a US trade or business, or when income is not effectively connected with a US trade or business, and the taxation of this income. Calculate the branch profits tax, and review other taxes that may affect the corporation Implement the rules applicable to the US taxation of foreign partnerships, trusts, and estates Section 1.3: Glossary of Key Terms Foreign corporation A corporation which is not created or organized in the United States. US-source income Income where the location of the activity for which the income is earned is the United States. US corporation Any corporation that is properly incorporated in the United States (the 50 states and the District of Columbia). Form 1120-F The United States tax return filed by those foreign corporations that meet the requirements. Income effectively connected with a US trade or business Fixed, determinable, annual, or periodic (FDAP) income derived from a trade or business effectively connected with the United States. US trade or business An activity with the intent of generating profit within the United States. Asset use test A test used to determine if a foreign corporation s trade or business qualifies as a US trade or business. The asset use test is satisfied if a substantial percentage of the total assets employed in the trade or business is located in the United States. Business activities test A test used to determine if a foreign corporation s trade or business qualifies as a US trade or business. The business activities test is satisfied if the activities of the US -2-

3 trade or business are collectively a material factor in the generation of FDAP income. Foreign branch A foreign corporation doing business within the United States in the absence of a US subsidiary. Branch profits tax A 30 percent tax paid by a foreign corporation on the after-tax profits of the corporation s US trade or business that are not reinvested in a US trade or business by the close of the tax year or are disinvested in a later tax year. Excess interest The interest, including capitalized and nondeductible interest, apportioned to income effectively connected with the US trade or business minus branch interest. Branch interest Any interest paid by the US trade or business of the foreign corporation. Unit 2: US Taxation of Foreign Corporations Section 2.1: Overview With regard to the taxation of corporate income, the United States follows the worldwide approach to taxation in that all income earned by a US corporation is taxed by the US Government, regardless of the source of the income. Furthermore, all US corporations are allowed all deductions and tax credits as provided for under US tax law. A foreign corporation, on the other hand, is not taxed by the US Government in the same manner as a US corporation due to the following overriding provisions: A foreign corporation is taxed by the United States on its US-sourced income only and is not taxed on its foreign-sourced income. A foreign corporation is taxed at a flat rate of 30 percent of gross income on certain forms of income. A foreign corporation faces discriminatory tax treatment when dealing with branch profit taxes on income and excess interest. A foreign corporation is not allowed all deductions afforded to a US corporation. Section 2.2: Determination of US Residency in the Case of a Corporation Because the tax scheme for foreign corporations is substantially different from the tax scheme for US corporations, and foreign corporations face discriminatory tax treatment, the first question is to determine residency: Which corporations will be classified as foreign corporations for tax purposes? This determination of residency is -3-

4 made under US tax law. The determination of residency in the case of a corporation is not a complicated manner. The following factors are considered: The primary factor to be considered is the corporation's place of incorporation. All corporations must be incorporated according to the corporation laws of some legal jurisdiction. A US corporation is any corporation that is properly incorporated in the United States. For this purpose, the United States is defined as the 50 states and the District of Columbia. A corporation that is incorporated in any other jurisdiction is considered as a foreign corporation. Therefore, a corporation incorporated in any foreign nation or any US possession, such as Puerto Rico, is classified as a foreign corporation. It is important to stress that both the actual ownership of the corporation as well as its place of effective management are considered irrelevant in determining the residency of a corporation. The foreign corporation must also be classified as a corporation under US tax law. Therefore, a foreign entity will be judged in terms of factors used by the Internal Revenue Service (IRS) to determine whether a foreign business entity will be classified as a corporation or as another form of business entity, such as a partnership. Foreign corporate law can deviate substantially from commonly practiced US corporate law such that a foreign entity may exist in a noncorporate form under foreign law but would still qualify as a corporation under US tax law. Also, a foreign entity may utilize the "check-the-box" regulations to qualify as a corporation under US tax law. Section 2.3: Filing Requirements The following foreign corporations must file a US tax return (Form 1120-F): A foreign corporation that has any taxable US-sourced income A foreign corporation that has any tax-exempt US-sourced income (unless the only source of US income is exempt from US taxation under Section 881(c) or (d)). A foreign corporation that is engaged in a US trade or business, whether or not the corporation had any income from that business A foreign corporation that has any income that is effectively connected with a US trade or business A foreign corporation that operates in the United States through either a US agent or a foreign agent A Mexican or Canadian branch of a US mutual life insurance company A foreign corporation in dissolution or bankruptcy in the United States A foreign corporation that claims any benefit under a tax treaty A foreign corporation claiming a tax refund A foreign corporation whose income tax due was not entirely withheld at the source (usually in the form of a 30 percent withholding tax) A foreign corporation that has elected to be treated as a foreign sales corporation (FSC) files Form 1120-FSC. An FSC that has elected to be treated as a domestic -4-

5 corporation files Form Actual filing requirements are identical to those facing US corporations Section 2.4: Accounting Methods and Periods Foreign corporations face the same rules as US corporations in terms of accounting methods and periods. As such, a foreign corporation must often state its income that is subject to US taxation in a manner different from that used in the country where it is incorporated or operates. Accounting and tax accounting rules may differ substantially. The foreign corporation may also need to change its reporting period from that used in its home country. Unit 3: Taxation of Foreign Corporate Income Section 3.1: Taxation of Income That Is Effectively Connected with a US Trade or Business Income that is considered as being effectively connected with a US trade or business is taxed on the same basis as income earned by a US corporation. The progressive marginal tax rates, ranging from 15 to 39 percent, that apply to US corporations also apply to foreign corporations. In the case of income that is effectively connected with a US trade or business, foreign corporations are also allowed all deductions available to US corporations. The same limitations governing deductions also apply to foreign corporations. In order to qualify as effectively connected with a US trade or business, such income must be "fixed or determinable, annual or periodic" (referred to as FDAP). In the case of a corporation, all income that is derived from a regular trade or business will qualify as being FDAP income, whether or not it is effectively connected with a US trade or business. To be considered as a trade or business, a foreign corporation must be carrying on an activity with the intent of generating a profit within the United States. The normal rules for determining a trade or business that apply to US corporations also apply to foreign corporations. Tests for Determining a Trade or Business The foreign corporation's trade or business must also qualify as a US trade or business. For such a classification to occur, the foreign corporation's trade or business must be carried on in the United States or must derive income from assets located within the United States. One of the following tests must be satisfied: Asset use test. A substantial percentage of the total assets employed in the trade or business must be located in the United States. A safe harbor rule states that at least 20 percent of the total assets used in the trade or business must be located in the United States. -5-

6 Business activities test. The activities of the US trade or business must collectively be a material factor in the generation of FDAP income. If either of these tests is satisfied, the trade or business will qualify as a US trade or business. All of its US-sourced income will be taxed as FDAP income that is effectively connected with a US trade or business. The foreign corporation will also be allowed to deduct all ordinary and necessary expenses associated with the generation of the US-sourced income. To be deductible, the expenses must be paid to an entity located in the United States or must be associated with the generation of the US-sourced income. All limitations that would be applicable to a US corporation apply to the foreign corporation. Examples include the 10 percent limitation on charitable donations (recipient must be a US charity), depreciation deduction limitations, and inventory capitalization rules. A foreign corporation is also entitled to a dividends-received deduction on the same basis as a US corporation. In determining the dividends-received deduction, only dividends from US corporations are taken into account. Section 3.2: Taxation of Income That Is Not Effectively Connected with a US Trade or Business FDAP income that is not effectively connected with a US trade or business will be taxed at a flat rate of 30 percent of gross income. For income to be judged as not being effectively connected with a US trade or business, the foreign corporation would normally fall under one of the following scenarios: It has a revenue-generating activity that does not qualify as a trade or business. It has a trade or business that does not qualify as a US trade or business. It has investment-related income. It receives dividend, interest, or royalty income from a US subsidiary corporation. It must be stressed that a foreign corporation may have both income that is effectively connected with a US trade or business and income that is not effectively connected with a US trade or business. A foreign corporation with income that is not effectively connected with a US trade or business will be taxed at a flat rate of 30 percent of gross income. As gross income is taxed, no deductions associated with this income are allowed. The following forms of income not effectively connected with a US trade or business are taxed at a flat rate of 30 percent of gross income: Interest income Dividend income Rental income Royalty income Income from annuities -6-

7 Gains from the disposition of timber, coal, or domestic iron ore with a retained economic interest Gains from the sale or exchange of intangible property Fiduciary distributions Other FDAP income A flat tax of 4 percent is assessed on a foreign corporation's US-sourced gross transportation income. A foreign corporation may elect to treat any income from rental real property as being effectively connected with a US trade or business. This election must be made annually. For the purposes of this election, income from rental real property includes the following: Actual income from the rental of real property Gains from the sale or exchange of rental real property or any interest therein Rents or royalties from any form of mineral extraction Section 3.3: Tax on Branch Profits A foreign corporation that operates in the United States as a foreign branch is subject to a special tax on foreign branch income. A foreign branch is defined as a foreign corporation doing business within the United States in the absence of a US subsidiary. Whenever a foreign corporation wants to do business in the United States, it must operate as an unincorporated entity within the United States, or it must establish a subsidiary corporation incorporated in the United States to carry on its US operations. If it operates as an unincorporated entity, it is operating as a foreign branch. If it operates as a subsidiary corporation, the subsidiary corporation will qualify as a US corporation and be taxed as a US corporation. The branch profits tax scheme exists because the normal withholding tax on a dividend paid by a subsidiary corporation incorporated in the US to a foreign corporation is 30 percent, as this is FDAP income not effectively connected with a US trade or business. A foreign corporation could, therefore, avoid this tax by not incorporating a subsidiary corporation in the United States, hence, avoiding the double taxation of US corporations. In essence, any remittances sent by the US operations to the foreign corporation would merely be deemed shifting assets within the same foreign corporation rather than be deemed a dividend payment. A foreign corporation must pay a 30 percent branch profit tax on after-tax profits of the corporation's US trade or business that are not reinvested in a US trade or business by the close of the tax year or are disinvested in a later tax year. The amount subject to this tax is the dividend equivalent amount. The branch profits tax is determined by the following mechanism: The branch profits tax is 30 percent of the dividend equivalent amount (DEA). -7-

8 The DEA is, in turn, defined as the foreign corporation's current earnings attributable to the [foreign] branch, reduced by increases in US net equity and increased by decreases in US net equity. US net equity is the sum of cash and the excess of assets over liabilities owned by the US branch. The DEA is limited to current earnings and profits (E&P) and post-1986 E&P effectively connected with the branch. E&P must be calculated in accordance with US tax rules. The foreign corporation pays the branch profits tax in addition to any other corporate tax payable. Determining Branch Profits Tax Example. F Corp., a foreign corporation, operates a US trade or business as a foreign branch in the United States. In 2009, it posted pretax profits effectively connected with its US trade or business as $10,000,000. It remitted $3,000,000 to F Corp. It made an additional capital investment of $100,000 in its branch. Solution Step 1. Determine the change in US net equity. Pretax profits = $10,000,000 Less: US corporate taxes = ($3,500,000) (or $10,000,000 taxed at a US corporate rate of 35 percent) Plus: Additional capitalization = $100,000 Less: Dividend remitted = ($3,000,000) Increase in US net equity = $3,600,000 Step 2. Determine the DEA. After-tax profits = $6,500,000 Less: Increase in US net equity = ($3,600,000) DEA = $2,900,000 Step 3. Determine the branch profits tax. Branch profits tax = $870,000 (DEA of $2,900,000 times branch profits tax rate of 30 percent) Note that F Corp.'s total US tax liability is $4,370,000 (US corporate taxes of $3,500,000 plus branch profits tax of $870,000.) All US tax treaties currently in force significantly reduce or eliminate the branch profits tax. -8-

9 Section 3.4: Tax on Excess Branch Interest Any foreign corporation operating in the United States as a foreign branch, and that has income effectively connected with a US trade or business or has assets in the United States, is subject to a tax on excess interest associated with the foreign branch. The tax rate is 30 percent, unless a lower rate is provided for in an income tax treaty. Excess Interest Versus Branch Interest Excess interest is defined as the interest, including capitalized and nondeductible interest, apportioned to income effectively connected with the US trade or business minus branch interest. Branch interest, in turn, is defined as any interest paid by the US trade or business of the foreign corporation. Branch interest generally consists of the following: Interest on liabilities shown in the financial books and records of the US trade or business Interest on liabilities that are secured predominately by US assets or that cause a certain nondeductible interest, such as capitalized interest, related to US assets Interest on liabilities identified as liabilities of the US trade or business on or before the earlier of the following: the date on which the first interest payment is made or the due date of the foreign corporation's tax return If at least 80 percent of the foreign corporation's total assets is located in the United States, the foreign corporation is generally exempted from the tax on excess interest. A foreign corporation is also generally required to withhold 30 percent of all interest paid to foreign persons as a withholding tax. US income tax treaties, however, may lower this rate. Section 3.5: Other Taxes Personal Holding Company Tax If a foreign corporation qualifies as a personal holding company (PHC), it is subject to the PHC penalty tax. PHC rules applicable to the determination of a PHC, its classification of income, and the actual calculation of the PHC tax are the same for foreign corporations as for US corporations. The sole difference is that only USsourced income is considered in determining this tax. Note that US tax law does provide that a foreign corporation can be classified as a foreign personal holding company (FPHC) if certain requirements are met. However, a PHC cannot also qualify as a FPHC. Also, under the FPHC scheme, affected US shareholders but not the foreign corporation are subject to US taxation. As the foreign corporation cannot be taxed by the United States, this subject of the FPHC is ignored here. -9-

10 Accumulated Earning Penalty Tax A foreign corporation is also subject to the accumulated earnings penalty tax (AET) on the same basis as a US corporation. Again, the only difference is that only US-sourced profits are considered, and the determination of income retained to meet the reasonable needs of the corporation is calculated only with regard to the foreign corporation's US operations. Section 3.6: Other Tax Considerations Foreign corporations must report all tax data in accordance with US tax rules. Foreign corporations must submit all documents required by the IRS in English. Foreign corporations must make the same quarterly tax payments as US corporations do. Foreign corporations are subject to the same interest and penalty provisions as US corporations are. Foreign corporations are subject to the same rules affecting US corporations with regard to the determination of a controlled group of corporations. A foreign corporation can file a consolidated US corporate tax return with a Mexican or Canadian corporation only. A foreign corporation is subject to the alternative minimum tax (AMT) scheme. A foreign corporation is allowed all business-related tax credits. All such credits are calculated with regard to its US operations. A foreign corporation is allowed a foreign tax credit for US-sourced income only. Unit 4: US Taxation of Foreign Partnerships, Trusts, and Estates Section 4.1: Overview of Foreign Partnerships Determination of Residency The residency rules defining a partnership are identical to those that define the residency of a corporation. A foreign partnership is defined as any partnership that is organized under the partnership laws of a foreign nation or a US possession. Conversely, a US partnership is any partnership that is organized under the partnership laws of one of the states or the District of Columbia. The partnership must also resemble the partnership form as defined under commonly practiced US partnership law. Taxation of Foreign Partnerships Foreign partnership taxation rules also closely follow those applicable to foreign corporations. US tax rules applicable to foreign partnerships can be summarized as follows: Income that is effectively connected with a US trade or business will be taxed to the partners of the partnership as if the income had been earned by a US partnership. This income will be taxed at regular US income tax rates -10-

11 applicable to the partner. All deductions and most tax credits are allowed to pass through to the partner, as do all limitations. Whether the partner qualifies as a US taxpayer is not a relevant factor. A foreign corporation or individual partner is deemed to be engaged in any US trade or business carried on by the partnership. Any distributive share of partnership income that is treated as being effectively connected with any US trade or business is then treated as being effectively connected income in the hands of the partner. Partnerships with effectively connected income must withhold tax at the top individual tax rate on such income that is allocable to individual foreign partners. Foreign partnership income that is not effectively connected with a US trade or business (i.e. interest, dividends, etc.) will be taxed at a flat rate of 30 percent of gross income if the partner is not a US person. Such income would be taxed at regular US tax rates if earned by a partner who qualifies as a US person, as US persons are never subject to the 30 percent rate on gross income, in the case of income that is not effectively connected with a US trade or business. A US person who is a partner of a foreign partnership will be taxed on his or her proportionate share of the partnership's worldwide income. A foreign partner of a foreign partnership will be taxed on his or her proportionate share of effectively connected income. Other rules governing the tax treatment of a foreign partnership also follow the US tax rules applicable to US partnerships. Examples include the determination of inside basis, outside basis, a partnership year, partnership filing requirements, partnership distribution rules, and determination of gains and losses. Section 4.2: US Taxation of Foreign Trusts and Estates Determination of Residency The determination of residency with regard to an estate or trust is more complex than in the case of a corporation or a partnership. Residency rules can be summarized as follows: A trust or estate is normally classified according to the laws of the country in which the trust or estate is organized or operates. This rule is quite similar to that which defines residency in the case of a corporation or a partnership. A foreign trust or estate that carries on a US trade or business or that has US-sourced income can be reclassified as a US trust or estate. A foreign trust or estate that is managed by US persons or that exists for the benefit of US persons can also be reclassified as a US trust or estate. -11-

12 The transfer of property to a foreign trust or estate can cause the trust or estate to be reclassified as a US trust or estate. The estate of a foreign national who died in the United States can be reclassified as a US estate. Taxation of Foreign Trusts and Estates The taxation of foreign trusts and estates closely resembles the taxation of foreign partnerships. In the case of a foreign trust or estate, the following rules apply: A foreign trust or estate will be subject to US taxation only on undistributed US-sourced income. Undistributed US-sourced income that is effectively connected with a US trade or business will be taxed to the trust or estate as if it had been earned by a US trust or estate. Therefore, regular US tax rates apply. Undistributed US-sourced income that is not effectively connected with a US trade or business will be taxed to the foreign trust or estate at a flat rate of 30 percent of gross income. All US-sourced income distributed to an heir or income beneficiary will be taxed at the recipient's regular tax rate. All foreign-sourced income distributed to an heir or income beneficiary will also be taxed at the recipient's regular tax rate. All US-sourced income that qualifies as income effectively connected with a US trade or business distributed to a foreign heir or income beneficiary will be taxed to the recipient as if the recipient is a US person. Therefore, regular tax rates apply. All US-sourced income that does not qualify as income effectively connected with a US trade or business distributed to a foreign heir or income beneficiary will be taxed at a flat rate of 30 percent of gross income. Other rules governing the tax treatment of a foreign trust or estate also follow the US tax rules applicable to a US trust or estate. Examples include the determination of income, deductions, the distribution deduction, and distributable net income. -12-