Branch level tax regulations.by Yu, Angela W. Y.
Consider a U.S. corporation, subsidiary of an FC, that is subject to U.S. income tax on its worldwide profits. In addition to the regular corporate income tax paid by the subsidiary, the parent is generally subject to a flat 30% (or lower treaty rate) tax on either interest or profits that it receives from its subsidiary. This tax on the dividend or interest is referred to as the "second-level tax." Prior to TRA 86 an FC that conducted business in the U.S. through a branch was liable for a second-level tax on its interest and dividend payments; however, this tax was triggered only when more than 50% of the foreign corporation's gross income for a three-year period was effectively connected with a U.S. trade or business.
Congress was dissatisfied with this test; most FCs successfully circumvented second-level taxes either by keeping their incomes below the threshold or by structuring their U.S. operations through tax treaty networks that eliminated the taxes. Congress also was concerned with the problems encountered in enforcing the second-level withholding tax because the tax would be imposed on payments by FCs to foreign persons who rarely had nexus with the U.S. As a result, the BLT appeared to be an appropriate substitute for the second-level tax at the shareholder level.
The BLT provisions in Sec. 884 of TRA 86 are effective for taxable years beginning after December 31, 1986. They apply to U.S. branches of FCs at a 30% rate unless prohibited, or reduced, by income tax treaties. There are two kinds of BLT--the branch profits tax (BPT) and the branch level interest tax (BLIT)--and each involves a different computation.
The provisions also authorized the U.S. Treasury to prescribe regulations "necessary or appropriate" to carry out Sec. 884. In August 1988, the IRS issued proposed and temporary regulations on Sec. 884 setting forth guidance for the application of the new taxes. These regulations are extremely complex and contain elections and transitional rules as well as burdensome documentation requirements for taxpayers claiming treaty benefits. The discussion herein analyzes their impact on FCs.
Branch Profits Tax
The BPT, imposed on the dividend equivalent amount of an FC, is payable by the due date of the corporation's federal tax return. No estimated tax payment is required. The rate of tax is 30% unless reduced or eliminated by a tax treaty, as discussed later.
Dividend Equivalent Amount
The dividend equivalent amount is defined as the FC's effectively connected earnings and profits (ECE&P) adjusted as follows:
* Increased by disinvestment--(certain reductions in the FC's U.S. net equity USNE); and
* Decreased by amounts reinvested--(increases in USNE) but not below zero.
If an FC has a deficit in ECE&P for the current year and has a disinvestment in excess of such negative ECE&P, it would have a positive dividend equivalent amount, and hence be subject to the BPT. However, any increase in the dividend equivalent amount by virtue of a disinvestment is limited to post-1986 ECE&P of an FC that has not previously been subject to the BPT (non-previously taxed accumulated ECE&P). The example in Figure 1 illustrates this principle.
Effectively Connected Earnings and Profits
ECE&P is earnings and profits in the traditional context under Sec. 312 attributable to effectively connected income, except that dividend distributions and the branch level taxes imposed by Sec. 884 do not reduce ECE&P. In determining the amount of ECE&P, the Regs. require an FC to allocate and apportion deductions and adjustments to ECE&P and non-ECE&P under the principles of Reg. Sec. 1.861-8; i.e., expenses not specifically allocable to ECE&P or non-ECE&P will be allocated to each category based on the gross income or gross assets in each category. ECE&P does not include certain types of income, including transportation income under Sec. 883(a)(1) and Sec. 883(a)(2), gain on the disposition of stock of a domestic corporation that is treated as a U.S. real property interest, and income earned by foreign governments that is exempt under Sec. 892.
The 1988 Technical and Miscellaneous Revenue Act (TAMRA) added a new item that is excludable in computing ECE&P: income treated as effectively connected with the conduct of a trade or business within the U.S. under Sec. 882(e). Sec. 882(e) states that a corporation created or organized in (or under the law of) a U.S. possession, which is carrying on a banking business in a U.S. possession, generally must treat interest on obligations of the U.S. as effectively connected with the conduct of a trade or business within the U.S. The interest is taxable under Sec. 882(a)(1), whether or not such corporation is engaged in trade or business within the U.S. Under the exception mentioned previously, this interest income is not included in ECE&P for BPT purposes.
U.S. Net Equity
USNE is the difference between the U.S. assets and U.S. liabilities of an FC. Generally, property is considered a U.S. asset if all income from its use and all gain from its disposition would be effectively connected income. U.S. assets are valued at their adjusted basis for earnings and profits purposes.
Specific guidance is provided as to when certain assets qualify as U.S. assets. These rules govern depreciable property, inventory, short term notes and accounts receivable, money, U.S. real property interests, installment obligations, marketable securities (see discussion on special election) and partnership interests.
Additionally, an FC may make an election to treat a limited amount (25% of the sum of the foreign corporation's current year ECE&P and non-previously taxed accumulated ECE&P for the two preceding years) of marketable securities that are otherwise not U.S. assets as U.S. assets, thereby reducing its dividend equivalent amount. If an FC makes the election, the income, gain or loss on disposition of such securities, will be treated as effectively connected. Furthermore, to qualify for the election:
* The fair market value of each such security may not be less than its adjusted basis;
* The securities must be held for the entire taxable year following the year of election, or if disposed of during that taxable year, must be replaced on the disposition date by other marketable securities purchased on or before such date, or received in exchange for the disposed securities; and
* The election may be made only with respect to securities identified on the books and records of the U.S. trade or business within 30 days after the close of the taxable year for which the election is made.
Assets that do not give rise to ECE&P or are no longer used or held for use in connection with a U.S. trade or business are not treated as U.S. assets. In addition, an anti-abuse rule stipulates that any artificial increase/decrease in U.S. assets/liabilities by taxpayers to manipulate USNE will be disregarded--for example, injecting assets into the U.S. trade or business at year end. The anti-abuse rule would be invoked based on a review of all facts and circumstances.
The Regs. adopt the "fungibility approach" in the determination of the U.S. liabilities of an FC, i.e., liabilities are viewed as funding all the assets of the FC. The amount of U.S. liabilities is the product of an FC's U.S. assets at the close of the year and either 1) the ratio of the FC's worldwide liabilities to its worldwide assets at the close of the year, or 2) the fixed ratio (95% for banking institutions and 50% for all other corporations) if such ratio is used in computing the FC's interest expense. An FC that is a partner in a partnership shall include its allocable share of partnership liabilities in computing its worldwide liabilities. An FC's share of liabilities is determined by using the same percentage used to determine its allocable share of interest expense. See Figure 2 for an example of this.
Termination, Liquidation, Reorganization or Incorporation
of a U.S. Trade or Business (Reg. Sec. 1.884-2T)
The BPT generally will not be imposed in the year in which an FC completely terminates its U.S. trade or business. Likewise, the BPT will not be imposed on certain liquidations or reorganizations of an FC that has conducted a U.S. trade or business, on a tax deferred (Sec. 351) incorporation of an FC's U.S. trade or business or on certain transactions with respect to a domestic subsidiary of an FC.
Complete Termination of a U.S. Trade or Business
An exemption is provided from BPT for the taxable year in which an FC terminates all of its U.S. trade or business. Any non-previously taxed ECE&P will generally be extinguished for BPT purposes if all of the following conditions are satisfied:
* The FC has no U.S. assets as of the close of the taxable year or its shareholders adopt an irrevocable resolution to completely liquidate and dissolve the corporation by the end of the following year and all of its assets are either distributed, used to pay liabilities or cease to be U.S. assets;
* Neither the FC nor a related corporation uses any of the U.S. assets of the terminated U.S. trade or business (or property attributable to ECE&P earned by the FC in the year of complete termination), in a U.S. trade or business for the following three years;
* The FC has no U.S. effectively connected income for the following three years with the exception of certain deferred payments;
* The FC extends the statute of limitations for the year of complete termination to the end of the sixth taxable year following the termination year.
A special election permits an FC to designate a certain amount of marketable securities as U.S. assets for the taxable year of complete termination and the following year and still qualify for the termination exemption. This rule permits FCs to hold cash or property with the expectation of continuing a U.S. trade or business in the near future. The procedures that apply to this election (maximum two years) are similar to the election for expansion capital as previously discussed.
FCs with operations both in and out of the U.S. that intend to phase out their U.S. operations must be careful with the rules provided under this Reg. By definition, only a complete termination by the end of a taxable year qualifies for the extinction of any ECE&P not previously taxed under Sec. 884, unless the FC intends to completely liquidate itself by the end of the following year. Since a taxpayer's U.S. net equity is in part a function of its U.S. assets, a decrease in the effectively connected assets (without any increase in the worldwide equity ratio) would cause a corresponding decrease in its U.S. net equity, possibly resulting in a dividend equivalent amount subject to the BPT. Therefore, if such an FC intends to terminate its U.S. business completely it should do so within a single tax year, otherwise it will likely incur some BPT.
Liquidations and Reorganizations
The BPT generally does not apply to the transfer of assets by an FC to another FC or a U.S. corporation pursuant to a distribution in liquidation or a non-divisive tax-free reorganization as described in Sec. 381(a). However, the transferor FC continues to be subject to the BPT during the year in which the transfer occurs and during subsequent years in accordance with the rules in this section.
If the transferee is another FC, then the transferee's increase or decrease in U.S. net equity under Reg. Sec. 1.884-1T for the taxable year of the Sec. 381(a) transaction will be calculated by adding the U.S. net equity acquired from the transferor FC to the transferee FC's closing U.S. net equity for the immediately preceding taxable year. If the transferee is a domestic corporation, a subsequent disposition of the transferor FC's stock or of the transferee corporation's stock within prescribed time limits may trigger additional BPT, plus interest from the due date of the transferor's tax return in the year of the Sec. 381(a) transaction.
Transfers to a Wholly Owned U.S. Subsidiary
The incorporation of the U.S. trade or business of an FC into a wholly owned U.S. subsidiary in a Sec. 351(a) transaction will not result in BPT provided that:
* The FC owns at least 80% of the voting stock and value of the transferee after the transaction.
* The transferee agrees to be allocated an amount of the FC's ECE&P and a proportionate amount of its non-previously taxes accumulated ECE&P; and
* The transferor FC agrees to an increase in its dividend equivalent amount when it disposes of the transferee stock received in the transaction.
Branch Level Interest Tax
The branch level interest tax is imposed on two separate, yet interrelated items: the actual interest paid and the "excess interest" of an FC that is treated as engaging in a U.S. trade or business during the year. An FC is treated as such for purposes of this section, if it owns U.S. assets at any time during the taxable year or it derives gross income that is effectively connected.
First, any interest actually paid (but not including any interbranch interest payments) by a U.S. trade or business of an FC is treated as U.S. source income and consequently could be subject to withholding if the recipient is a foreign person. Statutory exemptions such as for portfolio interest and interest on bank deposits apply to exempt any such interest from withholding. Original issue discount, as defined in Sec. 1273(a)(i), is treated as interest for purpose of this withholding tax.
Second, a tax is imposed on the excess of the FC's allowable interest deduction over the interest actually paid (but not including interbranch interest payments) by the U.S. trade or business. Such excess is treated as interest paid to the home office by a wholly owned domestic corporation, and thus subject to the U.S. withholding tax. The statutory exemptions will not apply to allow a reduction of this tax; however, a tax treaty between the FC's country of residence and the U.S. that provides for a reduction in the rate of interest can be invoked to reduce or eliminate the tax, as discussed later. To avoid this tax on excess interest, FCs that are not fully protected by tax treaties must generate a sufficient level of interest actually paid, or deemed paid, under rules described later, by its U.S. trade or business to equal or exceed its allowable interest deduction. Consequently, the definition of "paid by the U.S. trade or business" becomes critical.
Definition of Interest Paid by U.S. Trade or Business
Interest paid by the U.S. trade or business is defined as interest paid with respect to one of four classes of liabilities. The first class consists of liabilities speciafically identified as liabilities of a U.S. trade or business of the FC, on books and records maintained in the U.S., subject to certain limitations.
The second class consists of liabilities specifically identified as liabilities of a U.S. trade or business of the FC on financial statements required for regulatory purposes. This will generally include the liabilities recorded on the books of a licensed bank branch or agency. The third class consists of liabilities predominantly secured by U.S. assets.
The fourth and final class consists of interest which has been disallowed (e.g., related to funding the purchase of tax exempt securities) or added to the basis of a U.S. asset (e.g., as required by the uniform capitalization rules). While this class of interest is treated as paid by the U.S. trade or business, and consequently is subject to withholding tax unless otherwise exempt, it does not reduce "excess interest" since this interest was not included in the allowable interest deduction.
The first class of liabilities effectively allows an FC to resource interest of non-U.S. operations of the FC as interest paid by its U.S. trade or business. The taxpayer must maintain a record, in the U.S., of these liabilities on a timely basis.
To permit taxpayers using the branch book/dollar pool method of calculating their allowable interest deduction to treat the interest paid on such liabilities as paid by the U.S. trade or business, they must be allowed a deduction under this method, at least in part, for the interest on these liabilities. For taxpayers using the separate currency pools method to qualify such interest as paid by the U.S. trade or business, the liability must be identified by the earlier of 60 days after it is incurred or the first payment of interest applicable thereto. A special transitional rule allows the taxpayers until September 15, 1989, to identify such liabilities before the 60-day rule takes effect. Certain liabilities are precluded from ever being classified as U.S. liabilities for this purpose. They include:
* Liabilities with interest that gives rise to a tax benefit in a foreign country in one of the following ways:
a. As a reduction of income from sources within such country for purposes of computing a foreign tax credit;
b. In the case of a foreign country that provides relief from double taxation by way of an exemption system, as a reduction of income from sources within that country; or
c. Is otherwise taken into account in a manner that is inconsistent with its treatment by the foreign corporation as interest stated on the books of a U.S. trade or business.
* Liabilities incurred in the ordinary course of a trade or business conducted outside the U.S. An exception is provided for banks; deposits that exceed $100,000 can be generally attributed to a U.S. trade or business.
* Liabilities that are secured predominately by non-U.S. assets.
The new Regs. adopt the fungibility approach to characterize U.S. liabilities for BPT purposes but, concomitantly, utilize the tracing method to identify the U.S. liabilities for BLIT purposes. The net result is to whipsaw taxpayers who cannot reduce their dividend equivalent amount by specific liabilities incurred by the U.S. trade or business but must undertake burdensome recordkeeping to identify U.S. liabilities for purposes of calculating the excess interest tax.
Additional rules concerning U.S. liabilities include the following:
* The classification of any U.S. liability must be consistent until the liability is satisfied in full.
* If an FC is a partner in a partnership that engages in a U.S. trade or business, some of the interest paid by the partnership is attributed to the FC to reduce any excess interest.
* If interest expense is accrued and paid in different years, an election may be made to treat interest as paid in the year of accrual to reduce the amount of excess interest. Interest accruing in taxable years beginning before January 1, 1987 may not reduce excess interest when paid.
* If an FC's interest paid and accrued exceeds its allowable expense, its interest paid is reduced under specific ordering rules. Thus, the amount of U.S. source interest that is subject to withholding would be reduced accordingly. Also included is an election to allow the taxpayer to specify those liabilities on which interest paid is to be reduced.
* FCs that engage predominantly in a U.S. trade or business (i.e., if the U.S. assets of an FC equal at least 80% of its total assets), would not be deemed to have any excess interest. Instead, all interest paid by the FC is treated as paid by its U.S. trade or business directly.
Coordination with Income Tax Treaties
Although a treaty can significantly mitigage the effect of the BLTs, an FC that is not a "qualified resident," as defined, cannot invoke treaty benefits against BLTs. The anti-treaty-shopping rules are designed to limit the extent to which third-country investors can use tax treaties to reduce their U.S. tax liabilities.
Generally, to claim treaty benefits with respect to the branch level taxes, an FC must be a qualified resident of its home country that has an income tax treaty with the U.S. An FC must satisfy one of the three tests below to prove that it is a qualified resident of a treaty country:
* Stock ownership and base erosion test;
* Publicly traded test;
* Active trade or business test.
If an FC cannot satisfy any of these tests, it may attempt to secure an IRS ruling that it is a qualified resident of a treaty country.
Requirements for a Qualified Resident
The new provisions regarding an FC's qualified residence in a tax treaty country appear in Reg. Sec. 1.884-5T and are explained as follows:
Stock Ownership and Base Erosion Tests. Both tests must be satisfied.
* Stock Ownership Test. Individual residents of the treaty country or of the U.S., the government of that country, or corporations whose shares are primarily and regularly traded on an exchange in that country, must own at least 50% of the value of all outstanding shares for at least one-half of the year. This test requires stringent documentation of proof of ownership as follows:
-- Penalty of perjury statements from individual shareholders and from officers of publicly traded corporations as to their beneficial ownership.
-- Certificates of residency of individual owners by the Competent Authorities of the treaty countries.
-- In the case of undisclosed shareholders, penalty of perjury statements from the nominee owner (referred to as intermediary verification statements) and written agreement to make all the documentation available to the IRS.
-- Statements from Competent Authorities, in case of government ownership, with the official seal.
-- Penalty of perjury statements from every intermediate owner (i.e., custodians, trustees, nominees) in the chain of ownership, verifying the intermediary's interest (referred to as intermediary ownership statement).
Except for a special transitional rule for the 1987 taxable year that allows an FC to gather the required statements by September 15, 1989 all the relevant statements must be obtained every year before the due date (including extensions) of the FC's tax return. Failure to do so could result in a denial of benefits. The FC must keep all documentation until the statute of limitations has expired for the taxable year. Intermediaries who supply verification statements must keep their underlying documentation for six years from the date of the statement.
* Base Erosion Test: Less than 50% of the worldwide gross income of the foreign corporation is used to pay interest, rent, royalties, etc. to persons who are neither residents of the treaty country nor of the U.S. Presumably this includes all administrative expenses of the FC, such as payroll, brokerage fees, and communications.
Publicly-Traded Shares Test. The shares must be "primarily and regularly traded" on one or more "established securities markets" in the U.S. and/or foreign country of residence, or at least 90% of the shares (by voting power and value) are owned by a corporation which is so traded.
Shares are "primarily traded" if stock representing more than 80% of the voting power and of the value of all classes of stock is regularly traded on securities markets in the U.S. or the treaty country, and additionally, for each class of stock, more shares are actually traded during the year on securities markets in either the U.S. or the treaty country than are traded in any other single foreign country.
An "established securities market" is defined as the principal exchange in a foreign country which is recognized, sanctioned, or supervised by the foreign government, with the value of its shares traded annually on the exchange exceeding one billion dollars. In the U.S., national exchanges registered under the Securities Act of 1934 are so treated.
Active Trade or Business Test. The FC must satisfy all of the following three requirements:
* It must be engaged in an active trade or business in country of residence. For banks, the taxpayer must qualify as a banking or similar institution under foreign law and actually conduct a banking business.
* It must have a "substantial presence" in its country of residence. This test is met if the ratio of each of the FC's treaty country assets, gross income from sources within such country, and payroll expense to its worldwide assets, gross income and payroll expenses, respectively, is at least 20%. Additionally, the average of the ratios must exceed 25%. This test is applied separately each year.
* The U.S. trade or business must be an integral part of the FC's active trade or business. A bank is presumed to meet this test if at least 50% of its worldwide loans are to residents of the treaty country. Alternatively, the U.S. banking business and the banking business in the treaty country must be shown to be closely linked (i.e., "complementary and mutually interdependent steps") in the performance of FC's services.
If an FC cannot satisfy any of these tests, it may attempt to secure an IRS ruling that it is a qualified resident of a treaty country. Such a ruling is effective for three years. Thereafter, or in the event of material changes in the FC's ownership or operations, another ruling must be obtained. To obtain a favorable ruling, an FC bank must demonstrate that there are substantial business reasons for residing in a foreign country.
Interaction with the Branch Profits Tax
Consistent with Notice 87-56, 1987-2 C.B. 367, the Regs. stipulate that an FC can claim treaty benefits with respect to a reduction in rate or exemption from the BPT if it is a qualified resident of a country that has an income tax treaty with the U.S.
FCs that are qualified residents of countries that enter into income tax treaties with the U.S. in the future can claim a reduced rate under the applicable treaty. Such reduced rate is the rate of tax on branch profits, if specified, or the rate of tax on dividends paid to a foreign parent by a wholly owned U.S. subsidiary.
Special rules are provided for FCs that are qualified residents of Canada. Special rules are also provided for determining when the treaty will provide an examption for non-previously taxed ECE&P which is included in the dividend equivalent amount. The rule mandates that a taxpayer who is a qualified resident on the basis of the stock ownership and base erosion tests and wishes to claim treaty benefits for the BPT must satisfy the test for a 36-month period that includes the taxable year of the dividend equivalent amount. An FC that fails the 36-month test can only claim treaty benefits on the BPT with respect to non- previously taxed ECE&P determined on a LIFO basis accumulated during prior years in which the FC was a qualified resident of such country.
Interaction with Branch Level Interest Taxes
The tax on interest paid by the U.S. trade or business may be reduced under the provisions of a tax treaty between the U.S. and the recipient's country or a provision of the tax treaty between the U.S. and the paying FC's country of incorporation which limits the U.S. from imposing a tax on interest paid by a resident of that country.
The excess interest tax may be reduced or eliminated under the tax treaty between the U.S. and the FC's home country based on the interest recipient provisions of that treaty. Furthermore, TAMRA provides that the excess interest tax will not apply to the extent it conflicts with income tax treaties. However, it is unclear whether the BLIT will be interpreted as conflicting with treaty non-discrimination clauses. Therefore, it is uncertain whether the treaty override will extent to more than the rate reduction or exemption on branch level interest paid or deemed paid by a U.S. subsidiary.
This analysis summarizes a complex area introduced by recent legislation. The rules in the area are so onerous that in many circumstances they effectively discourage foreign corporations from operating in the U.S. in branch form. Entities that must continue to do so for non-tax reasons (e.g., regulatory constraints) must closely monitor the impact of the new rules to avoid additional U.S. tax burdens.
As this article goes to print the authors understand that the IRS is in the process of seriously reconsidering numerous aspects of these regulations; however, it is uncertain as to when the final regulations or any other guidance will be issued.
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