Exceptions to Branch Profits Tax Available to Foreign Corporations With U.S. Tax Compliance Obligations

Editor: Alex J. Brosseau, CPA, MST

Sec. 884(a), enacted as part of the Tax Reform Act of 1986, P.L. 99-514, imposes a branch profits tax on the effectively connected income (ECI) of a U.S. branch of a foreign corporation when those earnings are repatriated, or deemed repatriated, to the home office of the branch. Sec. 884 was enacted with the legislative intent of eliminating any disparate tax treatment between U.S. corporate and flowthrough subsidiaries of foreign corporations when there are actual or deemed outbound distributions of the earnings from those U.S. subsidiaries to foreign corporate parents.

In certain situations, a branch profits tax may also be imposed on gain derived from certain direct or indirect dispositions of assets of a foreign corporate parent, which may result in the unintended double taxation of income of foreign persons. This item addresses certain limited exceptions to branch profits tax liability pursuant to Sec. 897, as enacted by the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), P.L. 96-499, and the branch termination exception of Temp. Regs. Sec. 1.884-2T, of which every foreign taxpayer and tax adviser should be aware.

Branch Profits Tax Generally

Unless otherwise provided for in the Code and Treasury regulations, each foreign corporation doing business in the United States through a branch (or entity otherwise treated as a flowthrough for U.S. tax purposes, such as a partnership) is generally subject to tax on a net basis at graduated tax rates on income effectively connected with a U.S. trade or business (branch) pursuant to the rules outlined in Sec. 882. In addition, unless reduced or exempted by an applicable tax treaty, a 30% branch profits tax is imposed on after-tax effectively connected earnings and profits of a foreign corporation’s U.S. trade or business that are deemed to be distributed by the branch out of the United States under Sec. 884. The branch profits tax is imposed on the dividend equivalent amount (DEA), which are the after-tax effectively connected earnings and profits (ECEP) that are not reinvested in the United States and are deemed to have been effectively distributed out of the U.S. branch. The Treasury regulations prescribe specific procedures to determine a corporation’s DEA.

As a first step, the ECEP is calculated pursuant to Sec. 884(d). ECEP is defined, under Regs. Sec. 1.884-1(f)(1), as certain earnings and profits that are attributable to ECI, subject to certain earnings and profits adjustments, limitations, and exemptions.

Next, the corporation determines whether its U.S. net equity has increased or decreased during the year. U.S. net equity is the difference between the adjusted basis of U.S. assets that produce ECI, as determined under Regs. Secs. 1.884-1(c)(2) and (d)(1), and effectively connected U.S. liabilities (U.S. assets less U.S. liabilities), as determined under Regs. Sec. 1.882-5. To the extent of an increase in U.S. net equity during the tax year, the corporation is deemed to have reinvested a portion of current-year ECEP in its U.S. assets.

The starting point for the calculation of the DEA is the ECEP. This amount is reduced, but not below zero, by the increase in U.S. net equity, which reduces or, in some instances, eliminates DEA. Conversely, if U.S. net equity decreases during the year, the effect is a deemed distribution. Consequently, the amount of decrease in U.S. net equity is then added to the current-year ECEP in calculating DEA. This increase in the DEA relating to the decrease in U.S. net equity is limited to non-previously taxed accumulated ECEP, as defined in Regs. Sec. 1.884-1(b)(3)(ii). As a result, the DEA, in the year the U.S. net equity decreases, is a combination of current-year ECEP and an amount equivalent to the decrease in U.S. net equity for the tax year pursuant to Sec. 884(b). Unless reduced or eliminated under applicable provisions of the Code or a treaty, a 30% branch profits tax is then assessed on the DEA calculated for the year.

Certain exceptions either reduce or eliminate branch profits tax liability. One exception is related to certain FIRPTA gain pursuant to Regs. Sec. 1.884-1(f)(2)(iii). Another exception that may apply, if certain statutory conditions are met, is with respect to the branch profits tax termination exception of Temp. Regs. Sec. 1.884-2T. This item addresses these exceptions in detail.

FIRPTA Considerations in Relation to Branch Profits Tax

The question regarding FIRPTA treatment of gain realized in a disposition is important for purposes of calculating branch profits tax, as certain FIRPTA gain is not included in ECEP (described in additional detail below), while other types of FIRPTA gain are, in fact, subject to branch profits tax. 

Sec. 897 operates to treat gain generated by a non-U.S. person on the disposition of a U.S. real property interest as effectively connected with a U.S. trade or business, under Sec. 871(b)(1) in the case of nonresident individuals and Sec. 882(a)(1) in the case of foreign corporations, and is taxed at the graduated tax rates under Secs. 1, 11, and 55. The gain is considered ECI notwithstanding the fact that the non-U.S. person is not otherwise engaged in a U.S. trade or business. If Sec. 897 applies, the transferee generally is required to withhold the amount of tax specified in Sec. 1445 from the amount realized by the transferor (Sec. 1445(a)). In addition, gain of a foreign corporation from the disposition of a U.S. real property interest is subject to a 30% branch profits tax unless specifically exempted under the Code or reduced by an applicable treaty.

Sec. 897(c)(1) defines a U.S. real property interest as any interest in real property located in the United States or the U.S. Virgin Islands or an investment in any U.S. corporation, other than an interest solely as a creditor, that is, or has been within the preceding five years, a U.S. real property holding corporation. Under Sec. 897(c)(1)(A)(ii), an interest in a U.S. corporation is presumed to be a U.S. real property interest unless the taxpayer disposing of the interest establishes that the U.S. corporation was not a U.S. real property holding corporation at any time during the shorter of the taxpayer’s holding period or the five-year period ending on the date of the disposition of the interest. Sec. 897(c)(2) provides that a corporation is a U.S. real property holding company if the fair market value of its U.S. real property interests is 50% or more of the fair market value of the sum of its worldwide real property interests and any other assets that are used or held for use in a trade or business. A disposition of a U.S. real property interest in Sec. 897 is defined broadly. It is not limited to sales or exchanges of those interests but can include any transfer that would constitute a disposition by the transferor for any purpose of the Code and regulations (Regs. Sec. 1.897-1(g)).

As discussed above, to determine a foreign corporation’s DEA and resulting branch profits tax liability, a foreign corporation must first determine its current-year ECEP. Regs. Sec. 1.884-1(f)(2)(iii) provides an exception of certain income received on the disposition of a particular type of U.S. real property interest from being treated as ECEP. Specifically, the regulations state that FIRPTA gain realized by a foreign corporation on the disposition of stock in a U.S. corporation does not generate ECEP. By contrast, gain on the disposition of an interest in other real property (including an interest in a mine, well, or other natural deposit) located in the United States, according to Sec. 897(c)(1)(A)(i), is not exempt from branch profits tax and, as a result, additional tax liability would apply to the gain.

Practical Issues Regarding Branch Profits Tax Liability on FIRPTA Gain

Often, due to a lack of proper analysis and the nature of the underlying assets being disposed of, it can be unclear whether any of the assets are, in fact, U.S. real property interests as defined in Sec. 897(c)(1)(A)(ii), such that any gain recognized on the disposition of those particular assets would be exempt from branch profits tax. As a result, it is essential that taxpayers and their advisers perform adequate analysis to determine the nature of the assets disposed of and the resulting treatment of gain realized. Without this clarification, taxpayers have to take the conservative approach and assume that they should treat none of the gain as FIRPTA gain from the disposition of stock in a U.S. corporation. As a result, foreign taxpayers may be subject to additional payment of branch profits tax (i.e., estimated taxable income multiplied by 30%, unless the entity qualifies for a reduced treaty rate).

Considerations Concerning Branch Profits Tax Liability in Terminations/Liquidations of U.S. Trades or Businesses

A foreign corporate taxpayer with a U.S. trade or business may also obtain relief from branch profits tax liability for the tax year in which the foreign corporation completely terminates its U.S. trade or business pursuant to Temp. Regs. Sec. 1.884-2T. Specifically, Temp. Regs. Sec. 1.884-2T(a)(2)(i) provides that a complete termination exemption applies when the following circumstances are satisfied:

1. At the close of the relevant tax year, the year of disposition of the U.S. trade or business, the foreign corporation has no U.S. assets (i.e., money and all property that qualify as U.S. assets, and property attributable to U.S. assets or ECEP), or its shareholders have adopted an irrevocable resolution in that tax year to completely liquidate and dissolve the corporation and, before the close of the immediately succeeding tax year, all of its U.S. assets are either distributed, used to pay off liabilities, or cease to be U.S. assets (additional considerations may apply when a foreign corporation uses the income allocation method instead of the asset allocation method to determine the portion of the total assets that is attributable to U.S. assets under Regs. Secs. 1.884-1(d)(3)(i) and 1.882-5);

2. For a period of three years post-termination, neither the foreign corporation nor a related corporation, as defined in Temp. Regs. Sec. 1.884-2T(a)(2)(iv), uses (i.e., reinvests), directly or indirectly, in the conduct of the U.S. trade or business (a) any of the U.S. assets of the terminated U.S. trade or business, or (b) property attributable to U.S. assets or ECEP of the foreign corporation;

3. The foreign corporation may not have income treated as ECI during a period of three years from the close of the year of complete termination; and

4. The foreign corporation attaches a waiver of the period of limitation (Form 8848, Consent to Extend the Time to Assess the Branch Profits Tax Under Regulations Sections 1.884-2(a) and (c), or substitute form) to its income tax return for each year of complete termination, pursuant to Regs. Sec. 1.884-2(a)(2)(ii).

If all the requirements described above are satisfied, the foreign corporation will generally not be subject to branch profits tax on its current-year ECEP in the year of termination of its U.S. trade or business. In addition, under Temp. Regs. Sec. 1.884-2T(a)(1), the foreign corporation escapes tax on non-previously taxed accumulated ECEP. If, however, a foreign corporation fails to successfully terminate under Temp. Regs. Sec. 1.884-2T, the corporation would be retroactively liable for branch profits tax in the year of termination and all relevant subsequent years. In addition, interest and penalties will likely apply.

Practical Issues Regarding Branch Profits Tax and Complete Termination Exemption

A foreign corporation that has terminated its U.S. trade or business and elected to benefit from the branch profits tax termination exception under Temp. Regs. Sec. 1.884-2T may consider certain practical approaches to avoid the prohibitive consequences of a failed termination.

Generally, as discussed above, any reinvestment or use of proceeds from terminated U.S. assets or ECEP by the foreign corporation or related parties is disallowed for a period of three years. To demonstrate compliance with this provision, a foreign corporation may consider creating an escrow for the property for the requisite statutory period to avoid the inadvertent reinvestment of the funds in a U.S. business by the foreign corporation or 10% shareholders and related persons. In addition, tax advisers of foreign corporations may advise their clients to obtain appropriate affidavits certifying nonreinvestment of earmarked funds from any related parties to which Temp. Regs. Sec. 1.884-2T(a)(2)(i)(B) may apply.

Conclusion

The branch profits tax exceptions discussed above can provide a foreign corporation significant tax savings, which could then be channeled to the overall growth of the corporation and its investments. It is essential that foreign corporations with U.S. trades or businesses and U.S. tax filing requirements become familiar with these limited exceptions from branch profits tax available to them under the U.S. tax rules.

EditorNotes

Alex Brosseau is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.

For additional information about these items, contact Mr. Brosseau at 202-661-4532 or abrosseau@deloitte.com.

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP. This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte, its affiliates and related entities, shall not be responsible for any loss sustained by any person who relies on this publication.