How The IRS Taxes Profits From Foreign Branches
Foreign Branch Profit Tax Provision
A US branch of a foreign corporation is treated as a US Subsidiary of a foreign corporation when taxing profit repatriations. Put differently, the earnings and profits of a branch of a foreign corporation deemed remitted to its home office are on an equal footing with the earnings and profits of a US subsidiary paying dividends to its foreign parent.
IRC §884(a) was part of the Tax Reform Act of 1986 to replace the “second-tier” withholding on dividends” under IRC §861(a).
IRC §861(a): A foreign corporation is treated as paying US source dividends if more than 50 percent of the foreign corporation’s income is effectively connected with a US trade or business for the previous three years. This was tough to administer because:
- The foreign corporation became a US withholding agent,
- The percentage of the dividend resourced depends on the gross income rate that is effectively connected income (ECI) for the previous three years.
Most of the concurrent US income tax treaties exempted the above dividends from US withholding tax because the address of tax was not an effective means of tax collection.
As a result: A foreign corporation could transfer the profits of its US branch to its home office without incurring any tax legally by treaty. There was little risk of detection even absent a treaty because the withholding agent was not a domestic corporation.
A US subsidiary was subject to a 5 percent dividend withholding tax on any payment to its foreign parent under a treaty and 30 percent absent a treaty.
- Branch profit tax is calculated and paid by the foreign corporation on Form 1120-F.
- The tax is applied whether the foreign corporation’s US trade or business is substantial compared to its worldwide activities or not.
- The US trade or business of the foreign corporation is treated as if it was incorporated as a subsidiary of the foreign corporation.
- The profits of the US trade or business – of the foreign corporation – are deemed to be remitted to the foreign corporation at the year-end.
This eliminates the competitive advantage in operating as a branch instead of a subsidiary regarding the repatriation of profits. In addition, branch operations are discouraged because the tax computation formula takes away control of the payment of the dividend equivalent amount. A subsidiary can declare and pay a dividend during the year, but a branch must pay it at the year-end.
Also, suppose the foreign corporation conducts business outside the US. In that case, a branch is deemed to pay a larger dividend than a subsidiary – even if it reinvests all its profits back into the branch.
As a result, after congress enacted the branch profit tax, many enterprises reorganized and incorporated or terminated their US branches to avoid the complex way the base on which branch profit tax is determined.
In principle, the branch profit tax was put in place to create an equal footing between the earnings and profits of a foreign corporation deemed remitted to its home office and the earnings and profits of a US subsidiary paid out as a dividend to its foreign parent. IRC § 884 accomplished this by imposing the same 30 percent tax rate on deemed remittances to a home office as on dividends paid by a US subsidiary to its foreign parent.
It is straightforward to determine the dividends declared and paid by a subsidiary. However, to measure the earnings of a branch deemed remitted to its head office is a lot harder.
- Branches do not declare and pay dividends.
- Branches remit funds via intra-company transfers, which is hard to track.
To solve the problem, congress elected to impose the tax on a formulary basis. As a result, branches are treated as effectively operating with the same debt-equity ratio as the foreign corporation.
Effectively Connected Income (ECI)
- A foreign corporation must be engaged in a US trade or business to be subject to the branch profit tax and have ECI.
- A foreign corporation that performs services in the USD is engaged in a trade or business in the US and has ECI.
- A foreign corporation regularly selling products in the US is engaged in a trade or business in the US.
- Before its income becomes ECI, the title of the products must pass to the buyer in the US.
- The sale must be attributable to a US office.
- As a rule, ECI must be from a US source.
- The only foreign source income that can be ECI is described in IRC §864(c)(4)(B).
- Foreign corporation resident in treaty countries and which qualify for treaty benefits will not be taxed on their ECI unless:
- They have or are deemed to have a permanent establishment (PE) in the US.
- If they do not have a PE in the US, they will not be subject to branch profits tax.
- A foreign corporation that has a PE but its ECI is not wholly attributable to the PE, the branch profit tax will only apply to the effectively connected earnings and profits (ECEP) attributable to the profits of the PE.
- Nonresident alien individuals and complex trusts are not subject to the branch profits tax.
- A foreign corporation can have ECI by:
- Engaging in a US trade or business.
- Electing to be treated as engaging in a US trade or business under IRC §882(d).
- If the foreign corporation owns US real property, it will be subject to the branch profit tax IF:
- It has ECI under IRC §897 on the disposition of a US real property interest.
- ECI gain from the sale of US real property holding corporation (USRPHC) is excluded.
- A foreign corporation that is a partner in a partnership or the beneficiary of a trust or estate is subject to the branch profit tax IF:
- The partnership, trust, or estate is engaged in a US trade or business.
- And it is involved in the same to the extent of the foreign corporation’s distributive share of income of the partnership, estate, or trust treated as ECI in its hands.
- If the branch profit tax applies, any dividend distributions made by the foreign corporation are not taxed.
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After the enactment of IRC §884, foreign corporations with US branches are subject to two levels of tax:
- Entity level: On income earned by US branches.
- Shareholder level: When the above earnings are repatriated.
IRC §884 was enacted to impose a second-level tax on branches of foreign corporations over and above the tax imposed on income effectively earned by a US trade or business under IRC §882.
A branch profit tax of 30 percent is imposed on the after-tax earnings of a foreign corporation’s US trade or business that are not reinvested in its US trade or business. The branch profit tax is equal to 30 percent (or the treaty rate if it is lower) of the dividend equivalent amount (DEA).
Remember: The branch profit tax treats a US branch of a foreign corporation as a subsidiary of a foreign corporation.
Dividend Equivalent Amount (DEA)
The effectively connected earnings and profits (ECEP) for a taxable year is reduced by increasing a US branch’s US net equity (USNE*) or supplemented by a US branch’s decrease in USNE.
- The DEA is similar to dividends paid by a subsidiary out of:
- Current earnings and profits (E&P) not yet invested,
- OR Accumulated E&P invested in subsidiary assets.
- The only way to eliminate the DEA is by increasing the USNE by the amount of the ECEP of the branch each year.
- USNE can be increased if:
- If profits are used to purchase additional US assets.
- If US liabilities are reduced.
- Suppose a foreign corporation has other assets or liabilities that are not US assets or US liabilities. In that case, the formulatory nature of USNE makes it very hard to continuously increase USN by the amount of ECEP for the taxable year.
US Income Tax Treaties
- The tax rate of branch profits tax reduced by US income tax treaties is typically 5 percent.
- To qualify for the total exemption, the foreign corporation must meet:
- The treaty’s limitation on benefits article.
- The additional requirements in the dividend or branch profit tax articles.
- Treaties that had not been renegotiated since January 1, 1987; the foreign corporation must be a qualified resident within the definition of Treas. Reg. §1.884-5.
- The regulations provide tests to prevent treaty shopping, like the limitation on benefits articles.
- Suppose a foreign corporation is a qualified resident under a treaty. In that case, no branch profits tax will apply because the regulations acknowledged the tax as violating the non-discrimination article of the treaties unless the treaty allowed the other state to impose its branch profits tax.
Taxpayers must file Form 8833 with its Form 1120-F to disclose the basis of their claim for a reduced rate or exemption from branch profits tax under a tax treaty BUT NOT under IRC §884. Failure to file a Form 8833 can be punished by a $10,000 fine as imposed under IRC §6712.
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