Under certain realistic scenarios, shareholders of a U.S. company with a foreign subsidiary who do not correctly structure their situation with an exit plan in mind may find themselves paying three levels of U.S. tax on a foreign corporation’s profits due to the interplay between the branch profits tax and the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). Fortunately, with proper tax planning, there are ways to avoid this draconian tax treatment.
The threat of triple taxation looms when a parent U.S. company (USCo) conducts international activities through its wholly owned foreign corporation (FC). If the FC is based in a country with no U.S. income tax treaty and finds itself with excess cash, it must give careful consideration before lending any excess cash back to U.S. investors, even if they are unrelated. If such loans have U.S. real property or U.S. real property holding companies as collateral, a loan default may leave the FC, directly or indirectly, holding U.S. real property and subject to income taxes under FIRPTA.
FIRPTA rules characterize the disposition of U.S. real property by foreign persons as gain effectively connected with a U.S. trade or business (Sec. 897). With such characterization, the eventual income from the sale of U.S. real property would be subject to U.S. income tax. FIRPTA provisions indirectly cause a second layer of taxation on the gains because when those gains are treated as gains from a U.S. effectively connected trade or business, the FC will be deemed to have a branch in the United States and will therefore be subject to the branch profits tax (BPT).
Before the passage of the BPT provisions under Sec. 884 in 1986, foreign corporations were able to avoid the
dividend tax. However, to ensure that the United States could collect this tax, the BPT rules were enacted. The BPT is assessed at 30% of any non-U.S. treaty country FC’s U.S. effectively connected income (ECI), with adjustments for increases or decreases in U.S. net equity of the FC’s U.S. branch. Basically, unless the FC reinvests its U.S. effectively connected earnings back into U.S. assets, it will be subject to the BPT. This dividend-equivalent tax represents the second layer of taxation on a potential sale of the U.S. real property.
Example: X, an FC, is owned by C, a U.S. company, and owns U.S. real property, which it received when one of its loans defaulted. X has decided to sell the real property and transfer the funds as dividends to C. Upon doing so, X will have ECI under FIRPTA rules and will therefore be subject to corporate income tax. In addition, unless X reinvests the gain proceeds in U.S. assets, it will not have any change in its U.S. net equity on this sale, and the 30% BPT will be applied to the dividend equivalent amount, in this case the gain on the sale. Therefore, the gain is subject to standard income tax and BPT. Also, once the U.S. parent distributes the proceeds it received from X, the standard dividend tax will be applied to the shareholders who receive those dividends because currently no credit is allowed against U.S. taxes for BPT paid.
Tax planning can be done to avoid such disastrous tax consequences. The most evident planning strategy would be to avoid the traps of FIRPTA by actively avoiding any investments by an FC that could result in its holding U.S. real property. If avoiding this situation is impossible, careful planning can eliminate the BPT.
A simple solution that mitigates the BPT’s effect is to conduct transactions through a company based in a U.S. income tax treaty country that minimizes the BPT. Although most treaties do not completely eliminate the BPT, many provide for lower tax rates than the regular 30%.
In the example, X holds U.S. real property and cannot claim relief under an income tax treaty. Another method of avoiding the BPT could be achieved by structuring the sale of the U.S. real property and the subsequent dividends to C as part of a complete liquidation of X. The BPT rules provide that upon complete termination and liquidation of X’s U.S. trade or business, the BPT can be avoided if (1) X no longer has any U.S. assets, (2) it does not reinvest in U.S. activities for three years, and (3) it has no ECI for the three years after termination (Temp. Regs. Sec. 1.884-2T(a)(2)). The rule against reinvestment in U.S. activities includes reinvestment through a related company, so the dividends paid to C would at first seem an impediment against claiming the benefits of this provision. However, the regulations provide that upon a complete liquidation in a Sec. 381(a) transaction, C may effectively take on X’s attributes for BPT purposes (see Temp. Regs. Sec. 1.884-2T(c)). In other words, X’s effectively connected earnings and profits will not be subject to the BPT; they will be transferred to C and incorporated into C’s accumulated earnings and profits (AE&P).
Caution: Special attention should be given if C has foreign shareholders, because dividends paid to such shareholders from X’s AE&P may not be eligible for treaty benefits.
Even though the triple taxation result described above may have originally been unintended, Congress is now aware of the issue but has not acted to correct it. Until the issue is corrected (if it ever is), simple tax planning can make sure that these unintended results do not become a real and costly issue.